VR Logo

When Funds Merge

Fund companies merge funds to hide underperformance; but as investors, you shouldn't be invested in them anyway...

Mutual fund schemes are vanishing. Nothing sinister—it’s just that fund companies are merging some schemes into others at a far higher pace than they used to. In the first seven months of 2011, as many as 41 funds have been merged into another one. During the previous three years put together, this number was just 37. In fact, in the five years from 2006 to 2010, there were a total of 58 fund mergers. On current trends, 2011 could comfortably exceed this number.

On the face of it, there’s nothing wrong with this. These fund mergers are obviously done with regulator SEBI’ permission and follow all the rules and regulations that have been put in place for investors’ protection. However, fund mergers are an unfamiliar subject for most investors and it’s useful to understand exactly what is going on.

The first question that would be about the need for all this. Why do fund companies merge funds in the first place. The answer is simple (if uncomfortable for the fund companies’ management); they do it to bury poor performance. In the roster of practically every Indian fund company—even the ones with the best investment management—there are some black sheep. These are funds that for whatever reason, have lost a lot of money for investors. In my view, they tend to be flavour-of-the-month funds that were launched during some period that was hot for a particular theme. By the time the fund got going, the theme became yesterday’s idea and the fund never did well.

Eventually, whenever investors look at the list of funds that the company has, it just becomes an embarrassment for everyone. A distributor goes and pitches a good, high-performing fund from a fund company; the customer looks up the list of funds, perhaps on a website like valueresearchonline.com. However, when the prospective investor asks questions about the duds that are there on everyone’s list, the distributor or the fund company has no answer.

Therefore, the best course for them is to merge the fund into another one that has good performance. When this happens, all the investors of the fund meant for the guillotine are informed that the fund will be merged into another one. They have to be given a choice of redeeming their money, or having it transferred to the fund into which the merger is to take place. Either way, they are effectively redeeming their investment from the original one. In theory, this would lay them liable to capital gains tax on any gains that they have made. In practice, this never proves to be a problem. The kind of fund that is merged tend not to have ever made any profits for their investors. And if there are no gains, then where is the question of paying any capital gains tax?

Apart from capital gains tax, there’s also the question of paying securities transaction tax (STT) on the transaction. However, the fund companies generally pick up the tab for the STT. Or at least, they all seem to be doing so in recent times.

Since the transaction is basically one of selling one fund and buying into another one, the arithmetic is somewhat like that in the case of a corporate merger. The value of your investment stays the same , but the NAV and the number of units change. For example, lets say that pre-merger you hold Rs 10,000 in a fund with Rs 2 NAV and you have 500 units. If the fund being merged into has an NAV of Rs 50, then post-transaction you’ll have 200 units totaling Rs 10,000 in value.

At the end of the day, if one of the funds you hold is getting merged, then what it means is that you have been careless. If the fund was such a dud that it’s being merged, then you should have sold it long ago.