Outlook for the Brazilian Funds Industry

Prof. William Eid Junior and Prof. Ricardo Ratner Rochman – Center for Finance Studies Getúlio Vargas Foundation/São Paulo

May/2014

The 20th anniversary of the Plano Real takes place in 2014 and deserves to be celebrated. It means that the same currency, the Real, has remained in circulation for two decades. In the 1980's and the beginning of the 90's, when hyperinflation was at its peak, this seemed a practically unimaginable dream. Despite the success of the Plano Real, Brazil's financial stability is still a challenge in progress and will only be completed with much effort from not only the government, but also from the financial market and society as a whole.

The investment funds industry has grown and developed significantly over the past 20 years. During this period, the number of funds has increased from 632 in December of 1993 to 14,097 in December 2013, representing an increase of 2,131%, while net shareholder equity has risen from R$ 171 billion (in constant currency) in December 1993 to R$ 2,478 billion at the end of 2013, or 1,348% growth in constant currency, which is equivalent to an annualized rate of 14% growth throughout the period.

While the Brazilian investment funds industry has consolidated over the last 20 years as one of the largest in the world thanks to its exceptional growth, development and security, there are still many challenges that need to be addressed in the near future, including: the lack of equality between the taxes levied on different investments; investor education; the internationalization of the industry; and funds as a channel for family saving.

The lack of equality between the taxes levied on different investment products impacts on market development and innovation, investor saving and government policies. Investors make investment decisions based not only on the risk and return profile, but also consider the impact that taxes will have on their profits.

Income Tax (IR – Imposto de Renda) is the main tax levied on investment funds in Brazil. Under income tax rules, and the way it is levied, there are three different categories of assets: Those that are exempt, those that are taxed when the investment matures and those which are periodically taxed, even if the investor has made no profit.

The government uses income tax exemptions to promote or stimulate a determined market, as in the case of the agribusiness, real estate and infrastructure sectors, where there are bonds exempt from income tax, such as Agribusiness Letters of Credit (LCA – Letras de Crédito do Agronegócio) and Real Estate Letters of Credit (LCI - Letras de Crédito Imobiliário). There are also income tax exemptions for income from real estate funds and infrastructure debentures. It is interesting to note that, for a long time, access to many of these products was restricted to accredited investors with greater assets. Today they are available at more accessible prices and, with the income tax exemption, come within the reach of many.

Other investments are taxed when redeemed, as in the case of some public bonds, such as the floating rate bonds (LFT) and the Brazilian Inflation Linked Series (NTN-B Principal), and long-term deposits, such as Certificates of Deposit (CDB's – Certificado de Depósito Bancário) and Bank Deposit Receipts (RDB's – Recibo de Depósito Bancário). This form of taxation provides an advantage over the periodic taxation that applies to fixed income and multimarket investment funds. These are taxed under what the market refers to as a "share erosion" system. The tax does not directly affect the value of the investment fund shares, but the quantity of shares held by the investor. Accordingly, levying the tax does not cause share price volatility. However, funds are taxed twice a year, at the end of May and November, while investments in individual fixed revenue bonds are taxed when they are redeemed.

Inequality between the assets with regard to tax has serious consequences for the economy in general, and more specifically for families, since investment funds are key products for managing monetary policy. The funds account for 66% of public debt financing, according to data from the Brazilian Association for Financial and Capital Market Organisations (ANBIMA – Associação Brasileira das Entidades dos Mercados Financeiro e de Capitais) for January 2014 and the Brazilian National Treasury management report. The resources raised by investment funds for investment in public bonds contribute to government investment in infrastructure works, services for the population and a series of initiatives that affect the well-being of families.

Accordingly, the lack of tax equality undermines not only the growth of the funds industry, but also of the nation, and so needs to be addressed by market regulators and participants.

Educating investors has always been very important for the financial market. The development of the funds industry, and the increase in diversity and complexity of products and services, makes it even more important to train and educate investors. Today there are products in the market which allow leverage, private credit and investment abroad, not to mention those that enable better tax planning and formation of long-term saving for Brazilian investors.

Brazilians invest little. Currently, Brazil is ranked 26th in the world for individual saving, with sums of about US$ 950 or R$ 2500. Given that per capita income was R$ 24,000 in 2013, the average saving per person is equivalent to little more than a month's salary for that person. This is totally inadequate to produce a scenario of financial tranquillity.

Significant investment in the financial education of all age groups of the Brazilian population is required to improve this situation. The population needs to understand the importance of building savings and that funds are the most appropriate vehicle for society to accumulate savings. Above all, they have advantages over other investments, including: professional management; access to assets that in another form would be inaccessible to individual investors; portfolio diversification; and products suitable for the differing aims of investors are available. In addition, they are very safe as they are made in companies that are separately managed.

With regards to internationalization, it is important to show national investors, through financial education, that it is easy to diversify their investment into assets located abroad without the need to open foreign accounts, for example, via funds that invest in BDR's (Brazilian Depositary Receipts) or in indices that track the stock exchanges of the United States of America. It is also vital that international investors are exposed to the Brazilian funds industry as in the last 10 years the funds have shown attractive profitability in US$ as shown in Table 1 and have the potential to perform even better in the coming years with the investments being made in the Brazilian economy and international financial stability.

Table 1. 10 major average rates of return of ANBIMA categories in the last 10 years.