AUM of local F-o-Fs at Rs 2,300 crore

MUMBAI: Several intermediaries in the financial market are mobilising funds from investors to run unofficial, self-styled mutual funds. As in most market stories, the going is good as long as the Sensex behaves; but if there is a crash, the investor may find it difficult to salvage any money in the absence of a legally enforceable contract between them and the MF distributors who are doubling up as F-o-Fs.

In the past, there have been cases of private pools of money going into stocks and MFs through unregistered operators who act as portfolio managers. The F-o-F by distributors is somewhat similar to these, though a little more sophisticated. Sources said the money raised through such arrangements is more than what has been collected through official FoF schemes sold by fund houses. The total AUMs of domestic F-o-Fs as on February 28 was around Rs 2,300 crore.

The point is, why is it thriving? Official FoFs aren’t classified as equity, under income-tax law. Hence, FoF schemes are hit by dividend distribution tax, while investors do not enjoy tax exemption on long-term capital gains. As FoFs invest a large amount, at least 65% in equity schemes, fund houses have been asking the government to correct the anomaly. Thus, unofficial FoFs are a way to side-step the tax.

Besides, mutual funds have not paid dividends for their F-o-F schemes in recent times.

The modus operandi is simple. An investor, mostly with deep pockets, gives a power of attorney to a trusted distributor for operating his bank account. The distributor, in turn, uses the money in the account to invest in schemes of his choice on behalf of the investor. In this arrangement, which is solely based on trust, the investor is just concerned about the net returns and gives the distributor a free hand in operating it. The distributor also takes care of the paper work.

The distributor usually does not charge any fee from investors for managing the portfolio and only collects distribution fees from fund houses. The arrangement resembles portfolio management services by brokerages and mutual funds, and wealth management services banks offer to HNIs. However, mutual fund distributors are not directly regulated by either Sebi or the RBI. Distributors usually invest the clients’ money in a mix of equity and short-term debt schemes.

Clients of such distributor services score over F-o-F investors in terms of dividends, as they are required to pay dividend distribution tax, unlike equity schemes. Also, influential distributors are known to have prior knowledge about dividend announcements, enabling them churn higher profits for their favourite clients.

Distributors also hold a portion of the portfolio in equity schemes for more than a year for long-term capital gains tax benefits, which investors in F-o-Fs do not enjoy. This is because F-o-Fs do not purchase equities as an asset class.

Industry officials, however, feel such services are not free of risk: Investment guidelines are not concretely spelt out since it’s an informal agreement and risk management systems are not in place.