I’ve had two questions on email recently about Dynamic bond funds.

The concept of Dynamic bond funds needs an understanding that bonds are complicated, way more than stocks. A few things that make bonds different:

a) Issuer creditworthiness: Is a government bond more likely to default, or a second rate corporate bond? Would a Reliance bond have a chance of default more than say an ICICI Bank bond? The lower the credibility the higher the interest rate one asks for.

b) Yield: How much interest will I get, on a comparative basis, for this bond versus that one?

c) Time to maturity: A lesser time to maturity usually means a lower interest rate, since the haziness about whether an issuer is creditworthy (or will not default) is lower in the short term.

d) Smaller things like “is this bond secured against the company’s assets?”, “is this bond liquid?” etc.

Dynamic bond funds are essentially those that vary the above based on the fund manager’s discretion. Usually the fund manager will go into shorter term securities in a rising interest rate cycle, or move from corporate to government bonds at a time when the economy is slowing, and so on.

Now to the questions:

What’s the difference between a Gilt Mutual Fund and Dynamic bond funds?

A Gilt fund invests in Government securities only. Within Gilt funds you have further classifications: “short term” gilt funds that invest in T-Bills (<365 days) or in 1 to 3 year govt securities. Or “long term gilt funds” that hit the higher terms.

Dynamic bond funds are supersets; they can choose to invest in gilts or in corporate bonds or commercial paper, or all of the above.

Second Q:

I typically purchase funds with valueresearch rating of 4 or 5. Hence, I have selected and started investment (redirecting new investments for fixed income and proceeds from redemption of ultra-short schemes) in L&T Flexi Debt fund - Growth (VR 5 star fund). Now I am looking at diversifying by investing in another fund of similar philosophy. I was evaluating Birla Sun Dynamic Bond, SBI Dynamic Bond, BNP Paribas Dynamic Bond (erstwhile Fortis Flexi Debt), Kotak Flexi-Debt (which is surprisingly classified in ultra-short term in VR, I think due to maturity of currently held portfolio) but could not reach a conclusion.

Can you please suggest approach for identifying such a fund? Also, can you please suggest some good ones (from them or apart from these)?

Now I don’t invest in dynamic bond funds, but I would use the following rules:

- The fund has to be at least five years old, or you should really trust the fund manager.

- Check the performance in a rising interest rate cycle, and a dropping one. For the record, here if the interest rate history in India:

- Here’s where you really need time and effort: During the periods of falling rates, you will need to go back, download the fund’s disclosure statement and see if the average maturity of their portfolio went UP or DOWN, and whether you liked their move into/out of government bonds.

- Check relative performance with other fund categories (like gilt funds, income funds or other such).

- Make sure exit loads aren’t onerous.

- Lastly, understand that the product carries risk. Bonds are not risk free.

If you can’t do the analysis, get your advisor to provide you with it. (And pay him; tell him you’ll buy the product online) If you can’t do that also, don’t buy the product. A fixed deposit at a bank also works.

Dynamic bond funds basically are like that Indian Software company that says, “Boss we do Windows, Java, Web, C++, Linux, Android, iPhone and Nokia coding, any language, any platform, anything”. There are very few companies that have successfully done all of them, so you have to analyse past performance and be able to trust the fund manager.

While I’d like to analyse the funds, I think it’s better if I let each interested person do it himself – the exercise itself provides the learning. Also because I can’t afford the time, but that’s a different matter!

Jago Investor is running an “action month” where they talk of “pure action”, you commit to taking certain action: buying a term plan, buying health insurance, starting an SIP, organizing your financial life, and surrendering useless policies. Manish will keep in touch and there are prizes from multiple sponsors, such as MProfit (a neat software to manage investments), Moneysights (a fin portal), FundsIndia (buy or sell MFs online).

Disclosure: These are all people I know, and folks I think are doing a great job on the financial internet, so deem me interested. There is nothing in it financially or otherwise from me, other than the goodwill of these awesome people.

What am I going to do? I’ve already got term plans but I’ll buy the next round ditching the current ones next year after premiums go down (they will after the results from the census are incorporated). I’ve got health insurance for the family. I won’t do an SIP because I actively manage my money. I need to reorganize some of my financial life like get out of some very old mutual fund investments or to at least get them online so I can transact when I want (I will do this). And finally, I will not surrender my useless policies because surrender is worse than paying to the end of term for them (I’ve calculated). My actions shouldn’t determine yours – you should take your own decisions.

