ADVERTISEMENT

The Mutual Fund Show: Affluent Investors Likely To Switch To Growth Funds From Dividend Option 

Investors in higher tax brackets may move to growth plans from dividend plans.

An office worker walks through a building in front of an Indiabulls Real Estate Ltd. commercial building construction site in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)
An office worker walks through a building in front of an Indiabulls Real Estate Ltd. commercial building construction site in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

Investors in higher tax brackets may move to growth plans after the Narendra Modi-government abolished the dividend distribution tax that is levied on dividends issued by companies and instead made it taxable in the hands of investors.

It may make sense for affluent investors to switch to growth plans rather than dividend plans before March, Vishal Kapoor, chief executive officer at IDFC Asset Management Co Ltd., said on BloombergQuint’s weekly series The Mutual Fund Show.

Kapoor, along with Kaustubh Belapurkar, director of Fund Research at Morningstar, said the government’s clarification that 10 percent ‘tax deducted at source’ will be levied on dividend income and not capital gains is a relief.

The two advisers, however, were divided on the impact of the new tax structure on mutual funds.

Under the existing tax regime, investors used to make mad rush to Equity Linked Savings Schemes which are seen as an attractive tax-saving option by the salaried class, Belapurkar said, adding that employees would now like to switch to the new tax option as they could view this more beneficial in term of absolute tax saving, or for that matter with an instant gratification of having more money.

Kapoor, however, highlighted that the ELSS category was just 4 percent of the overall industry size and that the new tax structure wouldn’t find favour with salaried employees who would still prefer to choose other exemptions like Leave Travel Allowance and House Rent Allowance, apart from other deductions under Section 80C.

Watch the interview here:

Here are the edited excerpts from the interview:

There are a lot of specific queries, but let’s start with an initial broad-brush. What did the budget throw up for you from a mutual fund perspective?

Vishal: I think on the mutual fund side, no major changes are one way to look at it. So, I think the industry’s been doing well. We hope to continue to do well.

Kaustubh: I would kind of mirror what Vishal said. There were no direct changes, per se. I know a wish list had been drawn and those were directly addressed. But yeah, I mean, there have been some incidental changes which we will talk about.

So, let’s cut to the chase and get straight to the point. Let’s discuss three or four things in no order of importance. Firstly, there is the taxation of dividends at slab rates versus dividend distribution tax. Now a lot of individual stock investors have said that from an Indian perspective that this increases the tax incidence from a mutual fund perspective as well. How do you think this impacts mutual funds and the returns to investors?

Vishal: So firstly, yes, I think for affluent investors­ it may make sense to be in the growth plan rather than the dividend plan. This is because earlier it was quite clean, it was tax-free in your hand and the tax incidence was relatively low. However, now that it’s coming to you, you have to not only pay your marginal tax rate but also worry about the paperwork and everything else involved to compute it. So, it’s not just the amount, but it’s also the administration of it. Hence, the growth plan is simple and clean. If I look at our book, the bulk of our investors, in fact, almost 90 percent are already in the growth plan.

Furthermore, that was in any case the more popular one. Which is why I’m saying it is a chain, but it’s not that material. But yes, if investors who are affluent, who are in the dividend plan and don’t need the cash, could move to growth plans. If you need the cash, a systematic withdrawal has always been a far better way for you to control your cash flows.

I would guess you would second this, Kaustubh. As Vishal said, there may be a large proportion of investors who were anyways in the growth plan. Maybe it’s a difficult one to assess but is that the larger industry piece as well? And what are your thoughts on this?

So, if you just look at the data, right? I can actually break it down to asset classes, but if I look at equity schemes, maybe about 10 to 15 percent was in the dividend plan across managers. In the balanced category, I suspect the number would be a lot higher, given the way some of these were structured to pay out regular dividend.

So, that’s where it’s going to be the challenge where, like, you know, Vishal said that if you’re an affluent investor, especially in a category like equity where you can pay 10 percent LTCG and be better off doing that. So, you want to move to the growth plan, but for investors who are in the dividend plan to move, that’s the other thing they need to keep in mind in terms of that switch. One has to consider how he can do it and the tax implications of when he can do so.

