Entry Fee of Funds in UK

This article in financial times talks about fund are using entry load fee to exploit naive investors and also how UK regulator is looking into the issue. As the article has noted India is ahead of Europe in this issue. Indian regulator SEBI has banned entry load of mutual funds in 2009. I have mentioned this fact in my blog earlier here.

An interesting difference I found in this article between India and UK is that Indian investors are charged less if they directly buy from the fund (direct option) while it is reverse in UK. This doesn’t make sense because if the investor directly approaches the asset management company(AMC),  AMC doesn’t have to pay any amount to the intermediary and they should pass on this benefits to the investor. But it seems European AMCs prefer having investors coming through regular channels.

I think I am missing something in the whole issue. The article does note that the investors directly approaching the AMC will increase costs over the regular channels like exchange but I am still not convinced that the costs increase to that extent. because of the cost structure the investors who are approaching the AMC directly can be considered as naive investors. This is exactly opposite in India. Investors directly investing with the fund management company are considered intelligent!! In fact SEBI has been bringing several new regulations into effect to ensure that investors directly approach AMC rather than regular channels.


Wash sale in Mutual funds

An old article in Forbes on Wash sales in mutual funds. In US you cannot claim a short term loss on a security if you buy the security within +/- 30 days of selling the security. This article explains this concept and how to overcome it. As far as India is concerned I haven’t come across any such rule. Though in India if you buy a mutual fund just before ex-dividend date and sell it immediately afterwards then you cannot claim capital loss on it. This is to ensure that investors do not use this mechanism to avoid taxes on their capital gains as dividends of equity mutual funds do not attract tax.

Taxation of Mutual funds

Investment Company Institute (ICI) has a very good FAQ section on taxation of Mutual funds. Especially the last question on how timing of buying mutual funds can affect the amount of taxes one pays. Essentially what it says is that the distribution of returns by the funds affects the timing of taxes you pay but the amount of tax one pays is not affected by when you buy or when the profits are distributed. In a world where there is no concept of time value of money, timing of distribution of profits by MFs do not affect your profits otherwise they might.

“Is it true that mutual fund shareholders have to pay “someone else’s taxes” if they buy fund shares at a certain time? 

No—fund shareholders do not pay someone else’s taxes. Every fund shareholder is taxed only on his or her own economic income over the life of the investment.

Shareholders purchase and sell a fund at the fund’s net asset value (NAV), which is calculated daily. A fund accumulates realized and unrealized capital gains, interest, and dividends until it makes distributions. These gains and income increase the fund’s NAV until they are distributed. A fund distribution reduces the fund’s NAV; thus, amounts that are distributed reduce the gain (or increase the loss) that a shareholder realizes when fund shares later are sold.

Assume an investor purchases fund shares on Monday for $10 per share. The fund distributes a $1 capital gains dividend (attributable to previously realized gains accrued in the fund’s NAV) on Tuesday. The $1 distribution reduces the fund’s NAV to $9. If the investor sells the fund shares on Wednesday for $9, the investor will have no gain or loss.

  • No economic gain or loss: The investor purchased the fund for $10, and received a $1 distribution and $9 upon the sale of the shares. Thus, the investor paid $10 and received $10, for no net gain or loss. 
  • No taxable gain or loss: The $1 of capital gains distributed (on which tax would be due) is offset fully by the $1 loss realized when the shares purchased for $10 are sold for $9. Thus, the investor has no taxable gain or loss.

For a more detailed illustration, consider the following two scenarios:

Scenario 1: Assume that Investor A bought 100 shares of a fund for $10 a share. The shares rose in value to $20. Investor A then sells her shares, and owes taxes on $1,000—the capital gain of $10 a share times 100 shares. Investor B buys 100 shares at the fund’s new NAV of $20 a share, which includes the embedded gains. If the shares rise to $30 a share, and Investor B sells his shares, he would owe taxes on $1,000—the capital gain of $10 a share, times 100 shares. In other words, Investor A owes taxes on the $10 gain accrued while she owned the fund, and Investor B owes taxes on the $10 gain accrued while he is invested. Each shareholder is paying for his or her own gains earned.

