Taxes eating into your investment returns?

After costs, taxes affect your investments the most. Not taxsaving strategies, but the capital gains tax that you pay on your investments. Most investors, however, are unaware of this and do not include tax costs as part of evaluating an investment strategy.

Our tax laws accounts for two kinds of capital gains taxes for equity investments. If you hold an equity investment for less than one year you are liable to pay 15 per cent taxes on any gains. This is called Short Term Capital Gains tax (STCG). If you hold an equity investment for more than one year then you are liable to pay 10 per cent taxes on any gains. This is called Long Term Capital Gains tax (LTCG). Additionally, up to Rs One lakh of LTCG are tax-free in any given financial year, which amounts to up to Rs 10,000 in LTCG tax savings. Finally, not all investment options are created equal. When a Mutual Fund, index or active, trades in stocks to rebalance its portfolio it creates no-tax incidence on a fund unit investor. If an individual investor does the same trades to rebalance their stock portfolio, either under a thematic basket or PMS or just trading account then they will have to pay STCG or LTCG taxes as per the holding period. In short Mutual Fund rebalancing is tax advantaged.

Given this context, lets look at three different equity investment strategies over a 20-year time horizon. The first strategy simply buys and holds an equity index. Let’s assume that this simple strategy will get us 12 per cent p.a returns. After 20 years, when we redeem from this strategy, we pay the 10 per cent LTCG tax on all accrued gains in one go.

The second strategy is a little adventurous. It tries and times funds or stocks that will do well and rebalances after one year to avoid the higher 15 per cent

STCG tax rate. Essentially this strategy pays the 10 per cent LTCG tax every year. If the second strategy also has 12 per cent p.a returns then which one will do better over 20 years? After all, how does it matter if you pay 10 per cent LTCG tax once after 20 years of compounding or 10 per cent LTCG tax every year for 20 years if the rate of compounding (12 per cent p.a) is the same?

As it turns out it matters a lot. The first strategy is getting tax-free compounding and it makes a big impact. Just churning your portfolio every year to chase the newest shiniest stocks or funds will dock your returns by 1-1.5 per cent p.a by creating a LTCG tax liability every year. Your annual fund selection strategy should create a 1-1.5 per cent alpha just to break even with a simple index investment strategy after taxes.

Strategy three is even more ambitious. It is a thematic basket strategy of stocks and churns multiple times a year — essentially paying the full 15 per cent STCG taxes on all gains. Such a strategy will have to generate a 2-2.5 per cent excess returns every single year just to break even with a simple index buy and hold strategy on a post tax basis. While many thematic and PMS fund managers will claim 2.5 per cent excess returns or more based on dubious backtests or other claims, I will leave you with a simple fact. In the long history of global stock investments, only a handful of investors and funds have generated 2.5 per cent or more excess returns over a 20-year time period.

Not churning your stock or mutual fund portfolio has a bigger impact. If you want to invest in a high churn strategy pick a mutual fund to invest in it. Second, be aware that the bar for a strategy that churns is much higher than a simple index buy-andhold strategy. As a rule of thumb, the high churn strategy should give you 2-2.5 per cent excess returns per year to be equivalent to a simple buy and hold strategy post taxes.

(Gaurav Rastogi is the Founder & CEO of Kuvera.in, a free direct mutual fund investing platform)