But even if it is accounted for in the long run, it would be better to actually switch to that plan as opposed to stay in the plan—accounting for the tax implications as well. The other bit is this clarification that came out last evening, wherein I think it’s now mentioned that the 10 percent TDS on mutual fund income above Rs 5,000, it’s only on the dividend and not on capital gains. I would presume that’s a big relief. I mean, most people say it would be logical that way. But is there still clarity needed here?

Vishal: There was some interpretation that was doing the rounds after the budget was announced that, does this or does this not? I think it’s good to have the clarification that redemption or capital gains are not subject to TDS. So, I think it’s good to have that clarified in black and white.

Do you guys believe, just hypothetically now, that should that not have been the case. (though it’s very unlikely that the government even by mistake intended it that way) Would it have had a major impact on flows into funds in any fashion, whatsoever?

Vishal: You mean, if they was TDS on capital gains?

... Yes

Vishal: So, we have to keep in mind that any form of TDS traditionally has been seen as a deterrent across many other products. So, I guess it is speculative to imagine why it would be the case. It’s not.

The other bit is about the noise that is larger and on the insurance side. I think one insurance company after another has come in and said there is no impact. From ELSS perspective as well, what are the options available for investors to move to a new tax regime? It means that investors who wanted to save tax necessarily do not have to offer ELSS with a presumption that it was the best available option any which way. Do you think this has the power to change what used to typically happen between January to March when a lot of people opted for ELSS schemes?

Kaustubh: There used to be a mad rush in the last three months where people would get a move. Obviously the last few years have seen more steady money coming into ELSS. But if you ask me, I think there is going to be an impact. To what extent, I don’t know, but if I were to just look at the numbers, given that, you know, there will be lots of investors who would probably look at the new regime as more beneficial in terms of either absolute tax saving or just instant gratification and having more money in their hands can potentially opt for that.

This means ELSS doesn’t become something they would do because they could save tax. If that option doesn’t exist, flows there could slow down. That’s the retail investor base, the sheer numbers would add the flows to the ELSS. Because with HNIs—even if they had some allocations to ELSS—the numbers are much smaller than that. So, to my mind, I think there will be an impact in terms of the flows in this category.

Vishal, I would want to dwell on this a bit because this is important. To your mind, in your fund house at least, is there a breakup of any sorts about investor behaviour towards ELSS, whether it’s a high-income category, low-income category, whether it’s by default or otherwise. Any thoughts here?

Vishal: So, I think there are a couple of things I want to just lay out. Firstly, I think going in, we have to reiterate that the purpose of investment should be meeting your goal, wealth creation, growth of capital or income etc. rather than just merely saving tax. I’m highlighting this because often one finds that the behaviour for investors not just in a mutual fund but overall tends to focus on the tax benefit and you can make your first error there.

The purpose itself of the investment is lost or relegated to the back-end. Here, tax-saving becomes the primary port, which needn’t be the case in the first place. Now coming to ELSS, it’s a great category, not just because of the tax benefit but also because it allows you to benefit from at least three years’ worth of capital growth. It’s granular, and over time, I think a lot of happy investors have been generated for the industry because their experience out of ELSS was so positive. So, you’ve got a three-year investment horizon locked away and then at the end, you’re converted, and you see the benefit of staying long term in equity.

So that’s the second point I want to reiterate. The third is coming to the immediate impact because this section may or may not be now availed of, I think two-three points to keep in mind. Firstly, while it is a valuable category for the industry for some of these reasons, it’s absolute size, relative to the industry, is still quite small. I think if I recall, it’s about Rs 100,000-105,000 crore compared to the industry’s Rs 27 lakh crore, which is 2 percent or 2.5 percent. Even in terms of flows, it’s granular and it gets a lot of retail investors, but in absolute size, it’s still under 4 percent or so. So, on a relative basis, it’s not going to significantly disturb the industry structure per se.