Scenario 2: Now assume this same set of transactions occurs, except that the fund distributes its $10 accrued gain on the day after Investor B bought his shares at $20. Investor A still owes taxes on $1,000—the $10 gain on her shares, bought at $10 and sold at $20, times 100 shares. Investor B must now pay taxes on $1,000—the $10 per-share distribution, times 100 shares. The distribution reduces the fund’s NAV to $10. If Investor B pays the taxes from other assets and reinvests the full amount of the $1,000 distribution, he will now own 200 shares. The first 100 shares were purchased at $20 a share, while the second 100 were purchased at $10 a share. Investor B’s average cost basis for tax purposes is $15 a share.

The shares then rise by 50 percent, as in Scenario 1, to a new value of $15 a share. When investor B sells his 200 shares at $15 a share, for tax purposes he is treated as having purchased all those shares at his average cost basis of $15 per share. Thus, he has no new tax liability because he has already paid taxes on his own gain.

Is Investor B paying Investor A’s taxes when he pays taxes on the $1,000 distribution? No. Investor A paid her own taxes on the $1,000 gain when she sold shares at $20 with a cost basis of $10; she delayed paying taxes until she sold. Investor B paid taxes on the $1,000 distribution up front, but owed no additional taxes when he sold his shares with the same price ($15) as his cost basis. Thus, he pays taxes only on the $1,000 that he earned while he owned the shares.

Compared to other forms of investments, the only issue with a mutual fund is the timing of the taxes paid, not the amount of taxes paid. Taxes may be paid sooner (if gains accrued before purchase are realized and distributed) or later (if losses accrued before purchase offset realized gains), but total taxes paid will be the same.”

Here is another article in Forbes on taxation of mutual funds. In India the tax rules are very simple.The amount of taxes an individual pays is only dependent on amount of time he invests his money in the fund and not on the amount of time the fund holds its assets. This article and this article explain the taxes one has to pay at individual level in India. However this means people can game the system. If I have a strategy which entails high turnover it would make sense for me to float a mutual fund and invest the my money through mutual fund. This way I will avoid short term capital gains tax and pay long term capital gains tax  which is generally less than the former.


Switching securities b/w schemes in Mutual Funds

Similar to my last post where the post talk about ‘River crossing’ in Mutual fund industry, this article talks about MFs transferring debt securities from Fund to other Fund for liquidity reasons.

“There were 4,745 such transactions, called inter-scheme transfers, in fiscal 2016, the second highest since the financial crisis. These totaledRs.93,931 crore or 11.42% of debt assets under management.

Why is this important?

First, because FY2016 saw a record Rs.3.8 trillion of corporate debt downgrades, according to rating agency Crisil Ltd. Three fund managers that Mint spoke to said that transfer of papers from one scheme to another to tide over credit quality issues is the likely cause of the spike in inter-scheme transfers.

Dhirendra Kumar, chief executive officer of fund tracker Value Research said that it could also have been to meet liquidity requirements as investors switched between funds in line with a change in expectations of where interest rates would go, but added that turbulence in credit opportunity funds is also one of the likely reasons.

Second, the problem with inter-scheme transfers—as opposed to the fund house selling debt in the open market—is that there is some elbow room on the valuation of such securities since both the buyer and the seller are the same fund house. Fund houses were found guilty of using the route to transfer losses from one scheme to another in 2011 and investors had to be compensated for the losses they suffered as a result.

Capital market regulator Securities and Exchange Board of India (Sebi) said earlier in the year that it has noticed fresh irregularities.

“In some instances, we have also found that valuations and inter-scheme transfers are not exactly according to the Sebi requirements…I want you to note…that we are watching,” Sebi chairman U.K. Sinha said at a mutual fund summit organized by lobby group Confederation of Indian Industry in July 2015.

For mutual fund houses, it sometimes makes sense to switch papers between schemes rather than sell in the open market because they can save on transaction costs such as brokerage. It particularly helps if a debt security is difficult to sell in the market because of liquidity issues; it can simply be transferred to another scheme which has surplus cash and can invest in such securities. Globally, regulators frown on inter-scheme transfers, but the practice has just carried on in India.

“Inter-scheme transfer is not normally considered positive…(though)…it reduces the cost,” said Ramanathan Krishnamoorthy, chief executive officer at Spectrum Wealth Solutions, a boutique wealth management firm.

The last time there was such a spike in inter-scheme transfers was in fiscal 2011 (note that Sebi started collating data only since 2009). Then, a possible reason could have been a change in valuation rules. Sebi had then said that mutual funds must value securities which mature in over 91 days on a mark-to-market basis.

