1 February 2006, Financial Times

Things are a little bit different in Italy, especially in the mutual fund world where funds, not investors, are responsible for paying taxes on income and capital gains. This distinction can significantly affect fund valuations, portfolio strategies, and the overall decision to buy Italian-domiciled funds.

How important is this?

Italy is the second largest fund market in Europe with assets of more than €584 billion. And Italians have more than one-fifth of their non-real estate investible assets in mutual funds.

Some important background. In 1997, the government instituted a flat tax of 12.5 percent on dividends, interests, and all capital gains. Funds mark-to-market on a daily basis, and pay taxes on all net gains at the end of each year, regardless if underlying securities were sold.

According to Fabio Galli, director general of the Milan-based mutual fund industry group Assogestioni, the industry initially saw the new rules as a clever way to simplify the issue of taxes, eliminating their consideration when making investment decisions. They also appeared to focus on creating a steadier revenue flow for the government, which at the time was seeking ways to meet the fiscal requirements of Maastricht.

However, with a growing number of off-shore funds being offered in Italy, these rules seem to handicap locally-managed issues when shares rise and especially when they fall.

Take Aletti Gestielle’s World Communication fund, which racked up big gains in the late 1990s. Taxes on unrealized profits prevented the fund from fully benefiting from compounded growth.

But the dramatic impact of this tax regime appeared when TMT shares started crashing, which sent the fund down 21.8 percent in 2001 and slashed more than a third of its value in 2002. The fund’s investing power was further compromised by the significant build up in tax credits which, in Italy, are part of the fund’s NAV.

By the end of 2003, 42 percent of the Gestielle World Communication’s NAV was comprised of tax credits. In other words, though trading around €5.5, the fund had only €3.2 worth of hard assets with which to invest. While tax credits have helped hard-hit funds sustain NAV, they make it difficult for a fund to subsequently track its benchmark.

Making matters worse, when investors pull out of a fund, they receive the full NAV–investments plus tax credits. According to Assogestioni’s Galli, “this means that the remaining investors are implicitly lending hard assets to the fund to pay off exiting investors in exchange for higher tax credits.”

This phenomenon is evident in the World Communication Fund as net redemptions combined with a collapsing telecom market to cut the fund’s assets by 60 percent between the end of 2001 [€500 million] and 2004 [€200 million]. These forces not only accelerated the build up in tax credits, but sustained the level at 42 percent through 2004 despite the rebound in telecom shares.

Fund companies, however, can deal with this issue of undercapitalized porfolios in several ways. Following an EU directive, the Bank of Italy now permits managers to leverage up to 100 percent of assets, a proportion which had been limited to 10 percent until this year. This means that a fund manager encumbered with tax credits can use derivatives to achieve a more fully invested portfolio. Many buy options and futures in underlying stocks or indices that track their benchmarks, which helps fill in the performance gap created by tax credits.

Davide Barattini, Gestielle’s World Communication Fund manager, says that in 2002 the fund had asked Goldman Sachs to create a basket of world telecom shares through which the fund established derivative positions [buying calls and selling puts on the basket] valued at nine-percent of the portfolio. However, the previously low limit on derivative usage still left a sizable portion of the NAV uninvested.

Another strategy fund companies employ to diminish tax credits is to swap away profitable funds’ tax debits with those that have built up credits. By receiving the equivalent value in euros from funds that owe taxes, a fund company is essentially paying its tax liabilities to itself. Using this tax strategy, Davide Barattini expects that his fund’s tax credits to be reduced to 15 percent by March 2006. At that time, he expects to match that remaining percent with derivative exposure.

Italian mutual fund data trackers further cloud the issue by reporting tax credits as cash. According to Morningstar and Blue Financial Communications, Gestielle World Communication has nearly 28 percent of its portfolio in cash as of the end of 2005.

Foreign fund companies have been prompted to sell their products in Italy because regulators do not require them to contend with the issues of tax credits and liabilities within their funds’ NAV. Conversely, according to Adriano Nelli, of Capitalgest SGR, a Brescia-based fund company with €8 billion under management, local fund companies are setting up off-shore funds in places like Luxumbourg and Ireland to avoid the issue of tax credits, while benefiting from lower corporate tax rates and less cumbersome and costly regulatory environments.

Italian mutual funds are also hampered by generally high expenses. Mauro Casati, managing director of Milan-based Pioneer Investment Management SGR, with €25 billion of Italian fund assets under management, says that “this makes it more difficult for some Italian funds to keep up with their respective benchmarks and comparable off-shore funds.” But he anticipates regulatory changes should bring down expenses by 10-15 percent over the near term.

Increasing globalization of the fund industry may encourage Italian authorities to further rationalize rules that currently weigh on local players in one of Europe’s most important fund markets. But given the pace in which change occurs in Italy, don’t expect this to occur any time soon.

Source: Assogestioni