Dec 8, 2008

10 FAQs About FMPs

1. What are FMPs?
Fixed maturity plans (FMPs) are low risk, close-ended passively managed debt funds with a fixed duration which could vary from 3 months to 3 years or even more, thus catering to the needs of very short term to long term investors but one year is the most popular. The aim is to give better post tax returns than a bank FD.

2. Why are FMPs so popular?
FMPs have emerged as the most popular product offered by fund houses. They constitute almost 20% of total assets under management (AUMs) of the entire mutual fund industry, with more than 1 lakh crore of average AUMs. Earlier they were in the investment domain of corporates and HNIs only but of late they have also become popular among common investors as a viable alternative to fixed deposits (For details please see: FMPs vs FDs - Which is Better) because of lower tax incidence. These plans combine returns and safety of bank deposits with tax-efficiency of mutual funds and are particularly suited for risk averse investors falling in higher tax brackets.

3. What is the unique selling proposition (USP) of FMPs?
The basic objective is to provide a shield from interest rate volatility by locking into higher yields at the inception. The fund locks into investments with maturities corresponding with the maturity of the plan.

4. How do FMPs reduce the interest rate risk?
FMPs help investors avoid volatility associated with other debt schemes. In a rising rates, yields can be lower only if the bond is sold before maturity but a typical FMP ensures that there is no capital loss as the bond and the FMP have the same maturities. As investments by the fund are held till maturity; therefore, a FMP runs zero or little interest rate risk.

5. How do FMPs indicate the yield in advance?
FMPs are able to generate predefined returns because they plan and lock-in their portfolio in advance and also because they invest in debt securities the residual maturity of which matches with the tenor of the FMP. Thus, they don’t get affected by interest rate movements and therefore are able to indicate the returns in advance.

UPDATE: Sebi has banned mutual funds from disclosing indicative yields.

6. How do FMPs differ from income funds?
First, income funds are open-ended whereas FMPs are close-ended schemes. Second, debt schemes have three major risks – interest rate risk, liquidity risk and default risk. Each of the three risks is almost negligible in case of FMPs.

Finally, their expense ratio is low as compared to other debt funds.

UPDATE: Sebi has made listing of FMPs mandatory, as a result exit before maturity is a bit difficult due to low trading volumes.

7. How can the expense ratio of FMPs be so low?
Expense ratio of FMPs is low due to following reasons.

Low transactions costs
The transactions costs are low as no active fund management is involved.

Low commissions
These schemes don’t pay any upfront commissions to distributors and trailing fees (recurring fees paid to distributors till a person remains invested) is also very low.

Thin margins
Main reason behind floating these schemes by fund houses is ‘asset retention’ (a tool to shore up their AUMs) rather than earning revenue. Therefore, although wafer thin margins, there is lot of competition among mutual funds.

8. How are FMPs different from liquid funds?
First, unlike liquid funds, FMPs are close-ended i.e. open for subscription only during NFO period. Second, both these schemes serve different purposes. While basic purpose of liquid schemes is to provide liquidity at all times, FMPs aim to provide reasonable and assured returns. Third, dividend distribution tax rate (DDT) applicable on liquid funds is 28.325% whereas for FMPs DDT is 14.1625% (individuals and HUFs) and 22.66% (other entities).

9. How do FMPs differ from interval funds?
Interval funds which are cost effective alternative to FMPs are a recent innovation from the fund houses. In an interval fund there is automatic rollover while in an FMP there is redemption. In an FMP, you must redeem at the end of the tenure and reinvest in another FMP whereas interval funds simply roll over your investments.

In an interval fund, exit option is provided at specified transactions dates with no exit loads. If you want your money back on the transactions dates, then you have to exercise the option or it will automatically roll over to the next interval.

Main reason behind the launch of debt interval funds (which combine the features of both open-ended and close-ended funds) was that last year (2007) there was a steep increase in filing fees of FMPs which made the short term FMPs (which were already operating under wafer thin margins) a non lucrative proposition.

So, the fund houses started reclassifying short term FMPs as ‘interval funds’ to avoid paying the filing fees to SEBI repeatedly. Interval funds are open for sale and redemptions during predetermined intervals and hence the fund houses are able to attract fresh money during these intervals without paying the filing fees. In other words, unlike FMPs, interval funds pay the filing fees only once during the initial launch.

10. How to invest in FMPs?
FMPs are available for subscription only during the period of launch (as close-ended funds these can’t accept any fresh investment once the NFO is over) and thereafter allow only redemptions subject to an exit load (which may vary from scheme to scheme). The NFO is open for a few days and minimum investment is usually kept at Rs 5,000.

A few days back, Sebi has put a ban on early exit from FMPs (for details, please read: Sebi bans early exit from FMPs) and provided an alternative route through secondary market listing. In future, if you want to make a premature exit, you will have to route it through the stock exchanges. On the other hand, if you wish you will be able to buy these debt instruments through the stock exchanges.

FMPs have fixed time horizon which means that at the end of the maturity period, the money is returned back to the investors, but roll over facility is also provided. To help investors reinvest money from maturing FMPs, fund houses launch a continuous series of FMPs with each new scheme replacing one that has just matured. Thus, the money redeemed from a scheme can be automatically invested in a new series.

However, before investing, please remember these important considerations.

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