*****

SEBI has in a new circular, allowed transaction charges of Rs. 100 per transaction for transactions above Rs. 10,000, to be deducted from the transaction itself. For new subscribers, distributors will be paid Rs. 150.

That means for a cheque of Rs. 10,000, only 9,900 will be invested for new investments into new fund schemes, and Rs. 9,850 for existing subscribers of a fund scheme. Distributors can opt-out of this charge entirely for all of their customers (not selectively per customer or per transaction). SIPs will be charged that amount as well, but over 3-4 installments.

FundsIndia has announced that they won’t charge this for any of their customers; I hope others will follow suit. I buy online with HDFC Bank right now, but if they start charging, I will move to FundsIndia or go direct. (Haven’t bothered because I’m lazy)

*****

AMCs have also been asked to deduplicate folios within six months. I wonder how many folios will be shown once deduplicated.

MFs will now have to reveal data by geography (top n cities and so on), and total commissions paid to distributors of Retail/HNI investments greater than 100 cr. AUM raised.

Fixed Maturity Plans are being touted as the new way to lock yourself into about 10% yields. But Sandeep Shanbhag mentions why the Direct Tax Code screws the FMP buyer.

FMPs are locked in for a period, the biggest that are being sold now are 370 days or so. That is, you get in now, you get out a year later. Since no one else can get in meanwhile, the fund buys 1 year securities (currently at around 10%) and locks in the interest.

Why is this better than a fixed deposit? FD income is taxed as part of your other income, which could be 30% at the highest slab. FMPs, when held for a year, attract both indexation and Long Term Capital Gains Tax. (Read my post on how LTCG is calculated).

If inflation is 7% and you get a 10% return, your net taxable portion is just 3%, on which 20% is the tax, so you pay just 0.6% of your principal as tax, for a net return of 9.4%. (10% minus 0.6%)

Not any more. The DTC says that for long term capital gains to apply you have to hold for one year after the END of the financial year of investment. Meaning, if you buy today (August 1, 2011), you have to hold the investment till April 1, 2013. (Financial years end on March 31)

Secondly, there's no "20%" tax - the special rate for LTCG expires with the DTC. All long term non-equity gains, post indexation, are added to income.

1 year FMPs will mature after a year; with the new rule, the investment won't qualify under long term holdings. Short term gains cannot be indexed, and are directly added to income. For a one year FMP, you'll earn 10% and all of it will be taxed, which at the highest slab is a tax rate of 30%. You'll earn a net of 7% - exactly the same as a Fixed Deposit.

Equities on the other hand have zero long term cap gains taxes, and the holding period for qualification is one year from the date of investment (not from the end of the financial year like above). Short term gains have better treatment - only half the gains are added to your income.

If you're looking to buy, only consider FMPs that are 20 months or more.

If you had not invested in the tax planning funds to save tax, the three-year lock-in does not apply which is mandatory for only those seeking tax deductions by investing in these funds. You can redeem your investments in these two funds whenever you wish.

This is not true. I tried to redeem certain tax-saving funds ahead of time but the application was rejected.

And then, how will the fund know that the applicant didn't try to use it to reduce tax? Will they ask for a tax return? Many tax returns are so convoluted that it takes experts to decode them - so will funds hire a tax analyst?

I doubt this is the case. The tax department won't be happy if ELSS funds (called "tax-saving" funds) are allowing early redemptions; the tax saving is contingent on their not being accessible for three years.

Of course ELSS is being scrapped from next year, so any further argument will be moot.

Update: Value Research has acknowledged the error, both on Twitter and in the comments section, and changed the original post.

In theory, if you make investments in ELSS funds and you later discover that you were not liable to pay tax, then you may redeem your investments within the lock-in period. This would involve getting a certificate to the effect from the tax authority and then approaching the fund for redemption. We are not sure how easy or difficult this may prove in practice and whether the tax authorities and the AMCs have the processes in place to actually do this.

The committee headed by Prashant Saran , member of the board at the markets regulator, last week nearly concluded that a Rs 100 transaction fee could be imposed on investors for every new investment that will help distributors cover costs

But quite interestingly:

"The committee turned down industry body Association of Mutual Funds in India's suggestion to reintroduce entry loads on specific funds," said a person privy to the discussions. "Entry load was no longer an option."

