There are two interesting trends in the figures above. One has been the shift towards debt in the overall portfolio. While equity remains a larger 58 per cent of total AUM, its share has been falling steadily. In 1998-99, though there was an insignificant net inflow of funds, there was a shift of Rs 13 billion of assets from equity to debt. In the current year too, inflows have been directed towards income/liquid funds (debt) while balanced/growth funds (equity) areseeing withdrawals. The other has been the significant growth shown by private sector funds in comparison with their older counterparts in the public sector, namely the Unit Trust of India (UTI) and nationalised bank sponsored funds. Though the UTI retains at a dominating 76 per cent of the industry assets, its share in collections has been declining steadily from 73.5 per cent to 54 per cent and to 44 per cent so far in the current fiscal.

It is not the sharp rise in the BSE Index or the high yields given by equity funds which are driving the growth. It is something entirely different. The trend started with the benefit of long-term capital gain taxation available on shares (held for one year) being extended to mutual fund units. Due to oversight, no distinction was made between units of a growth scheme (equity) and an income scheme (debt). Thus interest income could be transformed into long term gains and the tax liability would drop from 30 per cent+ to 10 per cent. The marketing logic of "doublebenefits", i.e. indexation as well as concessional rates of taxation, was obvious to high net-worth individuals (HNW) and other savvy investors. The shortcoming was that units needed to be held for at least one year and liquidity was therefore compromised.

The 1999 budget removed this hurdle. It extended another benefit available on equity, and by definition justifiable for equity funds to debt funds. Income received by investors in mutual funds was made fully exempt from income tax. Debt funds, i.e. those with 50 per cent or less exposure to equity have to pay a 10 per cent tax, but this is less than the 33 per cent+ taxation on interest income. The investors fear for liquidity is gone. They can use relatively risk-free, liquid and no-load income funds to park short term surpluses throughout the year. Interest income appears in the form of capital gains. At the end of the year, a dividend stripping transaction can be undertaken that offsets thee multiple capital gains into a single dividend payment,attracting only 10 per cent tax.

In an extreme example, a corporate can convert profits attracting 38.5 per cent taxation into mutual fund dividends attracting 10 per cent taxation through a series of book entries between itself and the fund. The smaller retail segment is unaffected by the above tax-arbitrage calculations. They enjoy the Rs.12,000 exemption limit on bonds & fixed deposits or pay no taxes.

The tax anomaly has had other significant impacts. According to Sebi guidelines, mutual funds may invest only in transferable securities and are barred from term-lending activity. With yields on sovereign bonds declining, funds are channeling resources raised through sale of income units into corporate bonds and longer tenor instruments. Spreads of "AAA" corporate paper over GOI treasuries have fallen to historically low levels and yield curves have flattened. The trend may extend to weaker borrowers and even longer tenors. At current yields, higher credit risk of corporate lending is not adequatelydiscounted. Also domestic money/debt markets remain underdeveloped and lack liquidity. What will happen when the tax anomalies are reversed, leading to a reversal of flow? The growth is coming from fleet-footed savvy investors and not the more stable retail ones. Funds need to continue to focus on liquidity and credit quality, rather than yield chasing to attract the latest batch of investors. Imposition of loads on short-term investments in all but the liquid schemes may also reduce "hot flows". It would be disastrous for the industry if the widespread disenchantment, which occurred after Morgan Stanley's over-subscribed(!) public issue of units, recurs with income funds these days.

(The author is head of treasury marketing in a leading foreign bank. The views expresed herein are his own and not that of his bank.)