Earlier, the fund house had some discretion in terms of the price they valued the security at in their portfolio. Mark-to-market means that such securities would have to be valued based on their market value, making them more volatile.

Fund managers whose portfolios were hit by the rule change then could have resorted to inter-scheme transfers, said two fund managers, who declined to be named because of the sensitivity of the issue.

Now, with inter-scheme transfers spiking again, the regulator is contemplating action against malpractices in inter-scheme transfers. The Economic Times reported in February that Sebi was looking into it, particularly in the wake of credit-rating downgrades in Jindal Steel and Power Ltd’s debt securities.”

“River Crossing” in Mutual Funds

This economic times article talks about “river crossing” in mutual funds.

“River crossing, or parking or holding period return, is a rampant practice, which takes place mostly at the financial year end when mutual funds connect with cash-rich entities to tide over redemption pressure. Regulators normally consider the practice imprudent since it raises investor risk.”

“This time the redemption pressure was somewhat higher in the middle of the year, triggered by the Amtek Auto fiasco

In September, CD rates had spiked about 25 basis points across maturities as banks aggressively raised money to shore up their deposits ahead of quarterly earnings. But, this time, the rates slid following RBI’s borrowing cost reduction exceeding estimates.

At the same time, mutual funds, the biggest buyer of CDs, face redemption pressure in their liquid and ultra short-term funds as lenders want to avoid setting aside any extra capital for MF exposure to maintain a good capital adequacy ratio.

At this point, some intermediaries or brokers connect with a few cash-rich entities, be it corporates or bankers, which extend funding support to MFs by temporarily buying CDs at higher rate than normal.

Beginning next quarter (October), those financial entities sold back CDs to MFs at a predetermined price. The price is calculated in such a manner that the financing institute gains 10-20% annualised return for 5-10 days.

For instance, state-owned Syndicate Bank’s CD maturing mid-December has been traded at a high of 7.61% against a normal rate of 7.05% on October 1, said two market sources. On October 5, Andhra Bank and Axis Bank CDs yielded 7.63% each with both maturing in November-end.

“It is unwise for mutual funds to participate in this practice,” said Dhirendra Kumar, CEO of mutual fund portal Value Research. “The gains are few and if something goes wrong, the potential damage to reputation is immense. Showing higher asset for a few days can hardly be a big achievement.”

“Such practices could chip away at investor confidence just at a time when they have started reposing faith on the industry,” he said.

Selling and buyback of CDs at pre-determined rates are prohibited if reversal of trades are happening in the secondary at unusual rates,,” said a treasury head of a large bank.”

Simplification of Mutual Fund Plans

According to these article [1] , [2]  on Value Research SEBI is planning to ask the Mutual funds to simplify their plans and broadly categorize them into a small number of objectives. There are both pro and cons of this.

On the pro side it will help the investor by making different offering comparable. This will lead to increase in competition among Mutual Funds and improve their performance. On the other hand it can curb innovation. For example as discussed in this article Asset Management Companies (AMCs) are introducing funds which names having words like child care etc. These funds by invoking investor sentiment of children etc are trying to reduce the sensitivity of fund inflow to market conditions. Ultimately it is beneficial to both retail customers and the funds.

If the new regulation requires Mutual funds to not have more than one or two products in a given category then we might not see such innovations in future.

Side Pocket in Indian Mutual Fund Industry

This article says that SEBI is reluctant to provide rules for creation of side pockets.

“A side pocket is used by fund managers to separate stressed or risky assets from other investments and cash holdings. Fund houses create side pockets to ensure that while a proportion of investor money (in the scheme) linked to stressed assets gets locked until the fund recovers dues from a stressed company, investors are free to redeem the rest of their money if they choose to.”

The rational is that allowing isolation of risky assets from the rest fund would encourage fund managers to to take on more risk.

“Sebi is of the view that mandating the creation of a side pocket, to minimize the redemption pressure on the entire fund arising from their exposure to any particular company, could lead to some fund managers taking unnecessary risks,” said the chief executive officer of a large fund house, requesting anonymity. ”

However lack of rules can also lead to chaos and confusion among the mutual fund managers. Recently when Amtek Auto was downgraded JP Morgan had restricted redemption of Mutual Fund units and created a side pocket to isolate Amtek Auto from the rest of the portfolio.