While I'm happy to pay Rs. 100 per transaction, I will mostly likely go direct anyhow and avoid the fee altogether (and why should I pay? I'm a registered AMFI advisor myself!)

Distributors have costs per transaction - the petrol to the nearest CAMS office, dropping of cheques and what not. That might be covered. But for everything else, the current system affords them decent loads already; most equity products pay upto 1.5% upfront and then 0.5% trail every year.

(Reproduced)

"Bring back the entry load" seems to be the cry among distributors and advisors of mutual funds, as the new chairman of SEBI, U.K.Sinha, appoints committees to look into various aspects of the regulator's functioning. Mr. Sinha was the head of UTI Mutual Fund earlier, where he had complained about the SEBI move to remove entry loads altogether in 2009 — the intermediary community now desires that he reverse the earlier SEBI decision.

First, what do I mean when I say "distributor" or "advisor" or "intermediary"? For the most part, they mean the person or company that sits between you and the actual mutual fund. They all perform the exact same function — filling out a few forms, collecting and filing certain documents. Some of them actually go the whole yard and provide advice. For this, they would earlier get a commission out of your investment — so if you put in 100,000, a 2.25% entry load would give them Rs. 2,250, and what was invested was the rest — Rs.97,750.

SEBI's view was that you can't be paid a big percentage for just filling out forms, and if some of these people were actually providing advice, they should charge the investor separately for it. Like you pay a doctor's fee for advice and pay a pharmacist for the medicines, the idea was to separate the product from the advice. Now there was no lower bound on entry loads earlier, so mutual funds could have "self-regulated" themselves and made entry loads zero; they did try in spurts, with some funds making systematic-investing-plans (SIPs) load free for a while, and others keeping certain funds with high loads and others with low. But after 2005, the load situation set itself up at the upper bound of 2.25% from nearly all equity funds.

With banks and large companies setting up operations, the competition in the middleman space was intense — to the extent that they would tell investors that they would "share" the commissions received as part of the entry load to attract their money. This is like giving you part of your own money back, but in a field where the rest take that part anyhow, it seems like an advantage.

This became is a cartelized operation, even without the presence of an actual cartel - the industry behaves as one because they all believe it's in their interest to do so. In such an event only regulatory influences can change behavior, and the removal of an entry load altogether was a great move. Yet, market players complain today that it was "too sudden", they should have been given time, distributors lost big chunks of income, that funds lost a lot of investors.

But I pooh-pooh that argument. If distributors were paid 2.25% earlier, they are paid 0.5% to 1% today. Upfront. How? Since fund managers would take about 2% of the fund as an annual management fee (in part over the entire year), they were happy to part with some of it upfront to the distributor. What then, you might ask, if someone put in a large chunk and withdrew it immediately? Answer: Exit loads. Mutual funds started charging a sum if you withdrew too early, and in line with the commissions such loads are about 1%.

Additionally, distributors are paid 0.5% as a "trailing" load, every year. The total payment to a distributor over the year is now over 1% for most equity funds.  This money is paid by the fund management company as part of the fees they charge you (deducted from NAV every day).

Payments have moved from about 3% earlier, to about 1% now. So distributors do get paid, it's just a little bit lesser. And that was on the cards. Worldwide, hedge funds charge 2% of investments as management fees, mutual funds charge about the same. This money is used for research, to set up trading infrastructure, to pay top-quality fund managers and so on. Why should a distributor — whose job is plainly to transport a filled form and a cheque from an investor to the fund house, get just as much? And then get paid every year for doing nothing?

For advice, they should charge the investor directly — and many entities have started to do that, from individuals to large companies. The concept of paying for advice separately will sink in, and like every disruptive change, it will hurt existing players first, who have no infrastructure for providing advice, and whose customers don't understand the concept of paying separately. The immediate reaction is, and should be, to deny these customers service unless they pay — the smart customer will do his own research and buy from a mutual fund directly (most already provide online and direct access), and the rest will learn to pay. This will take time, but this is how a flawed business model needs to be fixed.

The distributors answer goes like this: "Listen, if you don't give me commissions, I will go sell insurance, where they give me 5-20%, okay?" And they did. For about a year, the mis-selling in Insurance policies went up until the big SEBI-IRDA spat happened, and IRDA decided to clamp down on commission structures at ULIPs. Still, insurance policy commissions are very high and in comparison with a mutual fund, they have proved to be horrible investments. The mis-selling only lasts so long and as investors realize that their investments haven't quite done spectacularly, they stop putting money in.

