New risk-o-meter bodes well for investors

Following the recent episodes in the debt market, Securities and Exchange Board of India, or SEBI, has overhauled the product labelling guidelines in a bid to help investors better understand the risks associated with each fund.

What has changed?

Earlier, the risk-o-meter was not dynamic. It didn’t reflect the underlying change in the portfolio composition, unless a fund was merged with another fund or the fundamental attribute of the scheme itself changed. Now, the risk-o-meter is more dynamic and reflects the current state of the portfolio.

Henceforth, fund houses will be required to communicate to investors if the risk level in a scheme undergoes a change. The risk assigned to each fund will have to be evaluated on a monthly basis and modified as per the changes in the underlying portfolio.

What has changed in the new risk-o-meter for investors? So far, fund houses were showing 5 levels of risks: low, moderately low, moderate, moderately high and high. Now, the risk-o-meter will display one more notch of risk - very high risk.

Methodology

Fund houses now have to follow a templated methodology for calculating the risk value for each fund.

For debt funds, schemes will consider parameters like liquidity risk, interest rate risk and credit risk. For instance, while evaluating credit risk parameter, gilt securities will be assigned a value of 1, AA+ rated paper will be assigned a value of 2, and below investment grade paper on the other extreme will be assigned a value of 12. Higher value (12) denotes higher risk while a value of 1 denotes low risk.

AMCs have to assign a final value derived from the weighted average value (weight based on AUM) of each instrument. The final rating assigned to the scheme is calculated by taking the simple average of all the underlying parameters (liquidity risk value, interest rate risk, credit risk, etc.).

Debt funds will now give higher importance to liquidity risk. If the simple average risk value of a debt scheme gets a score of 3.8 (average of liquidity risk, credit risk and interest rate risk) while the standalone liquidity risk profile value is 4, the fund will have to denote the risk rating as 4. A value of 4 means that the scheme is bucketed under moderately high risk category.

Value - Risk

1. Low
2. Low to Moderate
3. Moderate
4. Moderately High
5. High
6. Very High

Equity funds will factor in parameters like market capitalisation, volatility of the stock price, impact cost, cash, and so on. While assessing the market capitalisation risk value, large cap stocks will be assigned a value of (5), mid caps (7) and small caps (9).

Mutual funds are required to comply with this diktat from January 1, 2021.

Dwijendra Srivastava, Chief Investment Officer, Debt, Sundaram Mutual Fund, says the revised norms will help investors. “Fund houses give out many such disclosures in the public domain and discerning investors look at them to make informed decisions. The methodology to measure risk on the fixed income side is exhaustive and very explicit. More disclosure is good for the industry and investors. It is distributors/adviser’s responsibility to explain the product risk profile well to investors.”

Level playing field

Fund officials say that the new product labelling guidelines have plugged an important loophole. So far, risk was being assigned based on category. For instance, a large cap and a small cap fund would both be categorised as moderately high risk funds, even if small caps stocks exhibit higher drawdown in comparison to large caps. Now, the new risk-o-meter will reflect the true picture of the fund and should raise a red flag, should the quality of the portfolio undergo a change, especially in debt funds.

“If low risk funds such as ultra short term funds hold high risk paper, the risk-o- meter will now flag it. If there is a blip, and resultantly the risk profile changes, fund houses have to communicate it to investors. Advisers and investors can now clearly see how the risk profile of a scheme has changed over one year or how many times it has changed in one year. It is a good first step by SEBI. The methodology in equity valuation is not as exhaustive as it is in the fixed income funds. Going ahead, we may see some fine-tuning by SEBI on the equity side,” says Swarup Mohanty, Chief Executive Officer, Mirae Asset Mutual Fund.

Does low risk mean your capital is protected?

In the current regime, liquid funds are labelled as low risk products. While the product labelling does provide a hint of the risk a fund carries, investors should err on the side of caution and consult their financial adviser before choosing a fund. Low risk does not mean that your capital is risk-free, especially in mutual funds. It is worth noting that even liquid funds have delivered negative returns on a few occasions. Data from Morningstar Direct shows that during the week of March 15, 2020, to March 21, 2020, many liquid funds yielded negative returns as yields jumped due to the panic redemptions in response to COVID-19 outbreak. However, such instances are few and far between. Investors make up for the lost returns if they stay invested in the fund.

Take another example. Franklin India Credit Risk Fund and Franklin India Ultra Short Bond Fund, which were among the six schemes that shut down in April 2020, are denoted as suitable for investors who wish to take moderate risk as per the current risk-o-meter. If someone, would have invested in the fund by merely looking at the risk-o-meter, their money would have been locked up. Thus, risk-o-meter could be just a starting point in matching the risk profile of a scheme with your own risk appetite. Investors should look under the hood to evaluate the quality of the paper. The chances of AAA rated paper being downgraded are not ruled out. The new risk-o-meter addresses this concern.

