Are your assets earning enough?

I invited 2 of my clients —let’s call them Sanjay and Vijay-- over for dinner once.  After dinner, we sat down for a chat and the conversation turned to property, equity market, retirement and lifestyle. Who is more likely to have a more secure retirement and why? I just listened to their respective points of views without agreeing or disagreeing to their points of view/

Background

Sanjay is a top marketing executive—based out of Mumbai-- in an Indian company having operations all over the globe—drawing an enviable eight figure package. He owns a flat in Salt Lake City, Kolkata where his family lives. He has also invested in a flat in Rajarhat. He strongly believes in safety of capital and so has invested a bulk of his savings in bank fixed deposits. He has a small investment in mutual funds also (small compared to his total investments/savings). He has at most 5-6 years for his retirement. Having been a busy professional, he does not have much interest in managing money. He firmly thought that with bank fixed deposits and a flat in Salt Lake his retirement was secured.

Vijay—a first generation entrepreneur —had far more calculated approach towards his finances. He was very clear about creating a 2nd. earning member for his family when he retired. He started to set aside a fixed sum every month towards SIPs in equity mutual funds knowing that he is not going to need the money for at least twenty years till his only daughter was ready to pursue higher education. He also had a small portfolio invested in equity shares.

So now the question was who is doing better? Sanjay or Vijay?

Despite Sanjay’s confidence of a secured retirement, Vijay was far better placed in terms of a secured retirement owing to following points:-

Firstly, Sanjay failed to realize that retirement requires a regular cash flow. His investments in Salt Lake flat in and fixed deposits will not be able to generate the monthly cash flows needed to sustain the lifestyle that he was used to all these years. Moreover, being a private sector employee, he does not have the security of post retirement income viz pension which can augment his monthly cash requirement.

Secondly, Vijay understood equity better. He knew that only equity as an asset class can deliver returns in excess of inflation but only over long term. He was also very clear that he was not going to need the money for next 20 years or so. So he ignored the short term market fluctuations—fully confident that the long term trend of the market was up. He started SIPs in equity funds to run for 20 years—coinciding with the time his daughter was ready for higher education. He will have a corpus ready for it and will not have to dip into his retirement corpus.

Thirdly, Vijay operated from a point of expertise. While Sanjay failed to realize or overlooked the fact that his core assets—Rajarhat flat and bank deposits were not generating regular income in excess of inflation. They were on the other hand losing money—deposits by earning less than inflation and the flat by way of maintenance charges and taxes. Vijay’s portfolio on the other hand was earning positive returns. He focused –and rightly so-- on annualized returns rather than annual returns.

Sanjay was convinced that he was better off compared to Vijay. Many of us live under the same illusion. We overlook the wisdom of people like Vijay, who align their life, expertise, income and future to their assets. Such an approach helps in managing risks better. Instead, we approach life like Sanjay. We are happy with scattered residential property that earns too little income; we focus too much on the current job and resultant cash flows; we do not explore the need for additional income to protect us during bad times or retirement.

How we work with our assets and the incomes they generate critically determine how secure our financial lives will be. What are the lessons? 

1. Owning assets means little if they are not made to work hard to generate income. In other words your investments have to work harder than you do. 
2. The assets that are core, huge, and not intended to be sold, should be in prime shape and not remain idle. 
3. Investing in expertise in managing assets is important to make the most out of them after all it is said that managing money requires more skill than making it. 
4. Assets should be diverse in terms of their nature, location, and productivity, so that the risks are lower. 
5. One is not wealthy based on the asset one owns, but on the basis of how he manages them. Before blindly accumulating assets, pause to consider: how you will get them to work for you and your future?

Best time to buy is NOW---I

“Far more money is lost while waiting for a reaction, rather than in the reaction itself.”

Retail investors are comfortable investing when there is peace prosperity all round and then complain about low returns. However, it has been time and again proved that investments made during the bad times are the best investments.

Warren buffet is not what he is today because he invested in tranquil times. He deploys his cash when markets are bleeding.

