Should you choose hybrid funds instead of debt funds for tax benefits?

Please note that debt fund taxation has changed with effect from July 2024. Please refer to this article for updated tax rules.

We have had a number of queries asking if you should choose hybrid funds with indexation benefit, instead of debt, in the wake of removal of indexation benefit for debt funds since April 2023. The alternatives that you considered ranged from aggressive hybrid, balanced advantage, multi asset, arbitrage to more recently, the balanced hybrid category. 

It is not uncommon for Indian investors to go where the tax benefit lies. And it is not without logic, since the net gain, post-tax, is the actual return that you earn from an investment. But what seems to be ignored by most is whether the tax benefit alone will suffice to meet the objective of a portfolio. 

Should you choose hybrid funds instead of debt funds for tax benefits?

For example, if your idea of having debt is to have asset diversification and lower portfolio volatility, then you need to ask whether a different category of fund will help meet that objective. 

When you base your investment decision only on tax benefit, here are the downsides: 

  • By substituting debt with another asset class, you are changing the risk profile of your portfolio and making it vulnerable to falls. 
  • You are counting on high inflation (a factor not in your control) to provide you with high indexation benefit.
  • You are also betting on tax laws (which is an extraneous factor that can change for any asset class at any time) to help you keep tax outflows in check. 

So, when you choose hybrid funds instead of debt how much are you altering the risk profile of your portfolio? And does the lower tax outgo work all the time if you have indexation benefit? Let’s analyse to understand. 

SEBI’s categories of hybrid funds and their tax status

Before we move to taxation volatility and risk profile of hybrid funds let us first try to understand the SEBI classification for these funds and what tax status they get.

When you look for a debt substitute with tax efficiency, you either look for hybrid funds that give you equity taxation or which give you at least indexation benefit. Now let us first look at SEBI’s definition of each category of hybrid funds.

Source: SEBI Categorisation and Rationalisation of Mutual Fund Schemes

Do note that SEBI does not decide whether a fund qualifies for equity or debt taxation or indexation benefit. It is the Income Tax Act that decides. And based on equity allocation this is what the Income Tax Act says on taxation, for the above class of funds:

  • Where the equity allocation is above 65% – long term is holding for greater than 1 year, and capital gains here are taxed at 10% with the first Rs 100,000 of gain being tax-exempt. Short term capital gains are taxed at 15%. For the 65% proportion, equity derivatives are also considered as equity instruments. This is where aggressive funds, most BA/DAA funds, equity savings funds and some multi-asset funds get their equity tax status, depending on whether they have a gross holding of 65% in equity.
  • Where the equity allocation is between 35-65% –short-term capital gains on holding period of less than 3 years will be taxed at your slab rate and holding beyond 3 years will be taxed at 20% with indexation. The categories that fall into this set primarily would be the Balanced Hybrid category, where there only a couple of new funds launched recently. Some multi asset funds may fall in this tax bucket while others may retain equity tax status, depending on their equity holding. 
  • When the equity allocation is lower than 35% – the gains are taxed at slab rate for investments made from April 1, 2023. For investments made before April 1, 2023, LTCG (over 3 years of holding) would be taxed at 20% with indexation. Conservative hybrid funds would fall under this (similar to debt funds). STCG would be at slab rate. We will leave this fund category out of our purview in this discussion, since they don’t give you any better tax status than debt funds. 

Here are the points to note when it comes to identifying a fund’s tax status based on their equity allocation:

  • SEBI classification clearly requires a minimum of 65% equity for hybrid aggressive, arbitrage and equity savings funds. So, by way of such holding, these funds will always be treated as equity for tax purposes. Their tax status is therefore clear.
  • SEBI does not state what proportion of equity BA/DAA funds should hold. SEBI simply allows this category of fund to hold derivatives. So, it is up to the fund to decide how it wants to position the scheme and what equity allocation it has. Therefore, these funds may either have equity taxation or have taxation with indexation benefits. At present, BA/DAA funds have equity taxation because they have generally maintained equity holding of over 65% (i.e., gross equity before hedging is 65%; the post hedging can be lower). However, newer ones like the Parag Parikh Dynamic Asset Allocation fund seek to lower equity and perhaps get indexation benefit (as mentioned in their presentation). If more funds decide to adopt such a strategy – whether it is a new or old fund – you may see more funds in this space shift into taxation with indexation benefits.
  • SEBI mandates just a minimum 10% holding for multi asset funds across equity, debt and commodities. So, these funds give themselves long leeway in their scheme information documents on equity and debt holding. So, unless these funds clearly state their minimum intended equity, their tax status is always subject to interpretation based on their 12-month average holding in equity. 
  • SEBI requires balanced funds to hold between 40-60% of equity/debt and mandates that they should not use arbitrage. This automatically qualifies them for indexation. Thus far, no AMC was interested in launching this category of funds since an equity-tilted allocation structure with debt taxation was not appealing. However, post the tax change in March 2023, there are now a couple of funds in this category. Note that an AMC can have either a balanced hybrid fund or an aggressive hybrid fund but not both. Therefore, it will be only newer AMCs or those without aggressive hybrid funds in their fund line-up that may launch such funds. 

To sum up, when you are looking at superior taxation in hybrid funds – hybrid aggressive, equity savings and arbitrage fit in automatically as equity funds for tax purposes. BA/DAA also get equity tax status for the most part but you need to check the SID and presentations and present allocation before you conclude.

Multi-asset funds can be anything – equity tax status, debt tax status or taxed with indexation benefit – depending on their asset allocation. You definitely need to check the SID to know if the fund intends to maintain specific cut-offs, or look at its asset allocation in its portfolio (use the MF Screener). The multi-asset fund we have in Prime Funds enjoys tax status and the fund clearly states its minimum equity intention. 

Volatility and loss risk

Now, let’s get to how much weight to place on taxation alone. When you hold a debt fund, you hold it for its ability to contain downside and cushion your portfolio against equity falls in bear markets. It would be imprudent to assume that hybrid funds will automatically do the same for you. Most of them don’t and the data below will tell you this. 

The table shows how volatile most classes of hybrid funds are (see standard deviation) compared with debt funds. And this data is over a one-year rolling return basis. If you plan on holding a hybrid fund over shorter periods, the risks are much more elevated. For example, there is a 17% chance that BA/DAA funds deliver negative returns over 6-month periods (in the 5-year duration below). The same jumps to 23% over a 3-month period! 

Since we do not have balanced funds with any track record, we simply built a 50:50 equity debt blend (Nifty 50 and ICRA Composite Bond) to look at its volatility. 

From the above you will be able to largely classify the hybrid funds in the order of least risk to highest risk (not considering conservative hybrid here) as follows:

  1. Arbitrage funds come close to debt (as low as equity and even slightly less volatile than short duration) in terms of low risk profile. However, there are issues with performance and we have discussed that in this article: Should you replace debt funds with arbitrage funds to save tax?
  2. Equity savings funds are far riskier than debt but are less volatile than BA/DAA/multi asset/Aggressive in terms of volatility and loss risk.
  3. BA/DAA and balanced funds (based on sample constructed) score higher on risk than equity savings but better than aggressive and multi asset funds.
  4. Aggressive and multi asset are the relatively highest risk ones in this category. 

So, you need to weigh the quantum of risk you can take for tax benefit purposes. Aggressive and multi asset funds certainly don’t make the cut unless you have a holding period of at least 3 years to ride the volatility.

Is the 20% indexation a boon? 

Many of you are already aware of the equity status of BA/DAA funds but now want to retain the indexation benefit wherever possible. 

In our view, taking a hybrid fund other than arbitrage is never a direct substitute for debt in terms of risk profile.  If you still take a fund with equity tax status, you need to understand the risk of downside. Further, remember that every time you substitute debt with hybrid, you are also increasing your portfolio’s equity allocation also.

