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The Mutual Fund Show: The Road Ahead For Debt Funds

Recent decisions to withdraw tax benefits for debt mutual funds will see some drastic changes in the segment.

<div class="paragraphs"><p>(Source: Freepik)</p></div>
(Source: Freepik)

As the tax benefits on debt mutual funds cease, the mutual fund industry will rethink the way it looks at the category, according to analysts.

However, debt funds will not disappear from investing strategies, courtesy the benefits they offer.

The government took away the tax advantage offered by debt mutual funds via an amendment to the Finance Bill 2023, which comes into effect from April 1. Now, the gains arising from mutual fund schemes with equity allocation below 35%, including debt mutual funds, will be counted as short-term capital gains.

The primary predicament for the debt funds category will be loss of growth potential, Anthony Heredia, managing director and chief executive officer of Mahindra Manulife Mutual Fund, told BQ Prime's Niraj Shah. "I don't think it's the loss of current business because… there is only a limited amount of retail money that exists in debt funds."

There will be some reallocation from the debt mutual fund category to direct bond or fixed deposits where the rates are attractive, said Yogesh Kalwani, head of Investment and Family Office at InCred Wealth.

Heredia advises investors to rethink how they look at dynamic bond funds. "If there is equalisation of tax, then you have to earn your fee and the category that allows you to earn your fee and deliver an alpha over a static debt portfolio that the investor would have bought themselves is dynamic bond," he said.

Dynamic bond funds are debt schemes which invest in instruments with different durations or maturities.

With the recent changes, high net-worth and ultra high net-worth investors will look to park their money in a mix of bonds and funds, as it would not have any tax implications, said Kalwani.

According to him, corporate bond markets are still not very liquid in India. Even if investors allocate for that, it will not be a sizable portion because when they need liquidity, it may not be sellable or will take time to sell off, he said.

"Debt mutual funds will remain core because of the liquidity reasons, professional management and a diversified pool which means lesser credit risk."

Watch The Full Interview Here:

Edited Excerpts From The Interview:

For a lot of people, it levels the playing field. Do you believe that if you had this category or debt fund category in a meaningful way for you, you would have been in a disadvantage or are there products enough within the arsenal of the mutual fund industry to still get in customers on the debt side? 

Anthony Heredia: So, I am an optimist by nature. But let me just state that obviously the changes last Friday are a dampener. When I say this in the context of the fact that in spite of the many efforts of the industry, the retail investor really hasn't been buying debt funds in any event till this point. This particular change creates an even higher level of difficulty in terms of getting the category to be more retail. So that's part one.

Part two, if you step back and I think you made an interesting point, you know, it's been almost a week. The reality is that 80% of the category of fixed income and liquid within the industry really has not changed because anybody who invests with typical durations of a year and below doesn't do it with a tax arbitrage point of view. So, I would say we are discussing and debating the 20%. 

The difficulty the industry would have is the loss of growth potential. I don't think it's the loss of current business because there is only a limited amount of retail money that exists in debt funds. There are solutions. For example, I am sure the industry will work on trying to make the hybrid categories more relevant and we will need some policymaker action within that as well because there are funds like conservative hybrids that do have the ability to go to 25%. But obviously, the new norms require 35. So, you need some adjustment and fundamentally, we would have to look at how we, from an investing philosophy standpoint, rethink how we look at dynamic bond funds, because that genuinely becomes the main funding focus. If there is equalisation of tax, then you have to earn your fee and the category that allows you to earn your fee and deliver an alpha over a static debt portfolio that the investor would have bought themselves is dynamic bond, and I think that's an area that I would believe the industry will start to focus on as well.

Yogesh, what's your sense? Do you concur with Anthony? And, in your case, because I reckon that the bucket that you cater to will be the HNI and the ultra-HNI community, and while the sub one-year things don't change, but let's talk about the change or about the change that's happened. What is in it for those people? Will you, as their well-wisher, look at debt fund options or are there other options out there for your clients? 

Yogesh Kalwani: Sure. Definitely, that's a big change. It definitely changes the way investments are considered by HNIs, UHNIs and even not so much okay, maybe retail investors but investors who were worried about the tax angle, the post-tax returns were the key decision-making factor. Definitely.

Having said that, if you look at those scenarios, I mean, we are coming out of a low-interest-rate environment where interest rates have moved up. The reason I bring that point in is because HNIs and UHNIs or investors were considering bonds as well as high yield opportunities alternate funds, as an avenue to make an additional return.

Now, the mutual funds return started looking up when the quality AAA started... better returns after the policy rate hikes, etc. So, that hike was good enough to attract back AUMs to the mutual fund industries on the debt side, etc.