And finally, the aspect of losing investors in the last two years: In case no one has noticed, nearly all kinds of equity assets have lost customers in the last few years, including Portfolio Managers and Stock Brokers. Investors have pulled out of equity markets directly as well — figures on the NSE show us that we are below turnover levels of May 2007, four years ago. Turnover in single Stock futures, which were what retail investors loved, have gone down to a desperate 8,000 cr. on Tuesday (figures in 2007 were above 20,000 crores a day). With banks offering 10% returns on FDs, investors are flocking to them instead of equity funds, and with increasing interest rates, that migration will only go up.

And in this time — the last two years — equity funds have seen inflows return as markets went up (end-2010) and then some exits as markets fell. This is not abnormal. Markets fall because of selling pressure, and an exit from an equity mutual fund is just another form of selling pressure. The fact that mutual funds have lost some customer money to withdrawals has more to do with market dynamics than a drop in loads.

One method that advisors suggest, because investors don't like to give multiple cheques, is to have those investors write down that "[N]% of my money should be paid as a commission". But given the glorious track record of advisors in mis-selling, and the dubious record of investors in actually seeing what they sign, this would be equivalent to feeding investors to the vultures. And if getting an additional signature is fine, why not get it on a cheque instead?

The demand to reinstate entry loads for mutual funds is on shaky ground. Mr. Sinha has already stated that he won't reverse the policy, and instead concentrate on what makes funds more investor friendly. Mutual funds have been phenomenal vehicles for investing — unlike the west, most of our top funds have consistently beaten our stock indices, delivered healthy returns, and kept costs very low. It would be useful to highlight that, instead of reinstating retrograde incentives for intermediaries who are getting increasingly irrelevant anyway.

More Yahoo Columns:

• Loaded in Disfavour (Archive)
• Spooked By The RBI (Archive)
• India's Inflation Kool-Aid (Archive)
• Five Easy Ways To Get Suckered (Archive)
• ETFs and Skewed Indexes (Archive)
• Statistically Losing The World Cup (Archive)
• Accelerated Correlation (Archive)
• The Japanese Fallout:Is Nuclear Power Dead? (Archive)
• Amnestasia: A disease where you forget to pay tax (Archive) #Budget2011
• Cutting Real Estate Down To Size (Archive) #Budget2011
• Good Stock. Bad Stock. (Archive)
• Budgets and Stock Markets (Archive) #Budget2011
• Losses and Endowments (Archive)
• Moving Averages (Archive)
• Did you Know? (Comments)
• Reconsider That Fixed Deposit (Comments)
• Market Interventions (Comments)
• ULIPs or Mutual Funds? (Comments)
• Taking Stock of Commissions (Comments)
• Innovations and Curses (Comments)
• Free Money (Comments)
• The Illusion of Low Risk (Comments)
• Tips about the Tipsters (Comments)
• The Good, Bad and Ugly of Credit Cards (Comments)
• The Problem with Multi-Level Marketing (Comments)
• Planning for the Grim Reaper (Comments)
• Of Options and Choices (Comments)
• Riding the Equity Wave (Comments)
• The Art of Picking Stocks (Comments)
• (The Whole Lot)

(Reproduced)

"Bring back the entry load" seems to be the cry among distributors and advisors of mutual funds, as the new chairman of SEBI, U.K.Sinha, appoints committees to look into various aspects of the regulator's functioning. Mr. Sinha was the head of UTI Mutual Fund earlier, where he had complained about the SEBI move to remove entry loads altogether in 2009 — the intermediary community now desires that he reverse the earlier SEBI decision.

First, what do I mean when I say "distributor" or "advisor" or "intermediary"? For the most part, they mean the person or company that sits between you and the actual mutual fund. They all perform the exact same function — filling out a few forms, collecting and filing certain documents. Some of them actually go the whole yard and provide advice. For this, they would earlier get a commission out of your investment — so if you put in 100,000, a 2.25% entry load would give them Rs. 2,250, and what was invested was the rest — Rs.97,750.

SEBI's view was that you can't be paid a big percentage for just filling out forms, and if some of these people were actually providing advice, they should charge the investor separately for it. Like you pay a doctor's fee for advice and pay a pharmacist for the medicines, the idea was to separate the product from the advice. Now there was no lower bound on entry loads earlier, so mutual funds could have "self-regulated" themselves and made entry loads zero; they did try in spurts, with some funds making systematic-investing-plans (SIPs) load free for a while, and others keeping certain funds with high loads and others with low. But after 2005, the load situation set itself up at the upper bound of 2.25% from nearly all equity funds.