The granular portfolio approach in the risk-o-meter is a step in the right direction, allowing investors to compare relative risk levels of funds within the same category based on underlying fund portfolios. It will also be beneficial for existing investors to gauge if there have been changes in the underlying risk of the funds they are invested in. Investors should look at this as another useful comparison metric when picking funds for their portfolios but shouldn’t be the only decision-making tool. Investors will need to keep in mind the appropriateness of the fund from an asset class exposure, fund category & investment time horizon. Additionally, investors should further understand the underlying sources of risk for each fund type and invest appropriately. There are other areas for improvement too when it comes to the methodology, for instance, it would be more appropriate for risks such as credit risk and liquidity risk to have an exponential scoring curve rather than a linear one to better represent the risk associated with lower rated credits.

Evolution of product labelling

Product labelling guidelines were introduced in 2013 in a bid to provide investors with a reasonable understanding of the kind of fund they are investing in and its suitability. From 2013, funds started disclosing the nature of the scheme (short, medium or long term), investment objective (equity, fixed income, gold, etc.), followed by three labels – blue (low risk), yellow (medium risk) and brown (high risk).

In 2015, SEBI increased the level of risks from three to five notches and introduced risk-o-meter.

To sum up, investors should not get overwhelmed by the exhaustive valuation methodology. That is for the fund houses to take care. What investors will get to see is the outcome – which risk profile the scheme fits into.

Arbitrage Funds: Why you must be prepared for low and volatile returns

Investors are often told in mutual fund sales pitches that they will enjoy fixed-income like (stable and safe) returns along with tax efficiency from arbitrage schemes. However, 2020 turned out to be a period of great disruption for this category as well. Two fund houses – ICICI Prudential and Tata Mutual – suspended fresh inflows into their arbitrage schemes for a short period of time in March 2020. Also, arbitrage funds as a category have seen tapering of returns in the current financial year. Investors need to understand the working of these schemes and realign to the changing framework of risks and returns.

How do arbitrage funds work?

Arbitrage funds aim to capture the difference between stock prices in the cash (or spot) and futures markets. For example, let's say ACC quotes at Rs 1497 in the cash market and at Rs 1508 in the futures market. These funds aim to capture such price differential by simultaneously buying the same quantity of shares in the cash market and selling in the futures market. This way, they do not take any stock-specific risk. As the expiry of the futures contract nears, the prices converge and the fund manager reverses the trade done earlier, to complete the second leg of the transaction. Since these trades are guaranteed on the stock exchange, they are perceived to be free of counterparty risk.

Returns are not stable

Contrary to the belief of many investors, arbitrage funds do not deliver stable returns. The returns from the strategy mainly depend on two key determinants – interest rates prevailing in the economy and price volatility in stock markets. The higher the rate of interest, the higher the cost of funding for the futures position. This gets reflected in the high premium investors need to pay for futures in a bullish market. In case the rates are low, the cost of carry and thereby the premium erodes for all derivative instruments.

If the price volatility is high with an upward moving bias, then you make more money in the cash-future arbitrage. But if there is a bearish sentiment in the market and the stock is quoting at discount in futures market or at a negligible premium, then there is little money to be made for mutual funds.

Arbitrage funds' returns have been impacted by these two key factors. Daily rolling return for the one-year period has gone down to 3.98 per cent on October 7, 2020 for arbitrage funds as a category compared to 5.91 per cent as on January 1, 2020, as per Value Research data.

“As interest rates in the Indian economy have come down, other things remaining the same, the spreads between spot prices and future prices have also eroded accordingly. This in turn has reduced the returns on spot-future arbitrage in last few months,” explains Vijay Bhambwani, Editor, Equitymaster.com.

Availability of arbitrage

Over the years, the increased use of technology has led to enhanced availability of the information, which in turn makes spotting and capturing arbitrage opportunities easier. But there is a flipside. Sumeet Bagadia, Executive Director, Choice Broking points to the declining arbitrage opportunities over a long period of time. “The moot question is whether an investor will get arbitrage opportunities consistently. In today's time, where all the information is handy, this type of difference doesn't exist for long,” he adds. He advises entering into such a strategy at the beginning of the month when there are relatively better opportunities.

Investors' participation in the financial markets also need to be watched. “As the market recovered from the March lows, investor participation has gone up. It has ensured that there are enough opportunities for arbitrage funds,” says Sailesh Jain, Fund Manager, Tata AMC.

There are many ultra-high net-worth individuals along with institutions and proprietary desks of brokerages looking for arbitrage opportunities. If too many investors go for arbitrage and the pie does not expand, then one has to settle for less. A look at the assets under management (AUM) of the arbitrage funds can give you some idea.

