Archive for the ‘Mutual funds’ Category.

 

I typically don’t write much on personal finance. The key reason is that it does not hold much interest for me and does not challenge me. After you have spent 1-2 years reading on investing, evaluating a scheme is quick and easy. In addition, there are a lot of other blogs and magazines which do a better job of explaining personal finance for the lay investor.

Let me a list a few criteria I use to arrive at a decision on any personal finance instrument
–        What has been the performance of the instrument in the past? If this is a new instrument of scheme avoid
–        Has the instrument or scheme out performed a benchmark? If it is related to equity, has it outperformed the index for the last 3-5 years. If not, avoid
–        What are the costs involved ? what is the expense ratio, sales load, exit loads etc. The total of all costs should not exceed 2% (typical of most open ended mututal funds which in itself is too high). If the expenses per annum exceed 2%, avoid
–        What is the lock in period ? I typically avoid products with lockin periods. Product with high lockin periods do not necessarily perform better than open ended product. They just tie your money up and you can lose flexibility if the performance is poor
–        What is the kind paperwork involved ? can I do it online ? I personally hate paperwork and have no interest in running to the bank to fill up forms and fill up paperwork every year.

I finally don’t care what is pedigree of the fund house or whether the fund or instrument is from a reputed bank or AMC. In addition I don’t care if the name sounds good or the sales person is a cute looking girl. I will open up my wallet only if the instrument meets my criterias listed above.

Finally you can see this post where I have listed how I select equity based funds. As you can see, it is not complicated to decide on a personal finance instrument. Most of the times, I don’t bother to look for one and tend to buy mutual funds, stocks or ETFs online directly.

 
 

I recently visited icici and HDFC bank for some personal work and some of the sales folks at these branches went into a sales pitch, pushing their respective unit linked plans. These unit linked plans are a combination of an Insurance policy and mutual funds. The key highlights of these plans are

 Highlights
–        An annual ‘premium’ payment towards the plan for around 15 years.
–        An option to pick from a range of 100% equity to 100% debt plans
–        If the primary holder passes away, the nominee get the insurance amount in addition to the accumulated value of the mutual fund component (varies by plan)
–        A max total insurance cover of around 12.5 lacs even if the annual premium exceeds 2.5 lacs
–        40% premium charge in year 1, 30% charge in year 2 and 2% thereafter.
–        A plethora of other charges some of which are not very clear unless you dig further such as mortality charge, admin charge etc
–        A 1.25%  fund management charge

Now these sales folks are well intentioned and all that. But frankly my initial feeling was that anything this complicated and convoluted cannot be very good. Lets look at some math

For ex : I invest 2.5 lacs per annum for 15 years in a 100% equity option. So around 1.75lacs are deducted in year 1 and 2 combined and around 5000 rs per annum thereafter. The rest would be invested in a mutual fund of choice.

 The insurance component
Lets look at the insurance component first. A pure risk policy (which is what the above is) is currently priced at around 4000-6000 p.a premium for a duration of 15 years. So clearly the insurance component is overpriced.

There is a bumper component which is paid at the end of the policy term which equates 70-80% of the premium. If you look at it in another way, this equals the 70% you pay upfront at the start of the policy.

So in a nutshell, the company is taking 70-80% of the annual premium from you and holding it interest free for 15 years. At an interest rate of around 9% per annum that is 3.6 times your annual premium !!

The 2% annual deduction would get you a similar pure risk policy with all the attendant benefits including tax deductions.

 Mutual fund component
 Lets look at the mutual funds component – Nothing special here. The company is taking 60% of your premium in yr 1, 70% in year 2 and 90% in yr 3 and onwards and investing it on your behalf for 15 years. At the end of 15 years, you redeem based on the NAV then.

What are the negatives here ?
–       For starters my money could be locked for 15 years – a big negative if the performance turns out to be poor.
–       The brochures, which I have seen show very average performance for all the concerned funds (most of them, barely beating the index before charges and actually underperforming the index after the fund management fees).
–       A plethora of charges I noted earlier, get deducted from the mutual fund component. There is not much clarity in the brochures on the quantum of total charges, but I don’t expect it be less than 1% of the total (maybe more).

