What’s Your Tax Quotient?

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One of the major factors that require attention is the tax efficiency of the instruments that one wants to invest in. Unfortunately, not many investors give much thought to this aspect while making investment decisions. No wonder, in spite of not being so tax efficient, traditional instruments like bank deposits and small savings schemes continue to be popular among millions in our country. More importantly, while investing in these traditional instruments, investors compromise on the returns as well. It happens because they opt for the ‘safety first’ principle. Though, it is quite natural to be concerned about the safety of one’s hard-earned money.

No doubt, tax efficiency alone cannot be the main driver of an investment strategy. However, it is a fact that it can make a substantial difference to a portfolio’s ultimate size. In other words, tax efficiency has to be an essential element of any investment plan along with portfolio mix, investment philosophy and management. While paying taxes when necessary is understandable, paying more taxes than necessary is not. The ultimate objective of investing should be to meet your short term as well as long-term goals by maximising your returns in a manner consistent with your means and risk tolerance.

The tax efficiency becomes even more relevant when one intends to invest in safer instruments offering predictable returns. Mutual funds, as an investment vehicle, are one of the most tax-efficient ones. Let us examine what role each one of these can play in an investor’s portfolio and what difference their tax efficiency can make to overall returns.

Liquid Funds
Liquid funds are ideal for investors looking to park their short-term funds. These funds primarily invest in low duration and liquid investments such as money market as well as debt instruments. Liquid funds currently pay a dividend distribution tax of 28.33 per cent for all categories of investors as compared to 14.16 per cent for individual investors and 22.66 per cent for corporate investors by other debt funds including liquid plus funds.

Floating Rate Funds
Floating rate funds invest in instruments whose interest rate keeps changing as per the market condition. Simply put, the coupon rate is not fixed. Instead, it is benchmarked against a market-driven rate like Mumbai Interbank Offered Rate (MIBOR). As the coupon rate is adjusted to the benchmark rate, the NAVs of these funds do not react much to the changes in the interest rate environment.[PAGE BREAK]

Short / Medium Term Debt Funds
Short as well as medium term debt funds aim to generate income and capital appreciation through a portfolio of debt as well as money market instruments. Short term debt funds however are less volatile compared to medium term debt funds as they have relatively lower average maturity of the portfolio. Besides, short term debt funds have a favourable risk return profile as they have lower standard deviation compared to medium term debt funds. Medium term debt funds or income funds invest in corporate and sovereign debt with maturities ranging from 2 to 5 years.

Arbitrage Funds
Arbitrage funds are essentially equity funds that aim to provide capital appreciation and income through arbitrage opportunities that exist between the spot market and derivative market. It is important for investors to know that though these are termed as equity funds, they are suitable for those investors who are looking to get better and tax efficient returns compared to debt funds. On the negative side, these funds at times might struggle to find enough arbitrage opportunities in the market.