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Business News/ Companies / What’s the secret behind JM fund’s resounding success?
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What’s the secret behind JM fund’s resounding success?

Great going for a fund house with total asset size of Rs6,700 crore. Great marketing or innovative use of tax loophole?

JM Arbitrage Advantage Fund’s resounding success helped increase assets under management at the fund house by more than 80% and left market participants wonder-struck at the gush of money into just one fund. Photo:Premium
JM Arbitrage Advantage Fund’s resounding success helped increase assets under management at the fund house by more than 80% and left market participants wonder-struck at the gush of money into just one fund. Photo:

Mumbai: JM Arbitrage Advantage Fund collected more than half the net 10,800 crore that flooded into equity funds in July, possibly leveraging a tax benefit that became even more attractive after Union budget 2014-15 reduced the tax-saving appeal of debt mutual funds.

JM Arbitrage Advantage Fund, a scheme offered by JM Financial Asset Management Ltd, collected 5,500 crore of net inflows (inflows minus outflow) last month, according to data on the asset management company’s (AMC’s) website.

The fund’s resounding success helped increase assets under management at the fund house by more than 80% and left market participants wonder-struck at the gush of money into just one fund.

The wall of money would not have perhaps raised eyebrows but for the fact that total assets under management at the end of June for the scheme was just 157 crore, and the average quarterly assets under management, 199 crore. Indeed, the total average quarterly assets managed by JM Financial Mutual Fund as a whole, with 17 schemes under its umbrella, was 6,700 crore in June.

The total assets of all the 13 arbitrage funds in India was only 4,600 crore at the end of June 2014. So, what explains JM Arbitrage Advantage’s appeal? 

JM Financial Asset Management Co.’s chief executive officer Bhanu Katoch said the fund house had been promoting the fund for a very long time.

“It was the first arbitrage fund in the industry and interest in the fund has grown post the taxation changes for debt funds announced in the budget," he said.

An arbitrage fund is technically an equity-oriented fund. However, rather than investing only in equity stocks in the cash market, arbitrage funds’ objective is to take advantage of price differentials between the cash and the derivatives market. Some arbitrage funds also take naked exposure in equity over and above the pure arbitrage play.

The second part of Katoch’s answer may well hold the key to JM Arbitrage Advantage’s sudden popularity.

Union budget 2014 raised long-term capital tax on all debt funds to 20%. Earlier, withdrawal from debt funds attracted a long-term capital gains tax of either 10% (without indexation) or 20% (with indexation). The intention was to iron out the tax arbitrage between investing in banking instruments and other fixed-income products versus investing in debt mutual funds.

As existing debt fund investors began looking for an alternative, JM Arbitrage Advantage seems to have presented itself, holding forth (informally) the promise of a tax-benefit known as bonus stripping.

Mint has seen the sheets used by advisors to sell the scheme (and provided by the AMC), albeit minus its logo.

Katoch denied that the scheme was going to indulge in bonus stripping.

“The scheme has collected funds for bonus stripping. While this is not new and happens across schemes in the industry, the difference now is the amount collected," said the CEO of another AMC that also runs an arbitrage fund and spoke on the condition on anonymity.

Bonus stripping refers to the practice of investors buying units of a mutual fund with the purpose of participating in a bonus issue, which allows them to book losses on the original value invested and then subsequently set it off against gains from other sources.

“So far, bonus stripping was a practice popular in fixed income funds, but arbitrage funds also indulge in this," said Manoj Nagpal, chief executive officer, Outlook Asia Capital. “The reason JM Arbitrage Advantage Fund is getting talked about in this context is the quantum of money it collected."

This is how it works: suppose you know that the fund you are buying into will be announcing a bonus in three months and you buy 100 units at a price (net asset value or NAV is the price per unit of a mutual fund) of 20. The bonus is announced in three months and the NAV falls to the extent of the bonus paid out.

Suppose this is 85% bonus, you get 85 bonus units at no cost and now have 185 units of the same fund. The NAV falls to 10.81 from 20 (100/185 * 20) . You now sell the original 100 units immediately at a loss of 9.19 per unit (the total for 100 units is 919).

This loss can be used to set off against gains from other assets, and you save on capital gains tax. At the same time, you keep the bonus units invested for another nine months and sell a year after you bought the original units. Because this is an equity scheme, the long-term capital gains tax is zero if you hold the investment for a year, so you pay no tax on the sale of the bonus units.

Why don’t all equity funds do this to attract high networth individuals (HNIs)?

Two reasons. First, because HNIs were getting this advantage on their debt funds, where this practice was called dividend stripping.

But after the changes made by the Union budget for debt funds, this is no longer a viable proposition. Second, other equity funds don’t do this because of the risk of capital erosion in the fund if markets fall. By their very nature, arbitrage funds are relatively low-risk while still sitting in the equity basket.

Market regulator Securities and Exchange Board of India (Sebi) frowns on fund houses making selective disclosures on bonuses and dividends. As a result, such disclosures are usually communicated directly, verbally, and informally to companies and HNIs investing in the scheme.

According to a senior executive of a foreign private bank, who asked not to be named, in the context of JM Arbitrage Advantage, “there has been some selective disclosure of a bonus announcement to the tune of around 85% to be done in October. It’s not just companies that are investing in this but also high networth individuals".

Katoch denied this. “People talk, and I am not sure why there is such talk going around," he said.

The fund house modified the structure of the fund in June 2014 by adding a bonus plan to the scheme and effected a further modification in July 2014 when it added an annual bonus plan. To be eligible for bonus units, an investor has to be invested in the fund at least three months prior to the bonus being announced and up to nine months after, making it a total of 12 months.

According to people in the mutual fund industry, JM Arbitrage Advantage Fund plans to declare a bonus of 85% at the end of October 2014. Katoch did not confirm this development. If this is the case, investors can earn a return of up to 35% on their investment for the financial year 2014-15. Product details available with Mint show the calculations that indicate this return. (see table)

“A bulk of the money getting invested in this scheme is through leverage against the units bought. If they are expecting a huge tax incidence on gains, they can take leverage and use the losses on this to set off against that gain," said the senior executive at the foreign private bank quoted above. Leverage can enhance returns to a much higher degree, as the interest cost can effectively be covered by the return from the product itself.

According to chartered accountant Gautam Nayak, “short-term capital losses can be set off against short-term capital gains from other assets as well."

To be sure, what JM has done is entirely legal, but it does appear to be on the borderline of regulatory acceptance.

Given the recent rally in equity markets that has pushed up the Sensex by 20.54% since the start of the year, the market has seen a lot of short-term gains and that may be one reason why the appeal for the product is high. Technically, this can still be done with fixed income schemes, but it has become more lucrative now to have an underlying equity scheme, as the taxation impact is lower.

“As long as investors are in the fund three months before the bonus announcement and nine months after, they are eligible for the bonus units," Nayak said. “The problem arises if there is selective disclosure in advance, which is not in the spirit of things.

The bigger concern, the AMC CEO quoted above said, “is that such practices over a period of time will be copied by others and lead to unhealthy competition and squeezing of margins in the industry".

Indeed, some other fund houses, too, have added bonus options to a handful of schemes in July and August. ICICI Prudential Asset Management Co. announced the introduction of bonus plans in a number of its fixed income schemes, and also its arbitrage scheme, ICICI Prudential Equity Arbitrage Fund, in August. Religare Invesco Mutual Fund announced the introduction of a bonus plan in its Arbitrage Fund in July.

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Published: 12 Aug 2014, 12:23 AM IST
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