With banks and large companies setting up operations, the competition in the middleman space was intense — to the extent that they would tell investors that they would "share" the commissions received as part of the entry load to attract their money. This is like giving you part of your own money back, but in a field where the rest take that part anyhow, it seems like an advantage.

This became is a cartelized operation, even without the presence of an actual cartel - the industry behaves as one because they all believe it's in their interest to do so. In such an event only regulatory influences can change behavior, and the removal of an entry load altogether was a great move. Yet, market players complain today that it was "too sudden", they should have been given time, distributors lost big chunks of income, that funds lost a lot of investors.

But I pooh-pooh that argument. If distributors were paid 2.25% earlier, they are paid 0.5% to 1% today. Upfront. How? Since fund managers would take about 2% of the fund as an annual management fee (in part over the entire year), they were happy to part with some of it upfront to the distributor. What then, you might ask, if someone put in a large chunk and withdrew it immediately? Answer: Exit loads. Mutual funds started charging a sum if you withdrew too early, and in line with the commissions such loads are about 1%.

Additionally, distributors are paid 0.5% as a "trailing" load, every year. The total payment to a distributor over the year is now over 1% for most equity funds.  This money is paid by the fund management company as part of the fees they charge you (deducted from NAV every day).

Payments have moved from about 3% earlier, to about 1% now. So distributors do get paid, it's just a little bit lesser. And that was on the cards. Worldwide, hedge funds charge 2% of investments as management fees, mutual funds charge about the same. This money is used for research, to set up trading infrastructure, to pay top-quality fund managers and so on. Why should a distributor — whose job is plainly to transport a filled form and a cheque from an investor to the fund house, get just as much? And then get paid every year for doing nothing?

For advice, they should charge the investor directly — and many entities have started to do that, from individuals to large companies. The concept of paying for advice separately will sink in, and like every disruptive change, it will hurt existing players first, who have no infrastructure for providing advice, and whose customers don't understand the concept of paying separately. The immediate reaction is, and should be, to deny these customers service unless they pay — the smart customer will do his own research and buy from a mutual fund directly (most already provide online and direct access), and the rest will learn to pay. This will take time, but this is how a flawed business model needs to be fixed.

The distributors answer goes like this: "Listen, if you don't give me commissions, I will go sell insurance, where they give me 5-20%, okay?" And they did. For about a year, the mis-selling in Insurance policies went up until the big SEBI-IRDA spat happened, and IRDA decided to clamp down on commission structures at ULIPs. Still, insurance policy commissions are very high and in comparison with a mutual fund, they have proved to be horrible investments. The mis-selling only lasts so long and as investors realize that their investments haven't quite done spectacularly, they stop putting money in.

And finally, the aspect of losing investors in the last two years: In case no one has noticed, nearly all kinds of equity assets have lost customers in the last few years, including Portfolio Managers and Stock Brokers. Investors have pulled out of equity markets directly as well — figures on the NSE show us that we are below turnover levels of May 2007, four years ago. Turnover in single Stock futures, which were what retail investors loved, have gone down to a desperate 8,000 cr. on Tuesday (figures in 2007 were above 20,000 crores a day). With banks offering 10% returns on FDs, investors are flocking to them instead of equity funds, and with increasing interest rates, that migration will only go up.

And in this time — the last two years — equity funds have seen inflows return as markets went up (end-2010) and then some exits as markets fell. This is not abnormal. Markets fall because of selling pressure, and an exit from an equity mutual fund is just another form of selling pressure. The fact that mutual funds have lost some customer money to withdrawals has more to do with market dynamics than a drop in loads.

One method that advisors suggest, because investors don't like to give multiple cheques, is to have those investors write down that "[N]% of my money should be paid as a commission". But given the glorious track record of advisors in mis-selling, and the dubious record of investors in actually seeing what they sign, this would be equivalent to feeding investors to the vultures. And if getting an additional signature is fine, why not get it on a cheque instead?

