Closed-end funds lose sheen on LTCG tax

With the tax disadvantage almost gone, more investors may be willing to venture into international funds to diversify their portfolios

Closed-end funds have always been a less attractive investment category than open-end ones. The imposition of the long-term capital gains tax (LTCG) of 10 per cent is set to reduce their attractiveness further. Earlier, many retail investors avoided international funds because of their inferior tax treatment vis-à-vis domestic equity funds. With the tax arbitrage almost gone, most of them can venture into these funds now.

In recent times, the number of new closed-end funds being launched by fund houses has far exceeded open-end funds. When marketing these funds, mutual fund houses highlight two points. One, exiting these funds in the middle of their tenure is difficult. Though they are listed on the exchanges, these have to be sold at a steep discount. This, fund houses say, deters investors who lack the will power to stay invested in open-end funds for the long term from exiting. Two, fund managers can invest the fund's assets for a longer tenure without worrying about redemption pressure.

Closed-end funds, however, suffer from a number of disadvantages that they will not tell you about. Investors are subject to timing risk in these funds. They cannot do a systematic investment plan (SIP) as these funds are open for only a limited period. Investors can, therefore, end up investing a lump sum at high valuations, as is the case now. Investors also have to withdraw their

money at a particular time when the fund's tenure ends. If the markets are down, their returns can be affected. Moreover, since the corpus size of closed-end funds tends to be typically lower than that of open-end funds, their expense ratio, on average, tends to be higher.

With the introduction of the LTCG tax, one more negative has been added. Says Neil Parag Parikh, chairman and chief executive

officer, PPFAS Mutual Fund, “If you are a long-term investor, say, with a horizon of 8-10 years, and hold on to your investment in an open-end scheme till the time you actually need the money, you will have to pay tax only once. On the other hand, in a closed-end scheme, you will be forced to pay tax on two or three occasions due to the compulsory rollover on account of the scheme's fixed tenure.” Closed-end funds usually have tenures of three, five or seven years. The repeated taxation of the corpus will reduce the compounding benefit.

Many investors earlier steered clear of international funds because of their inferior tax treatment. While equity funds were tax-free after a year, debt funds were taxed on a par with debt funds: at the rate of 20 per cent tax after indexation. The tax arbitrage will almost disappear from the next financial year. The effective tax rate on these funds could, in certain circumstances, be lower than the rate levied on domestic equity funds, depending on the rate of return and inflation ( see table). “Through a bit of tax planning, investors can reduce their tax incidence in these funds even further. By investing towards the end of a financial year, and for slightly more than three years, they can get indexation benefit for four years,” said Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor (RIA).

Post-tax returns from domestic equity funds may continue to exceed the posttax return, from international funds even in the future, despite the LTCG tax. Nonetheless, experts suggest that investors who wish to reduce their dependence on the home market should diversify into international funds. “Indian investors should enter markets with which the Indian market has a low correlation, says Raghaw.” The US is one such market. Begin with a 10 per cent exposure to US funds and raise exposure gradually.