FMPs: The devil is in the assumptions

There is never a dearth of ideas among the AMC (asset management company) think tanks, when it comes to drawing investors towards their offerings. The AMCs usually adopt innovative ways to promote their products. Often these ideas have the desired impact and get investors all interested.

While such promotional gimmicks have always been in vogue, they have become more visible over the years as AMCs scramble to mobilise assets. A glimpse of this can be seen in some of the recently launched FMPs (fixed maturity plans), with some AMCs projecting a relatively higher cost inflation index (CII) to make the FMPs returns more attractive.

The scenario at present

The returns earned on FMPs are treated as capital gains (short-term or long-term depending on the investment tenure). In case of long-term capital gains (if investments are held for more than 365 days), the tax liability is computed using two methods i.e. with indexation (charged at 20 per cent plus surcharge) and without indexation (charged at 10 per cent plus surcharge); the tax liability will be the lower of the two.

For computing long-term capital gains by taking into account indexation, CII needs to be factored in. For this, CII is required for both, the year of investment as well as the year of sale of investment. Most FMPs that have been launched recently have investment tenure of more than 365 days. With this, the FMP's tenure is spread over two financial years i.e. 2008-2009 and 2009-2010, enabling investors to avail of double indexation benefit.

For this, the CII for both the years must be available. While the CII for the year 2007-2008 (the year of investment) is available, the same is not yet declared for the years 2008-2009 and 2009-2010 (the year when the FMP matures).

This has led the AMCs to make their own CII assumptions in order to provide indicative returns on their FMPs over its investment tenure. So AMCs have come up with their own estimates on what this figure could be in the financial year 2009-2010 (by when the FMP will mature). And thanks to the lack of standardisation in the mutual fund industry, the projected CII figure varies across AMCs.

So, while some AMC are projecting CII at 607 (inflation at 5 per cent per annum) in the year 2009-2010, some have exaggerated their CII projections to as high as 621 (inflation at 6.2 per cent per annum). Such outlandish assumptions could misguide investors in a big way.

How investors can get misguided

For this, investors must first understand the implication of CII on the FMP returns. FMPs that have a maturity of more than 365 days attract long-term capital gains tax liability. As mentioned earlier, this is computed using two methods, i.e. with indexation and without indexation. CII is used while computing long-term capital gains tax liability with indexation.

How inflation can impact FMPs returns

(We have not considered the 'without indexation' option, as the tax liability in the 'with indexation' option is lower.)

In the above illustration, we have assumed three scenarios targetting different inflation rates and hence different CIIs. While the first two scenarios (with 6.2 per cent and 5.0 per cent inflation rates) are from two recently launched FMPs, the third scenario gives investors an idea about what their returns will be if inflation is at a lower level.

As is evident from the table, in the first two scenarios the investor is actually incurring a capital loss, which in turn results in zero tax liability. Hence, he is likely to get post-tax return equivalent to the indicative yield of the FMP i.e. 9.75 per cent.

However, in the third scenario where inflation is taken at 4.0 per cent (which is the average rate at which inflation has risen since 2000-2001), the investor will have a capital gain leading to a long-term capital gains tax of Rs 41,924. Therefore, under this scenario his return will be 9.34 per cent, which is lower than the other two scenarios (i.e. 9.75 per cent).

The trouble is that AMCs are silent on the third scenario where returns can actually be lower than what have been projected. Since investors are oblivious to this, they have no idea that the higher FMP return is arrived at by inflating a key variable.

By taking a closer look at the illustration another important point comes to the fore; the inflation figure estimated by the AMCs is either equal or above 5.0 per cent. The reason for this is - anything below 5.0 per cent will amount to capital gains and consequently capital gains tax liability, which in turn would result in lower return for investors. Having said that, atleast AMCs falling in the second scenario (that assumes inflation at 5.0 per cent) have taken a more realistic view on the inflation rate than the AMCs falling in the first scenario (that assumes inflation at 6.2 per cent).

So if the inflation figure coincides with the estimates made by the AMCs (or rises even higher), then investors are likely to get the return projected by the AMCs. But if it falls below their estimates, then returns will dip below projections.

The key learnings

1.  FMP returns are based on assumptions. Due to a lack of standards in the industry, AMCs have a free hand in making assumptions. As for investors, they should evaluate all possible scenarios.

2.  The decision of investing in FMPs should not be guided only by returns; instead, it should also depend on the investor's investment objectives and asset allocation.

On the regulator's part, we would like Sebi (Securities and Exchange Board of India) to introduce standards in this regard so that assumptions/estimates made by AMCs can be regulated. This will be instrumental in providing investors a transparent picture of their proposed investments, which in turn will help them take informed investment decisions.

Make the most of Sebi's 'zero entry load' guideline. Read on.