Sebi sets about making MFs safer, more open, more accountable

Investors in mutual funds (MFs) have a lot of positives to look forward to. In the past three months, the Securities and Exchange Board of India (Sebi) has announced reforms that make MFs better investment vehicles and is working to curb mis-selling, too. A summary:

Dividends from profits: The accounting norm has been tweaked for dividends. This will result in fund houses having less for dividend payouts. The market regulator has ordered MFs to use only the realised profits to declare dividends in a scheme. Fund houses cannot use the unit premium account to pay out dividends.

An example. Assume an investor enters an existing scheme that has a net asset value (NAV) of Rs 18. For accounting purposes, an MF breaks this NAV into parts. Of the amount, Rs 10, the face value of the scheme, goes to an account called unit capital. The remaining Rs 8 goes to a separate account called a unit premium reserve.

Sebi has said the MF cannot use the money in the unit capital account, Rs 8 in the example, to pay dividends. Rather, dividends should be declared only when the NAV appreciates. In our example, say the NAV moves to Rs 20. Fund houses can only use Rs 2 to declare dividends.

Experts feel this step will curb MF mis-selling. “Agents have been pitching the dividends declared to mis-sell schemes. Many investors still don’t realise that an MF dividend is different from dividends received on a stock. In an MF, an investor gets back his own money,” said Manoj Kumar Vijai, executive director, KPMG.

“We will need to trade shares every time the dividend would need to be declared. Despite this drawback, there is no way we can look away from the fact that dividend payment itself is a much questioned practice,” said the head of a fund house.

MF houses use this dividend to woo customers in its monthly equity-linked savings schemes and hybrid funds like monthly income plans.

Further, the regulator has directed the fund houses to mention the dividends in rupee terms, rather than a percentage of the face value. Funds usually declare dividends as a percentage to the face value, mostly Rs 10, of the scheme. That’s why dividends seem magnanimous when a scheme declares it. For example, if a fund declares a dividend of Rs 10, it means 100 per cent dividend.

Derivatives exposure: To make investors aware of the risk involved in a fund, Sebi has also mandated fund houses to declare their exposure in equity derivatives. Futures and options are risky and can lead to unlimited losses if the bets go wrong. This will force MFs to take lesser exposure to equity derivatives.

Sebi’s Mutual Fund Advisory Committee (MFAC) has also proposed to cap the exposure of any scheme to derivatives at 100 per cent of its actual holding in stocks. This will not allow a fund house to excessively play in the futures and options market. The requirement of only margin money in derivatives allows them to have a much higher exposure.

Making agents responsible: MFAC has also come up with recommendations that would make agents more responsible for their advice to investors.

The committee has proposed that agents categorise investors based on their risk profile, investment objective and affordability before selling funds. Among other recommendations, the committee suggested that distributors maintain written records of all recommendations and transactions. The committee has also proposed that while advertising, fund houses should present the entire picture of the scheme’s performance. This is because ads invariably talk only about the period in which a scheme had outperformed, not the reverse. The committee want funds to give both.

Source: http://www.business-standard.com/india/news/sebi-sets-about-making-mfs-safer-more-open-more-accountable/399227/

Ulips, equity MFs to lose tax cover in new-look Code

Unit-linked insurance plans (Ulips), equity-oriented mutual fund schemes and a number of other popular savings and investment instruments will lose their tax immunity, and with it, their attractiveness when the Direct Taxes Code (DTC) comes into operation.

The Central Board of Direct Taxes (CBDT) plans to reduce the number of instruments that qualify for tax deductions to only about half a dozen, its chairman SSN Moorty said, as the government overhauls the direct tax regime to try and make it simpler, boost revenues and encourage long-term savings. The Rs 3-lakh tax deduction limit proposed in the draft DTC will also be lowered.

Revised proposals for a new Direct Taxes Code to replace the nearly 50-year-old Income-Tax Act were unveiled on Tuesday. The government has said it hopes to operationalise the code by April 2011.

Ulips, which are hybrid products incorporating investment and insurance cover as traits, are particularly popular. In the 2009-10 fiscal, such products accounted for more than four-fifths of the total insurance premium of around Rs 2.60 lakh crore that was collected. They are controversial too: capital market regulator Sebi and insurance regulator Irda are involved in a tug-of-war over who has the right to regulate Ulip products.

“Ulips will be out of the exempt, exempt, exempt (EEE) tax regime,” said a senior finance ministry official, referring to the different stages at which financial instruments may be taxed.

At present, individuals who invest in Ulips do not pay tax at any stage—at the time of investment or contribution, during the tenure of investment, or at maturity. It qualifies for tax deduction along with a host of other savings schemes, including bank deposits, equity-oriented mutual funds, national savings certificate deposits and principal repayment on home loans. Taxpayers can claim a deduction of up to Rs 1 lakh a year on these instruments.

“Tax benefits are a key driver for insurance penetration and dilution of any benefits will have an impact on penetration,” said GV Nageswara Rao, MD and CEO, IDBI Fortis Life insurance.

