Liquid, ultra short funds will remain popular

(Rajan Ghotgalkar is Country Head - INDIA at Principal International and Managing Director of Principal Pnb Asset Management Company (in association with Vijaya Bank). The views expressed in this column are his own)

By Rajan Ghotgalkar

Despite the barrage of regulatory changes it has recently been subjected to, I fail to understand why the mutual funds industry deserves its whipping boy status. It is disheartening to see how much of what is written ends up misguiding investors.

Mutual Funds are by far the most actively regulated and transparent of financial products. Their net asset values (NAV) are published daily and portfolios are openly offered for scrutiny. The investment objectives are made known and so are the charges levied on investors. Most of them have excellent websites which offer all the information an investor would possibly need.

The recent regulatory changes are largely in the right direction and therefore, should be seen in positive light because at least from the investor’s point of view, they are extremely beneficial. Anything which is in the interest of the investors has to be in the interest of the mutual fund industry. Like with every change process, even this subject will emerge stronger from the initial shock and awe.

Fortunately, the liquid and ultra short funds as a category remained unaffected by the ‘entry load’ controversy.

I am particularly concerned at this message that seems to be sent out that, the recent SEBI requirement to subject all securities over three months to ‘marked to market’ valuations; will make ultra short funds so much more riskier than before and that, there will be an exodus into bank deposits. Nothing can be farther from the truth.

These funds which are actually debt funds with short maturities, beyond the three months permitted for liquid funds; came into existence to allow investors an opportunity to exploit the tax arbitrage whilst taking some additional risks in terms of maturities to get higher yields than offered by liquid funds. There was no secret about these portfolios and most investors who are knowledgeable corporates and HNWs knew exactly what the risks were.

The tax arbitrage we talk about is the difference in the Dividend Distribution Tax (DDT) of 22.66% (20% plus 10% surcharge plus 3% Education cess) applicable to Debt Funds as compared with 28.325% applicable to Liquid Funds (as defined by SEBI).

Most funds invested in money market paper like CDs and CPs with original tenors less than one year. True these were not marked to market but neither were they actively traded. There were some funds, in their eagerness to garner assets took risks by extending their maturities in order to generate higher returns for their investors; but did nothing as retrograde as is made out to be.

However, considering that, volatility reduces as the paper approaches its maturity, marking them to market should really give no cause for alarm.

After all, the investors who place money in these funds have access to the portfolio’s average maturity and modified durations and can appreciate the risks involved.

So how did the party end? Following the Lehman crisis and the sudden collapse in market liquidity; exasperated by the shock of a sudden increase in monetary policy rates and ratios; all paper became unsaleable resulting in even the near term paper values falling way below their book values, which till recently was in close proximity of their market values. This paper went ‘out of the money’ virtually overnight.

Fund managers came in next morning to see all hell let loose. Investors reacted like they did globally and rushed to pull money out - I believe more due to the panic resulting from the weather in general. Mutual Funds were left with little choice but to sell paper at a loss to meet redemptions because there was no money to borrow at reasonable interest rates either.

The regulators SEBI and the RBI acted admirably and responded to the call for assistance and the mutual fund industry which was inherently in good health recovered very well and quickly too.

Instead of highlighting the two or three small players biting the dust one should focus on the rest of the thirty odd funds which emerged unscathed; with many sponsors fully supporting their fund houses so as to ensure that, the investors did not suffer by having losses passed on to them. It is important that, investors know this and the mutual fund industry is recognised for this.

The industry is well equipped to dynamically handle the duration risks considering that, most asset management industries already offer Long Term debt and Gilt funds. There is therefore, no apprehension in my mind that, our fund managers will successfully manage the changes in the ultra short fund category in the best interests of the investors by effectively delivering on the risk reward equation.

The recent regulatory changes will make liquid and ultra short funds a more robust and transparent offering. If anything these changes have certainly removed misconceptions if any, in the minds of investors about the features and risks associated with these products.

At this stage, it would be useful to see why liquid and ultra short term funds will remain popular. Firstly, they provide liquidity as their primary USP. Investors do not have to surrender their right to withdraw their money like they have to with bank fixed deposits.

The returns they make could be in the range of 3.5% to 4.5% per annum; which is after they have been subjected to flat DDT of about 25% which is higher than their marginal rates or TDS. These are returns after the funds have learnt the lessons from the financial crisis and suitably adjusted portfolios.

The yields grossed up for tax could be as high 6.7% per annum which is about what they will earn on a year’s bank deposit. Mutual Funds do not charge any ‘premature withdrawal penalties’ and nor do they pass on the burden of Reserve Ratios.

These advantages will continue to hold good.

The other fear doing the rounds is that, the 2010 Budget will do away with the difference in tax rates applicable to liquid and ultra short funds. The impression I get from speaking with some of the corporates is that, the impact is too small for them to be worried about or impact their decision to invest.

All empowered investors are aware that, current accounts do not pay interest, so why should they leave surplus cash in current accounts when they can now electronically move money in and out of these funds in as less as two days at the most?

It will hopefully not be long before even retail/individual investors realises that, it pays more to keep surplus cash in these funds instead of in savings bank accounts which pay interest at an effective rate of about 2.2% per annum. Going forward, I would expect fund houses to expand their product range to cover more duration ranges.

The risk attached is marginal and if there is any, it should be evident from the extensive disclosures made by the mutual funds. Needless to say, investors will have to learn to pick a fund house which prides itself on maintaining the high standards in corporate governance and hygiene.

Interestingly, over 50% of the money in the ultra short funds is in growth plans and will therefore; remain unaffected by any changes to the DDT rates.

I am more than confident that, liquid and ultra short funds are here to stay and prosper!!

(You can e-mail Rajan Ghotgalkar at: ghotgali@gmail.com)