Home >Money >Personal-finance >Mint conclave: Tax advantage for arbitrage funds should go

In a panel discussion featuring chief investment officers from across fund houses titled ‘Asset Management: Lessons from the past’ at Mint’s annual mutual funds conclave in Mumbai on 31 July, panellists discussed the lessons learnt from their experiences in the mutual fund industry. Prashant Jain, executive director and chief investment officer (CIO), HDFC Asset Management Co. Ltd; Navneet Munot, CIO, SBI Funds Management Pvt. Ltd; Soumendra Nath Lahiri, head–equity, L&T Investment Management Ltd; R. Sivakumar, head- fixed income, Axis Asset Management Co. Ltd; and Santosh Kamath, managing director, local asset management–fixed income, Franklin Templeton Investments, India, took part in the discussion, which was moderated by Mint Money’s deputy editor Kayezad E. Adajania. Edited excerpts:

Adajania: When closed-end funds impose dividends on all its investors and insist on frequent profit booking and sharing, are fund managers, in some quarters, thinking it’s a good idea to distribute gains, as and when possible, instead of waiting for the markets to peak and then give a lump sum at the end?

Lahiri: Let’s look at closed-ended funds as a product category. Today, with 4 trillion as equity assets under management (AUM), this constitutes 5-6% of the overall AUM, which is not large by size. These products were launched at an opportune time and were catering to a particular segment. If you want to invest for a 10-15-year period, then a plain vanilla fund would suffice. But investors are concerned about the short term. These products were launched in the small- and mid-cap space; that’s why the valuation mismatch was there. While running a closed-end product with a limited time frame, it would make sense to pay out at regular intervals while making sure you make some money. This part of the market is small but it has been in the limelight in terms of overall management. Closed-end funds have done well in the past. There is more while these products come to a terminal stage. You will see more liquidity in these products because it caters to the segment of the market that is volatile and illiquid.

Adajania: People haven’t forgotten their 2006-07 experience, when they invested at peaks and got stuck after the markets crashed in 2008.

Lahiri: Yes, but this time the markets were at a low when many of these closed-end funds were launched. They have not been launched at higher, more elevated levels of the market. But they have been transparent in telling you upfront that they will pay you a dividend if good money is made. Now, markets have gone up so much it might not make sense, which is why we are not seeing many launches.

Adajania: If dividends are paid regularly, does this come at the cost of long-term investing?

Jain: There is hardly any investment merit in closed-end funds. There is no evidence that these funds have done better than open-ended schemes. Equities are about capital appreciation but we encourage them as income-generating products. Only 2% of household savings in India is in equities. The moment you start paying dividends, you reduce asset allocation of investors into equities. Dividend is good as an option for those who want it, but it reduces the power of compounding of equities.

Adajania: But even your fund house has a dividend calendar?

Jain: All open-ended funds have a dividend calendar but it is optional for investors. The amount of people opting for dividend plans is very small. Our yields at 8-10% a year are small. Equities are about accumulation—the longer you stay invested in equities, the more it compounds for you.

Adajania: Is there merit in giving an option to investors to choose to receive dividend or to receive growth? Would you as a fund manager go with one such fund?

Munot: There was a period when convincing people to invest for the long term was difficult. You could only do a 3-year or 5-year period, beyond which used to look like ultra long-term.... A fund manager has her entry and exit dates in mind; she has the flexibility to decide how to invest.

From an investor’s perspective, one shouldn’t get swayed by market volatility. In 2007, those investors who had started their systematic investment plan for five to seven years, stopped their investments after the 2008 crash. However, in these funds, there is some restraint that an investor comes for a 3- to 5-year period. The whole idea is to provide growth for three years, and after that if you think you are not able to identify some good stocks, then you can easily declare the dividend.

The choice should be left with the investor—has the investor come for regular income or for a 3-year capital appreciation?

Adajania: Soumendra, you have launched a closed-end fund. Does this put pressure on fund managers to generate dividends?

Lahiri: Yes, we have launched a closed-end fund catering to the micro-cap space and which becomes open-ended after two years. It gives an opportunity to investors to see how we build our portfolio after some period of time. It does (put pressure) in the initial period, but the option should be given to the investor. For longer time frames, plain vanilla products should suffice. Investors look at the short term in India rather than staying for a long period.