Now, with this change, where you have tax neutrality, in the sense of no difference between whether you buy a bond or you buy a fund the preference, I would say for HNI and UHNI investors will be a mix of both.

Earlier the Rs 100 would have gone to a mutual fund. Now, they will take some liberty... then we buy a single bond preferential basis that would also be considered. So, there will be some reallocation from a debt mutual fund category into direct bond or FD places where the rates are attractive.

Having said that, debt mutual funds remain the core. Why they remain a core is because it offers liquidity. Corporate bond markets are still not very liquid in India. So, even if people allocate for that, it will not be a very sizable portion because when they need liquidity that's probably a bond which may not be sellable or will take some time to sell off.

So, debt mutual funds will remain core because of the liquidity reasons, professional management and a diversified pool, which means lesser credit risk. So, it would be a balancing act between how much overall portfolio return they're chasing, but definitely there will be allocations to bonds and FDs which will come up with debt mutual funds still being a core because of the liquidity and stability which it offers. 

People who choose debt, do that for a reason and they don't arbitrarily invest between equity and debt. There are a lot of people who believe that for the small investor, who may be used to the corpus not being very high and therefore, portfolio allocation right at the very onset was not necessarily the prime thing to do. The prime thing is to grow the AUM systematically but to grow that AUM, does that bucket invest increasingly more on the equity side, because the debt side taxation indexation benefits and therefore the possibility of double-digit returns is now out of the window? 

Yogesh Kalwani: So, yes, I would agree that the preference of a category ... is towards equity-oriented products. When I say equity-oriented products, it includes a balanced fund, a balanced advantage fund or even pure play equity funds. Why so, because of past performance.

... People do tend to look at what's been our best performing fund. So, if you have a 15% CAGR on equity fund over three years or a five-year period and if you pick up even after this market decline, equity return of a mid-cap, flexi cap or any other category, you do find returns of upwards of 15% on a very long period of time.

So definitely the promise of making that outsized return, which is 15% plus, if you hold it for three five-year perspective is a reason why people get attracted to mutual funds. Because if they ever make that 8%, 7% or 9% return, they have their FDs or postal product solution or any other fixed Income solution. So, the category which is retail and mass-affluent is preferring mutual fund products largely due to equity and equity-oriented products like balanced and balanced advantage funds. 

Anthony, you mentioned that you are hopeful that in conservative hybrids, at some point of time the regulator may move on and instead of 25%, make it 35, so on and so forth. But within the current set of rules that exist for the debt categories, is there a first among equals when it comes to the debt side or somebody who's looking to invest in debt funds even now.

Anthony Heredia: For most investors, what we've been recommending is effectively the shorter end in any case, because we have a very flat yield curve in any event. So, for investors who are retail mass affluent, they're able to get a return without too much of volatility of interest rate view with a short-term bond fund and below. I don't think there are many changes on that front for them because the journey of convincing the retail industry to go longer term in bond in any case is a journey that's a long way from being fulfilled.

I just genuinely believe that while there's been a lot of media chatter and industry chatter that hybrids are an automatic solution, I don't necessarily agree because I don't see how products that have 50% equity or above become a solution to provide alternatives to stable income when it just doesn't add up.

So, I think we will need some innovation in terms of working with the 35% as a construct of a bit of equity and a bit of arbitrage so you kind of get the tax benefit, and then the remainder goes into long term bonds. I think that is clearly to me the product of the future that provides a sensible logical solution and I think over the next three or six months I'm sure you will find that.

Let me give you a very basic example although that's a flippant product idea at this point, but you look at target maturity funds that have been the rage for the last six months. What stops somebody from launching a target maturity fund with 35% arbitrage and the rest of the 65% still doing what it did? 

It's still a very attractive proposition, frankly, from a three- and five-year perspective because it has indexation and all of that. So, when you step away from the noise, there is enough and more than one can keep doing.

... Let me just address a macro concept first. Retail and mass affluent investors or Indian households in general are anyways underinvested in equity and traditionally have invested in fixed income, government savings. So, I think logically the path of getting them to increase allocations to equity will anyway continue. I think the journey for retail penetration will continue to be equity-led. 

I don't see anything, you know, not just over this year or next year, I think this decade will be about, you know, the SIP story, investors understanding that equity is a long-term wealth creation objective and I don't think they will worry too much about should they be looking at fixed income because I would believe that if you had to just kind of broad brush the population they are anyways, overinvested in fixed income, we can argue whether it's the right fixed income and so on so forth. But I think for them to come to mutual funds, I think equities are much natural port of call relative to hybrid or fixed income. 

Yogesh, just one quick follow up before I move to the next topic, and that is should there be innovative products like the one that Anthony spoke about? Would that be of interest to clients or are people a lot more specific about what they want?

