Truth about Highest Guarantee NAV policies

Over the last few months, one after another, a number of insurance companies have launched ULIPs which promise to repay the investor on the basis of the highest NAV that the fund has achieved. The pitch is that these funds' NAV effectively does not drop. Once a level is achieved, then the investor is assured of getting at least as much, no matter what happens to the market. It's certainly a very attractive idea. From the way insurance companies are stampeding into launching such products, I'm sure investors must be putting down their money in good numbers-in just a couple of months, six insurance companies have launched such products. Any investor who is told of this concept will immediately start salivating at the thought. Imagine how rich you could have been had you been invested over the last ten years and had been able to lock your investments at the magical value that the markets achieved on the day when the Sensex touched 20,873!

Any investor thinking about this product would say, "What a wonderful idea!" Why don't all investment schemes-whether mutual funds or ULIPs or even portfolio management schemes offer this kind of a protection on all their products anyway. The answer to this obvious question is simple. There is no free lunch. These products don't actually offer what you think they are offering. That is, they do not offer equity returns that never fall.

Instead, they offer an investment system with a very long lock-in (seven to ten years) in which protection is achieved by progressively putting your gains in a fixed income assets which will give returns far more slowly than a pure equity option. The lock-in and the non-equity assets make this a very different kind of investment than the equity-gains-without losses dream that these funds' advertising seems to imply.

However, even that's not the real reason that these funds are useless. The real reason is that if you are willing to lock-in for seven to ten years, then practically any equity mutual fund would deliver this dream of equity-gains-without-losses. Seven years is a very long time. Over such a period practically any equity portfolio into which any kind of thought has gone would capture substantial gains. This is not mere conjecture. Since at least 1997 the minimum total return that the Sensex has generated over its worst seven is 12 per cent, which was over the seven year period from 6th July 1997 to 5th July 2004. The truth is that in a growing economy like India's it's extremely hard to lose money over a long period like seven years. If you are willing to lock in your money for seven years, then for all practical purposes, you have a guarantee of making a profit.

Of course, this is not a guarantee that is signed in a contract and legally enforceable, but it's the kind of guarantee that any thoughtful investor would be willing to believe in. Mind you, this is also not a guarantee that you will get the highest NAV achieved but again, that's the kind of thing that can't be attained if you want the gains of pure equity anyway.

The most instructive thing in this whole business of guaranteed highest NAV products is the contrast between the illusions spun by those peddling complex financial products and the reality of simple, straightforward investing. It just reinforces one's belief that financial products are being designed whose goal is nothing more than to create a marketing hype which can manipulate the psychology of the ordinary saver.

Is free financial advice costing you?

Everyone loves financial advice – if it’s free. A tip from a colleague, broker, or any other joker who knows little more than what the SENSEX is, is welcome, and actually sought after. But the minute a fee is quoted, even if the individual is a genuinely smart person with valuable advice, we roll our eyes and say, you must be crazy if you think I will PAY for financial advice.

It’s especially amazing because we will, gladly or grudgingly, write a check to a doctor, lawyer or even CA, and for the most part, listen to what they have to say. When we are so kind to our medical, legal and tax advisors, what about a little charity for our financial advisors?

The blame is not entirely on the investor, because while it is pretty clear what your doctor or lawyer is supposed to do, most of us aren’t even sure what a financial advisor is or does. I’ll start by saying a financial advisor is NOT a broker. A broker’s job is purely transactional – execute the trades you want to do. A financial advisor is also NOT an agent. An insurance or mutual fund agent’s job is to sell you a financial product and help you with the paperwork required to purchase the product. It’s a different matter that many so-called financial advisors are mutual fund agents in disguise. Finally, a financial advisor is NOT a mutual fund manager. A fund manager’s job is to manage a specified portfolio of assets given to them, not to give individuals financial advice.

So, what is this eponymous advisor? For starters, a financial advisor is someone who has your interests in mind – not that of a particular AMC, broker, or insurance company. He or she is someone who will take the time to sit down with you and understand your goals and tailor a unique investment portfolio for your needs.This is more than buying equity funds and holding fixed deposits, but understanding the entire range of investment classes available to you and knowing specific products within each asset class. Gold funds, commodities, PPFs, post-office schemes, art investments, real estate, private equity – this is the tip of the iceberg of a good advisor’s knowledge. Financial products, like the human body and the Indian legal system, are complex and financial advisors should be professionally qualified – you don’t go to a doctor without a MBBS right? Finally, a good financial advisor will be your financial companion and that means having more than one meeting with you. A financial advisor’s relationship with you should be open, honest, and ongoing – one that evolves with your changing financial situation.