After a panic exit, which led to a Rs 33,767 crore net outflow from arbitrage funds in March, investors came back with net investments of Rs 20,930 crore in the April-June period, as per data released by the Association of Mutual Funds in India. However, as the returns taper down, investors are now seen exiting. In the three months ended September 30, 2020, investors have sold arbitrage funds worth Rs 8008 crore. The AUM of these funds stands at Rs 63,138 crore as on September 30, 2020 as compared to Rs 85,460 crore as on January 31, 2020.

Should you invest?

Arbitrage funds are suitable for the short term. Nitin Rao, CEO, InCred Wealth says, “As far as expected returns are concerned, arbitrage funds score above liquid funds and ultra short bond funds in a stable or upward trending stock markets.” Equity taxation makes returns delivered by arbitrage funds even more attractive, he says.

Profits in excess of Rs 1 lakh earned on units of arbitrage funds held for more than twelve months, are treated as long term capital gains and taxed at 10 per cent. In case investments are sold in less than one year, the gains are taxed at 15 per cent, which is less than the tax rates charged on bond funds.

But they cannot be used as a replacement for liquid or ultra-short bond funds. Vishal Dhawan, founder and chief financial planner of Plan Ahead Wealth Advisors says, “There is a possibility that opportunities in cash-future arbitrage may dry up for a month to three months in a year. Hence investors must have six to 12 months' investment time frame.”

You should calibrate your expectation of returns downwards. If the short term rates remain range-bound with downward bias, as indicated by the RBI Governor, in the foreseeable future, then you too should not expect significant uptick in returns from these funds. Another risk that you cannot ignore is the downward volatility in the market. At times when the futures prices quote at significant discount to cash markets, returns from these funds take a beating.

For an arbitrage fund, high volatility is welcome. “Increased volatility in an upward trending market, such as the one we are into now, is a good entry point for investors in arbitrage funds,” says Jain.

If you are content with returns in excess of ultra short term bond funds and have a one-year investment timeframe, then arbitrage funds make sense for you. Investments in growth option of arbitrage funds can offer better post-tax returns.

Can SEBI's new risk meter help MF investors make better choices?

Is an equity fund riskier than a debt scheme? Conventional wisdom would say an equity fund is riskier than a debt scheme. But what happens if your debt fund takes considerable credit risks and your equity scheme is a relatively safer large-cap index fund? From the events of the past two years, we now know that the former can get quite risky, even lethal. That's the anomaly that SEBI's latest revised product labelling – or risk-o-meter – guidelines (issued on October 5, 2020) seek to address. Through a scoring mechanism for various parameters, MFs will grade each investment in the scheme between 1 and 14. The least risky investment will be given a score of 1. For example, an AAA-rated PSU debt instrument will get a score of 1 on both credit and liquidity risks.

After your fund house computes the risk levels of every underlying instrument, it needs to arrive at a final score, which can be less than 1 or more than 5. Accordingly, its risk label will then be classified as ‘low risk', ‘low to moderate', ‘moderate', ‘moderately high', ‘high' and ‘very high'.

Here is a look at how the new risk-o-meter can help MF investors take a informed decisions.

Not just credit risks, liquidity also important

Currently, your debt fund's risk level is being largely determined by the credit rating of its underlying instruments. While credit rating is important, it's also necessary to assess how liquid the scheme's investments are. The new risk-o-meter takes into account both factors.

For instance, an AAA-rated listed instrument will now be assigned a lesser risk score (2) than an unlisted AAA-rated security, or one that comes with a credit enhancement (3). A credit enhancement is a structure whereby the borrower (in this case, the company in whose security the debt fund invests) attaches a collateral to improve its own credit worthiness. If the debt structure allows and the value of these collateralised shares falls below a certain level, it gives the right to the mutual fund to sell and recover the dues.

“As the new methodology adopts a conservative approach on risks, the idiosyncratic risks of a portfolio will also get picked up,” says Dwijendra Srivastava, chief investment officer-debt, at Sundaram MF.

Credit risk scores will be based on the credit rating of the debt securities. The liquidity risk's scores would take into account credit rating, as well as aspects such as credit enhancement, listed or unlisted debt and the put option. An unrated or below-investment-grade debt will get the worst score of 14 on liquidity risk value. MFs will have to arrive at the liquidity and credit risk values of the debt scheme portfolio, based on the weighted average scores of these parameters.

The new risk-o-meter will now also look at duration-strategy funds closely. Hybrid funds that invest in debt securities would now be subject to such rigorous scrutiny on the debt side of their portfolios.

The final risk value assigned to the scheme would be a simple average of the scores of various parameters. For example, a portfolio with risk value of one or less will be graded as a low-risk fund, a portfolio with a risk value of between 4.1 and 5 will be graded as high-risk, while a risk-value of more than 5 would be deemed to be of ‘very high-risk' grade.

