Saturday, October 1, 2011

The Great Mutual Fund House / ULIP Paradox

ULIP = United Looters of Indian Public

MF - Need I say anything for this - samajhdaar ko ishaara kaafi hai; for purposes of decency it is Mutually FHundd

ETF: Eat Trader's Fund

This is how one can describe some of the most commonly used, heard and read terms in all periodicals and business news channels and what not. Whether through an ETF, or MF or ULIP, you think you are depositing funds with a responsible fund management team who care to grow your money?

Wrong - you just fund them for trading margins so that they can speculate as much as they want, earn fat bonuses and get away with the bad stuff [Red Herring Prospectus?]

So just in case as a mango man, you still don't realize how a fund house plays with your money - let us look at how the Fund house supposedly calculates the NAV in your folio

Here is some thematic fund [or ETF or ULIP] that ties the value of your portfolio to a set of companies. The justification given is that funds are invested in equity shares of a certain list of companies. As the value of this equity goes on increasing, the NAV will increase and vice versa when the market falls. For those who like to do number crunching and graphs - try to plot the curve of the NAV of the portfolio vs the benchmark index performance - no surprises for guessing; when the markets go up, your NAV also goes up but not in the same proportion as the markets. On the other hand, when markets go down, your NAV drops faster than the general market's lows.

So what exactly is happening with all your hard earned money apart from keeping aside cash for redemption pressures and a fund management fee (less than 2% and you thought this is what helps fund houses maintain such plush offices and all the marketing hoopla on television and out of home media?]

Picture this - when you have a DP account with a trading broker, the first thing he will tell you is that you can use 1:4 leverage for share trading, 1:1 for FnO trading [which works with 10% as margin for futures contracts and the rest as determined by exchange and some Black Scholes formula for options] and then we have the vast forex market with 1:400 leverage on currency pairs.

So a smart fund manager decides to allocate the cash, some equity companies for investments and then starts looking at the PnL - let us face a simple fact - with just 2% as management fee of which a cut needs to be paid to the fund agent, it is simply not possible for a fund house to have such plush offices, sophisticated computer terminals and lavish spending on media. So the money has to work for some purpose. A vast proportion of the money is deployed in the derivatives markets that help reap profits regardless of bull or bear conditions.

Assumption: Funds in place = 1 Crore Rupees
Allocation is 100% Equity [for simplicity]
Cash Reserve = 35%
This means 35 lakhs are lying as cash and the remaining 65 lakhs are [supposedly] invested in a list of companies. Let us assume that this fund manager is good and in fact does deploy 30 lakhs in shares listed. This still leaves him with 35 lakhs that needs to be deployed and money earned out of it. Market conditions are good, there is a bull market on-going and he decides to put in 15 lakhs of the remainder for futures, 10 lakhs for commodities and 10 lakhs for forex. Assuming that the fund manager and his team do well and are prudent risk managers, this 35 lakhs can more then triple in good conditions. Fantastic news and due to the bull market conditions, the shares in which money was deployed are also doing well and hence the NAV is pretty good. However, have you really got bang for your buck? The answer is a big fat NO. YOUR hard earned money was used to gamble on the various speculative instruments of the market but the returns of which were never disclosed or shared with you. All that you got as growth was the appreciation in equity holdings of the declared companies. The balance - of course they all need it for paying off for all the plush offices and the fat bonuses for the staff doing asset management.

Scenario 2: Everything else same but the bear market conditions prevail. However, the fund manager and his team are smart and play the trends well and make good money in the speculative markets as bears but this time, the job is very very easy for them. There need not be any justification whatsoever because the system based NAV calculator has already made you poorer by marking down the value of YOUR hard earned money so it is perfectly ok. As far as profits generated in secondary markets are concerned - of course they belong to the management of the fund house and the team of asset managers. They were smart enough to deploy the funds properly and your NAV is enough to keep you quiet.

Scenario 3: Everything else same but the bear market conditions prevail. However, this time, the fund managers are also caught on the wrong foot, betting on the wrong side of the trend and lose money big time in the derivatives market. No problems whatsoever as there is still cash and equity [though lower in value] that can be used to spook a sell-off thereby viciously increasing the rate of fall of the NAV.