The revised proposals make it clear that only six schemes—public provident fund (PPF), the pension scheme administered by the Pension Fund Development Regulatory Authority, general provident fund, recognised provident funds and pure life insurance and annuity schemes—will be tax-free. Tax will not be levied at any stage on these schemes.

The new pension scheme will also be covered by the EEE method of taxation and withdrawals will not be taxed at maturity.

However, investments made before the DTC comes into force will continue to be eligible for the EEE method of tax treatment for the full duration of the financial instrument. This means an investor who buys a Ulip before the DTC comes into force will not be taxed at any stage during the full tenure.

Ulips could be taxed at the time of maturity, but the government has not clarified yet the tax treatment of the products.

“The existing tax treatment of Ulips is beneficial as it helps in the flow of funds to the infrastructure sector, besides contributing significantly to the capital market”, said R Kannan, member-actuary, Irda.

The original code had proposed the concept of savings intermediaries that would invest the amounts deposited with them in Ulips, equity-linked mutual fund schemes, debt-oriented mutual fund schemes or other financial products depending on investors’ choice. Withdrawals would be taxed, but not a rollover.

CBDT has dropped the proposal to tax savings instruments at maturity in the absence of a social security system.

The aim now is to encourage taxpayers to invest in long-term savings schemes. PPF, for instance, has a 15-year tenure, although partial withdrawals are allowed after the sixth year. The revised discussion paper has said the rules for contribution and withdrawal will be harmonised and made uniform so that savings are made by the taxpayer for the long term.

Source: http://economictimes.indiatimes.com/personal-finance/mutual-funds/mf-news/Ulips-equity-MFs-to-lose-tax-cover-in-new-look-Code/articleshow/6056607.cms

India delivered better returns than most: Madhusudan Kela, Head-Equities, Reliance Mutual Fund

His rise within the organisation as well as in the fund management industry has been dramatic. But for the past few months, there has beenspeculation that Madhusudan Kela, head-equities, Reliance Mutual Fund, is quitting. Untrue, insists Mr Kela. In an interview with ET, he says that he is still bullish on the big picture India story. However, in the short term, global sentiment will prevail, he cautions.

How do you see the market playing out near term in light of global developments?

In the next 6-12 months, the market will still be ruled by global sentiment. The ongoing debt crisis in Europe can have a meaningful impact on markets globally as in India, if the situation worsens. If one or two Eurozone countries were to default or the euro as a currency breaks down, there will be chaos.

Similarly, if there is slowdown in China, the Indian market will be impacted. Currently, the Indian market is trading at a 25% premium to China. If China’s earnings multiple contracts, there could be a valuation challenge for India as well. However, we have seen over the past six years that the market has produced significantly better returns than most countries in the world. The India story is getting stronger.

For instance, this year, you will see a significant fiscal consolidation, which was a major worry for the market. Over the next 2-3 years, the gas and oil reserves will materialise and this will further improve our fiscal position. And the real dark horse could be the UID project which can significantly prune the subsidies and improve tax collection. And hopefully, the pilferage will reduce. I believe a 8-9% growth with more reforms from the government looks real in the next five years.

How steep do you expect the correction, if it does come through, to be?

If the situation in global markets worsens, we could even see a 15-20% correction in Indian shares. But since India’s fundamentals are only getting better, and viewed in the global context, overseas fund managers will be compelled to increase their exposure to India. Any meaningful correction will be a great buying opportunity for retail investors with a long-term view on equities.

Which are the sectors that interest you?

We continue to remain overweight on the pharma sector. We are bullish on companies which will benefit from the domestic consumption story in India. We like public sector banks. They have underperformed the market for a while due to concerns over rising bond yields and hence marked-to-market losses on the bond portfolio.

Our view is that PSU banks can grow their loan books 25% for each of the next three years, and they have the capital adequacy to meet the loan demand. The stocks are available at 1.2-1.5 times their book value, and you can’t go wrong if you have a 2-3-year perspective.

There is a lot of pessimism about the telecom sector, more so after the recent 3G bids. Would you take a contrarian view?

Much of the bad news in the sector is behind us. If these stocks see any sharp correction, we would definitely buy them. The stock prices may have underperformed over the past couple of years, but the customer base has more than doubled during the same period.

What about mid-cap stocks in general? Would you still go for them in current market conditions?

Yes, if there are opportunities, we will continue to invest in companies with scalable business models, with earnings growth faster than large-caps, and available relatively cheaper to large-caps.

Your strategy of betting on mid-caps in a big way has been criticised by your peers. They accuse you of boosting portfolio returns by buying into firms with low-floating stock.

Companies like Siemens and Jindal Steel & Power were mid-caps when we first bought them. Not only have they delivered better returns, but are now ranked among the large caps. But I must admit that there have been some wrong bets as well. We have tweaked our mid-cap strategy a bit. We will not buy into very small companies, and would focus on companies with a minimum m-cap of Rs 1,000-1,500 crore.