The trickier business is wanting a fund with indexation benefit. Now, let us say you understand the risk of a balanced fund (which is certainly not a substitute for debt) but want to go for it for the indexation benefit, and such a balanced fund has a 50-50 equity debt allocation. Can you be sure you are benefiting in terms of tax outgo for the risk you take? You cannot!  The following factors will decide whether your net return is higher:

  1. The cost inflation index rise in the period
  2. The return of the balanced fund in that period (we have no track record now to assess this)

Now, what if you decide to take on the same risk but by taking separate exposure to equity and debt say at 50:50 each, instead of a balanced fund? We tried to do this with the simple Nifty 50 for equity and ICRA Composite Bond for debt taking their returns for the past 3 years for both options.

  • The equity and debt portfolio would have 10% LTCG for equity and slab rate for debt (assuming investment is after April 1, 2023).
  • The balanced fund (same Nifty and ICRA Composite Bond 50:50 blended) would get 20% indexation benefit.

Assuming a cost inflation index of 4.9% for the past 3 years, it turned out that the equity and debt portfolio did better than the balanced fund on a post-tax basis for 10% and 20% tax slab. For those in the 30% slab, the net value post tax was just 0.47% higher for the balanced fund than the equity-debt split portfolio. 

However, this can easily reverse if you construct an equity portfolio with some careful blend of large and midcap with option to choose the best fund in each segment (which is not possible in a single hybrid fund) and choose the right blend of debt as well. In other words, a proper asset allocation should help balance risk and give a chance to even beat the tax status. This, to our knowledge, is a better way to build a portfolio than choosing funds for tax purposes. 

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10 thoughts on “Should you choose hybrid funds instead of debt funds for tax benefits?”

  1. Kudos. Good informative article on SEBI classification of Hybrid funds and the associated taxation rules!! I wonder why you chose not to include conservative hybrid funds in the table when you included pure debt funds like short duration funds and money market funds.
    Even though conservative hybrid funds are taxed like debt funds, I would be interested in knowing this category’s worst average returns, standard deviation, category instance of loss and the average loss during falls? Can you please share this data?
    Regards

    1. The purview of this report was to discuss hybrid funds with better tax status than debt funds. Since conservative hybrid funds do not get that, we left it out. You can use our screener to get details about this category https://www.primeinvestor.in/mf-screener/ Or you can look at slightly dated article on them to understand how they compare, here: https://www.primeinvestor.in/varsity/conservative-hybrid-vs-equity-savings-balanced-advantage-which-is-the-best/ thanks Vidya

      1. Thanks. The MF screener wants me to be a Growth subscriber to be able to add filters. 🙁

  2. nikhil.abhyankar

    How most things get back to the basics like asset allocation! Better learn to spend the time and mind space on one’s actual profession rather than optimizing finances to the minute details, unless of course that itself is one’s profession.

  3. Gopalakrishnan CS

    Hi,
    Very informative and relevant article. Keep going.
    I have big chunk of my portfolio with BAF (aggressive and passive), Equity Savings Fund and Multi asset . All with equity taxation. Is it wrong to assume 33% as your debt component here ? Plus arbitrage benefits.
    Error for correction – “Further, remember that every time you substitute hybrid with debt, you are also increasing your portfolio’s equity allocation also” It should be debt with hybrid.
    Regards

    1. Hello Sir, thanks for pointing out the error. Corrected! Other than arbitrage, you would need to consider the others either as equity or apportion then (if you have few funds, based on their individual allocation) between equity and debt. Or you can use a broad proportion such as 65:35 for aggressive hybrid and multi asset, a 60:40 for BA/DAA, and a 45:55 (45 in equity and 55 others) for equity savings. thanks, Vidya

  4. Is Parag Parikh Dynamic asset allocation fund (whose NFO is just closed) eligible for indexation benefit ? In Neil Parikh’s video he had told that this fund is for indexation.

    1. Parag Parikh – we have mentioned it in the article that they seek indexation benefits. But their SID has a broad range of 0-100 for equity and debt. Vidya

      1. With the changes in new budget, it looks like Parag Parikh Dynamic Asset Alloc Fund will be taxed at 12.5% if held for more than 2 years assuming they maintain <65% equity allocation? If yes, Is this applicable for funds bought from today onwards or funds bought in current FY from Apr-2024?

