Taxation Impact on Portfolios - Part 2: Mutual Funds vs Direct Equity

Welcome to the second installment in our series ‘Taxation Impact on Portfolios’. You can catch up on Part 1 here. In that post, we discussed why taxation is a critical, but often overlooked, component of net investment returns (post fees, post taxes). Today, we turn our attention to the most common vehicles for equity investing in India: Mutual Funds (MFs) and Direct Equity (which includes PMS, Smallcases, and DIY stock portfolios).

Now, choosing between MFs and Direct Equity depends on several factors: fees, strategy, flexibility, regulation, and so on. But for this discussion, we will strip away everything else and focus solely on the tax impact, assuming all else is equal.

Understanding the Types of Gains

From a taxation standpoint, equity investments primarily generate two types of income:

1. Dividends - A share of company profits distributed to investors.

2. Capital Gains - The profit(loss) from selling securities at a higher(lower) price than the purchase price.

How Are These Taxed?

• Dividends are taxed at the investor's slab rate, which we assume to be 30% for this analysis.

• Capital Gains are taxed based on the holding period:

  • Short-Term Capital Gains (STCG): Taxed at 20% for securities held <1 year.

  • Long-Term Capital Gains (LTCG): Taxed at 12.5% for securities held ≥1 year.

We’ll also ignore surcharges and cess to simplify comparisons.

Taxation of Direct Equity (PMS, Smallcase, DIY)

When you invest directly - whether it's via a Portfolio Management Service (PMS), a basket of securities (e.g., Smallcase), or managing your own stocks - the investments are held in your name. That means:

• Dividends are taxed at 30% as they are received.

• Capital gains are taxed in the year they are realized, based on the holding period.

• You pay taxes annually on gains and dividends.

Taxation of Mutual Funds

Mutual Funds benefit from structural tax advantages:

• Dividends are reinvested in the fund’s NAV, so investors don’t pay annual taxes on them.

• Gains realized within the fund are not taxed. Only the NAV increase is taxed when the investor redeems the units.

• Fund management fee is tax-deductible within the NAV.

This leads to significant tax deferral and compounding advantages:

• Dividends are effectively taxed at 12.5% (LTCG) instead of 30%.

• Short-term churn inside the MF becomes part of LTCG for the investor.

• LTCG is only taxed on exit, allowing longer compounding.

A Head-to-Head Comparison

Let’s consider a hypothetical scenario to make this tangible:

• Dividend yield: 1%

• Holding period: 7 years

• Investor tax bracket: 30%

• Short-term churn: 20% annually

• Long-term churn: 10% annually

• Annual return (net of fee): 20%

• Same churn and return assumptions for both PMS and MF

Direct Equity (PMS/Smallcase)

• Returns over 7 years: 3.016x

• CAGR: 17.08%

• Taxes are paid annually - the largest tax outgo is during the final year (withdrawal), but you can see the tax leakage every year in red.

Mutual Funds

• Returns over 7 years: 3.26x

• CAGR: 18.39%

• Taxes are only paid at the time of redemption.

The difference in CAGR—over 1.3% annually—comes purely from tax deferral and lower effective tax rates in the MF structure as shown in the graph below.

What Does This Mean?

All else being equal, the same equity strategy run as a Mutual Fund delivers better post-tax returns than Direct Equity. The tax advantage is significant enough that even high-performing PMSs may struggle to bridge the gap unless they consistently outperform by at least 1.5% annually - a tough ask.

It’s no surprise then that several successful PMS managers have launched their own mutual funds in recent years - Old Bridge, Helios, White Oak, CapitalMind among others.

So, Should You Switch Completely to MFs?

Not so fast.

While Mutual Funds offer a tax edge, they may not always align with every strategy or every investor's needs or preferences.

In a future post, we’ll explore the pros and cons beyond taxation. Stay tuned!

Let us know your thoughts or questions in the comments. If you’re evaluating investment structures for your portfolio, you can write to contact@wealthbeacn.ai - we’re happy to help break down the numbers for your specific situation.