Throwing light on credit risks

With the new fund categorisation norms, duration strategy schemes are technically allowed to take higher exposure to lower-rated debt papers. However, these funds do not follow the prudent credit risk exposure norms that SEBI laid down for credit risk schemes. Thus, investors could end up losing a substantial portion of their money.

The new risk-o-meter framework lays down a set of parameters to factor in the credit risk in every debt scheme portfolio, irrespective of the category. The liquidity risk of the scheme would also have to be considered, which tends to be high in schemes exposed heavily to lower-rated corporate debt. In other words, an ultra-short duration fund can be just as risky as a credit risk scheme.

“A shorter duration fund, which has higher credit risks, will now get graded as a higher-risk scheme in its category. This can keep investors on the alert when they are evaluating such a scheme,” says Vidya Bala, co-founder of Primeinvestor.in

Gauging risks in equity schemes

The new risk-o-meter methodology also aims at giving a more accurate picture of the risks in equity schemes. Within certain equity categories, fund managers have a wide room to take higher exposure to mid and small-cap stocks. However, such investment decisions are unlikely to reflect in the existing product labels. The risk-o-meter will consider all investments in large, mid and small-caps, and accordingly assign a market-cap score to the equity scheme.

“In categories such as large and mid-cap, value, contra or focused, there can be stark differences in market-cap orientation in different portfolios. The new risk-o-meter would factor in higher exposure to mid- and small-cap stocks or stocks with high volatility, and grade those schemes as higher-risk funds in their respective categories," Bala says.

The final risk value of an equity scheme will also consider the volatility and impact cost of investments.

Your scheme's risk-o-meter every month

Earlier, a scheme could take more risks as it gets older, without it getting reflected in the risk-o-meter at the time of its launch. If you just invest in it going by its risk-o-meter, you might not get the true picture of what the scheme actually does.

Not anymore. Your fund will now have to evaluate it on a monthly basis. Experts say that over time the risk-o-meter would give the path that a scheme has taken. “Like the industry has created an NAV history, now it can also create a risk history for schemes. This risk-o-meter has the potential to finally start the discussion on risks," says Swarup Mohanty, chief executive officer at Mirae AMC.

More people talking about a scheme's risk-o-meter may usher in a new way of selecting the right mutual fund scheme. "The MF industry should start talking more about risks and the new risk-o-meter, so that investors' focus shifts from just looking at past returns. All rating and ranking of schemes, which are just based on past returns, should now also focus on risks as SEBI has created a whole new framework for this," says Jimmy Patel, managing director and chief executive officer of Quantum MF.

Fund houses have time till January 1, 2021 to come out with new sets of product labels or risk-o-meters for all their schemes.

Where do the best overseas investing opportunities lie now?

Countries across the world are recovering differently from the COVID-19 pandemic. The varying extent of infections, stringency of lockdowns, and government stimuli mean that countries are looking at different recovery curves, and therefore present differentiated opportunities. This is segregating markets that are usually clubbed together, as emerging or developed markets, and splitting up the usual baskets for global investing.

Recent Fitch and Bloomberg studies on emerging markets highlight this divergence. According to the reports, indicators such as market performance, GDP outlook, and fiscal debt place countries such as India, Indonesia and South Africa on a different footing than other emerging economies such as China, Korea and Taiwan. A similar divergence can be seen in the developed markets, with the still raging virus and political uncertainty threatening current valuations in the US. Table 1 presents our estimates of global GDP growth over the next four quarters.

From a retail investor's perspective, this makes entering international markets a bit more complicated. However, the need to diversify is stronger than ever, as concentrating your investments in one market may expose you to greater risk of uncertain recovery. This is especially true for the Indian market; Indian equities are looking at an uphill struggle due to a weak capex cycle, continuing demand and supply shocks with a rising COVID-19 graph, bank credit de-growth and no immediate relief from fiscal stimuli.

Amidst all the uncertainty, and the contradictions in economic outlook and market behaviour, we are looking at two key indicators for our research recommendations in this period: rate of economic recovery from COVID-19, and outlook on equity valuations. Let's look at how these indicators can help us identify a steady course of action in global investing.

(R)Acing the curve

Different timelines and intensities of COVID-19 infections have led to different states of unlock across countries. Nations that are past the peak of COVID-19 infections have been able to kick-start their economies, posting better-than-expected trade and manufacturing data, and will therefore benefit from greater price momentum as optimism builds up. For example, research estimates that the 2021 growth for Australia and New Zealand, countries with early success in flattening the curve, will be higher than the US .

China, the earliest country to cross the peak, has been pegged by the IMF as the only economy in the world to avoid a contraction this year, while its growth in 2021 and 2022 is expected surpass that of its peers. This estimate is supported by expansionary service and manufacturing PMI data since May, and the country's ability to counter disruption to supply chains and foreign demand through domestic production and demand.

