Highest NAV plans!!! A guarantee or another financial alchemy?

First thing first, does highest NAV mean highest ROI? Nope, they say that it is the highest of whatever they can manage to attain. It is very unlikely that with such a guarantee in place, they can provide even bench mark returns.

Let’s have a close look at how a possible highest NAV plan will work. They use Dynamic Hedging and Constant Proportion Portfolio Insurance. Although I don't fully understand these concepts, we actually don't need to digest this financial alchemy. Let's try to figure out how a common man would manage such plans.

Rule1#: If you have to provide some guarantee, you will have to charge some money for that. That money has to be taken from the fund value.
Rule2#: Stock market can never be guaranteed anything. It may crash anyway. So fund managers will have a pressure to minimize their risk and keep money in debt instruments and fixed deposits.
Rule3#: Since the lock in period is pretty big, 7-10 years, some amount of market risk can be adjusted here and there.

Let’s assume that the average interest on a secure debt instrument will be 7%. For the sake of simplicity I am assuming that the fund administration charges and other charges are 0.

Suppose the current NAV (and total fund value) is Rs 100. The fund manager wisely allocates the money in stock market, and after 1 year it gives 20% returns. The total NAV is Rs 120. Now the fund manager has the obligation to pay at least Rs 120 after 9 years. Now fund manager cannot take the risk of putting everything in stock market as it doesn't come with the guarantee. The debt product gives the guarantee. So the fund manager will have to pass a portion of total fund value to debt product to assure Rs. 120.

X*(1.07) ^9 = 120 gives X as ~ 65.

So the fund manager will allocate Rs 65 to some debt product and 120-65 to equity market again.

Let’s say after another year, the market resulted in good returns, and Rs 55 invested in the market sees another 20% jump. Now the total fund value becomes 65*1.07 + 55*1.2 ~ 146. Now the fund manager has the obligation to pay at least 146 Rs after 8 years. To provide this fund manager will need to solve this equation.

65*(1.07) ^9 + Y*(1.07)^8 = 146

This gives Y ~ 11.

Now fund manager will allocate additional Rs 11 to debt market, and put rest 44 in the equity market.

Let’s assume this process continues and after 6th year you have assured sum as Rs 180. By that time the equity component will be almost negligible and even if the market is highly volatile, it will not affect the fund value.

So absolute returns after 7 years will be 80%. (This is another gimmick, they will immediately say, sir which bank assures 80% returns and YES THEY DO SAY SO). If we calculate the effective rate of annual return it will come around ~8.7%. Which is marginally better than an FD (if we include the tax saving, it may be a bit better) but do we really want ~9% from the equity market for next 7 years period? Even the balanced mutual fund will give much more than 12% for this time frame. The few best MFs in my view have given more than 25% over the period of 15 years.

Pictorial representation of what I wrote will be like this.

So what is my conclusion today?

Whenever someone is guaranteeing something, please ask...what is the cost of guarantee? Are you into charity? :-)

ULIP and MF: A comparison from my portfolio

I think I was lucky that I chose a good ULIP (an oxymoron? ) SBI ULIPII. Around the same time I invested in a Tax Saving MF SBI Magnum Tax gain (G). After 4 years, lets see what is the actual absolute profit in both the investments.

I started my ULIP in April 2007 for 30000 annual premium (paid annually). I lie into the tax slab of 30%; rebate is given to me (for whole 30000) monthly at the very start of the financial year. I will use discount rate of 9% (assumed average inflation rate) to discount the time value of money back and forth.

Now I will do the similar calculation for my SIP in SBI Magnux Tax gain.

The difference is clear between the two. It doesn't look a lot since my choice of fund was not good. Had I chosen the HDFC tax saver, the current profit for the ELSS MF would have been much more than Rs 1,25,000

So what is my conclusion today:

Avoid ULIPS as much as you can and invest wisely in an MF which has a good track record.

How to know if you are being trapped into mis-selling

I think the various agents have mastered the art, the science and what not of miss-selling. Still a few key sentences can be observed and you should be alarmed of the miss-selling.

