Portfolio changing

An intelligent investor may plan for long term finances, which are tax efficient as well. So the investor may invest in mutual funds. If the investor is churning his portfolio frequently to earn shorter, better returns then he may not always be smart.

Investors are often tempted to shift their investments from one fund to another. They don’t realize that shifting comes at a cost. Let us take the case of MT who is a regular investor in mutual funds, especially equity funds. He makes it a point to shuffle or alter his portfolio on a regular basis, usually six to eight months, at times, even three months. His friend TQ is surprised and asks MT about benefits from frequent portfolio changes. MT replies that his investment advisor has told him how he can earn good returns by churning his portfolio on a regular basis. TQ reminds him that mutual funds are meant for good, long term tax efficient returns. By frequent changes MT is putting his capital at risk.

If an investor has been advised similarly, he should be careful. The change or shuffle may end up in the investor losing money, which otherwise he would have earned if he had not disturbed the portfolio or end up even with his capital erosion in the worst scenario.

Investment in funds attracts an entry and exit load. Entry load refers to the charges levied at the time of investing whereas exit load is levied at the time of redemption. Some funds charge both. Over a long term, if an investor frequently alters his portfolio, entry load costs add up and have a detrimental impact on overall returns.

The entry and exit load is higher for equity-oriented funds, medium for balanced and monthly income funds, and the least for debt-oriented and liquid funds.

Assume that an entry load of 2.25 per cent is payable for an equity-oriented fund. If investor invests Rs 10,000, then only Rs 9,775 will be available for investment – Rs 225 will be deducted by the mutual fund. Similarly, at an exit load of 1 per cent, if the redemption amount is Rs 10,000, then investor will receive only Rs 9,900 – Rs 100 will be deducted as load by the mutual fund.

Capital gains tax is applicable in case of any capital appreciation at the time of redemption. The gain
can be short-term (where the holding period is less than a year) or long-term (where holding period is greater than a year). The tax rates are different for equity-oriented funds and debt funds.
Short-term capital gains tax for equity funds is 10 per cent plus applicable surcharge and cess. Short-term gains for debt-oriented funds is added to the income of the investor and taxed accordingly.

Long-term gains are exempt from tax for equity-oriented funds. However, Securities Transaction Tax (STT) is payable on equity-oriented funds at the rate of 0.25 per cent, at the time of redemption. This is another reason that churning funds causes reduction in returns.

For debt-oriented funds, long term capital gains tax is 10 per cent, without indexation benefits, and 20 per cent with indexation benefit plus applicable surcharge and cess.

Because of the tax impact, it is likely that the effective yield on an investor’s investment may go down because of frequent portfolio changing. Suppose the absolute return from an equity fund investor held for less than six months was 30 per cent, then due to short-term gains tax, it will come to approximately 27 per cent. It is very important to note that in case of any investment, investor should look at the effective yield and not the absolute return.

Churning of investor portfolio may not be totally eliminated. There are times when investor needs to redeem existing units due to the following reasons:
* Poor fund performance: Here, by investing in another fund, investor may earn better returns.
* Perceived changes in economic factors such as interest rate changes, commodity prices, market sentiments, etc. Here, investor can exit from investments likely to diminish in value and enter other investment avenues offering better returns.
* As a strategy to maintain asset allocation ratio:

In case there is an appreciation in the value of equity-oriented funds, investor may redeem the same and invest in debt-oriented funds. Similarly, investor can make changes in allocation or fund preferences such as large cap, mid cap or small cap, etc.

Churning of portfolio is avoidable in the following cases:
* Timing the market, i.e., anticipating a rise or fall in the market;
* To earn income by way of ‘pass-on’ of commission by the fund advisor;
* To invest in New Fund Offers (NFOs) advised by investor’s investment consultant as its NAV is near to Rs 10 and hence perceived to be cheaper as compared to existing schemes.
Investor should invest in mutual funds after evaluating the fund on various performance parameters. Once investor decide up on his strategy and understand what investor fund can do for him, he will be less tempted to alter his portfolio intemperately.