[Incidentally, there is seldom a case for bull market conditions to prevail and fund managers getting on the wrong side of the trend for too long!]

Whether it is scenario 1, 2 or 3 there is 1 DEFINITE LOSER - The Investor
In majority of the cases, regardless of bull / bear conditions, fund managers use your hard earned money to generate maximum profit possible for themselves and you come last [the book Employees First - Customer Later may have been a best seller but our MFs, ULIPs and ETFs took that literally from a pretty long time]

Hence it is no surprise that a vast majority of the Indian public are not invested or get out pretty soon. Whilst they get out on a simple premise that most often than not, they lose money in such ponzi schemes and decide to stick to FDs, Gold and Real Estate. This is how most of your fund houses operate and loot your money. It is really a sad state in India right now that people work so hard to earn their money but spend very little time in deploying it appropriately and being informed about how to manage the funds. There are four distinct categories emerging in the middle class right now

1] Invest and Forget category [the most wanted people as far as fund houses are concerned]
2] Trading category [The gambling variety that wants to increase net worth exponentially each passing day and leaves the markets for good most of the times; most wanted by brokerage houses]
3] Consumerist Epicurus - Eat, Drink and Be Merry - Credit Card zindabad - no cash - no interest in savings or trading or investments. May decide to do some betting with poker, horse racing and cricket but certainly nothing to do with what involves a little research and time. [Some alec smart marketing agent might convert a few of such people as clients by telling them how important it is to have funds in place for the same lifestyle at later stages of life]
4] People with little savings after taking care of all family priorities and find themselves clueless on trends, terms and just stick to known forms of low risk low return investments always [oh oh - no point in wasting time with such people thinks a sales person for a fund house]

These very demographics [in most of the middle class of India] have put in a very potent ground for ULIPs, MFs and ETFs to thrive with your money. In fact, there is a certain degree of control brought in by SEBI/RBI that keeps some damage under control unlike the West.

The laundry list can go on and on but there have been numerous instances of ETFs, Hedge Funds and Institutions going bust with their ponzi schemes courtesy free markets fallacy

A Gold ETF pegs its value against a certain weight of gold price per unit of the ETF. So with each additional unit one buys, one is technically buying gold to be used for later purposes. Now as per principles, the ETF must have a significant portion of gold deposited in vaults and/or enough solvent long futures contracts that can be liquidated against redemption pressures. You think after hiring all levels of financial engineers and business school graduates, such ETFs would play fair? In most cases an emphatic no. A statistical expert models the probabilities of redemption pressures under certain conditions and tells the big guys how much cash should be reserved. The rest - voila for speculation to be used by one and all in the fund house for the big fat bonuses.

Surprise surprise -  there is absolutely no risk modelling technique for surprise events like sudden interventions by central banks to control prices, more than anticipated redemption pressures and of course losses by taking unidirectional bets. And of course if you thought that your ETF had enough gold reserves to honour your redemption pressures you are wrong.

Bottomline: Never ever trust your MF, ETF, ULIP [ULIP is something that should be completely avoided]

The typical sales pitch of the ULIP seller: Regardless of what happens, if you are not in a position to pay your premiums, then the value of the portfolio will pay off for the premiums.

Inference: Don't worry - we want to suck your premium and portfolio value i.e. loot your money.
Insurance and Investments should NEVER be linked together. Insurance is to ensure that you take adequate protection for covering your life and family against unforeseen circumstances of life. My counter argument as far as creating corpus for future premium payments is simple - I would rather work my own way out for reserves and hedges against inflation, uncertainties of life so that the premiums are paid up. My first concern with insurance is that I must have enough insurance to cover all my loans / liabilities should something untoward happen to me and further to that, there should be a corpus to provide liquidity to my family members in such a case.

