The Union Budget 2024-25 has introduced significant changes to the capital gains tax structure, particularly affecting equity investors & high-net-worth individuals (HNIs) and their preferred investment vehicles. The alterations in the short-term and long-term capital gains tax rates have brought about substantial implications for Portfolio Management Services (PMS), Mutual Funds (MFs), Smallcase, and Alternative Investment Funds (AIFs). This analysis delves deeply into how these changes impact investors' returns and the strategic responses of various investment managers.

Key Changes in Taxation that Impact Stock Investments

1. Short-Term Capital Gains (STCG) Tax: STCG has increased by 33% from 15% to 20% for any gains from stocks held for less than 12 months. After including cess, the effective STCG is 20.8%.

2. Long-Term Capital Gains (LTCG) Tax: LTCG has increased 25% from 10% to 12.5% for any gains from stocks held for more than 12 months.. Including cess, the effective LTCG is 13%.

The difference between STCG & LTCG has also increased from 5% earlier to now 7.5%. These tax changes have critical ramifications for investment strategies, particularly those involving frequent trading. Let’s look at this in detail in today’s article.

Impact of Capital Gains Hike on PMS Investments

Challenges for PMS:

• High Churn Rates: PMS strategies often involve high turnover, which means frequent buying and selling of stocks. Under the new tax regime, each sale within 12 months incurs a 20.8% STCG tax, significantly eroding returns.

• Post-Tax Return Requirements: To be competitive, PMS providers must generate higher pre-tax returns to offset the additional tax burden compared to mutual funds. For example, if an MF generates a 12% return, a PMS would need to achieve approximately 13.97% to match the MF's post-tax return.

• Increased Competition and Consolidation: The higher tax burden may lead to industry consolidation, where only the PMS providers who can consistently generate high alpha (excess returns) will survive. Weaker players might exit the market, while stronger ones consolidate their positions.

Strategic Shifts:

• Focus on Long-Term Investments: PMS providers may pivot towards long-term investment strategies to minimize the frequency of taxable events. This shift aims to reduce the impact of STCG and leverage the lower LTCG tax rate.

• Tax Efficiency Measures: PMS managers might adopt tax loss harvesting strategies, selling securities at a loss to offset gains, thereby minimizing the overall tax liability.

Advantages:

• Potential for Higher Returns: Despite the tax disadvantages, PMS has historically outperformed mutual funds by significant margins. Over a 10-year period, PMS strategies have delivered excess returns of approximately 70% on average, compared to mutual funds' 48%.

Impact of Capital Gains Hike on Smallcase Portfolios

Smallcase involves direct equity investments, similar to PMS, and hence the same tax rules apply. The 20.8% STCG tax and 13% LTCG tax impact returns directly. Smallcase allows for tailored investment strategies, which can be advantageous for personalized portfolios. However, frequent rebalancing can lead to significant tax liabilities, similar to PMS. Investors using Smallcase need to be acutely aware of the tax implications of their portfolio changes. Finding the right smallcase investment manager that can identify long term, alpha generating stocks is more critical in the current tax regime.

Impact of Capital Gains Hike on Mutual Funds

Tax Efficiency:

• Deferred Taxation: One of the primary advantages of mutual funds is the deferral of taxation. Investors are only taxed upon redemption, not during the churn within the fund. This structure inherently provides a tax shield, making MFs more attractive in a higher tax regime.

• Lower Immediate Tax Impact: Unlike PMS, where each transaction can trigger a tax event, mutual funds' internal transactions do not result in immediate tax liabilities for investors. This makes MFs more tax-efficient for short-term gains.

Investor Considerations:

• Simplicity and Efficiency: For retail investors, mutual funds offer a simpler and more tax-efficient way to invest, as they do not need to manage the tax implications of each transaction.

Impact of Capital Gains Hike on AIFs

AIFs (Alternative Investment Funds) similar to mutual funds generally enjoy a pass-through status, where the tax liability is borne by the investors rather than the fund itself. This can provide tax advantages, particularly for long-term investments. AIFs can employ a range of strategies, including hedge funds and private equity, which might offer better tax planning opportunities and potentially higher returns. Unlike PMS, AIFs can use derivatives beyond hedging, providing greater flexibility and the potential for higher returns through strategic risk-taking.

What outperformance do Smallcases & PMS need over the Mutual Funds?

We analyse returns of Smallcases/ PMS with mutual funds, incorporating the impact of both short-term and long-term capital gains taxes. The goal is to determine the outperformance required by smallcase or PMS portfolios to match or exceed the post-tax returns of mutual funds under different holding period scenarios.

Assumptions Undertaken for Smallcases & PMS vs Mutual Funds Analysis

Here are the key assumptions and calculations we taken:

1. Taxes:

• Short Term Capital Gains (STCG): 20.8%

• Long Term Capital Gains (LTCG): 13%

2. Smallcase/ PMS Holdings Scenarios:

• Scenario 1: 70% short term and 30% long term

• Scenario 2: 50% short term and 50% long term

• Scenario 3: 30% short term and 70% long term

3. Market Index 1 Year Return: 5%, 10%, 15%, 20%, 25%, 30%

4. Long Term Redemption: MFs Funds are assumed to have redemption over a long term duration to incur only LTCG

Effective Smallcase/ PMS Return Required vs Mutual Funds

You can access the full calculation here .