In turn, the steady recovery in macro conditions across the second half of 2020 are creating headroom for further expansion in both, earnings per share and price to earnings ratio (PE) for China A and China H equities. We estimate potential upsides of 20 per cent and 60 per cent, respectively for the China A and H equities over the next two years.

When compared to India, therefore, whether in terms of economic growth or potential market returns, China's position on the curve is its biggest advantage right now. Looking forward, with India's GDP expected to shrink, and its earnings recovery uncertain, China represents a strong diversification opportunity for investors.

Valuation windows

For an illustration of the valuation opportunities in global markets, we can look at the Eurozone. Rated ‘Neutral' as a market by our global research desk since last year, the Eurozone entered a recession in the second quarter this year on the back of already anaemic growth. However, better-than-expected economic recovery, the recent agreement on the Euro 75 Bn EU Recovery Fund, along with European Central Bank's planned quantitative easing up to end-June 2021, have significantly improved economic sentiment and investor confidence in the region.

With more than half of Europe's STOXX 600 index comprising cyclical sectors, the region's equities are particularly well-positioned to benefit from this economic rebound. Given the structural composition, European equities (especially in comparison to the US) tend to have a heavier weight in ‘cheaper' sectors. Even the valuation for Europe's IT sector remains greatly below that of the US. Investing in Europe thus offers a play on value, and should benefit during the expansion phase of the business cycle.

According to a recent Bank of America Global Fund Manager Survey report, fund managers have been rotating into European equities, seeking greater exposure. There was significant rotation into European equites in August, making it the topmost overweight region at that point. The survey further reveals that Fund Managers' current positions in Europe have still not reached their long-term average, indicating a continuation of inflows if the pandemic is kept in check.

Valuation-wise, we believe European equities are trading cheaper than their estimated FY21 earnings, and our team expects a long-term upside potential of +18.4 per cent by end-2022. This is relatively attractive within developed markets, and also offers Indian investors the opportunity to invest in larger, more stable companies at fair prices.

Conclusion

As markets everywhere remain noisy in the aftermath of the pandemic, and economic and market data create divergent views, knowing the right parameters to look at can make all the difference. Investing via mutual funds remains the best bet for retail investors new to global markets, whether through feeder funds available in India, or as direct investments abroad. The Indian market is already reflecting this, with September inflows into Fund of Funds investing overseas showing a 470 per cent increase over August inflows.

How you must choose among ultra-short, low and short-duration funds

Are you aware of the number of categories of debt funds?

For the uninitiated, the answer is 16. Yes. That's not a small number. And hence, it's natural for retail investors to feel confused as to which categories are suitable for their investments. On the shorter side of the debt fund maturity spectrum, lie three categories that many investors are interested in: ultra short duration, low duration and short duration funds.

What is the difference among these categories and how should you choose what is suitable for you?

Segregation based on maturity

At a very basic level, the categorization is based on the maturity profile of the funds.

That is, the funds in these categories invest in debt and money market instruments so that:

-Ultra-Short Duration Funds - Macaulay duration of the portfolio is 3-6 months

-Low Duration Funds - Macaulay duration of the portfolio is 6-12 months

-Short Duration Funds - Macaulay duration of the portfolio is 1-3 years

The Macaulay duration is a technical term. But simply speaking, it refers to the weighted average maturity of bonds/papers in a fund's portfolio after factoring in all the cash flows.

In general, the higher the duration, the higher is the interest rate risk. Since low-duration funds take a slightly higher duration stance, they also carry higher interest rate risk. Similarly, short duration funds carry higher interest rate risk than low duration schemes.

One thing that most investors don't realize is that if the average duration is 3-6 months (like for Ultra-short duration funds), it doesn't mean that all the papers/bonds held by the fund will be maturing in 3-6 months. It is just the average profile of the fund's portfolio. So some bonds in the portfolio would be maturing in the next 1-3 months while some other might be maturing in the next 2-3 years!

Sounds odd right? But that is how averages work.

And there is another aspect to this. Due to the mismatch between the average maturity figure and the actual individual maturity timelines, the funds may carry a little more interest rate risk than what their category (or average maturity profile) might tell you. So you need to be careful about what you see and what you make of it.

What about credit risk?

Structurally, ultra short duration and low duration funds are more suited for taking lower credit risk due to their shorter maturity profile. Short-duration funds on the other hand can take comparatively higher credit risk as they have the comfort of the longer maturity profile for their portfolio.

Sadly, the existing categorization guidelines only refer to the duration of the scheme portfolios. Nowhere does they prescribe any credit rating profile for these three categories.

So, fund managers are free to take as much credit risk as possible to try and generate extra returns. This will work at times. But it may also not work occasionally. And this is what happened in the on-going debt fund fiasco of Franklin India AMC. Try to understand it like this.