        1. The Section 50AA amendment is effective only April 1 2025. So this will apply from then. And yes, if PPFAS does so, it will be taxed at 12.5% if held for more than 2 years. If it qualified as equity, then holding period will only be 1 year. thanks, Vidya

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Although the client may notify to us his/her intention to his/her subscription, such notice will only take effect at the end of his/her then current subscription period, and he/she will not receive a refund other than as set out under Clause 8 in these Terms.

The client may notify us of his/her wish to cancel his/her subscription by sending an email to [email protected]. The client must provide at least 5 business days advance notice for this to be implemented.

Refunds: There can be no cancellation and refund of subscription fee paid once the subscription is active, other than as stated in Clause 8 of these Terms. If the client is entitled to a refund as specified under Clause 8 of these Terms, the RA will credit that refund to the card or other payment method used by the client to submit payment, unless it has expired - in which case the RA will contact the client to proceed with the refund. If we do issue a refund or credit due to circumstances outside the obligations specified under Clause 8, we are under no obligation to issue the same or a similar refund in the future.

General disclaimers: The recommendations made herein in the Research Services are expression of views and/or opinions and should not be deemed or construed to be advice for the purpose of purchase or sale of any security, nor a solicitation or offering on any investment/ trading opportunity on behalf of the company, AMC, insurance company, or issuer of security referred to herein.

The content and research reports generated by the RA does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities.

The information/ opinion/ views mentioned in research reports or by the RA are not meant to serve as a professional guide to the client or recipients of this Report. The research report, recommendation, or any other content published by the RA do not assure or guarantee any minimum or fixed returns to the client or recipients of the reports/ recommendations/ content.

Use of this information is at the client’s own risk. The client must make his/ her own investment decisions based on his/her specific investment objective and financial position and using such independent advisors as he/she believes necessary. The services rendered by the RA are on a best-effort basis. All information in the content or research report of the RA is provided on an as is basis. Information is believed to be reliable but the RA does not warrant its completeness or accuracy and expressly disclaim all warranties and conditions of any kind, whether express or implied.

While due care has been taken to ensure that the disclosures, information, and opinions given are fair and reasonable, PrimeInvestor Financial Research Pvt Ltd and/or none of its officers, directors, partners, employees, agents, subsidiaries, affiliates or business associates shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way whatsoever from the information/ opinions/ views contained in the research report and recommendations that form part of the Research Service, and/or mails, social media or notifications issued by PrimeInvestor Financial Research Pvt Ltd or any other agency appointed/authorised by PrimeInvestor Financial Research Pvt Ltd. Returns and performance figures mentioned in the research report represent past performance and should not be constituted to be future returns or guaranteed returns.

Any agreements, transactions or other arrangements made between the client and any third party named on (or linked to from) the Website are at your own responsibility and entered into at your own risk. Any information that you receive via the Website, whether or not it is classified as “real time”, may have stopped being current by the time it reaches you. Market price information may be rounded up/down and therefore may not be entirely accurate.

The purpose of these disclosures is to provide essential information about the Research Services in a manner to assist and enable the prospective client/client in making an informed decision for engaging in Research Services before onboarding.

History, present business and background: PrimeInvestor Financial Research Private Limited is registered with SEBI as Research Analyst with registration no. INH200008653. The Research Analyst got its registration on August 19, 2021 and is engaged in offering research and recommendation services.

Disciplinary history: There are no pending material litigations or legal proceedings against the Research Analyst. As on date, no penalties / directions have been issued by SEBI under the SEBI Act or Regulations made thereunder against the Research Analyst relating to Research Analyst services.

Details of the RA's associates: No associates.

Usage of Website Content: This Website is controlled and operated by the RA. All material, including research reports, recommendations, portfolios, ratings, lists of financial products, illustrations, statements, opinions, views, photographs, products, images, artwork, designs, text, graphics, logos, button icons, images, audio and video clips and software (collectively, “Content”) are protected by copyrights, trademarks and other intellectual property rights that are owned and controlled by the RA or by other parties that have licensed their material to us.

