Impact of New Capital Gains Tax on PMS Investments of UHNI Investors

The Union Budget for 2024-25 has increased the short term capital gains (STCG) tax rate from 15% to 20% and the long term capital gains (LTCG) tax rate from 10% to 12.5%. Increasing the tax gap from 5% to 7.5% has led to considerable discussion about the challenges of PMS strategies, especially those with high portfolio turnover.

Here we share some data on how taxes play out in different strategies. This analysis assumes an average annual return of 25%, net of fees and expenses, over a 10-year period, consistent with historical averages (PMS market):

Short-term momentum-based PMS strategies were already at a disadvantage due to their frequent churn, and recent tax changes have only exacerbated the issue.

For example, over a 10-year period, a short-term PMS with 100% churn increases an initial ₹1 crore investment to ₹6.19 crore under the new tax regime, a reduction of ₹ 6.87 crore under the old regime. 67.6 lakhs (10%).

In contrast, the impact of increased taxes on long-term PMS strategies is almost negligible. By deferring the tax till the final year, the compounding effect can be fully achieved.

Under the new tax regime, the long-term PMS approach increases the same investment of ₹1 crore to ₹8.27 crore, a drop of only ₹20.8 lakh (2.5%) as compared to ₹8.48 crore under the old regime.

This shows that long-term PMS strategies with negligible churn not only avoid the impact of higher taxes but also provide 33% better returns compared to short-term approaches.

Assuming a 25% rate of return, short-term strategies see their after-tax IRRs drop to 20% over 10 years, while long-term strategies maintain a high IRR of around 23.5%.

There is also ongoing debate about the perceived inefficiency of PMS compared to mutual funds under the new tax regime, mainly because mutual fund investors are not taxed on portfolio churn, while PMS investors are.

However, when evaluating long-term investments, PMS platforms can provide returns comparable to or even higher than mutual funds.

As shown in the table above, an apples-to-apples comparison suggests that both long-term approach PMS and mutual funds face a 12.5% ​​tax on exit. Additionally, a study by PMS Market found that PMS approaches outperformed their benchmarks by an average of 70% over 5 and 10 years, compared to 48% for mutual funds. This suggests that with a disciplined, long-term approach, PMS fund managers can match or exceed the performance of mutual funds, effectively neutralizing their tax efficiency advantage.

The proof of the pudding is in the eating. At Equity Capital, we practice extremely long-term investing with a typical holding period of 5-7 years outlook. This has helped us effectively minimize the tax impact on returns for our investors.

For example, an investor who started three years ago experienced only a 0.5% difference between pre-tax and post-tax returns.

As of the end of July, this investor’s portfolio shows a pre-tax IRR of 44.14% and an after-tax IRR of 43.57%, showing the consistency and strength of the long-term approach despite tax changes.

In conclusion, adopting a long-term investment approach is key to maximizing returns, harnessing the full potential of compounding and avoiding the impact of higher tax rates. PMS strategies optimize by offering customized portfolios, enhanced investor communication and greater transparency.

We expect investors to increasingly favor long-term PMS solutions for their potential to generate significant alpha relative to mutual funds.

(The author is co-founder of Equity Capital)

(disclaimer: Recommendations, suggestions, opinions and views given by experts are their own. (These do not represent the views of The Economic Times)