Suppose you want to choose between two ultra-short duration funds, namely A & B. You check the maturity profile and it's within SEBI specified limits of 3-6 months. Now you look at the historical returns. You see that the fund A has given much higher returns. You decide to figure out the reason for this outperformance. You open the bonnet (check funds' portfolio) and realize that fund B has 95 per cent of its assets invested in high-credit (AAA) rated papers. On the other hand, fund A has invested only 25 per cent in AAA-rated papers, while the rest of it is parked in lower-rated, riskier but high-yield securities. So the fund manager of fund A is taking extra credit risk to generate high returns.

Since we are talking about debt funds, it's best not to take too much risk in debt. Risk taking should be limited to the equity side of your portfolio.

So, when should you invest in these three fund categories?

Ultra short duration and low duration funds can be used for short-term investments which are due in more than a few months, but up to a few years. Short duration funds are suitable as the debt component for medium to long-term portfolios. It's not suitable if you plan to park your money for just a few months or 1-2 years. But having said that, even ultra-short and low duration funds can also be part of your long-term portfolio. Or, one can hold a combination of these categories to have a well-diversified (maturity timeline) debt fund portfolio.

Choosing debt funds is not easy, though it's simple. Do not go after high returns alone. Stick to large well-diversified debt funds that give reasonable returns but don't compromise on credit quality and hold highly-rated securities.

How to disclose dividends and capital gains on MFs while filing tax returns

Many of us would have dipped into our mutual fund (MF) investments before March 31; the end of the financial year 2019-20. But withdrawals from MFs attract tax. Here's what you should know about how gains are taxed.

Are dividends and capital gains taxed?

Budget 2020 made dividends taxable. However, for the year (FY) 2019-20, dividends are tax-free. So, if you've earned dividends till March 31, 2020, then your dividends were tax-free in your hands. However, your fund house would have paid dividend distribution tax (DDT) of 29.12 percent, including tax and surcharge in the case of a debt fund and 11.648 percent for an equity fund. The same should however be reported under Schedule-EI of the relevant ITR of AY (Assessment Year) 2020-21.

Now, in the current financial year (FY 2020-21), you would need to add dividends earned to your income and it would be taxed as per your slab.

Sale proceeds from mutual funds are also taxed, depending on how long you've held on to your MF units. For equity funds, if you sell your units within one year, it is termed as short-term capital gains (STCG) and taxed at 10 percent. If you sell your equity fund units after a year, then that is long-term capital gains (LTCG) and taxed at 15 percent.

For debt funds, the threshold is three years. Units sold within three years will attract STCG tax, which is your normal bracket. Any LTCG from your debt fund units are taxed at 20 percent with indexation benefits.

How to report MF gains and losses?

Several taxpayers treat gains or losses from the sale of shares/MFs as ‘income from capital gains,' while others treat it as ‘business income.' CBDT (Central Board of Direct Taxes) has issued a circular giving a choice to the taxpayers of how they want to treat such income. “Once the taxpayer selects an option, he/she must continue with the same method in subsequent years also,” says Rahul Garg, senior tax partner, PwC India.

If the individual selects ‘business income' then such income is to be reported in Schedule BP of the ITR form. Alternatively, if an individual opts for capital gains, then such transactions should be reported in Schedule CG of the ITR form.

I have bought and sold many MF units in the past year, including systematic investment plans (SIPs) and systematic transfer plans (STPs). Is it possible to get a concise report of all my mutual transactions?

Yes, it can be quite a cumbersome task to keep track of all your schemes that you've bought and sold. Especially, if you invest a lump-sum amount in, say, an equity fund, though an STP from a liquid scheme. Each such transfer calls for a sale of your liquid fund units and a purchase of your equity scheme units.

Fortunately, registrar & transfer (R&T) agents offer help. Computer Age Management Services (CAMS), one of India's largest R&Ts offers various such reports on its website that give you details of your capital gains, dividend income returned and so on.

You do not need to submit scheme-wise details of your dividend or capital gains income. But segregate income earned from equity-oriented schemes and debt schemes, because both these categories attract different tax rates. “However, it will be prudent for people to preserve these documents in case the tax officer asks for such documents or requests for a clarification about the transactions reported in the returns,” PwC's Garg says.

What happens if the individual incurs losses in an equity or debt fund? Can he/she set it off against other heads or claim deductions? Where should he/she report it in the ITR?

Any loss arising from transfer of units of mutual funds can be of two types—short-term capital loss and long-term capital loss. Long-term capital loss can be adjusted only against LTCG whereas short-term capital loss can be adjusted against short-term as well as long-term capital gains. “If the loss cannot be set off or adjusted in the same year, then the unadjusted capital loss can be carried forward for 8 years and set off only against income from capital gains, provided the return of income in which loss is incurred is filed on or before the due date of filing the return,” PwC's Garg says. The amount of loss shall be auto-populated under relevant the schedules of ITR such as Schedule CG, Schedule CYLA, Schedule CFL and Part B-TI.

