A reader wants to know that after the LTCG tax, does investment in a large cap + debt fund combo expected to generate a better tax adjusted return versus investing in one of the balanced funds. We find out.
Here is the query:
With LTCG on equity, without any indexation, debt funds can be more attractive from tax perspective. Even with 20% tax, since there’s indexation, this would be less than the 10% LTCG tax on gains of more than 1L.
I was putting 2500 INR / week into a Balanced fund, for a 5-6 year horizon to build a 10L medical fund. But with a 5 year horizon, I think a pure large-cap equity fund and a short term debt fund would be a better combo, with a proper asset allocation strategy where I reduce equity exposure year on year.
Is this really the case? If so, I’ll stop investing in Balanced fund, and invest in the large cap – debt fund (combination) from next month.
Let’s work this out.
So, what are the key points here and the assumptions?
- A fairly long term goal with a 5+ years horizon; Let’s use a 10 year horizon to work with.
- Regular investments of Rs. 10,000 a month (2500 / week). For simplicity, we will use Rs 1 lakh per year for the workings.
- Two scenarios
- Scenario 1: Invest in one of the aggressive balanced funds, which typically has 65:35 equity:debt ratio
- Scenario 2: Invest in the 65:35 ratio in separate funds. A large cap fund for equity and a short term debt fund. This has 2 sub scenarios:
- Sub scenario 1 – No rebalancing
- Sub scenario 2 – Rebalancing the portfolio to keep the allocation near 65:35
- Taxes – The tax treatment of an aggressive balanced fund is equal to an equity fund.
- Equity – we now know that long term capital gains greater than Rs 1 lakh in a financial year will attract 10% tax. There is no cost indexation benefit allowed.
- Debt – Debt funds held over 3 years benefit from cost inflation indexation and a flat rate of tax at 20%. On a 3 year period, this works out to be about 0.6% tax.
- Cost inflation Index – We have assumed the cost inflation index at a constant 5% per year. This will be used to inflate the cost of debt for calculation of capital gains.
- Expected returns: It is easy to assume the expected rate of returns at say 12% for equity and 7% for debt. If you do the workings based on these, what my reader has said will hold true.
However, as you understand, we are using a linear rate of growth for both equity and debt. In reality, we know, that’s not how it works. Equity is volatile and so are the returns. There are ups and downs.
So, to get some real answers , we will use actual calendar year returns for the past 10 years (2008 to 2017) for:
- An aggressive balanced fund (minimum 65% in equity)
- A large cap fund
- An ultra short term fund
Though it is the past data but helps us map the likely returns scenario going forward. The returns data is sourced from ValueResearch.
Let’s look at the workings.
#1 Own separate portfolios (without rebalancing) OR invest in one single balanced fund
In our first working, we will create 2 separate debt and equity portfolio as also invest in one of the balanced funds. Here’s what the numbers look like.
At the beginning of every year, Rs. 1 lakh of investment per year is divided into 65: 35 ratio and invested in a large cap equity fund and a debt fund.
Equity and Debt fund values as well as % are calculated at the end of the respective year.
The year 1 in the table corresponds to the year 2008 and hence the negative returns number for equity and balanced funds.
The final values are shown with the purple background. Counting for taxes, the CAGR in the two scenarios is:
The taxes are applied on the final values, assuming the entire amount is withdrawn in one lumpsum. If you were to withdraw over several years and take the benefit of Rs 1 lakh exemption every year, the taxes can be lower.
As you can see, there is a huge difference between the two CAGRs. 13.5% for the separate portfolios versus 19.8% for a single balanced fund.
Let’s now look at another scenario and answer the question if we can improve the returns of the separate portfolios via rebalancing.
#2 Own separate portfolios (with rebalancing) OR invest in one single balanced fund
All other numbers remain the same as above except for the rebalancing part. This is how it turns out to be.
The numbers in the blue background for “investment in equity” are the points where we used our yearly investments to rebalance the portfolio. We did not actually sell anything, only used incremental cash flows. This way we avoided any interim capital gains taxes.
How does the CAGR fare in this case?
The difference because of rebalancing is to the tune of 0.8% in CAGR. From 13.5%, it has now moved to 14.3%. But it still remains lower than the return of a single balanced fund investment.
I guess the answer to my reader’s query is obvious. The bottomline is we can keep it simple.
OK, I know the query mentioned a 5 year horizon. I did it for 5 years and the difference remains. If we take the last 5 years of the same data as used above, the CAGR is 16.1% / 17.2% for separate portfolios and 26.2% for the aggressive balanced fund.
What is your view? What are the other assumptions at work here? What can go wrong? Do share in the comments.