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Big FMP push by funds; should you invest?

We always recommend FMPs, but the point here is buy them only if you want them

Be warned: your mutual fund (MF) distributor may just try and persuade you to invest in a fixed maturity plan (FMP). That is, if she hasn’t done it already. Let’s make one thing clear: we like FMPs and we recommend them regularly, especially the double-indexation ones that come out in February and March every year. But we also insist that it’s when you invest in any product for the wrong reasons that you suffer. Also, if distributors get higher-than-usual commissions, chances of mis-selling obviously go up.

A chief executive of a fund house and one of Mumbai’s leading MF distributors told us, on condition of anonymity, that one of the reasons behind the stark rise in collections from FMPs is high commissions paid to distributors to sell these products. “Some fund houses are believed to give commissions in excess of 3% upfront to distributors to sell their FMPs," said one of the persons mentioned above. Besides, various distributors and fund houses have confirmed to us that commissions paid by some fund houses have gone up recently. It may be noted here that different fund houses pay different quantum of commissions to different distributors. Many fund houses have issued FMPs since mid-July 2013; according to data from Value Research, an MF tracking firm, 55 FMPs were launched in July that together collected 9,866 crore, up from 48 launched in June that collected 3,687 crore and 54 launched in May that collected just 1,798 crore.

Rising popularity

On 15 July, the Reserve Bank of India (RBI) restricted liquidity in the debt markets, in a bid to prevent speculation in the currency market, by making it more expensive to borrow money. This spooked the debt markets and yields of debt securities went up. According to Bloomberg data, yields on 3-year certificates of deposit (CDs) have risen to 11.41% as on 22 August, up from 7.97% on 12 July. Yields on 3-month commercial papers (CP) have risen to 12.16%, up from 8.38% during the same period. Similarly, yields on long-term debt instruments have also shot up.

An FMP is a closed-end scheme that invests in fixed-income securities and remains invested in them till maturity. It invests in scrips in such a way that they mature a day or two or few days before the FMP itself matures. The FMP realizes money from such sale of its underlying assets and then pays the money back to investors. Higher yields prevalent in the market at the moment help FMPs give attractive returns.

Is high fee justified?

Typically, FMPs these days are of two types; type-1 that has a low total expense ratio (TER) and therefore pays low distributor commissions; type-2 that has a higher TER and a higher expense ratio. Of the total TER of about 10-12 basis points (bps) that the type-1 FMP charges, very little goes to the distributor these days; the investor gets to make most of the money (see graph). One basis point is a hundredth of a percentage point. The type-2 FMP charges about 100 bps as TER every year, of which about 60-75 bps go to the distributor.

Here’s where the latter makes a killing. Since the fund house will deduct, say, 1% as TER every year, it pays the distributor’s share of all the subsequent years, upfront, when the investment comes in. This means if the agent’s commission every year comes to 75 bps or 0.75%, his total commission for the next three years (assuming it’s a 3-year FMP), comes to 2.25% (0.75% x 3 years). All this gets paid to your distributor upfront.

The MF industry seems to be divided here. Says Himanshu Pandya, vice-president and head (products and communication), ICICI Prudential Asset Management Co. Ltd: “In a sense, FMPs are to debt funds what index funds are to equity funds. Therefore, it’s okay if the fund house retains a minimal portion of the amount it makes through an FMP and gives the rest to the distributor." This side of the industry argues that if more retail investors are to be attracted, more distributors need to be engaged.

“When a fund house pays incentives, it has to keep in mind future returns. Many fund houses paid high brokerages on debt funds till as recently as three months back when interest rates were low. These funds lost heavily in July when RBI tightened liquidity in the market," said the chief executive of a fund house quoted earlier.

Mind the checklist

We repeat: FMPs are good products, provided they are what you really want. Here’s a checklist that you should look at before putting your money in an FMP.

Lock-in: All FMPs come with a lock-in. Most FMPs have a tenor of one to three years; some mature after five years. If you want the best out of your FMP, you have to stay invested till maturity to realize its full potential. Premature withdrawal may not give you the same yield; it may even result in a loss.

“Investors must understand the features; that it comes with a lock-in is an important feature. And although investors can go to stock exchanges in case they want to sell their FMPs prematurely and get out, the fact is there are hardly or no buyers there," said Nilesh Sathe, chief executive officer, LIC Nomura Mutual Fund Asset Management Co. Ltd.

Tax brackets: If you are in the lowest tax bracket or carry no tax liabilities, we suggest you avoid FMPs and instead opt for bank fixed deposits. Here’s why: if you invest in FMPs that mature after one year, you pay 20.6% (including cess) long-term capital gains tax with indexation, irrespective of your income-tax bracket. This benefits investors who are in the 20% and the 30% tax brackets. Interest from fixed deposits are taxed according to your tax bracket (10%, 20% and 30%). “For people who belong to the lowest tax bracket, FMPs are not worth the effort. Bank fixed deposits are a better option for such investors," says Pranav Muzumdar, chief executive officer, Mangsidhesh Investments Pvt. Ltd, a Mumbai-based financial planning firm.

Asset quality: Effective August 2011, an FMP needs to start giving an indication of how its portfolio would look like. It has to give upper and lower limits of instruments in which it intends to invest, as per their credit rating, under various asset classes like CDs, CPs, securitized debt and so on. Sathe says that if an FMP invests its entire corpus in CDs, it’s the safest option, “especially if they are CDs issued by government-owned banks". Check with your distributor or look up for such indicative asset allocation in your scheme offer document.

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