Should the individual report each and every transaction involved in selling of MF units in the ITR?

In the case of short-term capital gains (STCG), there is no requirement of reporting each and every transaction involved in selling of MF units. For long-term capital gains (LTCG), the scrip wise details in the return of income for FY 2019-20 should be filled up as they are eligible for the benefit of grandfathering.

The Finance Act 2018 grandfathered the investments made in listed equity-oriented MFs on or before 31-01-2018 as the LTCG arising from the sale of such units were previously exempt from tax. “The scrip-wise reporting is required (under Schedule 112A) only in respect of long-term capital gain arising from transfer of listed equity oriented mutual funds acquired before 01.02.2018,” says Naveen Wadhwa, deputy general manager, Research and Development, Taxmann Publications, a leading publisher on taxation and corporate laws.

“In any other case, the aggregate amount of capital gain arising from transfer of units of mutual funds can be reported in Schedule CG,” he says. “In case you had invested in the MF through systematic investment plans (SIP) route, the holding period for each such SIP will have to be calculated separately,” Garg says.

Explained: Where do debt mutual funds invest?

It's easy to understand where equity funds invest and how they generate returns. They buy and sell equity shares. When share prices go up, equity funds generally tend to gain.

But debt markets work differently. To put it simply, it's a market place for borrowers to borrow money and lenders who are willing to lend. Timely payment of interest and principal is crucial. And because retail investors usually cannot buy them directly (face value of one bond is typically around Rs 1 lakh), there is little understanding on how such debt instruments work.

Where do short-term debt funds invest?

Typically, such funds invest in instruments that mature within a year. They include TREPS (Tri-Party Repo), repurchase agreements (repo), Certificates of Deposits (CDs), Commercial Papers (CPs), T-bills and so on. Banks, Non-banking finance corporations (NBFCs), PSUs, corporates and the Government issue such money market instruments to meet their short-term funding requirements.

Repo and TREPS are the instruments used to provide loan for the very short term of, say, overnight or up to a year. Repo allows institutions such as banks and NBFCs to borrow funds by putting up government securities as collateral. These firms can also lend in the repo market. Interestingly, mutual funds can only lend in the repo market (barring extreme conditions).

To vitalise the debt market, the RBI recently allowed repos to be backed by corporate bonds as collateral.

Interestingly, even equity funds park their short-term surplus in the repo market.

Short-term debt funds also invest in CDs, CPs and T-bills. These are also instruments that allow the borrowers – banks and corporates – to borrow for their short-term needs. Banks issue CDs, corporate firms issue CPs and the government issues T-bills through the RBI. Typically, CDs are rated higher than CPs and come with better credit quality. That is also why CPs come with slightly higher interest rates to compensate for their sometimes lower credit rating.

Most of these instruments are zero-coupon bonds, which are issued with discounts. For instance, a three-month T-bill of Rs 100 (face value) may be issued at say Rs 98, that is, at a discount of Rs 2. At maturity, the issuer repays the face value of Rs 100. So, the return to the investors is Rs 2.

While short-term debt funds invest a significant chunk of their corpus in such avenues, long-term debt schemes too invest a sizeable portion. 

Where do long-term debt funds invest?

Government securities: The safest among long-term instruments are government securities (g-secs). The central government needs funds to run its day-to-day operations and finance the fiscal deficit. Apart from other avenues such as tax, it also borrows money from the debt markets, through the RBI, its banker, by issuing g-secs. State governments, too, borrow by issuing State Development loans (SDLs).

Since these instruments are backed by sovereign guarantee, they are the safest and most liquid. G-secs can come with maturities as long as 40 years. G-sec mutual fund schemes predominantly in these gilts. But other debt and hybrid funds, too, hold g-secs to manage their duration (interest rate sensitivity) and maintain a good credit mix.

Bonds and Debentures: Likewise, when companies need to borrow money for their long-term requirement, they issue bonds and debentures. These come with tenors of 1-15 years. But since corporate bonds do not come with a government guarantee (unlike g-secs and T-bills), they carry higher credit risk. To compensate, they also pay higher interest rates.

Therefore bonds also come with credit ratings. Unless, you invest in a credit risk fund, go for bonds that invest sizeably in highly-rated instruments. Typically, bonds issued by government-owned companies are considered safer than private-sector firms, but that is not always the case.

Note that short term debt funds too hold certain portion in G-Secs and bonds with short residual maturity of, say, less than a year.

Securitised debt: Securitized debt instruments are securities that are created by securitizing individual loans.

Simply put, a bank has a car loan portfolio worth Rs 1000 crore. To free up the capital, the bank creates debt instruments (which are called pass-through certificates or PTCs) backed by the asset, which is the car loan portfolio here, and sells to the mutual funds and others.