The second thing we have to keep in mind is that most of the investors into ELSS products or the ATC beneficiaries are largely the salaried-employed and affluent-affluent plus. From whatever calculation we’ve seen so far, this block of savers and investors are likely to continue with the exemptions, because it’s not just ATC, there is the HRA benefit, LTA and the other benefits. So, on the whole, from the calculation that we’ve seen, non-employed and the low taxpaying investors or savers, maybe the ones who will choose to be in the new scheme rather than the old scheme. The bulk of ELSS investors to my mind are in the category where you will continue to go with the exemptions.

There’s no data that you have here, it’s a belief of the investors that will be there within the industry or within your house?

Vishal: That’s right. It is just talking to our partners, distributor of the data, etc. and what’s the average ticket size? So, what’s the implied earnings of that individual and, therefore, what’s the tax bracket the person is likely to be? That I would think, would imply that most of these investors will be in the higher tax slab and employed, that’s important because it’s not just about ATC, it’s about the other benefits. So, if you’re employed and you have an HRA benefit, are you really going to give that away now and go into the new tax lab in many of these calculations, it may not be as beneficial to you.

So that is one pertinent point. Kaustubh, the other factor is I mean, when I asked around my office as well, because the average age is very young out here. A lot of them millennials who might be around that income bracket wherein this decision may make a material difference either direction. So, one point where I think the large sample size agreed with Vishal’s assessment was that there are other benefits available as well. Not everybody has a house, but people are living on rent and therefore all of that benefits. The other point is, though, that most said that while they make the mutual fund investments which are ongoing, or above the mutual fund investment, which was goal-based, they used to make an ELSS investment because it was necessary.

Now, I’m guessing it’s difficult to figure out because people may not move but if they move to this, then the ELSS investments will in all likelihood, take a hit. The question is it might be a very small fraction of the overall investing population.

Kaustubh: So, I will come to things and I’ll actually touch upon what Vishal alluded, it was a very pertinent point so. So, if you look at data globally also, right? But if you look at the U.S., for about 60 percent of new investors, their first investment came in through a 401k plan (forced investing). So in that sense, the ELSS was this beautiful thing where you had that character to come in and invest and then you got used to this beast called mutual funds, equities, and they stayed at least for three years- which generally gave them a much better experience than maybe looking to redeem in the shorter term. Then obviously, they kind of graduated to others. So, I’m hoping that at least with the guys have already tasted, investing and set classes with equities, nothing really changes. It is either ELSS or continues to do it. Even if they say they take the new, they qualify, they think that the non-exemption tax labs of the good ones. So, then they still come into investments, hopefully, equity investments, maybe not necessarily through ELSS that’s my first point.

It’s very hard and like Vishal was saying, that there are exemptions that are available beyond your ATC. It’s just not ATC, so the threshold of it is to do back of the envelope calculations about two-and-a-half lakh of exemptions. If you’re availing right now, then you are kind of indifferent between the two regimes. So, that’s really the call and each investor needs to take but my point is that any house coming in new- who’s not been exposed to it, needs a little bit of handling of that incentive to come into the investing space. In a way, I think maybe that part has at least gone away. That’s my thought about that.

Vishal, just give me that investor behavioural perspective as well. So, let’s say, I’m a number which is not too low, just about anywhere between 14-15 lakh rupees of income.

Because if I make the switch, I can’t come back. That’s what at least I heard the finance minister say as well. Then, I might not be tempted to move onto the new regime, because I would fear that when my income grows and I get a lot of other exemptions, I will not be able to move back.

So that is valid. So maybe the detriment or the impact on flows may not be too much, because the only ones who might actually move out are the really low-income guys. But the point is the whole idea of catching them young and getting them into the ecosystem, does that stand a chance of getting impacted?

Vishal: Yeah, so I think, of course, only time will tell. So, I think this is a new idea. If I look at it, what it does do is give more cash in the hands of this younger, new saver or employed, which does boost demand. So, keep in mind, one of the other imperatives that the industry was asking about from the budget was how do you get more consumption going?