Despite all modernism coming in the insurance space, I prefer sticking to the traditional money-back and endowment schemes of LIC like Jeevan Shree [I was lucky to enter in at a very early stage], Jeevan Anand, Bima Gold, Jeeval Saral etc. For pure risk management, I prefer Metlife Suraksha TROP that gives me excellent coverage till the policy is running and subsequently returns all my premiums with a simple interest of 10% on maturity. Whilst there are a few challenges with the way LIC plays the stock markets [sometimes forced by the government] there is no other insurance company in India with properties like LIC. Be it the Jeevan Beema Nagars of residential plots in all major cities of India, be it their plush offices - everything is gold dust. The introduction of other players actually forced LIC to eliminate a lot of bureaucracy, outsource projects to IT companies like Wipro and now a record of 1 policy settled per 2 minutes has been set. So much for the insurance part [Endowment schemes are good because the coverage covers a period even after you stop paying premiums which adds a cushion to your coverage]

Mutual Funds are worth investing into when a bear market prevails and despite the cash levels one has, one cannot invest in all blue chip firms. So allocating some portion to equity schemes that have exposure to the top 150 or 200 stocks on Nifty, Banks, and Mid-Caps help. The mantra to success here is SIP and invest when the bear markets prevail; book out when the trend turns bullish periodically [rather than how it is done currently - invest in bull conditions and withdraw in bear conditions]

Investment directly with the exchange like Nifty Bees, Bankbees will end up delivering stellar returns exactly as the index and if one entered at suitably low levels in mid-cap funds in bear markets, the odds of doubling or tripling the investment within 2 or 3 years is high.

The purpose of this post is to educate investors as to how innocent people are getting ripped off by financial engineers in the MF/ETF/ULIP schemes and how your hard earned money is deployed to the advantage of the fund managers and management. Unfortunately, the regulations in India are not strong enough to monitor these correctly. However, the periodic and sporadic interventions by RBI/SEBI ensures that most funds may not go bust due to excessive leverage. Had this not been the case, our MFs and ETFs would probably be sitting at 2% to 3% of cash as demostrated by the MFs/ETFs of Europe and US in the last few months of economic crisis. [The myth of market inefficiencies getting efficient by a complex web of derivatives is simply rubbish]

The main message is - Start doing your own homework rather than rely on advertisements, 'expert advisors' etc as the mechanism is very complex. The agent is worried about his commission, the sales person is worried about targets and 'concern' for your hard earned money is zero. At the end, we have been blessed by GOD with capacity to analyze and take a hard look at what we need to do for ourselves. As my lovely spiderman harshal bhai puts is 'Life is Simple - So let us keep things simple!'

You can design your own portfolio depending on your income and expenses. An ideal portfolio for middle class is

Assuming X is the total amount of investments to be made in a year [not counting a home loan and EMI of that and assuming that 40% of net take home salary is swept out for the home loan EMI]

30% in FD, Fixed Maturity Plans [I vote for FDs because you can easily sweep out funds in case of emergencies]
20% in Equity Mutual Funds
10% in NiftyBees / Bankbees
20% Directly in Top 20 counters of Nifty [Even if it is just 1 share of TCS or 1 share of LnT or 1 share of ICICI Bank - invest directly by yourself. Keep a fixed amount for equity investment and on the last Thursday/Friday of each month buy the number of shares that will be available with your cash outlay. Don't worry about bull and bear markets for this one. Just keep on accumulating but also keep a note of the profit / loss - if the portfolio value increases by 15% of the net amount you chipped in, book profits on some units] In a 5 year time horizon, these stocks will provide a CAGR of about 30% per annum

The remaining 20% needs to be kept aside for insurance - insurance is a must for the benefit of the family and also health insurance because of the rising cost of medical care. It is wrong to not take a Mediclaim policy just because you are covered by your company. That is simply a group policy and at some point of time, when you are out of the group, a lot of your problems may not be covered at a future date. The earlier the mediclaim is taken, in fact even with an increasing age, your premiums may start dropping due to No Claim Bonus. To the extent your medical expenses are covered by your organization, you are not claiming anything from your mediclaim policy. The benefit is bound to come and the earlier you take it, lower are your premiums. Most of the ailments are taken care of.

We don't need any tv channel or any advisor to tell us how to manage our money. All we need to do is evaluate our life goals, our priorities and hedge ourselves adequately under inflationary pressures. Salaries will not rise more than 7% to 8% on an average which is not sufficient to handle inflation at Consumer Price Levels [I never care about what the monthly numbers say because it is based on the Wholesale Price Index of a basket of goods that was made in 1950s. Today the basket has changed with the demographic changes - still our economists don't want to change that because it affects the netagiri!]

