Beware Buyer of MF Products - ET

Several intermediaries in the financial market are treading the regulatory twilight zone in mobilising funds from investors to run unofficial, self-styled mutual funds. The pool of money, collected without regulatory approval and on the back of a loose agreement between investors and these players — primarily mutual fund distributors — are being put into various mutual fund schemes. In a way, the product is like a regular ‘fund-of-fund’ (F-o-F), albeit entirely unofficial.

This may reflect the underbelly in the financial market, but there are reasons why investors are taking the bait. Market sources said such services from the unregulated distributor segment have mushroomed mainly because of the unfavourable tax treatment for Fo-Fs. The pitfall is that investors have little to fall back on if the bets go wrong.

Crash may make things difficult

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 instances 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 F-o-F schemes sold by fund houses. The total AUMs of domestic F-o-Fs as on February 28 was roughly Rs 2,300 crore.

The point is, why is it thriving? Official Fo-Fs are not classified as equity under income tax laws. As a result, F-o-F schemes are hit by dividend distribution tax, while investors do not enjoy tax exemption on long-term capital gains. Since F-o-Fs invest a large amount, at least 65% in equity schemes, fund houses have been asking the government to correct the anomaly. Thus, unofficial F-o-Fs 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.