What if I told you that even earning 0.75% to 1% higher returns for 10 straight years may still leave you poorer? Yes, you read it right. The real enemy is not lower returns - it is breaking tax compounding and creating a hidden Hurdle Rate for your investments.
Background
Many investors feel proud when they identify a “better” mutual fund and switch. After all, improving returns from 15% to 15.75% sounds like smart portfolio management. But investing is not just about chasing slightly higher returns. It is about preserving the power of uninterrupted compounding.
When you switch:
- You trigger taxation.
- You reduce capital.
- You reset the compounding engine.
- Over long periods, this break in compounding can silently destroy wealth - even when the new fund performs better.
To understand this properly, let us build a clean 20-year example.
Assumptions for our Example
Below are the assumptions that we will use in our example and why each one matters.
1. Initial Investment: ₹10,00,000
We use ₹10 lakh as a realistic middle-class long-term equity investment amount. The impact becomes even larger at ₹50 lakh or ₹1 crore.
2. Total Investment Horizon: 20 Years
Twenty years allows compounding to meaningfully express itself. Shorter periods may not fully reveal the tax-compounding damage.
3. Fund A Return: 15% Per Annum
We assume a strong long-term equity return. This ensures the example is not biased toward low-return scenarios. Higher returns actually increase embedded gains - and therefore increase the tax impact when switching.
4. Switch After 10 Years
We assume switching halfway through the journey. By Year 10, substantial gains have accumulated - meaning the tax triggered will be meaningful. Switching later increases the tax shock.
5. Fund B Return: 15.75% (0.75% Higher)
We assume sustained outperformance of 0.75% per year for 10 full years. This is generous. In reality, such consistent outperformance is rare. The purpose is to test whether even meaningful excess return can overcome tax compounding loss.
6. Long-Term Capital Gains (LTCG): 12.5%
We use the current LTCG rate on equity mutual funds in India. Switching is treated as redemption - so tax becomes unavoidable.
7. STT + Execution Impact: ~0.2%
Even if there is no exit load after long holding periods, there are always frictional costs like Securities Transaction Tax (STT), NAV slippage, and execution inefficiencies. These are small but real. Investing friction matters over long horizons.
8. No Behavioral Errors Assumed
We assume perfect timing, no panic selling, no additional switching. This makes the example conservative and fair. Real-life outcomes are usually worse for the switcher.
Why These Assumptions Matter
This example is intentionally structured to be fair to the switching investor:
- High base return (15%)
- Meaningful outperformance (0.75%)
- No exit load
- Only one switch
- No behavioral mistakes
Yet, even under these favorable conditions, let us see where the switcher ends up.
Example
Step 1: Investor A (No Switch, 15% for 20 Years)
Future Value: ₹10,00,000 × (1.15) ^ 20 ≈ ₹1,63,66,537
Capital Gain: ₹1,53,66,537
LTCG @12.5%: ₹19,20,817
Final Post-Tax Corpus: ₹1,44,45,720
This is our benchmark.
Step 2: Investor B (Switch After 10 Years)
First 10 Years at 15%
Future Value: ₹10,00,000 × (1.15) ^ 10 ≈ ₹40,45,557
Capital Gain: ₹30,45,557
LTCG @12.5%: ₹3,80,695
Other Costs (0.2%) ≈ ₹8,091
Total Leakage at Year 10: ₹3,88,786
Amount that can be reinvested: ₹40,45,557 – ₹3,88,786 = ₹36,56,771
Nearly ₹3.9 lakh permanently leaves any future compounding.
Next 10 Years at 15.75%
Now ₹36,56,771 grows at 15.75% for 10 years.
Future Value: ₹36,56,771 x (1.1575) ^ ≈ ₹1,57,60,000
Capital Gain (post switch): ₹1,21,03,229
LTCG @12.5%: ₹15,12,904
Final Post-Tax Corpus: ₹1,57,60,000 – ₹15,12,904 = ₹1,42,47,096
Final Comparison of In Hand Corpus
Investor A (15% steady): ₹1,44,45,720
Investor B (15% → 15.75%): ₹1,42,47,096
Difference: Investor B ends up ₹1,98,624 lower
So, even with a strong starting return of 15% and a meaningful 0.75% outperformance sustained for 10 full years (every single year - very rare), Investor A still wins.