Except where otherwise agreed in writing with the RA, material on the Website is solely for the client’s personal, non-commercial use. Except as provided below, the client must not copy, reproduce, republish, upload, post, transmit or distribute such material in any way, including by e-mail or other electronic means and whether directly or indirectly and the client must not assist any other person to do so.

Without the prior written consent of the RA, modification of the materials, use of the materials on any other web site or networked computer environment or use of the materials for any purpose other than personal, non-commercial use is a violation of the copyrights, trademarks and other proprietary rights, and is prohibited. Any use for which the client receives any remuneration, whether in money or otherwise, is a commercial use for the purposes of these Terms.

The client may occasionally distribute a copy of a research report, or a portion of the same, from the Website in non-electronic form to a few individuals without charge, provided the client includes all copyright and other proprietary rights notices in the same form in which the notices appear, original source attribution, and the phrase “Used with permission from PrimeInvestor Financial Research Pvt. Ltd.”

While the client may occasionally download and store research reports or information from the Website for his/her personal use, he/she may not otherwise provide others with access to the same. The foregoing does not apply to any sharing functionality we provide through the Website that expressly allows the client to share Content or links to Content with others. In addition, the client may not use Content he/she has downloaded for personal use to develop or operate an automated trading system or for data or text mining.

The client agrees not to rearrange or modify the Content available through the Website. The client agrees not to display, post, frame, or scrape the Content for use on another website, app, blog, product or service, except as otherwise expressly permitted by these Terms. You agree not to create any derivative work based on or containing the research products and Content. The framing or scraping of or in-line linking to the Services or any Content contained thereon and/or the use of webcrawler, spidering or other automated means to access, copy, index, process and/or store any Content made available on or through the Services other than as expressly authorized by us is prohibited.

The client further agrees to abide by exclusionary protocols (e.g., Robots.txt, Automated Content Access Protocol (ACAP), etc.) that may be used in connection with the Research Services. The client may not access parts of the Research Services to which he/she is not authorized, or attempt to circumvent any restrictions imposed on your use or access of the Services.

As a general rule, the client may not use the Content, including without limitation, any Content made available through one of our RSS Feeds, in any commercial product or service, without our express written consent.

The client may not create apps, extensions, or other products and services that use our Content without our permission. The client may not aggregate or otherwise use our Content in a manner that could reasonably serve as a substitute for a subscription to the Website.

The client may not access or view the Services with the use of any scripts, extensions, or programs that alter the way the Services are displayed, rendered, or transmitted to you without our written consent.

The client agrees not to use the Services for any unlawful purpose. We reserve the right to terminate or restrict the client's access to the Website if, in our opinion, the client's use of the Services may violate any laws, regulations or rulings, infringe upon another person's rights or violate these Terms.

Prohibited content: The Website includes comments sections, blogs and other interactive features that allow interaction among clients and between clients and the RA. We call the information posted by or contributed by users “Contributed Content.” In the course of availing of the Research Services or uploading any post or comment on the Website, the client shall not post any Contributed Content that (i) contains nude, semi-nude, sexually suggestive photos, (ii) tends or is likely to abuse, harass, threaten, impersonate or intimidate other users of the Website and/or Research Services, (iii) is lascivious or appeals to the prurient interest or if its effect is such as to tend to deprave and corrupt persons who are likely to use or have access to the Website and/or Services, or (iv) otherwise violates, is prohibited or restricted by applicable law, rule or regulation, is offensive or illegal or violates the rights of, harms or threatens the safety of other users of the Website and/or Services (collectively “Prohibited Content”).

We reserve the right to cease to provide the client with the Research Services or access to the Website, or terminate your subscription, with immediate effect and without notice and liability, for violating these Terms, applicable law, rules or regulations and reserves the right to remove Prohibited Content which is in violation of these Terms, or is otherwise abusive, illegal or disruptive. The determination of whether any content constitutes Prohibited Content, violates these Terms, or is otherwise abusive illegal or disruptive, is subject to the sole determination of the Firm.

