MF Returns: May 2010 CA Exam Question

Posted by: Uma Shashikant on Tue, Sep 21st, 2010

The following question had been asked in the CA examination in May 2010 (Management Accounting and Financial Analysis [old syllabus] - question 2[b] on mutual funds).

 

Question:

A mutual fund has a NAV of Rs.20 on 1-12-2009. During December, 2009, it has earned a regular income of  Rs 0.0375 and capital gain of Re: 0.03 per unit. On 31-12-2009, the NAV was Rs.20.06. Calculate the monthly return and annual return.

 

Suggested Answer by ICAI

Return = ((End NAV - Begin NAV) + (income earned in the period) + (capital gain earned in the period))/begin NAV

= ((20.06 - 20.00)+0.03+0.0375)/20.00

=0.1275/20

= 0.6375% per month or 7.65% per annum.

 

Error in the answer

Mr. D. J. Mehta, an 80-year old CA who is helping a friend’s son with the examinations thought that this answer was wrong.  His contention was that what was not distributed to the investor cannot be part of the return to the investor.  His answer is as follows:

Return to the investor = (20.06 - 20.00)/20 = 0.06/20 = 0.03% or 3.6% annualised.

 

His argument is that earnings of the fund have not been distributed and therefore cannot be the return to the investor. Since the earning of 0.0675p is gross and since NAV at the end of the period had increased only by 0.60p, the balancing figure of Rs 0.0075 is the expense charged to the fund for the period. 

 

Mr. Mehta wrote to the Board of Studies, pointing out the possible error in the suggested answer.  The Board of Studies defended its suggested answer saying that the mutual fund cannot earn any capital gain on its own and that it should be assumed to have been distributed to the investor.

 

Conceptual Explanation

My view is that Mr. Mehta is right and that the suggested answer of ICAI is wrong.  Following are the reasons:

  1. Distributable surplus of a fund is not equal to income and capital gains earned.  It is specifically computed before declaring dividends, to exclude any unrealized capital gains/losses and any adjustments to the unit premium reserves.  Therefore it is wrong to assume that what was earned was distributed, without a specific mention of dividend distribution to the investor.
  2. Even if we assume that what was earned was distributed, the NAV would not have appreciated from Rs.20 to Rs.20.06.  The NAV would have fallen to the extent of distribution.  What is earned by the fund remains in the NAV and reduces when distributed. By adding the income and capital gains to the difference in the NAV, the suggested answer of ICAI double counts the income earned by the fund.
  3. The formula used by the ICAI is wrong.  We can add income or gains to the change in NAV only if it is distributed to the investor. There is no question of adding either income or gain earned by the fund to the return, since it is already in the NAV.

Mr. Mehta has been running from pillar to post, trying to get the correct answer and will benefit from logical and correct explanations.  Please email him at djm2006@mtnl.net.in

 Posted by Uma Shashikant on Sat, Oct 2nd, 2010 9:23:05 am

Thanks, Supraja. The confusion arises from equating 'income earned' to 'income distributed'. The questions does not say that the income was distributed, it was only earned. In which case it is already in the NAV. If it has been distributed, it surely forms part of the return to the investors, and your interpretation holds.
 Posted by Supraja on Fri, Oct 1st, 2010 10:00:49 am

Being a CA student i'd like to share my interpretation. The return from the fund includes regular income and the capital gain. Accordingly, the distributed income and capital gain of 0.0675 forms part of the return. Also, the unrealised capital gain ( from investor's perspective ) of 0.06 (20.06-20.00) is included as a part of return. I perceive it is correct since: 1) The distributed capital gain during the intermittent period is already reduced while computing the NAV at the end of the period.Hence is there is no double counting. 2)Though a question may arise about the prudence of including undistributed gain, it is correct since the NAV is computed after excluding the expenses and liabilities for the period ("net" assets) and hence it forms part of the holding return earned by the investor without any further possible charge on it. The above holds good for calculating return from funds also!
 Posted by Uma Shashikant on Wed, Sep 22nd, 2010 11:13:14 am

The question does not clearly indicate whether the return has to be calculated for the fund or for the investor in the fund. There will be no difference in calculation, unless the fund has distributed any income to the investor. The investor's return depends on the NAV, so the investor's return is simply the difference between the NAV on the two given points that represent the holding period. ((20.06-20.00)/20.00) The fund's return is the income and capital gain earned, which should reflect in the NAV. In any case, it cannot be BOTH income and capital earned and change in the NAV as the suggested answers indicate.
 Posted by Prakash Ranjan Sinha on Tue, Sep 21st, 2010 4:57:57 pm

In the question it is not clear the income earned and capital gain earned is for the fund or for the investor. Also as they have asked for monthly return or annual return ( not clear for fund or for investor )I believe we have to take it for fund and not assume whther income has been distributed or not and so the answer given by ICAI is correct which is more assuming return for investor In case it is of fund then what calculated by Mr Mehta is correct. But Mr Mehta has assumed certain things of his own which is not mentioned in the question.

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