Locally, what are the factors that could dampen sentiment for stocks?

Below average monsoon would rank high on that list. The reforms process needs to be accelerated. The government has shown resolve, but it needs to build on it, especially in terms of attracting more FDI flows. Rising instances of Maoist and Naxalite attacks could make foreign fund managers nervous. We are highly dependent on inflows at this stage, because there is not much money coming in locally.

How much cash on an average would you be keeping in your portfolio? Your strategy of aggressive cash positions last year was criticised in industry circles.

We will use it more as a tool to improve the portfolio mix. We will not shy away from keeping a higher cash level than our peers if market conditions warrant. But it will not be as high (25%) as was the case last year.

Source: http://economictimes.indiatimes.com/opinion/interviews/India-delivered-better-returns-than-most-Madhusudan-Kela-Head-Equities-Reliance-Mutual-Fund/articleshow/6044698.cms

Right selling vs mis-selling in MFs

In mutual funds, intrinsic complexity and the absence of a physical product make it that much more imperative for institutions to be cognizant about potential mis-selling and implement a mechanism that would rest on the principles of right selling

Do I have to be like Ceasar’s wife and be above suspicion,” said a bank CEO on the subject of mis-selling. Instinctively, I felt that the point was missed. If you ask a banker about prevention of fraud or cash being stolen, the response would include charts, drawings, tables and process flows to impress you how robust the system is. However, on the question of right selling vs mis-selling, beyond the cliched “moral high-ground” and waxing eloquence, there is no attempt to implement a systemic solution.

Given the dominance of banks and other institutions distributing mutual funds in India, is there an institutional mechanism possible to guard against mis-selling? And, if so, what should it look like?

In mutual funds, intrinsic complexity and the absence of a physical product make it that much more imperative for institutions to be cognizant about potential mis-selling and implement a mechanism that would rest on the principles of right selling, the violation of which could result in mis-selling. For this, there would have to be some basic steps. One, each customer has to be profiled based on his risk appetite and investment objectives. Two, each product has to be profiled to reflect the customer category it is suited for. Three, there are potential conflicts in mapping the profiles of the products and customers. Four, it is the responsibility of the intermediary to recognize the potential conflicts and implement checks to ensure that these do not become real conflicts to the disadvantage of the investors. Five, it warrants an organizational mechanism to recognize these different roles and responsibilities and build in checks through a stringent compliance process. Six, it warrants a management oversight to ensure integrity for such systems to work efficiently and effectively.

To implement this framework, it is necessary to label roles and responsibilities. These include managers handling sales/relationship management, products, customer profiling, compliance, management, audit and board. Once that is done, it is important to identify and analyse potential areas of mis-selling and build preventive mechanisms.

Taking the customer on board: This should include implementation of know your customer norms, obtaining sufficient and accurate information to assess the customer, look at his risk profile and investment objectives, categorize him, putting in place mechanisms for feedback on efficacy, and ensuring that information about customers is reviewed periodically.

Product evaluation: The institution should create a universe of products that are evaluated and are investment worthy. The products should be reviewed for its risk level and should be assigned to a pre-defined customer risk profile category. Also, there should be a written record of the suitability of the product to that particular customer category.

Transaction: The institution should provide documentation to every client covering two aspects: one, product recommendation indicating its appropriateness for that customer category and two, a statement of the fees (one-time and ongoing) earned by that institution from that product. Further, it should obtain the client’s acknowledgement. When the product is sold from a client’s portfolio or switched to another product, the institution should document the reasons—was it the client’s requirement, or was the product taken off the approved list or was there a need to realign his portfolio.

When a customer buys a product that is not in the universe of recommended products, then the client should acknowledge and confirm that the decision is the customer’s and that he does not seek advice from the institution. It would help the institution to receive no fees—other than reimbursement of transacting costs—for such investments.

Compliance process: The difference between right selling and mis-selling is the difference between compliance in spirit versus form. The process is challenging here due to many conflicts—between the institution’s objectives for business and profit against that of the client and the conflict between the investment worthiness of a product and attractiveness of the commission structure. The key, therefore, is in recognizing that these potential conflicts of interests exist and putting in place review processes.

A sales/relationship manager should neither determine the customer profile nor the product profile. This role should be monitored for correctness in matching products to customers. Further, there should be no freedom to undertake “execution only” transactions. Under the principles of “maker–checker”, compliance should ensure that any discretionary authority is one level removed from customer engagement.

Management process: The key areas that influence the behaviour and outcome of team members are the incentive structure and compensation oriented towards customer retention. There should be no emphasis on transaction revenue as it encourages portfolio churn and conflicts with customer interest. It is also important to create an environment that encourages transparency in relationships with customers as well as fund houses. Customer franchise is built over the long term—building a system that encourages doing the right things daily certainly helps.

Source: http://www.livemint.com/2010/06/02212527/Right-selling-vs-misselling-i.html