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Rising Pace Of Fund Mergers

It’s useful for investors to understand that fund mergers may just be the right treatment for dumb money…

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 the regulator’s go ahead and all the rules and regulations put forth by the Securities and Exchange Board of India (SEBI) for investors’ protection is obviously followed.

However, fund mergers are an unfamiliar subject for most investors and it’s useful to understand exactly what happens when a merger takes place.

Why do fund companies merge funds in the first place? The answer is simple (if pointedly 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. Generally, they tend to be flavour-of-the-month funds that were launched during some period that was hot for that particular theme. By the time the fund got going, the theme became yesterday’s idea and the fund never did well. Eventually, these funds become a sore spot and a source of embarrassment. Therefore, the best course for them is to merge the fund into another one that has good performance. So then what happens? Well, all the investors of the fund meant for the guillotine are informed that the fund will be merged into another. They are then given a choice of redeeming their money, or transferring it 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 make 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 tends 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 net asset value (NAV) and the number of units change. For example, say that premerger you hold Rs 10,000 in a fund with NAV of Rs 2 and own 500 units. If the fund being merged into has an NAV of Rs 50, then post-transaction you’ll have 200 units totalling 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.