The switcher still ends up poorer by roughly ₹2 lakh.
Hurdle Rate of Switching (also called 'loss of Tax Compounding')
When you switch after 10 years, you are not starting from zero. You are disturbing a machine that has already compounded for a decade.
The portfolio had grown from ₹10 lakh to over ₹40 lakh. The embedded gain was more than ₹30 lakh. The tax paid at switching was nearly ₹3.8 lakh.
That ₹3.8 lakh did not just “go away.” It stopped compounding.
Had it remained invested at 15% for the remaining 10 years, it would have grown to roughly ₹15–16 lakh.
This is the invisible loss.
So, when you switch, the new fund is not just competing against 15%. It is competing against 15% return + the lost compounding on ₹3.8 lakh + frictional costs + a lower reinvestment base.
That means the new fund must deliver significantly higher returns - and sustain them for a full decade - just to catch up.
In our example:
- 0.5% extra return was not enough
- 0.75% extra return is still not enough
- 1% extra return may barely compensate.
Think about what that means. You would need close to 1% annual outperformance for 10 consecutive years to justify one single switch.
In mutual fund investing, sustained 1% alpha for a decade is rare. Very rare.
Look at the chart below for reference. This shows the returns of the most popular flexi cap funds in India.
Notice in the chart how the 10-year returns of leading flexi cap funds are tightly clustered between ~16.8% and ~18.8%. The difference between most funds is well under 1% per annum. And importantly, the leadership keeps changing across different time periods - making it impossible to predict the future winners.
Top-ranked funds rotate over time; ranking one period doesn’t guarantee ranking the next. Even when long-term leaders exist, the performance gap is rarely as large or predictable as the 0.75% excess return you’d need - consistent outperformance is rare. Chasing “highest return last year” often leads to buying high and potentially switching again later.
The Realization
Every time you switch a long-held investment, you create a hurdle rate. The longer you have stayed invested, the higher that hurdle becomes. Compounding builds a moat around your capital. Taxes punch a hole in that moat. And once punctured, you must run faster just to stand still.
It could have been far worse if:
- There was an exit load applicable (check your funds for an exit load) [Read this blogpost: Mutual Funds and their hidden costs]
- Tax was STCG instead of LTCG (if switched within a year of investing)
- More returns were made before the switch than after the switch - leading to higher taxes, thus more loss of tax compounding and thus needing a higher hurdle rate just to break even. This is highly likely in a changing market scenario where first 10 years market returns can be higher than the next 10-year market returns)
- Taxes go up from 12.5% (likely looking at the past trends)
Switching makes sense if:
- Moving from Regular to Direct Funds (because you are guaranteed a return rate improvement of more than 1-1.25% every single year consistently after the switch. [Watch this Video: Never get casual about staying in Regular Mutual Funds] [Read this Blogpost: Switching from Regular to Direct Funds - Breakeven Point]
- Executing Tax Harvesting in a Financial Year (since 1.25 lacs of gains are tax exempt) [Watch this Video: Tax Harvesting]
- Your current gains are too small or negative, thus no taxes being applicable, and hence compounding is not lost to taxes, and hurdle rate is almost 0.
Have a case to switch? Ensure that:
- When comparing returns, compare always the XIRR returns and not absolute or CAGR returns. [Read this Blogpost: CAGR vs IRR vs XIRR Methods]
- Compare the funds in precisely the same category. Do not compare the returns of a Flexi Cap with a Multi Cap or a Global Fund with a US based international fund.
- Since the switch is likely to be a movement of funds from equity to equity, the switch must be instantaneous and lumpsum (No SIPs, no waiting) [Read this book: FOOPS!]
The Practical Takeaway
Before switching a long-term mutual fund, ask yourself:
- Is the expected outperformance meaningful?
- Is it sustainable for 10+ years?
- Is it large enough to overcome the tax shock?
If the answer is uncertain, patience is usually the wiser strategy.
Official Website | Elite Program | Elevate Newsletter | My Amazon Book Store
No comments:
Post a Comment