The demand to reinstate entry loads for mutual funds is on shaky ground. Mr. Sinha has already stated that he won't reverse the policy, and instead concentrate on what makes funds more investor friendly. Mutual funds have been phenomenal vehicles for investing — unlike the west, most of our top funds have consistently beaten our stock indices, delivered healthy returns, and kept costs very low. It would be useful to highlight that, instead of reinstating retrograde incentives for intermediaries who are getting increasingly irrelevant anyway.

More Yahoo Columns:

• Loaded in Disfavour (Archive)
• Spooked By The RBI (Archive)
• India's Inflation Kool-Aid (Archive)
• Five Easy Ways To Get Suckered (Archive)
• ETFs and Skewed Indexes (Archive)
• Statistically Losing The World Cup (Archive)
• Accelerated Correlation (Archive)
• The Japanese Fallout:Is Nuclear Power Dead? (Archive)
• Amnestasia: A disease where you forget to pay tax (Archive) #Budget2011
• Cutting Real Estate Down To Size (Archive) #Budget2011
• Good Stock. Bad Stock. (Archive)
• Budgets and Stock Markets (Archive) #Budget2011
• Losses and Endowments (Archive)
• Moving Averages (Archive)
• Did you Know? (Comments)
• Reconsider That Fixed Deposit (Comments)
• Market Interventions (Comments)
• ULIPs or Mutual Funds? (Comments)
• Taking Stock of Commissions (Comments)
• Innovations and Curses (Comments)
• Free Money (Comments)
• The Illusion of Low Risk (Comments)
• Tips about the Tipsters (Comments)
• The Good, Bad and Ugly of Credit Cards (Comments)
• The Problem with Multi-Level Marketing (Comments)
• Planning for the Grim Reaper (Comments)
• Of Options and Choices (Comments)
• Riding the Equity Wave (Comments)
• The Art of Picking Stocks (Comments)
• (The Whole Lot)

ET has some data:

Banks' investment in mutual funds aggregated Rs 1.11 lakh crore on April 6 against Rs 70,999 crore on January 14, according to RBI. Fund managers said over 80% of banks' money in mutual funds is in liquid schemes. The investment restriction will limit banks' surplus money coming into mutual fund schemes at Rs 30,000 crore. The total net worth of the banking system is around Rs 3.13 lakh crore as March 31, according to fund managers.

How Much Goes Out?

So Investment in Liquid funds = approximately 90,000 cr.

Net worth = 3.13 lakh cr. and 10% of that = 31,300 cr.

So 60,000 crore will flow out. When? Not immediately - banks are given six months to ease out the transition.

How much do mutual funds lose?

Assuming liquid funds charge 0.25% as management fees, the total loss will be around 150 crores. This may not sound like much but it is, I think, a reasonable chunk of MF profits.

Why did RBI do this?

Banks would put money into liquid funds which would in turn buy bank Certificates of Deposit, sometimes of the very banks they got the money from. That's circular. And because of it there is a risk that if one bank starts withdrawing a lot of money, it will hurt the liquidity and capital raising ability of other banks (since CDs will be sold and prices fall) which will also start selling their liquid fund holdings and so on.

The other reason banks might happily do this is that if they couldn't really take on exposures of certain corporates beyond a limit, they could buy liquid funds that could in turn buy the same companies' commercial paper.

The overall impact is negative for mutual funds, surely. It's negative for banks in that they need other ways to get the easy 9% they were getting from the mutual fund route. The days of easy spreads are over?

Mutual funds have monthly income plans – MIPs – that provide a monthly dividend; how do these compare against Fixed Deposits (FDs)?

Risk-Free?

First, note that MIPs are not risk free – they invest a little in equities as a “kicker”. So if you’re looking for ultra risk-free return, this is not it. I’m just looking at it as something that a retiree or semi-retiree can invest in, and doesn’t mind the slight additional equity risk. A lot of people I know would qualify.

Example

Let’s take a 25 lakh investment made in an MIP – HDFC’s Long Term MIP Monthly Dividend plan is what I chose. Compare it with the same amount invested in a Fixed Deposit (FD) yielding 9% (Okay, no one gives 9% a year on FD monthly income, but let me be aggressive).

Taxation: Dividends on MIPs are tax-free; FD Interest is taxable. I’ve assumed a 20% tax. (Note, however, that about 13.6% of dividend distribution tax applies to mutual funds , including surcharge and cess, but this is paid by the mutual fund, not you. It reflects in the NAV.

