Can PPFAS lure investors with its tax-efficient ‘debt’ fund?

livemint.com:

The new year has seen the launch of several new fund offers catering to the growing interest of mutual fund investors. Parag Parikh Mutual Fund is launching a new ‘debt’ fund on 20 February: And its novelty: The fund will use a tax-efficient structure such that long term capital gains in it will be taxed at 20% with indexation. The fund’s new structure is aligned with an announcement in the 2023 Union budget.

Finance minister Nirmala Sitharaman had then made debt mutual funds taxable at slab rate, regardless of the holding period. That was a shocker for India’s mutual fund industry. Historically, debt mutual funds had enjoyed a lower rate of long term capital gains (LTCG) tax—20% with indexation if held for three years or more.

However, Sitharaman defined debt mutual funds as those with equity less than 35% of assets. According to the new tax rules, hybrid funds with equity between 35% and 65% of assets will continue to enjoy the old favourable tax rates for debt funds. They also allowed asset management companies (AMCs) like PPFAS to contemplate a new design—debt funds with 35% equity but using derivatives to bring it down further and make it truly debt-like.

Within the universe of hybrid funds, there already exist some categories that have fairly low equity exposure. First, let’s take dynamic asset allocation or balanced advantage funds (BAFs) in general. These funds generally keep 65% gross exposure in equity, allowing them the benefit of equity taxation (10% LTCG after one year).

Their net equity exposure (after hedging) can vary enormously from fund to fund. In the current environment, most large BAFs have brought it to the 30-50% range. However, the massive use of arbitrage in these funds creates a drag on this