Yogesh Kalwani: So, it's been there, I mean it is okay, the arbitrage of the tax advantage which a debt fund was offering is now not available. Hence, maybe this category gains some traction. But will it be a substantial category like maybe a balanced fund or pure play equity fund or a debt fund. Unlikely in my view, but definitely there will be some allocations which will be a blended hybrid or a multi-asset product, which can come, and it's been traditionally there, but never got too much traction or attention purely because the debt side was advantageous on the tax and equity side also had advantage.

Now, with debt tax advantage not being there, this category still has a better tax advantage than debt fund. So, that's the only reason why it will get traction. I don't think there's an investment case, per se, but the investment case will be driven from a tax benefit which comes through the hybrid sector. That's the view which I hold right now, but we will see if there is track record or there are some solutions built on a hybrid platform which have tax advantages and also meet the expectations of investors. 

Who knows, FY24 could turn out to be a year of multiple new innovative things, which we'll get a chance to talk about on the show as well. We asked on social media today and there are some positive responses to try and figure out active versus passive approach, an angle of what on the active side has the right to win as things stand over passive for the foreseeable future because the argument of large-cap active funds being beaten hands down by passive and large, as per Spiva and multiple other things is now a proven thing. But other active categories, which you don't even have to think about moving on to the passive side but stick to active for the foreseeable future. Now, Anthony, what's your view here? 

Anthony Heredia: So, I'll come to the large cap because I do have a different viewpoint. But logically, the small cap in the mid cap space are spaces in which one would feel very confident that there is alpha to be added over benchmark and I would say any fund that's a derivative of that. So, therefore, Flexi cap and Multi cap then become automatic categories where you would believe active would make sense, that's point number one.

Point number two is and this is acontroversial and debatable, I will admit, but what I find perplexing is the constant comparison between the regular plans of active funds and passive because somebody who's been passive is a do-it-yourself investor and I would believe that do-it-yourself investor is smart enough to buy the direct plan of the active fund and you will then find that the differential in TRs is very minimal. 

So, that builds on my point on large cap as well, which is that when you actually look at the direct plans, it's still not as stark a difference as the Spiva report makes it to be.

Larger than that and this is an admission, and I can say that even internally we have been talking about it. I don't want to take it as a given or let's say I am not accepting defeat that we do not have a right to outperform the benchmark on large caps. The point is, what do we therefore do in terms of portfolio construct or the way we approach it to give us a higher chance of beating the benchmark. Obviously, it will come with a higher risk of not beating it as well, which is where I am alluding to what is the degree of activeness that you've historically seen with large-cap funds. Is there a need to relook at that because at the end of the day, if the TR's are such a substantial portion of the differential if you have information symmetry, like you have with large caps, then you have to figure out ways and means to think out of the box to try and outperform. At least, we have been talking about the fact that do we need to think about running our large-cap fund differently from the way we do the other funds, particularly with regard to the extent of activeness that we will display and I am being very clear, it obviously comes with the downside risk as well because if you are making an attempt to be more active, higher tracking error, in order to outperform you obviously increase the risk of underperforming but that's the way to go because if you are accepting defeat and saying I will underperform but so what, please give me money, I think we are living in a fool's paradise. 

Yogesh, would you as somebody who observes these funds, maybe let's say that you even recommend these funds. Would you be comfortable with a fund house of your choice doing that kind of heightened activity? Two, would it be possible for a fund house or for a very high AUM to be able to carry out that activity very successfully? 

Yogesh Kalwani: So, we haven't seen anyone being successful so far in that attempt of generating alpha by not moving away dramatically from the benchmark. So, the current trend of large caps, I would not say a large part of the portfolio is hung to the benchmark, but at least in the top five, seven heavyweights, you do see an allocation which is there. ... The critical point being what's the benchmark. Is it Nifty 50 or is it Nifty 100 because from a large cap point of view, it should be Nifty 100, and it depends on what's the fund's benchmark which we are tracking. So, we haven't seen success so far because like Anthony said, the risk is you also underperform significantly. So, if in your attempt to increase active bets, end up making wrong decisions, and hence it's like if someone does it, right, it's like take it all. I mean, and every AUM will really move there, but people would not take that risk. It's too high a risk from a fund manager's perspective.  

Let's say, Anthony is taking that risk. Yogesh, would you be comfortable recommending a fund to your clients which is doing such heightened activity?

Yogesh Kalwani: Absolutely. I'll tell you why because when he's talking about outperformance of a benchmark, now, when everyone looks at Nifty 50, the minute you change it to a Nifty 100 large cap, you are talking about 100 stocks.