Now, the critical question – even if I find this wonderful advisor, why should I pay him, because I get plenty of free advice. Free advice is the bane of financial services and has cost many investors more than they budgeted.While very few people think they can be doctors, everyone thinks they are a closet fund manager or financial planner and everyone is happy to dole out free advice. The problem with free advice is that it has no quality, guarantee or liability. When a website gives you a free tip, you cannot blame them if anything goes wrong.

However, when you have paid for financial advice, you will definitely come back and blame the financial advisor – his business and reputation are both at stake. Free financial advice from professionals – brokers and wealth managers – is even more dangerous. Brokers give you free advice so that you will trade, and indirectly fill their pockets with brokerage. After all, who can ignore a well-sold tip? Wealth managers, who are supposed to look out for your interests, will charge you nothing for advice, but get compensated when you buy a product.Different products lure wealth managers with different commissions twisting their incentives from giving you the best advice to earning the highest commission. And at some level, wealth managers are not entirely at fault – they have to earn revenue, and because our mindset is so opposed to paying for advice itself, they have little choice but to make the advice free and benefit from the product sales instead.

Paying for financial advice feels painful but it is an inevitable part of India becoming a more transparent and conflict of interest free wealth management market. So, the time a smart capable financial advisor comes to you and wins over your trust, don’t balk when the word FEE comes up. A capable advisor can earn you multiples of the few percent he charges.

In the long run, free advice may cost you more than you think, and paid advice may quickly pay for itself – a quirky case where FEES are better than FREE.

MYTHS ABOUT FINANCIAL PLANNING

You've earned hard, now let money do the same for you

THEY say that money is on the top of everyone’s mind. That’s really true. The fact is that it stays right there, and it requires a big trigger to get moving on it. We then rationalize, and justify our inertia. While my personal view is that financial planning is a universal requirement, there are some show-stoppers which we must recognize. If these thoughts are there in your mind, banish them and achieve financial freedom. The top reasons for procrastination are:

I have too little money
Financial planning is required when the goals you have are more than the funds that you possess. Waiting for the great day when we have accumulated a sizeable corpus to start planning is like living for today, without any plans for tomorrow.

I don’t have enough to spend
Even if you are thinking this, you need a plan, manage credit (or debt) judiciously. Invest the money you receive in a liquid fund and keep a minimum amount in the bank. Prepare a budget and stick to it, you may be surprised with how much you can save.

After I complete my house
I have come across clients who have used marble-tops in their kitchen and granite on their floors as they had funds in their bank account. Only later they realized that their sons education was of greater priority.

I can’t afford planning
Its the same as refusing to consult a specialist doctor even when you are seriously ill and advised to do so. Constructing a financial plan is as important as getting the blueprints to build your home. Paying for these services also makes your advisor accountable to you, so don’t hesitate on this count.

I can do it myself
Some people have an inborn flair for numbers and are organized enough to keep regular track of all their investments. Now the question is: are they emotionally cut off from their investments enough to take the right decisions. A financial advisor has the requisite qualifications and training that a layman can only master to a small extent.

I only invest in FDs
Most of India’s domestic savings are heading to bank deposits. However, with inflation soaring and interest being taxable, you need an avenue which enhances the value of your investments, after inflation and tax.

I don’t need advisers

There is an information overload: the media and the internet make investing look like child’s play. There are many factors to consider: financial goals, cash flow, risk taking ability. If this seems overwhelming, take the help of an advisor, who can recommend changes not for the entire mass, but specifically for you.

I don’t trust advisers
If you lack trust, because of an awful experience previously, the mistake was probably made while hiring the advisor. Make sure you do your homework before choosing your advisor. Remember, you need to exercise the same care as you would while selecting your life partner.

I don’t have the time
This is the most popular reason that people give for procrastinating. Take one step at a time. Talk to people you know and trust, and ask them who manages their finances. Talk to a few advisers; look for the 3 Es empathy, ethics, and education. Invest some time to know your advisor and you can save yourself a lot of time, effort and money! But do it today.

Replace EPFO With NPS??