Indian equity market has been in existence only for a short time now as compared to that of the USA.

We believe that if we are able to prove that good investments are those that are made in bad times in context of United States, then it might as well hold true for the Indian equity markets.

2014 has been unnerving. Every day there’s a worrisome headline coming out of Russia, Iraq, and Libya, Gaza Strip or any other of the world’s hottest geopolitical hotspots.

So naturally the worried investors will ask: - Kya kare? FD kar le?

Warren Buffet would probably recommend taking a step back, reflecting on history and then looking to the future.

A peep into the past: -

• During the great depression, the Dow Jones hit its low of 41 on 8^th. July, 1932. Economic conditions though kept deteriorating until Roosevelt took office in March 1933. By that time market had already gained 30%.
• During the early days of World War II, when things were not good for United States, market hit bottom in April 1942—well before fortunes of Allied forces turned favourable.
• Again the best time to buy stocks in early 1980s was when inflation was high and the economy was down.

In other words bad news is investors’ friend. It lets you buy a slice of the economy’s future at a marked down price.

Over the long term, the stock market news will be good. In the 20th.century, United States endured two world wars, faced the great depression, expensive military conflicts, dozen or so recessions, and financial panics, oil shocks, a flu epidemic. Yet the Dow rose from 66 to 11497(between years 1932 to 2000)

None of the above catastrophic events made a slightest dent in Ben Graham’s investment principles. Political and economic forecasts, business channels, can prove an expensive distraction for investors.

Could Buffet have clocked an annual compounded growth of 19.7% in its book value since 1962 (compared to 9.8% of S&P 500 with dividends) had he deferred or altered deployment of investments in capital market?  Warren Buffet has gone on record saying that “we have usually made our best purchases when apprehensions about some macro event were at its peak. Fear is the friend of the fundamentalist.”

Essentially Buffet is saying 2 things:-

1.       Market will weather crises no matter how bad they are.

2.       Stop worrying about the direction of the markets. Irrespective of the direction, prices will likely be higher for patient investor.

Debt Funds & Bank deposits---What now?

The Finance Bill (2) 2014-15 was passed by the Lok Sabha on July 25, 2014.  There has been an amendment that impacts debt mutual fund investors. Non-equity oriented mutual funds, which were redeemed in the period April 1 to July 10, 2014 will be eligible for tax concessions available before the budget was announced.

Interpretation

1. All redemptions, STP, SWP and switches made from FMPs, debt funds, MIPs, gold funds and ETFs and international funds, before July 10, 2014 will enjoy the benefits that existed earlier. The holding period to classify gains as long term will be 12 months, and taxation at 10% before indexation will be available for these transactions

2. Any of the transactions as above, made after July 10, 2014 will be subject to the new rules. The holding period for treatment as long-term capital gains will be 36 months. These will be taxed at 20% after indexation. Any gains for holding periods less than that will be treated as short term capital gains, and taxed at the marginal rate applicable to the investor.

Implications

1. Capital gains accrue on sale of an asset. Therefore the new rules will apply at the time of redemption of units. There is no concession on purchases made before July 10, 2014. FMPs with maturity less than 3 years and non-equity oriented funds irrespective of when they were bought, will be subject to the new rules if they are sold within 3 years, after July 10, 2014.

2. Mutual fund investors can approve changes to the fundamental attributes of a scheme. Mutual funds are now sending investors such consent letters, to extend the maturity of shorter term FMPs to a period of 36 months plus 1 day.  Investors, who do not sign and return such consent letters, will receive the redemption of units on the original maturity date.

3. Investors can consent to a change in scheme features such as applicability of exit load, extension of maturity date, or change in the type of fund from closed end to open ended.

4. Investors whose marginal rate of tax is nil are not impacted by this change. Retired investors, whose income falls below the exempt limit for taxation, have a marginal rate of taxation of ‘nil’.  Therefore such investors are free to redeem, switch or continue with their SWP or STP as before.