To some extent, the budget always is a bit of a balancing act. You’ve got many requirements. So, at one level, yes, it does create a bit more of a consumption spur because so much money does not have to be locked away in a sense into longer-term investments, etc. and you can spend it. But on the contrary, and therefore, the flip side, which is I would caution, many of these young savers that yes, it may look very attractive to spend this money, etc.

But then I say all of the benefits of long-term investing (start early, staying longer), etc is something you have to be careful about. So, I think as an industry, we have more work to do, to spread our message and get some good savings and investment habits inculcated because we do also need long-term capital to fund capital growth. So, to that extent, yes, and the incentive is always sweeter. But without the incentive, we just have to work harder and get these investors to look at the longer-term picture.

The other point that I wanted to talk about before we also talk about a new fund offer from the IDFC stable is a proposal which is likely to happen. SEBI might look at reclassification of mid-cap and small-cap mutual fund schemes as well. Here, I know for sure that the industry has debated because I’ve spoken to three or four of mutual fund CEOs in the last six to seven hours. While a couple of them believed that this was a great time to do, others believe that we were getting used to so it’s okay. I wanted your opinion on what this means. Kaustubh, can I start with you on this?

Kaustubh: So, actually, that’s kind of a mixed bag in the sense that obviously, we’ve been now been more than a year-and-a-half in the sense that and rightly so, that is being used to the classification system. But the problem is especially if you look at in the mid-caps, it has been that. Now there are two ways of looking at it. One is that you have come 150 stocks, particularly in the mid-caps, some might have thought that that’s a constrained universe.

It was, but obviously, to the point that when the mandate to the fund allows you that 35 percent outside that, so it’s not that constrained as it seems. But as the category grows. That’s one of the challenges that it can be in terms of just that concentration towards those X number of stocks, and not necessarily all of them would be stocks that will meet investment merits in our portfolio.

So, that whittles down to a much lower number. But obviously, like I said, the flexibility is there because it’s only 65 percent of the portfolio not beyond that. So that’s really rare. So, it’s kind of tried to be nice to maybe have a little more flexibility. But so far, I think it’s worked okay. There were concerns that how would it hamper some of the large size funds. But largely, I think it’s been lousy, and it’s been well-contained in that sense.

Vishal, do you have any thoughts here? I mean, because there it’s been some time, Kaustubh- I think a year, year and a half that we’ve been used to this now and there is a change. I’m not saying it’s not a positive change, it may well be a positive change, but your fund house experience with classification as it stands right now, and if indeed there is a change, what could happen?

Vishal: I think one, it’s still a discussion, it cannot be cast in stone, in one sense. Second, when we first looked at it, one way to do this would be to look at chunks of the market cap and look at what the international experience has been in developed markets, etc. What proportion is classified as large-cap; what proportion is classified as mid-cap? I think there may be some room to expand the mid-cap area. That was one part of the feedback for the last 18 months as well that maybe 150 stocks were maybe too constraining for the real mid-cap space to develop and when you have got 65 percent of the mid-cap fund concentrated in this space, you really have enough width or not

So, to that extent, some amount of expansion may be welcome. But, of course, with any change, one has to look at what’s the portfolio impact and there is adequate room in the fact that this is the other 35 percent that fund managers have to balance out any such change or movement and not have an impact cost. So yeah, should they be that that part of that step taken, which is you expand the mid-cap to 200, or 250, or wherever that lands up, I think structurally, it’s better for fund managers because there’s more room. At a fund level, of course, every fund manager will have to make sure that the impact cost is not too much. As an investor, you would then look at what’s the change, if at all, and does it change the product that you bought into. In most cases, I would think, not necessarily, but you still have to be careful about that.

You do and it’s in these interesting times that while that might be changing as well or otherwise, but also, the fact that January was such a different month for equity markets compared to the last 24 that you guys have been thinking of launching a small-cap fund. In fact, you’ve announced it as well. Tell us a bit about it?