Portfolio Churn Rate and Its Impact on Returns

High Churn Strategies:

• Frequent Trading Impact: Strategies involving high churn rates (frequent buying and selling) are at a disadvantage due to the higher STCG. The frequent realization of gains within a short period triggers the 20.8% tax, significantly reducing post-tax returns.

• Need for Higher Alpha: To remain competitive with mutual funds, which do not trigger immediate tax events upon churn, PMS strategies must generate higher returns to offset the increased tax liability. For example, if a mutual fund returns 12% annually, a PMS must return approximately 13.97% to match post-tax returns.

Low Churn Strategies:

• Long-term Holding Advantage: PMS & smallcase strategies focused on long-term investments with lower churn rates will be less affected by the STCG hike. These strategies benefit from the lower 13% LTCG tax and reduced frequency of taxable events.

• Tax-efficient Returns: Such strategies can still deliver competitive post-tax returns, leveraging the benefits of compounding over extended periods without frequent tax hits.

What has performed better historically: PMS or Mutual Funds?

A critical analysis of long-term performance reveals that PMS consistently outperforms mutual funds over extended periods.

10-Year Performance

An investment of Rs 2.5 crores in the top 5 PMSs on April 1, 2014, would have grown to Rs 30.77 crores by 2024, generating Rs 8.75 crores more than the top 5 equity mutual funds, which would have grown to Rs 22.02 crores. The best-performing PMS returned 35% annually, compared to the top mutual fund's 26%.

5-Year Performance:

Investing Rs 2.5 crores in the top 5 PMS Multi Cap funds on April 1, 2019, would have resulted in a portfolio worth Rs 9.08 crores by 2024, which is Rs 1.68 crores more than a similar investment in mutual funds. In the Small and Mid Cap segment, the top 5 PMSs generated Rs 9.36 crores, Rs 0.83 crores more than mutual funds.

3-Year Performance:

A Rs 2.5 crore investment in the top 5 multi-cap PMS funds on April 1, 2021, would have grown to Rs 6.23 crores by 2024, Rs 1.01 crores more than mutual funds. The top 5 mid and small-cap PMS funds would have yielded Rs 8.43 crores, Rs 2.59 crores more than mutual funds.

1-Year Performance:

Over a 1-year period, an investment of Rs 2.5 crores in the top 5 multi-cap PMS funds on April 1, 2023, would have resulted in Rs 4.97 crores by 2024, Rs 1.18 crores more than mutual funds. In the Small and Mid Cap segment, PMS funds would have grown to Rs 4.52 crores, Rs 0.47 crores more than mutual funds.

Advantage of a Diversified Portfolio Allocation for Investors

Personalized and Flexible Investment Strategies

Smallcases & PMS offer a personalized approach to investment management, tailoring portfolios to individual risk appetites and financial goals. This customization allows for a more hands-on approach to portfolio construction and management, enabling investors to benefit from the expertise of experienced portfolio managers who can take advantage of market opportunities and mitigate risks.

1. Tailored Portfolios: Unlike mutual funds, which follow a standardized approach, Smallcases & PMS provides bespoke portfolios that cater to the specific needs and preferences of each investor. This individualized attention can result in more efficient asset allocation and better alignment with the investor's long-term financial objectives.

2. Dynamic Asset Management: Smallcases & PMS managers have the flexibility to adjust strategies in response to changing market conditions. This agility allows for more proactive management, potentially enhancing returns by capturing short-term opportunities and adjusting to market dynamics swiftly. This flexibility is significantly constrained for mutual funds that usually manage thousands of crores of capital and are under heavy regulation to abide by the investment objective of the MF, and have to follow the market cap requirements.

3. Concentration of Wealth: Smallcases & PMS often involves a more concentrated portfolio, which can lead to higher returns if the selected stocks perform well. This contrasts with mutual funds, which typically hold more diversified portfolios, potentially diluting the impact of high-performing stocks.

4. Tax Efficiency through Strategic Management: Despite the higher STCG tax rate, experienced PMS managers employ strategies like tax loss harvesting to offset gains and minimize overall tax liability. This approach can enhance post-tax returns and provide a more tax-efficient investment experience compared to less flexible investment vehicles. And investors should allocate a portion of their capital to mutual funds to benefit from the tax efficiency benefit.

Also Read - Union Budget 2024 Impact on Stock Market

What is needed from MF, Smallcase & PMS Fund Managers?

The increased capital gains tax rates have made PMS strategies less attractive relative to MFs and potentially AIFs, particularly for short-term investments. Mutual funds, with their inherent tax efficiency due to deferred taxation, emerge as a more favorable option for retail investors concerned with tax liabilities. Smallcases, while offering customization, require careful tax planning due to similar direct equity tax implications. AIFs, with their pass-through status and flexibility in investment strategies, might offer an attractive alternative, especially for high-net-worth individuals (HNIs) seeking sophisticated investment approaches.

• Long-Term Focus: To mitigate the impact of the higher STCG tax, PMS/ Smallcase providers are likely to adopt more long-term focused strategies, reducing churn and holding investments for longer periods.

• Enhanced Tax Planning: By strategically harvesting tax losses and optimizing the timing of gains, PMS/ Smallcase managers can reduce the effective tax burden on their clients.

• Maintaining Competitiveness: Mutual funds, with their inherent tax advantages and deferred taxation, will continue to attract retail investors. Fund managers might also focus on maintaining low turnover to further enhance tax efficiency.

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