Impact of Capital Gains Tax Changes on PMS, AIF, Mutual Funds and smallcases

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

Key Changes in Taxation

• Short-Term Capital Gains (STCG) Tax: Increased from 15% to 20% (effective rate of 20.8% including cess) for gains from stocks held for less than 12 months.
• Long-Term Capital Gains (LTCG) Tax: Increased from 10% to 12.5% (effective rate of 13% including cess) for gains from stocks held for more than 12 months.
• The difference between STCG & LTCG has increased from 5% to 7.5%.

Impact on PMS Investments

PMS strategies often involve high turnover, leading to frequent STCG tax events. To remain competitive, PMS providers must generate higher pre-tax returns to offset the additional tax burden compared to mutual funds. The higher tax burden may lead to industry consolidation, with only the strongest PMS providers surviving. Strategic shifts towards long-term investments and tax efficiency measures like tax loss harvesting may help mitigate the impact.

Impact on Smallcase Portfolios

Smallcase involves direct equity investments, similar to PMS, and is subject to the same tax rules. Frequent rebalancing can lead to significant tax liabilities. 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 critical in the current tax regime.

Impact on Mutual Funds

Mutual funds offer tax efficiency through deferred taxation, as investors are only taxed upon redemption. The fund's internal transactions do not result in immediate tax liabilities for investors, making MFs more attractive in a higher tax regime. For retail investors, mutual funds offer a simpler and more tax-efficient way to invest.

Impact on AIFs

AIFs 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.

Impact on International Stocks and Mutual Funds Investing Overseas

The capital gains tax changes also affect investments in international stocks and mutual funds that invest overseas. Here are the key implications:

• International Stocks: Capital gains from the sale of international stocks are taxed at the same rates as domestic stocks. STCG tax is 20.8% (including cess) for gains from stocks held for less than 12 months, while LTCG tax is 13% (including cess) for gains from stocks held for more than 12 months.
• Mutual Funds Investing Overseas: To qualify for Long-Term gains, international funds had to be held for longer than 36 months previously. This has been reduced to 24 months. Mutual funds that invest in international stocks are subject to the same capital gains tax rates as domestic equity mutual funds. STCG tax is 20.8% (including cess) for gains from units held for less than 24 months, while LTCG tax is 13% (including cess) for gains from units held for more than 24 months.

Outperformance Required by PMS over Mutual Funds

To match the post-tax returns of mutual funds, smallcase or PMS portfolios need to generate extra returns ranging from 2% to 3.3%, depending on the holding period scenario and Mutual Fund returns. Strategies with higher short-term holdings require more outperformance to offset the higher STCG tax.

The table below illustrates the excess return a PMS needs to deliver to compensate for the increase in the tax rate.

Portfolio Churn Rate and Its Impact on Returns

High-churn strategies are at a disadvantage due to the higher STCG tax, which significantly reduces post-tax returns. To remain competitive, PMS strategies must generate higher returns to offset the increased tax liability. Low-churn strategies focused on long-term investments will be less affected by the STCG hike and can still deliver competitive post-tax returns.

Historical Performance: PMS vs Mutual Funds

A critical long-term performance analysis 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.

These performance comparisons demonstrate the potential of PMS to generate higher returns than mutual funds across various market segments and time horizons. However, investors should remember that past performance does not guarantee future results and that the higher returns of PMS come with increased risk and potentially higher fees than mutual funds.

Capitalmind PMS Performance versus Mutual Funds

The chart shows the historical annualised performance of Capitalmind PMS investment strategies as of July 25, 2024 versus how Mutual Funds have done over the same time.

Advantages of a Diversified Portfolio Allocation

Smallcases & PMS offer several advantages over traditional mutual funds, particularly for investors seeking personalised and flexible investment strategies.

Personalised and Flexible Investment Strategies

PMS provide a personalised approach to investment management, tailoring portfolios to individual risk appetites and financial goals. This customisation 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.

• Tailored Portfolios: Unlike mutual funds, which follow a standardized approach, Smallcases and PMS offer bespoke portfolios that cater to each investor's specific needs and preferences. This individualised attention can result in more efficient asset allocation and better alignment with the investor’s long-term financial objectives.
• Dynamic Asset Management: Smallcases & PMS managers can adjust strategies in response to changing market conditions. This agility allows for more proactive management, potentially enhancing returns by capturing short-term opportunities and adapting 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 Mutual Fund and have to follow the market cap requirements.
• Concentration of Wealth: Smallcases & PMS often involve 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.

Tax Efficiency through Strategic Management

Despite the higher STCG tax rate, experienced PMS managers employ strategies like tax loss harvesting to offset gains and minimise overall tax liability. This approach can enhance post-tax returns and provide a more tax-efficient investment experience than less flexible investment vehicles. However, investors should allocate a portion of their capital to mutual funds to benefit from the tax efficiency inherent in their structure.

In summary, a diversified portfolio allocation that includes Smallcases, PMS, and mutual funds can help investors balance the benefits of personalisation, flexibility, and tax efficiency. By leveraging the strengths of each investment vehicle, investors can create a robust and adaptable portfolio that aligns with their unique financial goals and risk tolerance.

The Way Forward for Fund Managers

To mitigate the impact of higher capital gains taxes, PMS/Smallcase providers are likely to adopt more long-term focused strategies, enhance tax planning, and strive to maintain competitiveness. With their inherent tax advantages, mutual funds will continue to attract retail investors. Fund managers might also focus on maintaining low turnover to enhance tax efficiency further.

In conclusion, the changes in India’s capital gains tax rates have significant implications for various investment vehicles. While PMS and Smallcase face challenges due to higher STCG taxes, they can still offer personalised strategies and potentially higher returns. Mutual funds emerge as a more tax-efficient option for retail investors, while AIFs provide attractive alternatives for HNIs seeking sophisticated investment approaches. Fund managers across all vehicles must adapt strategies to navigate the new tax landscape and deliver competitive post-tax returns to investors.

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Contact our team to learn more about Capitalmind PMS and get a customised strategy consultation.