Suddenly, there’s seems to be an abundance of people who are eager to mark the New Pension System (NPS) as a failure. Everyone’s favourite statistic is the laughably small number of people (2,500 or so) who have actually, of their own free will, enrolled in the NPS. However, this number is completely irrelevant. It doesn’t tell you anything about the NPS. What it does tell you is that the NPS today is like a product that has been designed, but exists only in the design labs. It hasn’t yet been launched in the market.

Moreover, the 2,500 members that the NPS has got is a miracle because, out of the various entities who are supposed to be selling it, some are ignoring it completely, while others are actively de-selling it. If you walk into a bank that’s supposed to be an NPS agent, chances are that no one in the branch would have heard of the NPS and they will actively try to sell you an unit-linked insurance policy (ULIP) or a mutual fund as an alternative to the NPS. This is a product without a seller, and the way the world works, for all practical purposes, such a product doesn’t really exist.

I’ve read that the pension authority (PFRDA) is about to launch an advertising campaign to promote the product. That’s great and will surely result in more people hearing about the NPS. However, people who have first hand experience of marketing financial products would still doubt whether it would be enough to actually create participation without a structure that creates more profit for the seller than competing products do. It’s possible that the NPS’s future lies in being a mandatory saving, just like practically every retirement savings solution around the world.

Under the circumstances, the most significant step would the replacement of the Employees’ Provident Fund Organisation (EPFO) with the NPS for the private sector. It’s a puzzle that, as things stand today, the government’s pension money is being managed by the private sector (the NPS’s fund managers) and the private sector’s provident funds are being managed (though managed is not the right word) by the EPFO. Moving the private sector to the NPS is an urgent need. Not only would this free employee from struggling with the phenomenally hostile service quality of the EPFO, it could encourage many more businesses to come into the pension fold.

This is such an obvious step that it’s a puzzle that it wasn’t done right away with the launch of the NPS. In any case, if the NPS is ever to move beyond being just a solution to the government’s financial problem of financing pensions and fulfill its real potential, then it has to become an automatic and unavoidable option for every employee in the country.

When Should You Sell Your Fund??

The dilemma faced by some mutual fund investors on when to sell off an investment made in a fund often seems greater than the one they face while choosing a fund to invest in. The problem is that most — if not all — of us, who are active and involved investors, have a bias for action. We equate being good investors with doing something, often anything.

Unfortunately, this translates in practice to not just buying more funds than we need, but also to be ever ready to sell.

I frequently get questions from trigger-happy investors who are raring to sell a fund. There are generally three types of reasons they give for wanting to do so. One, they’ve made profits; two, they’ve made losses; and three; they’ve made neither profits nor losses.

That’s not a joke. At least, it’s not intended to be. Typical statements go something like this: “Now that my investments have gone up, shouldn’t I book profits?”; “This fund has lost a bit of money recently, shouldn’t I get out of it?”; “The fund has neither gained nor lost. Shouldn’t I sell?”

Basically, investors who have a bias for continuous action can create logic for taking action out of any kind of situation.The worst cases are those where investors want to sell a fund because it has done well, but not as well as its own past or its peers. Investors are willing to bail out of a fund that has done well for years on the basis of slight underperformance for a few months. The other day, I had a question from an investor who wanted to redeem a fund which, after six years of outstanding performance had given a ‘mere’ 60 per cent gains over a period when the top performing peers had done 70-90 per cent.

The problem is that investors’ actions while choosing a fund often mirror those while selling it. If you’ve chosen a fund because it was doing well for six months, then you’ll probably feel like selling it if it underperforms for three months and move on to another one, which has done well for six months. This doesn’t work. Investors in equity funds should choose one fund for sustained good performance over several years. As for selling them, the most logical reason for doing so would have more to do with your own finances.

Are the financial goals, for which you were saving, fulfilled? Then, by all means, you should sell off and redeem whatever money you need.

You should be a lot more circumspect, as far as getting rid of a fund and switching to another because it has started doing badly. The reason is that unless their management changes, funds that have a long history of good performance don’t suddenly become bad. It takes certain qualities for a fund manager to do well over years and those qualities do not vanish overnight. Everyone can have ups and downs and have bad phases, generally because one or two calls went wrong. In my years of analysing funds, I cannot recall a case in which someone was a good fund manager for years and then permanently became a bad one. And vice versa.