Nowadays banks deduct 10-20% tax at source for FD interest – so if you get a lower tax rate you have to ask for a refund. That is crazy for someone who’s investing for a monthly income!

Returns: I plotted the four-year graph (assumed started on Jan 1,2007) of the entire return. The line graphs are the return-to-date for MIP and FD (including interest/dividend post tax) and the bars are the monthly income levels.

The return (blue and red lines) are the simple interest on the FD - since we require income, I assume no reinvestment of either the dividend or the FD interest.

The purple and green bars are the cash-flows every month.

Cash flows: The FD interest is constant, as expected (a net yield of 7.2%). The Monthly Income Plan has wayward income but you see the equity kicker give spiky income, but they seem to cap themselves at the lower end to what FDs would give.

The FD income, post tax, is about 15,000 per month, while the MIP dividend which is tax-free anyhow, is about 13,000 per month. However the difference is more than made up by the huge change in

MIPs seem to generate slightly higher income in parts – sorta like getting a bonus every once in a while.

Verdict?

The MIP has done well in the last four years - an effective yield of 7.70% versus 7.02% for the FD (this is assuming interest and dividends were not reinvested).

But the last one year has seen a flattening down, because the equity markets haven't done too well and the long term debt market's suffered on account of rising interest rates. Also FD rates are up to 10% now and interest rate slabs have been rejigged so your eventual tax liability with a 25 lakh deposit should be at 10% - that brings the FD return much closer to the MIP.

Liquidity wise: both the FD and MIP are liquid (you can get money out in a few days). The FD carries a penalty for early withdrawals though, and the HDFC MIP has a 1% exit load for the first year.

On the face of it, with the higher risk, the MIP seems like a useful option for someone with a large corpus and wants a higher monthly income. And lesser tax reporting hassles or refund issues.

Considering tightening liquidity in the markets and the fact that I expect equity markets to hurt with rising rates, I would expect the FD to outperform the MIP but only if you are in low interest rate slabs and looking primarily for income. If you are in a higher tax slab, then a short term debt fund is likely to do better (even a short term MIP) If you're okay with keeping your money in for a year and then manually withdrawing money for cash flow each month, you could choose a growth plan and make higher returns because you don't get that 13% dividend distribution tax hit.

Finally, if you're already invested, moving to a different plan has a cost, that the new instrument will have a lock-in, work that out in your calculations before you move.

Note: Other options – tax free bonds that yield around 6.5% to 7.5%, Government 10 year bonds that yield a taxable 7.5% or corporate 10 year debentures that yield 10% or so. Some of these have monthly options too; and may be even better.

This post is written by Deepak Shenoy, at Capital Mind.

I was reading recently about rule change in March 2010 forbidding equity funds from paying dividends out of the unit premium reserve. My understanding is that dividend payments have come down after this and the popularity of dividend paying funds has declined (would you agree with this?) I can see two explanations for this.

One is that investors somewhat irrationally chased dividends before the rule change and some fund companies took advantage of this by paying large dividends to attract flows even though the dividends did not signal actual returns.

Another explanation is that investors used these high paying dividend funds for dividend stripping.

Which of these explanations is more prevalent? Are there certain fund companies that actively tried to attract investors by paying large dividends out of unit-premium reserve versus other companies that did not do this? I am looking for examples where it is easy to tell that investors were really fooled by dividends as opposed to just the dividend stripping (if you can think of any such examples that would be great).

This is a brilliant question. First,

What is Unit Premium Reserve?

Units start off as Rs. 10 of "face value". If it goes up to Rs. 12, and a new person buys, then Rs. 10 goes to the unit itself, and the Rs. 2 is a "premium". The Rs. 2 per unit goes into the premium reserve.

So why is shady to give dividends from it?

Because it amounts to paying off one unitholder by getting money from another unitholder. Let me explain.

Assume there are just 1000 units in a mutual fund at Rs. 25 each, for an AUM of Rs. 25,000. Let us say it only sold units at Rs. 10, so there is no unit premium reserve. So the "distributable surplus" is actually Rs. 15,000 (The Rs. 25,000 minus the Rs. 10,000 of the face value of the 1,000 units)

Let us say that the fund declares Rs. 12 (or "120%") as dividend.

Now another person comes in before the dividend date, and buys another 1,000 units at Rs. 25.

