The Hindu Business Line : Larger overseas pie, but a blow for liquid funds

Budget 2007 has an unexpected package of proposals for the mutual fund industry, with a mixed impact on players. On the positive side, it opens up new avenues for fund houses to expand their product suite through new infrastructure funds and international products.

On the other, it reduces the attractions of liquid and money market funds for retail investors by hiking dividend distribution tax. Here are the key proposals with their possible impact:

Proposal to converge different regulations on overseas investments: Currently, individual investors have the option of making direct investments in stocks/bonds overseas within the limit of $50,000 on overseas remittances. This move proposes to route all individual investments in overseas securities through mutual funds. For fund houses, this would mean a much larger pie of affluent individuals to tap into by way of new "international" offerings.

Fund houses that already run products that invest abroad (Principal PNB Mutual Fund, Franklin Templeton India) and those lining up new products (HSBC Mutual Fund, Kotak Mutual Fund) could look forward to a larger asset size to manage. Hopefully, this move would be accompanied by relaxations in the overseas investment limits for mutual funds, which now stands at $3 billion ($50 million per fund house).

Proposal to allow mutual funds to launch dedicated "infrastructure" funds: Most fund houses already operate open-end equity funds that piggyback on the "infrastructure theme", investing mainly in stocks of infrastructure, capital goods, construction and companies of this genre. Since the intention now is to open up flow of long term money into the sector, fund houses may be allowed to launch new closed end products with relatively long lock-in periods, which could adopt a hybrid structure (investing both in debt and equity instruments which fund infrastructure projects).

Proposal to allow short selling by institutions, settled by delivery: May give arbitrage and hedged equity funds greater leeway in fund management, improve their return potential and expand the number of derivative-based funds on offer. Fund investors too would have a few tools to benefit from a falling market.

Proposal to peg the dividend distribution tax on liquid and money market funds at a uniform 25 per cent: Presently, retail investors bear a concessional 12.5 per cent tax on dividend distribution by liquid and money market funds, relative to 20 per cent for corporates (excluding surcharge).

A uniform 25 per cent tax will significantly trim the attractiveness of the dividend option (on liquid funds) to retail investors. Liquid products generated an average return of 6.6 per cent in the past one year.

Assuming similar yields, the effective return could now decline to about 6 per cent on the dividend option. This may make liquid funds less attractive as a parking ground for temporary surpluses (less than a year), when compared to floating rate funds or short-term income funds.

For those with a holding period of over a year, the growth option would now be the more tax efficient way to earn returns, as gains would be subject to long term capital gains tax at 10 or 20 per cent, depending on whether you avail of indexation benefits.

The implications of many of these proposals will, of course, be clearer once the detailed notifications are out.