 Conclusion
A pretty bad investment option. The insurance component is way overpriced !!. The mutual fund component has nothing special in it and has a load of charges attached to it, which will reduce your returns substantially in the long run. I will not be surprised if the banks are getting a hefty commission or good fee from these kind of plans.

My initial feel was that anything this convuluted and complex is a nice way for the bank or AMC to make good money off the fees and leave the investor with poor returns

Recommendations
Buy a low cost pure risk policy for the insurance cover. These policies do not pay anything if you survive ( A happy outcome !! as I have survived) and have a very low premium. For the mutual fund component invest in a low cost index fund or ETF or a decent mutual fund (if you can find one).

Finally, buy something nice for yourself or your spouse/friend with the money you save and send me a gift for saving you this money (just kidding !).

 
 

I receive several comments and emails with questions which require a detailed response. Instead of replying through an email or a comment, I am posting my reply as I thought others may find the discussion useful

Question : Does the increase in inflation and interest rates, impact the intrinsic value calculation ? Would you not increase the discount rate and reduce the instrinsic value as the long term government bonds rates have increased?

My response : You can find my approach to calculating intrinsic value here. In addition my valuation template also has the format for calculating intrinsic value. You can download it from here.

As some of you would have noticed, the discount rate I use is around 12%. This is strictly not as per finance theory. The typical textbook way to calculate discount rates, is to use the CAPM model (use the cost of equity and debt to calculate the discount rate). I am however more influenced by buffett and munger and their way of looking at stocks. For me, the discount rate or hurdle rate is my opportunity cost.

What is opportunity cost ? It is the return I can normally get from other investment options (debt and equity included). So if I have to invest in a stock, the expected return should be more than my opportunity cost (with a margin of safety to compensate for the risk).

When the long term rates were around 10-12 % in early 2000, I had a hurdle rate of around 13-14%. However when the rates dropped to around 8-9%, I dropped the hurdle rate to 11-12%. If you believe that the long term rates are likely to stay around 10% or higher for quite some time, then it would make sense to increase the discount rate you are using. However in my case, I plan to hold the discount rate at 11-12% till I get a strong feel that the long term rates in india would be above 10% for quite some time to come. Even in that case I may bump up the discount rate by 1-2% at best.

The market is ofcourse adjusting the valuation due to rise in the inflation and interest rates by dropping the prices. However we cannot be sure if this rise in inflation is temporary (6-12 months) or we are in for long term inflation

From prashant

Wondering what you did with your mutual fund investment(I guess you hold diversified equity funds) during Dec 07 / Jan 08 when valuations were sky high? A friend of mine informed me in Dec, 07 that he is swapping all equity funds to debt / balance funds. I ignored the info and thought SIP would take care of any correction. At the peak, gains were around 60% on the total money invested (during SIP of 1-1/2 years – infact I invested extra money in MF during all corrections) and now around -8%.
Actually I was not tracking the market and was taking care of monthly SIP money only. Now looking at current situation, I think I missed the opportunity. I should have done the same as my friend did. Lesson Learned – at a very high cost!!!

My response :
I have done this swapping in and out, jumping up and down and sideways and all around in the past. So after all the jumping and hopping, I decided to do some analysis in 2007 to see how I would have done in the last 8-9 years if I had just done an SIP. Well to my utter surprise, my returns were only 1% better than what I would have got through a dumb SIP plan in a decent mutual fund. With expense loads factored in, I have fared worse than an SIP plan.

I have seen from my past experience when I tried to time mutual funds, I ended up second guessing myself. When the market tanked, I was out and still waiting to get in.Then finally the market resumed its upwards course, but I was still twidling my thumbs. So this jumping in and out over the last decade has costed me a lot.

So this is what I decided – find 4-5 decent mutual funds. I don’t mean the top 5 or top 3 funds which is diffcult to find in terms of future performance. You can find the top 5 funds for the last X years, but that is no assurance that those funds will do equally well in the next X years. So I look at the funds with long histories (more the better) and if they have beaten the market by 3-5%, I set an SIP in them.

Will this give me the highest possible returns ? No it would not. Will I have bragging rights that I was smart to recognize the market top and jump out at the right time ? No, I will not. But I think I will end up following a fairly intelligent investment policy and make good returns. In addition this frees up my time and energy to pursue other activities.