1. Sir, see this policy has give 100% returns. If you dig down, he will explore the papers and show you the absolute 100% returns since 2005. Well 100% return in 5 years doesn't make it much more than 15% returns (compounded annually). Although 15% annual is a good return, but it is not that 100%, of which you are being lured.
2. Sir, see this wonderful policy is the money maker! It has returned 60% in one year. Well if you look little deep, he has data from sensex at 8000 to sensex at 18000. Any mutual fund has given much more than 80% during this period.
3. Sir, there is a guaranteed bonus of 180%. Here you have to really understand and read between the line. Your agent will stop at 180% nonsense. If you are smart you will ask, 180% of what? total sum? Then the agent will sheepishly say, no sir of the annual premium. You then have to ask, ok when? As I buy the policy? The agent sweats a bit and says, no sir after 15 years. Suppose you take a policy of 10000 annual premium, you are being lured for 10000 additional bonus after 15 year. With the average 10% inflation, the NPV of that 10000 in today's term will be ~2400. So is it worth?
4. Sir, this is the wonderful time to invest in this mutual fund. Its NAV is only Rs 10. Why to invest in Rs 400 NAV mutual fund. Here you will get a big number of units. Well any sane person after a minute of inspection will understand the folly of the statement. Present NAV doesn't matter at all and secondly one should always wait to see the performance of the fund. Why be the guinea pig?
5. Sir, you wont believe us! This is the highest NAV plan. You know the market position currently, it is so low, market has to increase 10 times (as if he really plays the market). Just imaging, if you invest 10 Lakhs today, we are guarantying you 1 crore after 10 years. Well can you give it in the writing? No sir, but you see it is highest NAV plan, so there is guarantee anyway. It is guaranteed by IRDA as well. But the foolish agent doesn't tell me the guarantee of NAV going up!!! What if NAV increases well for first 3-5 years and then stops (actually thats how all highest NAV plans will work). Is there any respite?
6. Sir, this is unique ULIP plan and the most important point is that you can withdraw your money after 3 years. Someone bitten once like me can understand that the deductions in the ULIPS (old) are highest for the first 3 years. What indirectly he is suggesting is to pay him commission from your pocket and forget it.

Jai ho! The art and science of miss-selling is still being taught at the premier institutes of wealth creation.

My ULIP agent: Many many thanks to you

Flash back to January 2007. I had joined a new company, got good package and had a good sum returned from previous company. By the end of Jan it was raining tax savings schemes and alike instruments all around. I was asked to provide my tax saving stuff and alas I had nothing. Suddenly one fine day the God himself decided to meet me in the form of an ULIP agent. He offered me a product too lucrative to be ignored. I thought one should listen when opportunity knows. I wholeheartedly poured in 70K as the annual premium for the sum assured 7 lakhs. The God said, you look so healthy, nothing will happen to you, thus 7 lakh is more then sufficient for the insurance cover. I happily agreed, after all he was personal finance God.

Fast forward to Jan 2008; The stock market was euphoric and the wisest man inside me chose the "Growth" option in the ULIP, I was too happy to blab about my investment mantra and intelligent decisions. To boast about it I logged into the my savior ULIP web page and hit the 'fund value'. The whole world rolled in front of my eyes. While even my 'kam wali bai' had earned a lot in the stock market during that period, my safe fund showed me my fund value a little more than 30K. I thought to bash at the agent, who conveniently cut the phone. I then rang to the respective insurance company, who enlightened me with the fine details I didn't bother to read previously.

My policy had a funny deduction structure.

1. From the first premium 65% will be deducted as administration charges plus agent commission.(Oh God!)
2. Mortality charges
3. Some other management charges1%
4. 10% service tax and 2% education tax (close to 10.2%)
5. Some 2.75% annual charges

I was amazed at the scene of such a wonderful looting scheme and thought to cancel it. I then was enlightened about the surrender charges and I realized that I would have to pay more to surrender it :-) 

This was the mistake part of my investment life. I thanked my investment agent to teach me a wonderful lesson. I realized the importance of reading the fine print and more importantly, understanding the personal finance. That event left me a much more learned and motivated person.

Many many thanks Mr Agent!!!

P.S I still pat my back for not felling for this. The first year charges are 100%.

Stock selection methodology

Having served the role of project manager for a few projects, I like to present everything as a WBS. So here is my long promised my WBS for stock selection. It still needs a PERT chart analysis. Stay tuned...

A few dividend stocks I am looking into

I am looking into these three dividend paying stocks. The current filter criterion is dividend and nothing else. If this screen test passes I shall look into other matrices.
The graphic above tells the dividend paid as percent. This can help us analyze the dividend trend, stability and deviation (I use standard deviation to measure deviation).

I make a dividend portfolio which will give me a stable income after a few years, I am much interested in stable (if not increasing trend). I will put "Andhra Sugar" off based on this criterion. Having left with Castrol & Valson, it is imperative to understand yield part of the dividend. I will use today's prices to calculate the dividend yield. This will help me understand the trend.

Valson has been giving consistent dividends of more than 8%, it is much more than any A grade bond and FD provides today. At this stage I will place this stock in my to further screening criterion.
A closer look as Castrol dividend yield chart reveals that is has picked up an increasing trend. The financial health of the company is good and the brand image is good. I have multiple reasons to believe that it will yield 8+ % in coming 5 years. This should go to my dividend portfolio for sure.

My equity portfolio allocation

This is the state of my current portfolio. In spite of heavy rebalancing it is still tilted towards oil & gas sector. Any government policy change can decide the direction of my portfolio.

This metric is based on the current capital allocation. The another metric I follow for rebalancing is dividend income. I dont want my dividend income to be tilted on any side otherwise the stability factor goes away.