Somebody’s pain is Somebody’s gain

Five seconds of Finance Minister’s budget speech has changed the landscape of mutual fund for ever.  It was like a bolt from the blue which has far reaching implications and complications all stake holders - fund houses, investors, companies and distributors.

1. The word Fixed Maturity Plan (FMP) will be found only in the web pages in the next few months. The current lot of investors will tell the future lot the sweet (and effort less) success they has with these plans.
2. While numbers vary but close to a lakh crores will be taken off from the FMPs and a similar amount from the short term funds. The mutual fund (MF) industry which recently touched an AUM size of 10 lakh crores will be offset by more than 20%.  Even assuming a worst case margin of 10 bps, the fund houses cumulatively loose over Rs. 200 crores in profit. Hopefully, the increase in equity book should compensate for this loss.
3. On the positive side, the fund houses will now increase their focus on selling long term solutions diverting the disproportionate efforts spent on liquid, FMP and short term products.
4. Since it is difficult for investors to choose a fund category for three years, the immediately implication could be a rush to Credit opportunity funds. Since the optimal size of such funds is limited, the worry could be that the mutual funds could go deep down the credit risk which could entail greater risk at a later date. They could also lap up any corporate deposit that may hit the market with a pre-tax double digit return.
5. The investors may also move towards Dynamic debt funds with a three year horizon as they are best positioned to maneuver the view on the market. Atleast now, the dynamic funds will be compared with post tax returns from competing products and not the currently existing practice of comparing with income funds when market is good and liquid funds when the market is bad.
6. The interest could increase in Financial planning products. This is because the cost of rebalancing has increased for an investor and there is no cost incurred by these products in rebalancing.
7. Since Arbitrage funds enjoy equity taxation, the dividend plans of these funds will increase in size. Companies and individuals will target these funds for their short term investments. However, the market size for arbitrage is small and hence the scalability of these funds is limited.
8. Due to the reduced participation (or even absence) from the corporate, the expense ratios of short term funds might increase. Until now, the companies were keeping them in check and it will be nearly impossible for the fragmented retail participation to influence them.
9. The distribution fraternity has been massively hit. It started with the global financial crisis in 2008 which put a spanner in their dream run of garnering assets and earning high commissions. In 2009, it was followed by the ban of entry load in MFs and reduced commission in insurance products. In 2013, the direct plans were introduced which took corporate away from distributors. In the mid of 2013 was the event of 15/07 when the RBI increased overnight rates sharply. Just when things were stabilizing 10/07 happened. The finance minister administered a new dose of medicine. The institutional side of the business may have to be restructured further.
10. Mutual Funds’ pain is banks’ gain. The lazy banking will benefit at the cost of FMPs and short term funds. This could result in banks cutting deposit rates and inturn improving their NIMs. Assuming NIM of 2.7% on the two lakh crore that would move out of mutual funds into the banking system, the net interest earned will go up by 4,000 crores adjusted for statutory requirements.
11. The biggest gain is for the government. Assuming an average of 20% tax rate on the two lakh crore that would move out of mutual funds which could yield about 9%, the tax coffers will increase by over 3,600 crores. If we include the tax paid by the banks on additional income, the tax coffers would bloat by over 4,000 crores.

Mr. FM - You just threw out the baby with the bath water

On budget day, Mr.FM has denied the nation the chance to fully utilize (and not exploit) the chance of being prudent debt market investors. The pain point is that he has increased the period considered for long term taxation to three years from one year. Any redemption from debt funds before three years will attract marginal taxation (30% for most investors). There is an increase in tax post indexation which investors can live with.

The reason given is that CBDT showed him the data that supports the view that it is the corporates who benefit from the tax arbitrage present between debt mutual funds and bank fixed deposits. He added that CBDT mentioned that very few individual investors benefit from it. Only a FM who does not have a single rupee in debt funds cannot realize the value of these.

I do not doubt the data analysis of CBDT but wonder why we have such a conclusion. Investors (I am not talking of HNIs living in Mumbai) have never understood debt funds. They have never been properly educated about debt instruments by their financial advisors and wealth managers. So much so that they get immensely confused if they are told that bond yields and bond prices move in opposite direction. Slowly but surely they were getting educated just when Mr. Subba Rao administered the bitter medicine of sharply increasing rates overnight last July. This shock had erased all the learning of the investors instantaneously. Compounding this, there was only a small percentage of people who invested in debt  market as the real rate of return was negative. The savings were channelled into Gold and Real estate.

Just when real interest rates were turning positive (on a consistent basis), did our FM threw out the baby with the bath water - in order to prevent profiting by corporates from tax arbitrage. He has destroyed an important tool available for individual investors to save with lesser risk. He has forced investors to take on vehicles of sub-optimal returns adjusted for risk. Individuals will invest in fixed deposits which give post tax returns of 6.3% if one is lucky, earning less than inflation. The enterprising advisors will convince them to invest (or punt) in equities as the sentiment is up and volatility is low. We will have yet another market where participation from FIIs will be to the brim and the individual investors will be completely absent. In any case, Mr. FM has made sure that the individual investors will never get a chance to learn how to invest in debt markets. Just when the mutual fund and wealth industries were coming out of woods, the blow has been dealt. Since significant chunk of asset size is in debt, the two industries will have to find new ways to plug the hole in their earnings. They have to work even harder to create investor interest in non-equity-non-debt funds like Gold funds (FoFs), Fund of Funds and International funds. Mr.FM! did you have to do it? Do you have to break it before fixing it, Yet again?