Technically, a securitization transaction involves sale of receivables by the originator (the bank) to a Special Purpose Vehicle (SPV), typically set up in the form of a trust. Investors (mutual funds) are issued rated PTCs, the proceeds of which are paid as consideration to the originator.

These securitized debt instruments are rated by the rating agencies. Mutual funds prefer holding only those rated AAA.

Risk of investing in securitized debt is similar to investing in debt securities. In January 2019, a few debt funds from Aditya Birla and HDFC mutual funds were hit as the SPVs of two road projects owned by IL&FS, which they held, defaulted on interest payment.

A few mutual fund schemes allocate 0.2-10 per cent of their portfolios to these instruments. As on August 31, 2020, MFs held Rs 9,685 crore in such securitized debt instruments.

Why is KYC important? (KYC- Know your customer)

Why is KYC important?
Know Your Customer, popularly known as KYC, is a mandatory compliance procedure that RBI (Reserve Bank of India) and SEBI (Securities and Exchange Board of India) has specified for the banks and other financial institutions such as asset management companies (AMCs), insurance companies and stock broking firms, among others.

Under KYC, financial institutions collect certain important information pertaining to the identity of the client - whether an individual or institutional. This is done in order to increase the legal vigilance so that the cases of fraudulent monetary transactions, money laundering etc., can be minimized.

According to its KYC guidelines in 2002, RBI had directed all the banks to be fully compliant with the KYC norms by 2005. With digital innovations, KYC can be done online as well as in paper mode. Under KYC procedure, the information pertaining to the name, name of spouse and parents, address and its proof, PAN number and Aadhaar details, other valid identity proofs, details of education and profession etc. are collected.

Importance of KYCKYC is very important compliance requirement because it:

1. Establishes the truth and veracity of the customerBanks and other financial institutions enter into business with a multitude of people. As handling sensitive matters related with finance, institutions need to establish the authenticity of the identity of these people - whether individuals or business organizations. KYC helps the institutions collect sufficient proof as to the same purpose.

2. Helps keep track of the transactionsKYC helps financial entities to avoid transactions with persons or organizations involved with corruption, politically exposed persons (PEPs), and those with criminal motives such as terrorist financing and fraud. By following the KYC norms correctly, financial organizations can ensure that their services aren’t misused.

3. Is an important risk management strategyAs the KYC procedure detects the entities with suspicious background early on, it effectively minimizes the instances of money laundering, theft and other monetary fraudulent practices in a sector as sensitive and critical as banking and financial services industry.

Financial institutions, after collecting and verifying this information, send it to the KRAs (KYC Registration Agencies). KRAs upload the same in central database. In the event of any changes in the information in future, only the relevant section is updated.

The following documents are declared as OVDs (Officially Valid Documents) by the Central Government for the purposes of KYC procedure:

PAN Card
Aadhaar Card
Passport
Driving License
Voter’s Identity Card
NREGA CardIf you haven’t completed the KYC procedure, walk into the nearest branch of any financial institution with the above documents and get it done at the earliest.

How to fulfill KYC requirements as per CKYC norms

 How to fulfill KYC requirements as per CKYC norms

All individual investors of mutual funds are now required to fulfill KYC requirements as per Central KYC norms.

A CKYC form can be obtained from the AMC or can be downloaded from the AMC/ KRA website or registrar.

Central KYC or CKYC is a government initiative to bring KYC process of all financial sector entities under a single window.

CKYC is managed by CERSAI (Central Registry for Securitisation Asset Reconstruction and Security Interest of India).

All individual investors of mutual funds are now required to fulfill KYC requirements as per CKYC norms.

CKYC form:

A CKYC form can be obtained from the AMC or can be downloaded from the AMC/ KRA website or registrar.

Information:

Though PAN is not a mandatory information to be filled as per the CKYC form, since the PAN is mandatory for security markets KYC, the form has been modified to make the information mandatory. The form also captures Aadhaar, date of birth, investor’s maiden name and mother’s name in addition to the earlier KYC form.

Documents:

Duly filled and signed form along with the following documents (self attested) should be submitted along with one photograph:

* Proof of identity

* Proof of address Copies must be supported by original documents for verification at the time of submission

FATCA information:

The CKYC form also contains FATCA declaration that must be filled up by the investor.

Process:

Once the form is submitted, the information provided will be verified and a unique KIN (KYC Identification number) will be generated and communicated to the investor by SMS/email. Some KYC Registration Agencies (KRAs) provide information on status of CKYC wherein the investor can key in PAN and their KYC status is displayed.

Points to note:

* Currently CKYC is applicable only to individual investors (resident and NRI).

* Existing investors who have already completed KYC under earlier process do not have to undergo any additional KYC requirements under CKYC