What this means is that, as long as the fund management remains the same, and as long as the fund is a diversified one (not a thematic one whose theme has gone wrong), it is better to be patient than to be trigger-happy.

Life after 01/08/2009 for MF Investor

It has now been a month since the Securities and Exchange Board of India’s (SEBI) new rule on the abolition of entry loads on mutual funds sales came into effect. As most investors should know by now, mutual funds no longer deduct an entry load from the amount invested. Earlier, this amount was used to pay most of the commission that funds disburse to the distributor who sold you the fund. From August 1 onwards, the entire amount that you write on the cheque is invested in your name - none of it is deducted for any purpose.

Of course, it's too early to see how the larger picture has worked out. There have been plenty of pessimistic projections about how distributors would stop selling funds and investors would stop investing in them. However, one month's time is not enough to make sense of any macro numbers about total investment inflows from different investors and different channels.

During this month, different distributors - and different types of distributors – have implemented different models for getting paid for the services they offer to investors.

Investors need to be aware of the various alternatives and the pros and cons of each.

Firstly, investors need to appreciate the fact that no entry load does not mean no commission. All that the SEBI’s new rule says is that fund companies must not deduct an entry load. Distributors can charge investors directly for their services.

Essentially, there are three models by which distributors can charge investors. They can charge a flat amount per investment. Or they can charge a percentage of the invested amount. Or they can charge nothing. All three are being tried, with some variations. The nothing option works only because fund companies are still paying commission to distributors - they are paying some amount of upfront commissions. Along with that, they will continue to pay the so-called trail commission which is mostly around 0.75 per cent per annum of the value of the funds.

Many distributors, including some very large ones appear to have reconciled themselves to this ground zero reality. My guess is that the free mode will come with some strings attached. The service and advice level is likely to be minimal. Also, the distributor could well be aiming to use funds as a loss leader to get you as a customer and then try and sell other, more lucrative products like unit linked insurance plans (ULIPs) where they can get fat commissions.

At the lower end, small and individual distributors are having a tough time trying to find the right level to charge. Typically, most of them do not offer meaningful advice but do offer great operational service. Since most of them are known to investors, their personal service levels tend to be substantially better than the larger and slicker outfits. If you are already dealing with such a distributor, you should recognize that he offers a real service and expect to pay him a fair fee for his time and effort.

At the other end of this marketplace, there are plenty of large distributors who are making a pitched attempt at continuing to charge a percentage that is close to what they were getting earlier. I know of at least a few foreign and Indian private banks that are continuing to give their wealth management and personalized-advice spiel. You should not entertain such claims. You should be paying a fair value, but the days of paying a full two per cent or so are gone. In fact, the days of paying the same percentage regardless of the amount invested are also gone.

My advice is that if you are a knowledgeable do-it-yourselfer (and since you are reading this publication, you probably are), and then the best option is to make your own investment decisions. All you need is someone to service your decisions at a reasonable cost.

Depending on your inclination, the best options could be a low-cost online broker, or a neighborhood small-timer.

Electrifying Prospect

RELIANCE DIVERSIFIED POWER SECTOR FUND

In 2007, with a return of 124.42 per cent, it truly impressed. But in all fairness, it is a sector fund and the relevant stocks were trading at a significant premium to their earnings.

Since the fund's fortunes are restricted to those of the sector, a slump could badly hit the fund. But the fund's mandate allows it to invest in energy, power, financial institutions and banks engaged in funding power projects, as well as any company associated in some way or the other with the power sector. Besides this broad base, the fund manager is not restricted in terms of market capitalisation or asset class. He has the leeway to be fully invested in fixed income securities (of companies that fall within the mandate) or even cash.

So, while one can expect anything, the fund manager has worked hard to mitigate the danger. Towards the end of 2007, the fund began to take on a large-cap tilt and also increased the number of stocks to around 27. Simultaneously, the allocation to the top five holdings has drastically reduced from an average of 43 per cent in 2006 to around 20 per cent, end 2008.

This diversification, coupled with an increased cash allocation helped it get away with a modest fall of 50 per cent in the market crash last year. However, in the recent run-up from March 9-June 30 2009, the fund has gained an impressive 76.52 per cent.

The fund manager has a tough job partly because he is managing a sector fund and partly because of the large asset base - this is the largest equity fund. But he has delivered admirably, has taken the risks into consideration and looks well poised to capitalize on power sector reforms in the future.