Vishal: So, our belief has been that small-cap space especially being within the equity spectrum, needs to be recognised quite differently from what we see in the large, or the hybrid of the multi-cap space because there are some very distinct features in the space. The first is that it is a truly high risk, high return. So, the number of drawdowns that one can see in a small-cap can be quite extreme.

We’ve seen that over many years. So, the type of investor who should participate in a fund like this needs to be someone who is aware of the risk in the near term but does want the opportunity in the medium to long-term. So that’s one thing which is very different in a small-cap fund. The spectrum of risk and return is on the extreme side, which means be prepared for drawdowns which are sharp. The second is that, very interestingly, immediate past performance of the category seems to almost be a contra-indicator of the future, unlike many others sort of classical analysis where we look at one year returns to decide where we want to invest over the next few years. So classically, you look at a category and say, ‘Oh, this category has provided me great returns, and I should put more of that,’ In the small-cap space, if you apply that logic, you’re almost likely to go wrong. Because every time past one-year return was attractive, which is high double-digits, let’s say, your next five years CAGR was very modest at low single digits (five years). Every time the last one-year return was negative or steeply negative, your next five-year terms were actually quite attractive double digit CAGR. So, entry timing in this space can be very, very potent unlike the other categories, which are more broad-based.

So, these are two or three specific risks we want to highlight first for investors. Now, having said that, this is the space that provides you the real growth stories- which is what becomes fabled after 8-10 years. If you look at the real star performers of today, these were really small caps 8-10 years ago. That growth phase is what we like. We think that it’s always a good time to get into that growth phase, but right now may be quite opportune, because price volume and valuation is in favour of small-caps in our view. The earnings growth has been reasonable but that depends on across every industry segment that you’re looking at, but valuations at some level are trending much lower than average and at a significant discount to the rest of the market. So, to someone who wants to take a bit of a contra view, either for the immediate uptrend or for the long term, is aware of the risk, we think this is as good a time as any. Our fund team has a fantastic track record in that space in general. This is, of course, our first and only small-cap fund. But that’s a capability that we think we’ve had a lot of experience and a lot of track record in. So, we think combined, this is as good a time as any.

What’s it called?

Vishal: It’s called the IDFC emerging businesses fund. It’s been open already since last Monday, it’s on for about two weeks, and then it becomes open-ended after that.

Just wondering Kaustubh, would you believe what kind of investor should go in for a small-cap fund at the current juncture, because there is option of multi-caps available as is which also combined the best of all of the three worlds as well? Would you believe? I’m sure every fund has its merits. So, there might be merit in buying a small-cap fund or not buying a small-cap fund. What kind of investor should opt for such a thing?

Kaustubh: So, I think Vishal’s kind of articulated that really well, that understanding the risks in these funds is very important. So, if I were an investor and looking at some category like this, the first question I would ask myself is, ‘Can I take a drawdown as high as 40-50 percent?’

We’ve seen even more extreme draw downs at quite different points of time. So, that’s the first question that can I stake it out and realise this is a temporary phase that requires staying invested through the market cycles. One is the ability to kind of digest that drawdown is, stay sensible and sane. The other one is obviously a long-term horizon. When I say long-term, in my mind it should be about 7-10 years.

This is really a growth capital, you want to come in for the long term, and not really think about that. Can I make more quick money in five years or not? Because the market cycle could be against you for an extended period of time. So, I think these two things as an investor, you need to be really clear in your mind before you get into something like this. Because if you don’t have that expectation set and that’s what Vishal spoke about that- explaining those risks upfront to the investors, then the investors are a lot more attuned to when things go wrong, they understand where they are coming from. Because back in 2017, when the mid-and small-caps were rallying, investors like Vishal said, looked at one year returns and came and they had a different experience come 2018. If a lot of them had actually understood they would have been much more comfortable that this is just a market phase and let’s just go with it. I think that’s really the thing that we should be looking at.