Cash continues to remain king but one should also be willing to enter the markets in bearish situations - in fact when the sentiments are most bearish, the MF units and index units tend to more than double or triple in 3 years because of the meteoric rise from the lows. After all, as Pretcher Jr says, the stock market is nothing but the sum of the overall social mood. It is simply law of nature and markets that we take 3 steps forward and 2 steps back but the longer term outlook is progress/evolution.

You don't need a crisp suit bearing MBA to come and tell you about alpha and beta and all such academic stuff. Good to know better to ignore. All we need is a little bit of self application and money management.

3 comments:

Waverider said...

Dear King Nag,

Couple points on ULIP - very important. I took one company to court and yet I could not get ALL of my money back when I surrendered. Share that some other time. It a long story.

ULIP - Has no surrender value after the look back perios of 15 days elapses during the 1st year.

The surrender value at the end of year 2 = one year's premium.

If you pay an annual premium of Rs 50,000.00 on an "United Looters of Indian Public" policy and want to discontinue at the end of year 2, U lose Rs 50,000.00.

From the rest of the 50,000.00, a host of charges are deducted and what you get would be less than Rs 35,000.00

Of course, you will get more if the units have appreciated in 2 years, if they have declined in value, U get less than Rs 35000.00

RIP OFF.

The re-seller almost alwayz cons us into going for it. The easiest way to con which according to them is "You only have to pay for 3 years, after that you dont"

What they should say is, Yes, u have the option not to pay after 3 premiums, you coverage would still continue. What would occur is at the end of year 4, we will keep you policy in force, but will deduct the premium from the number of units in your account"

LOL. Not one ULIP bum has said it like this. But itz what it meanz.

And the most important point.

U pay close to 6% of each premium as fees. So if you pump in Rs. 1L each year, the units allocated would be for Rs 94,000.00 only

Generally the coverage is equal to 5 or 7 years worth of premium.

Taking Rs 7 Lakhs as the sum assured (Rs 1L x 7 years) on a 15 year policy.

AT the end of year 7, you have pumped in Rs 7L.

In case of a claim due to unfortunate event, the beneficiary gets

"THE SUM ASSURED" OR "THE REDEMPTION VALUE OF UNITS" WHICH EVER IS HIGHER - NOT BOTH.

You have already paid them BUMS Rs 7L, they allocated units worth 94000 each year. So in 7 years - those units iF they are worth more than when they were allocated.

The redemption value is Rs 94000 x 7 = 6,58,000 appreciated by a very nominal 10% in 7 years that leaves the value at Rs 7,23,800

This is what your beneficiary would get.

If the units appreciated more, they would of corse get the higher amount.

What I am tring to get at is:

Once the premiums paid amount to the sum assured. It is just like a mutual fund with hefty fees.

My suggestion and I have done EXACTLY that.

Get a term life policy for a higher amount and much lower premium.

Invest the rest on your own or just buy into couple of Mutual Funds.

This is how it would look:
Example quoted for Age 40

Rs 25L term life at annual prem of Rs 12,600.00 (LIC) 13,500 (Reliance)
This is risk only cover. No value at the end of the term. Will lapse when you stop paying premium.

In 7 years, we would have paid 84000.00 for coverage more than 3 times more.

Rs 7L - 84000 = 6,16,000 left with you.

Pump in 88000 each year into the MF. If they deliver the same 10% over 7 years - we have 6,77,600 which is all yours - no deductions like the ULIP bums at redemption.

If you have the time and inclination - scru the mutual fundz too.

Buy equities - with some research we may be able to catch the bottom of a big bull market.

Once a year goes by there is no cap gainz on equity - keep taking money off the table - a little at a time - new research and new stocks.

Remember Even Dhoni is not going to be skipper for ever. We will get a new Dhoni, maybe even better :D

Have a good one

Digesh said...

Dear nagji,
Very much informative post. Thanks for such a wonderful information.
Its 100 right. I faced same. My father has invested in mf, I am just doing switching. I.e. last month when market fell by 700 points my nav was down 4% and when marken rose by 500 points my nav was only 1-1.1% up. At that day i fell the same whatever you told.

Thanks.
Digesh patel.
Silent member of mmb and your post.

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