Generally, people who choose the dividend option have a requirement for the dividend to match their cash flow.

Adajania: Prashant, is there any place for dividends at all in mutual funds?

Jain: Regular income and equities don’t go hand-in-hand. If you want income, we don’t recommend equities. You should only devote risk capital to equities. The real charm of equities is investing long-term and it is meritorious. There’s nothing wrong with providing an option but one must explain it to the investors.

Adajania: Santosh, you have been assessing credit even before 2007. What has the financial crisis taught you and how have you enhanced your credit capabilities after that?

Kamath: Managers in fixed income are told to time the market. It is difficult to tell what will happen when a rate cut comes along or what will happen to government securities. Credit funds will identify companies which are not doing so well with the anticipation that it will do well and make lots of money over a period of time.

But our job is to identify good companies and we let them do what they are doing and we put our money and we get our money on time. But now people are coming back because of greed—we have 41 mutual funds houses with corporate bond funds; everyone thinks that credit is the best thing to do and deals are happening smoothly.

Adajania: Have you changed the way you look at companies as opposed to 2007?

Kamath: I am getting fearful as people are getting greedy now. But having said that, we have huge opportunities in the market. The entire market on credit is close to 60 trillion; that is the total bank credit book. Even if 10% is useful for us, which is 6 trillion and our fund size is 15,000-20,000 crore, the opportunity is huge.

Adajania: Siva, you, on the other hand, prefer AAAs and safe assets, and don’t take credit calls. Why?

Sivakumar: We started in 2009, so that’s a recent history of 2008-09 issues. Clearly, there was no appetite to take any credit risks then. In mutual funds, there is no history of credit defaults or credit risks passed on to investors. The mutual funds, the trustees or the sponsors have absorbed credit defaults wherever it has happened in the past. There is an expectation, based on the past 15 to 20 years, that whenever there is a credit event, the risk will be taken by the AMC or the sponsor. Mutual funds inherently is not a balance sheet business and there is no provisioning made at the AMC level for defaults.

When a default has happened for a couple of crores, the exposure was very small, some 5-10 years ago. But now the book size is becoming large, and underwriting a credit risk in mutual funds is very difficult even for the best-heeled sponsor. There is a need to recognize credit risk and that becomes the first step before we jump into the space. Can we figure out a way to make provisions for NPAs (non-performing assets)? Can we value risk of defaults so that it can be handled within the NAV (net asset value)?

Secondly, we might see credit default swaps (CDS) kind of a market. Today, the markets are so illiquid that many AAA securities and G-secs (government securities) apart from the top 5 most-traded ones, are illiquid. If you enter a position, it is a ‘hold to maturity’.

Mutual funds are risk-taking entities in general; if one buys g-secs with a layer of CDS written position, then a high yield book can be replicated without taking the liquidity risk. These are steps that can be taken to develop this sector in a safer manner.

Adajania: Fund managers say there is a lot of synergy between the equity and debt sides as far as assessing credit goes. Debt fund managers can take inputs from equity fund managers while assessing companies.

Munot: Equity analysts are always concerned about the upside, as to what can go right. While the bond analyst will always be concerned about what can go wrong; the focus is on interest coverage, debt-equity ratio, cash flows.... If both work together, that is where the synergy will come. Both can throw triggers and help each other.

Adajania: Money has been flowing into arbitrage funds because of taxation laws. What are the challenges faced by fund managers with regards to arbitrage funds?

Munot: As the size increases, there is a pricing issue. The percentage of the overall market hasn’t reached a limit where it will substantially impact the overall expected returns. As money keeps flowing in, given the overall opportunities, returns expectation will be muted.

Adajania: Are there enough opportunities in the market since there is always a liquidity risk. What happens when the market dries up?

Munot: There is no risk for arbitrage funds but if the size increases, then there could be liquidity risk. Limiting the number of investors can take care of the liquidity risk.

Kamath: No arbitrage can last long. If the arbitrage is a debt fund and has the taxation of an equity fund, it can’t last for long. Just see what happened to fixed maturity plans (FMPs). These were like fixed deposits and they were taxed.

Sooner or later, the tax benefit should go, and it will go.

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