We have:

Total AUM: Rs. 50,000 (original 25K plus new 25K)

Unit Capital: Rs. 20,000 (It's a face value of Rs. 10 per unit for 2,000 units)

Unit Premium Reserve : Rs. 15,000 (this is the new person's 25K minus his unit capital of 10K for 1000 units; or, the Rs. 15 premium per unit)

Distributable Surplus: Rs. 15,000 (A surplus doesn't change when new units are only bought).

Now there are 2,000 units and the dividend is Rs. 12 per unit. So Rs. 24,000 needs to be paid out as dividend, half of it to the original investors, and half of it to the new investor.

But there is only Rs. 15,000 as distributable surplus!

So the fund will have to dip into the "unit premium reserve" to pay the remaining 9,000. At some point this is stupid, because you are using the new investor's money to pay him dividend right back. And since people are attracted to dividends, they'll pile on without realizing this.

How is this different from stocks?

In Stocks, companies don't issue fresh stock. If you buy, you buy from someone else, the total number of shares outstanding doesn't change. (Yes, you might argue that the company can do an IPO in between. In any case, companies can't pay dividend from premium reserves, so the point is moot)

But SEBI decided to ban the practice precisely because it was being used by small funds to shore up AUM. (Full Circular)

What? Give me an example.

Take Birla Sun Life Tax Relief 96. It's a tax saving fund, and your money is locked in for three years, while you get a tax benefit (upto Rs. 100,000).

In November 2006, the fund had just Rs. 59 cr. in assets, and the NAV was Rs. 194. They decided to informally tell distributors to attract customers saying they would pay out Rs. 100 (or 1000%) as dividend over the next four months. (Read: Birla Sun Life Tax Relief 96 - beware of dividend pushers!)

Think about it, even if they had the full Rs. 184 (the NAV of 194 minus Rs. 10 face value) as "Distributable surplus", that would make about 57 crores of distributable surplus. Note that figure, we'll need it later.

They announced one dividend in December 2006, of Rs. 25 per unit, and then another in January 2007 at Rs. 26 per unit. And then on March 16, 2007, they announced another Rs. 50 per unit.

They would give out a total of Rs. 101 out of the original NAV of Rs. 194. More than 50%.

Note: for each dividend, the NAV will fall by the same amount. (See this video) So in December you'd see the NAV fall by Rs. 25, in Jan by another Rs. 26 and so on; in end March it would end up being less than 100.

By this time, because of salivating distributors (remember, this was before entry loads were banned) the fund AUM had increased to 300 crores!)

As you can see, the AUM in December 06 went up to nearly 200 crores, which expanded to 300 crores by March 07.

Take just March 2007: They paid out Rs. 50 per unit (which was about 1/3rd the then NAV of around 140 per unit) Since they paid out 1/3rd of their corpus, they paid out Rs. 100 crores in March 2007 alone. In December they would have paid around 10 crore, and in Jan 07, around 30 crores.

That adds up to Rs. 140 crores (and I think I'm underestimating the payout) of dividend paid out.

But they started with a distributable surplus of just Rs. 57 crores! (see earlier)

What they did was to take the fresh money coming in and give it back to investors.

But why?

This is a great way for an ELSS scheme to work, because you put in the money for the tax benefit. But it's all locked in for three years! To avoid that, the fund pays out money as dividend, and voila, you get the tax benefit for the whole amount, and lock in only a part of it.

(See: Dividends in ELSS funds have an advantage)

Oh okay. So now a fund can't distribute its unit reserve as dividend?

Not anymore. Since SEBI has said it can't. What it actually generates as a surplus, it can distribute. That means it has to invest and make a profit to distribute. Which makes sense.

What about the other questions?

Ah, yes.

Did investors somewhat irrationally chase dividends before the rule change?

Yes, and they continue to do so in regular equity funds. Not that we can make out much now, but I still hear of distributors pushing clients to put in money ahead of a dividend. In tax saving funds, though, there was a rationale - that it gave them a tax saving alternative without locking in money.

Did investors use it for dividend stripping?

Dividend stripping is not tax efficient - the tax department does not allow it anymore. (The loss on selling after the NAV falls is not considered if it's bought and sold within three months of the dividend)

Has the popularity of Dividend Paying Funds declined?

I don't know. In general dividends are more attractive for shorter term debt funds for their tax advantage. In equity funds, the dividend option is used as an automatic profit booking mechanism. I haven't checked to see if the dividend option has seen lesser interest.

Hope that helps!

This post is written by Deepak Shenoy, at Capital Mind.