Why You Should Prefer Recommending Open End Debt Funds Over FMPs

Go for FMPs only if your client does not want volatility; else you should recommend open end debt funds.

With the financial year nearing its end, many fund houses have come out with FMPs to attract investors with indexation benefits.

While the attraction of ‘one more indexation’ is technically correct, you have to first decide if you prefer investing in an open ended or close ended structure.

We will look at the comparative features of open versus close ended funds and then discuss the taxation aspect.

Return upside/downside: In an FMP, the maturity of the instruments cannot be more than the maturity of the product. In addition, the fund managers lock in yields at the prevailing market price at the launch.

In an open ended fund, the returns are volatile and in line with movement of prices in the underlying market, with some difference (better or worse) made by the fund manager’s performance. That is to say, as compared to returns delivered by an FMP over its tenure, returns delivered by an open ended fund over the same tenure can be higher if the market movement is favourable and vice versa.

Liquidity: Open ended funds are liquid as these can be easily redeemed with the AMC, though an exit load may apply. On the other hand, close ended funds i.e. FMPs cannot be redeemed with the AMC. These are listed at the exchanges but liquidity is poor. That means, the investor has to have the same investment horizon as the FMP.

Fund running expenses: In an FMP, the recurring expenses are relatively low as the efforts of the AMC are mostly one-time. In open ended funds, recurring expenses are relatively higher, (except liquid funds). Open ended funds require continuous management by the AMC personnel.

Tenure: Typically, the tenure of FMPs is three years to a little above three years. This is in line with the tax rules to make it tax efficient as we will discuss later. The important point is, if you want to match the tenure of the FMP with your investment horizon, you have only one option: three years to a little more than three years. Open ended funds are better from this perspective: you can buy a fund as per your time frame and risk appetite, ranging from days (liquid funds) to months (short term bond funds) to years (long term bond funds).

Taxation: Tax efficiency in debt funds kicks in after a holding period of three years. The LTCG tax rate is 20% (plus surcharge and cess) after indexation benefits. This is the reason why most FMPs are of a tenure of three years to little above three years. However, taxation rules are the same for close-ended and open-ended funds. If your objective is to avail of LTCG and indexation benefit, it is available both in open ended funds too. In my view, open ended funds are better because the LTCG eligibility remains till you redeem, whereas once an FMP matures, your three-year period starts afresh.

The concept of one more indexation: The cost inflation index (CII) of the year of sale/ redemption is divided by the CII of the year of investment to arrive at the indexed cost for payment of LTCG. For an investment made before  March 31, 2017, the year of purchase is 2016-17. If your sale/redemption is after April 1, 2020, the year is 2020-21. This gives you the indexation benefit of four financial years. If you invest after  April 1,2017 your year of purchase is 2017-18 and you get the benefit of indexation for three financial years i.e. one year less. Hence, if you invest before March 31, you get indexation benefit for additional year.

Suitability: FMPs are suitable for conservative investors who do not want any market volatility during maturity (though in the interim period, volatility will be there) and most importantly, have an investment horizon matching the tenure of the product.

Key takeaway: If your client has an objective of investing in an FMP to benefit from low fund running expenses and no interest rate risk, then invest in the growth option (as against dividend option) of FMPs before March 31 to avail of one more indexation. If your client prefers open-ended funds for their liquidity and potential benefit from market movement/fund manager performance, you can consider recommending an open ended debt fund in growth option. In both cases, you require a horizon of three years for LTCG eligibility.

The industry AUM gives a perspective on what is preferred by investors and advisors. AUM of FMPs is static because of liquidity issues. As on end-February 2017, the AUM of FMPs was Rs 1.43 lakh crore, little lower than Rs 1.49 lakh crore of end-March 2016 and similar to Rs 1.43 lakh crore as on end-March 2015. As compared to this, AUM of open ended funds has increased significantly. This tells you the story.

Source: http://cafemutual.com/news/guestcolumn/297-why-you-should-prefer-recommending-open-end-debt-funds-over-fmps


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