Now, you can't have a 100 stocks mutual fund portfolio. The reason why you're going to a professional manager is you are trying to help him trying to get better stock portfolio or well-allocated right companies in the portfolio, right stocks in the portfolio. You do that in a mid cap and small cap, wherein you tell the fund manager that this index is like 250 constituents etc. whereas you construct a portfolio which is 60-70 stocks and help me generate a better return than a small-cap index or a mid-cap index and it happens there because the index is too broad and the fund manager portfolio is relatively smaller: 60-80 stocks and you can generate that alpha because of stock picking businesses selections, etc., which plays out.

It can't be done in large cap, very few people have tried it, not too many have been successful. The problem is cyclical return, so not very consistent. Consistency is a challenge in a large cap alpha, whereas in a small and mid what we have seen is the consistency of generating an alpha compared to a benchmark has been phenomenal.

I was looking at some 10-year data on a small cap fund return. It's like 25% plus CAGR. You can't beat that--25% CAGR on a 10-year basis on a small cap is phenomenal return. Hence you have beaten the benchmark by 70 points each year. So out there it's more consistent long term, large cap, it's cyclical and not consistent. That's a challenge which one has to address.

Having said that, one more point which I would like to add on the same passive and large cap question is the other way to look at it is better risk adjusted return. So, aggressive balance category, there are funds which are able to deliver you a better return than a Nifty by taking lesser risk, by having a 35% component into fixed income, up to 35%, and thereby better risk adjusted returns.

If you have a lower volatility standard deviation and a return which is equivalent to a passive fund or index and hence, it's a better product. So rather than being passive, the other way to look at it is I reduce my risk standard deviation and still have an opportunity to get the same return as what a Nifty delivers. That's another way to look at it from an active allocation perspective and not really considered a pure passive fund. 

I don't remember, having studied mutual fund for so long, seeing too many funds which are trying to do quite a bit on the active side in order to beat the benchmark, on the large cap side that is?  

Anthony Heredia: Let me point out one contradiction that goes unnoticed, which is to look at the outperformance of focused funds, which is a separate category and that is a category that actually if you look at data has outperformed just in line with small caps and everybody is convinced that small caps, active is the way to go.

Interestingly, if you actually look at average exposure, capitalisation-wise within focused over the last three years, 70% is large cap. ... What's the difference and the missing ingredient in our view is focus and conviction, which requires therefore higher activeness. So, I think the industry is demonstrating because just remember, there is a flexi cap and a multi cap that typically runs 50-60% large cap. So, how is it that all of these categories managed to outperform the benchmarks, but the large cap doesn't? Is there therefore room to introspect, and when you introspect, I'm not discussing moving into a momentum or an extremely active or I'm just saying, clearly there are other spaces within the categorisation where we seem to be doing pretty well on large caps.

Why can't we translate that onto the main category itself and that's besides the fact that there are funds that do outperform the large-cap benchmark as it is. But I am just saying, if we have done it so far, that's not the point. The point is, what are you going to do going forward given these information symmetry, given the lack of options, given the five-seven heavyweight benchmarks.

To my mind, the answer is that you have to do something different. But that doesn't mean you have to do something silly just for the sake of being different. There are possibilities and activeness for me, at least at this juncture, is definitely something we have to take a look at. 

What within the active side is a no-brainer, in terms of beating the passive side. We have Anthony's views here, what are yours? 

Yogesh Kalwani: Small and mid cap goes without a doubt. India has a huge universe of investable stocks and a lot of it is under-researched. So, if you go beyond the first top 100 companies, it's an under-reserved space. You can't really go and buy; investors can’t go and buy stocks directly. You can always buy top 50 stocks directly and create your own portfolio bracket and it's too much information data available, company disclosures are great, etc. So that's a do-it-yourself segment. The mid cap, small cap a lot of opportunities, different themes playing out, prints playing out that is a segment which definitely needs professional investor help. That's where mutual funds comes to play. We have seen 10-odd years, 25% CAGR, small cap, two-three funds. You should look up that data; that's phenomenal. So, you don't need to really work too hard. 

What are those funds Yogesh? These are not recommendations from you; just naming the names. 

Yogesh Kalwani: Okay, that's, I mean, the data changes every month because it's point-to-point return.... It's Nippon and SBI. I believe Kotak also, it's not maybe 10, maybe five plus years. But all these three funds, small cap over a very long dated period, have delivered 23% to 25-26% CAGR for such a long period of time. So, by just staying put in the right manager in a small and mid-cap space, you can generate a phenomenal return and alpha. So, that's where passives really won't be able to do justice because in a passive fund, in a small and mid-cap space, you have 250 stocks; if you have 100-150 moving down, you'll never be able to make a great return, whereas some actives will do justice in that space.