Changes to Research Services: We are constantly endeavouring to improve the quality of Research Services provided to our clients. Due to this, the form and nature of the Research Services provided may change from time to time without any prior notice to the client. We reserve the right to introduce and initiate new features, functionalities, components to the Website and/or Research Services and/or change, alter, modify, or discontinue existing ones without any prior notice to the client.

Warranty and liability disclaimer: The Website, Research Services, and all the materials and services, included on or otherwise made available to the client through this Website is provided by the RA on an “as is” and “as available” basis without any representation or warranties, express or implied except otherwise specified in writing. Without prejudice to the foregoing paragraph, the RA does not warrant that:

  • This Website and/or Research Services will be constantly available, or available at all;
  • The information on this Website or provided through the Research Services is complete, true, accurate or not misleading; or
  • The quality of any products, services, information, or other material that you obtain through the Website or Services will meet your expectations.

The RA, to the fullest extent permitted by law, disclaims all warranties, whether express or implied, including the warranty of merchantability, fitness for particular purpose and non-infringement. The RA makes no warranties about the accuracy, reliability, completeness, or timeliness of the Website, Research Services, Content, Contributed Content, Services, software, text, graphics and links.

The RA does not warrant that this Website, Research Services, information, content, materials, or any other material included on or otherwise made available to you through this Website, their servers, or electronic communication sent by the RA are free of viruses or other harmful components.

Nothing on this Website constitutes, or is meant to constitute, advice of any kind.

Indemnification: The client:

  1. Represents, warrants and covenants that no materials of any kind provided by him/her will:
    1. Violate, plagiarise, or infringe upon the rights of any third party, including copyright, trademark, privacy or other personal or proprietary rights; or
    2. Contain libellous, Prohibited Content or other unlawful material;
  2. Hereby agree to indemnify, defend and hold harmless the RA and all of the RA’s officers, directors, owners, agents, customers/clients, information providers, affiliates, licensors and licensees (collectively, the “Indemnified Parties”) from and against any and all liability and costs, including, without limitation, reasonable advocate’s fees, incurred by the Indemnified Parties in connection with any claim arising out of any breach by the client of these Terms or the foregoing representations, warranties and covenants. The client shall cooperate as fully as reasonably required in the defence of any such claim. The RA reserves the right, at its own expense, to assume the exclusive defence and control of any matter subject to indemnification by the client.

Applicable law: This Website, including the Content and Contributed Content and information contained herein, and the provision of Research Services shall be governed by the Securities and Exchange Board of India, laws of the Republic of India and the courts of Chennai, India which shall retain exclusive jurisdiction to entertain any proceedings in relation to any disputes arising out of the same. As such, the laws of India shall govern any transaction completed using this Website.

Information gathered and tracked: Information submitted or collected on the Website or pursuant to the use of the Services is stored in a database. Specifically, we store the username, name, e-mail address, contact number, as submitted or collected on our Website or through the provision of the Research Services. We may use such information to send out occasional promotional materials, including alerts on new Services available, or other promotional and marketing material relating to our clients and customers.

In accordance with the Information Technology Act 2000, the name and the details of the Grievance Officer at PrimeInvestor is provided below:

Mr. Srikanth Meenakshi
PrimeInvestor Financial Research Pvt. Ltd., Registered office: 659, 4th Avenue, D-Sector, Anna Nagar Western Extension, Chennai 600 101.
Email: [email protected]

11. Mandatory notice:

Clients shall be requested to go through Do’s and Don’ts while dealing with RA as specified in SEBI master circular no. SEBI/HO/MIRSD-POD-1/P/CIR/2024/49 dated May 21, 2024 or as may be specified by SEBI from time to time.

12. Optional Centralised Fee Collection Mechanism:

SEBI has operationalized a centralized fee collection mechanism for IA and RA. Under this mechanism, clients shall pay fees to IAs/RAs through a designated platform/portal administered by a recognized Administration and Supervision body. This is an optional mechanism for the registered entities. At this time, PrimeInvestor has opted out of this fee collection mechanism. Therefore, all subscription payments for the Research Services will be through the modes as specified in Clause 5 of these Terms.

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