Mutual funds brace for mass withdrawals

The Unit Trust Association of Sri Lanka, the mutual fund industry body, warns that high taxes on money market returns will drive away investors, leading to massive revenue losses, fund closures and job cuts

The mutual fund industry is warning that high taxes on fixed income returns will lead to mass withdrawals, funds winding down and a couple hundred job losses, according to a report submitted to capital market regulator the Securities and Exchange Commission (SEC) in December 2016.

“The 2017 Budget’s tax proposals create an unequal playing field, making mutual funds unattractive as an investment option, resulting in a significant withdrawal of investments and the collapse of the mutual fund industry,” the Unit Trust Association of Sri Lanka warned in a report on ‘National Budget Proposals 2017: Impact on the Unit Trust Industry and Recommended Amendments’ sent to the SEC. It said many of the funds could eventually wind up with around 200 people losing jobs.

“I won’t be surprised if investors exiting drives down the mutual fund asset base to Rs20 billion by the end of 2017. This will force 50- 60% of the funds to wind up,” says Ruwan Perera, president of the Unit Trust Association of Sri Lanka and chief operating officer of NDB Wealth, which manages several equity and money market funds. Mutual funds, also called Unit Trusts, had Rs112 billion in assets at end-November 2016, of which money market fixed income instruments—like government securities, corporate debentures and commercial papers—accounted for 85% of assets.

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The 2017 Budget proposals increased taxes on fixed income returns of unit trusts four-fold. These taxes will impact corporate investors who account for 90% of fixed income investments in mutual funds. Returns from the year starting April 2017 will now be taxed at two stages: a 14% withholding tax on returns from fixed income instruments (increased from 10%) and the returns made liable to corporate tax—28% for most firms—removing the exemption that applied earlier.

This leads to an effective 38% liability on the return for private firms investing in a money market fund. Interest income from a bank-fixed deposit—higher than fixed income returns with interest rates rising—is subject to a 28% withholding tax.

Consolidation is another option mooted. “I think that is one of the things being discussed. There are 14 players, and it may be too much for the industry. There are proposals from the government side on consolidation, indirectly,” Perera says

“Bank-fixed deposits have a clear tax advantage over mutual funds, but more importantly, current tax proposals are forcing people to choose investments based on taxation as opposed to risk returns,” Perera says.

Mutual fund management firms had thrived on corporate income tax concessions. Managed by professional fund managers, mutual funds were conceived for individuals and small businesses. A fund typically invests in two types of assets: equity and fixed income like government bonds, corporate debentures, commercial papers and bank-fixed deposits. Mutual funds emerged in Sri Lanka in the early 90s, mainly investing in listed stocks.

Corporate investors swarmed money market funds after returns were exempted from corporate tax in 2012. Assets managed by mutual funds more than tripled in three years to Rs130 billion in 2015, because private companies invested in these to take advantage of low taxes. Perera says 90% of the funds the industry now manages is on behalf of corporate investors.

Low bank interest rates, tax breaks that encouraged corporate debt issues and stock market listlessness encouraged the mutual funds industry to set up money market funds investing in fixed income assets. Industry-wide fixed income grew from 47% of total assets in 2010 to 89% at end-2015. Nine new firms introduced mutual funds in the five years, joining five others that already existed.

Now, mutual fund businesses whose earnings are tied to the size of the funds they manage—from fees up to about 1% of assets—are waiting for the roof to come down as their biggest revenue generators, corporate investors, lose their tax concessions. The Unit Trust Association is discussing the tax implications on the industry with the SEC hoping to convince the government to change the unequal tax policy.

The Unit Trust Association is proposing that the government halve the corporate income tax to 14% for returns below Rs300 million for the next three years, taxing returns above this at the normal 28% rate. “This should give mutual fund management firms enough time to divert fee incomes to grow their retail client bases,” Perera says. “Elsewhere, corporates received tax concessions so mutual funds can use the earnings spike to invest in retail base growth. But this is not what happened here,” he says.

Consolidation is another option mooted. “I think that is one of the things being discussed. There are 14 players, and it may be too much for the industry. There are proposals from the government side on consolidation, indirectly,” Perera says.

Before the new taxes came, mutual fund management firms were already pressurized. Interest rates rising since 2015 have made bank-fixed deposits more attractive, offering higher returns to investors. As a result, mutual fund-managed assets fell by Rs26 billion in 2016, Perera estimates. “At the moment, the mutual fund management business is not profitable. Industry level revenue has fallen around 70% in 2016.”

Perera now predicts a crash in 2017, as the tax implications take hold. “We’re going to have some tough years ahead,” he says. Costs will increase and revenue will be a long-term build-up. Mutual fund management firms have no choice but to grow their retail client base fast enough to recover from a sharp earnings decline as corpo­rates exit. Also, future business growth can only come from this segment. “I am not sure many of the firms can afford to wait until they build a critical base of retail clients,” he says.

Building a viable retail client base is challenging for three reasons: First, the tax on returns from fixed income mutual fund investments applicable to individual investors is also too high now. Individuals’ fixed income mutual fund returns will be taxed at 14% both at instrument level and fund earnings for a real effective tax rate of 26%—it was previously just 10%—five times more than the 5% withholding tax on fixed deposit interest income. “We may be able to generate returns better than normal bank savings, so there is a slim opportunity, but we cannot compete with fixed deposit returns,” Perera says.

Second, equity offers higher potential returns than any other asset class in the long term, but these benefits are negated by the stock exchange’s lackluster performance over the past few years. It’s challenging to convince individuals about equity’s potential. “People prefer saving with a bank. Since 2010, equity funds have outperformed the main All Share Price Index, but I doubt they did better than fixed income mutual funds,” Perera says.

Even if they could convince individuals to invest in an equity mutual fund, acquiring new clients is expensive. Advertising and expanding investment advisory teams consumes money faster than fee incomes are collected. “Assume a mutual fund spends Rs1 million on advertising to acquire retail clients. If the management fee is 1% of investments—it’s usually lower than that—a mutual fund firm needs to collect Rs100 million just to recover the advertising cost,” Perera says. Targeting high-net-worth individuals is not an option because many of them prefer investing on their own, he says.

During the corporate client boom years, a few mutual fund management firms saw an opportunity to invest the revenue windfall into growing their retail client bases. “Many mutual fund management firms did not see this coming; they assumed tax concessions for corporates would last forever,” Per­era says. He singles out mutual funds managed by NAMAL, Ceybank, Carson (Guardian Acuity) and his own firm NDB Wealth for having invested in growing the retail segment early on.

“Our focus is on bearing fruit. Initially, we used to collect around Rs10 million a month from new individual clients into mutual funds. By 2017, we collect around Rs150 million a month,” Perera says.