5. Investors who have set up SWP or STP from their debt mutual funds will be impacted, but not as much as feared. Each withdrawal will be subject to tax, based on the first-in-first-out principle. Until the time difference between the investment and withdrawal is more than 36 months, they will be subject to short-term capital gains tax.  But SWP or STP or redemption from a growth option will include capital and income (recall that NAV represents both). Therefore the impact will be far lesser than the tax impact on interest from bank deposit

This difference is because the entire bank interest earned is treated as interest income, but a large part of redemption of the mutual fund is treated as withdrawal of capital invested. Only the gain is subject to tax in a mutual fund, whereas the entire interest income from a bank deposit is subject to tax.  Unless the investor redeems the entire amount invested, as may be the case in an FMP, the tax treatment as capital gains (short or long) will work in favour of investments in mutual funds. 

Date	Investment Value	NAV	SWP/STP	Balance Units	Capital Gains	Tax @ 30%
01/04/2014	3000000.00	10.000	0	300000	0	0
01/05/2014	3024999.00	10.083	300000	270247.92	2479.240	743.77
01/06/2014	2747706.42	10.167	300000	240741.56	4936.413	1480.92
01/07/2014	2468103.15	10.252	300000	211479.366	7376.424	2212.927
01/08/2014	2186169.96	10.338	300000	182458.836	9794.705	2938.412
01/09/2014	1901887.41	10.424	300000	153678.136	12193.00	3657.90
01/10/2014	1615235.94	10.511	300000	125135.284	14571.48	4371.44
01/11/2014	1326195.80	10.598	300000	96828.314	16930.30	5079.09
01/12/2014	1034747.09	10.686	300000	68755.276	19269.26	5780.89
01/01/2015	740869.74	10.775	300000	40914.238	21589.62	6476.885
01/02/2015	444543.51	10.865	300000	13303.281	23890.44	7167.13
01/03/2015	145747.99	10.956	145747.99		12715.17	3814.55
TOTAL WITHDRAWAL			3145747.99
CAPITAL GAINS ON WITHDRAWAL			43724.40			43724.40

This is a bit more detailed and assumes a 0.0833% return per month (10%/12 months) and the increase in NAV reflects that. The SWP is constant, until it falls below the value of Rs.3 lakh and is fully redeemed. The result will not alter unless the SWP is extended beyond 36 months. The investment value is balance units times NAV; balance units is after reducing units amounting to (STP amount/NAV); and capital gains are redemption value less cost of redeemed units.  

When one invests Rs. 30 lakh in a debt fund (first line) and begins an STP, the withdrawal does not get fully taxed, as is the case with a bank deposit. That is because each withdrawal has one portion as capital and one portion as income. Only a part of it is capital gain, and will be taxed.  Recall that I also wrote that taxation will be on first in first out basis. This means, as the investor draws money over time, the cost remains Rs. 10 per unit, but as the NAV grows the gain grows.  The sum total of capital gains tax, when the entire amount is withdrawn (last row) is the same as if the total of invested amount plus gain was withdrawn in one lump sum.  The small amounts of capital gains tax will grow, and add up, such that the gains from SWP/STP equal the gain from a lump sum income as in a bank deposit. There is no real tax advantage in a debt fund, if the withdrawal is before 36 months.

  

To those that still refuse to give up, there are two options:

1. If the first SWP is after a lapse of a period of 36 months, the indexation benefit will kick in.

2. If the investor does not redeem the entire amount, and if the SWPs spill over into a period   greater than 36 months, there will be a benefit of lower taxes for those SWPs

The summary therefore is, for all redemptions from a debt fund (SWP, STP, switch, maturity) which happen before a period of 36 months, the amount of tax an investor will pay is the marginal rate applicable to the investor. 

It is time to give up the tax arbitrage and focus on the real merit. The access to debt markets, the lower risk of a portfolio, the lower cost compared to a high spread of other intermediaries, the benefit of total return from marking to market, the flexibility of easy investment and withdrawal, and the professional management of credit and interest rate risks are all significant merits to invest in a debt fund. 

(Courtesy: - www.ciel.co.in)