Gauge market psyche0 commentsHere’s how you can read and make use of the data showing up on your terminal Mazhar Mohammad “There is nothing new on Wall Street or in stock speculation. What has happened in the past will happen again and again. This is because human nature doesn’t change and it is human emotion that always interferes in the way of human intelligence. Of this I am sure.” -Jesse Livermore, the eternal darling of traders Conventional economic theory safely assumes that homo sapiens behave rationally while making economic decisions so as to maximise their wealth. There is no place for emotions, sentiments and other external factors, which are likely to influence our decision making. Unfortunately, in the real world, man seldom behaves rationally while making financial decisions; more so when it comes to investing in financial markets. There are many instances where emotions and other factors influence our decisions, causing us to behave in an unpredictable and irrational manner. Behavioral finance, which is a combination of psychology, economics and finance, helps us understand why people behave irrationally when it comes to making financial decisions. Kirkpatrick, eminent author and market technician of USA, in his book Technical Analysis- The Complete Resource for Financial Market Technicians explains how behavioral finance is becoming a theoretical justification for technical analysis. Classical technical analysis is applied social psychology. Charting provides a window to mass psyche. The emotions of the crowd are reflected in the ebb and flow of prices. If one charts this actively over a period of time, patterns in the price action emerges. By studying these patterns, one can understand the current psychological state in the market, which in turn helps us in predicting the direction of the market. Price, volume, open interest, etc also reflect crowd behaviour. So do the indicators based on them. By meticulously studying these indicators, one can get an insight into the mass psyche of crowds. Let me explain how to read crowd behaviour reflected on the charts with a few examples. Volumes Prices quoted on the bourses reflect the consensus of value between buyers and sellers, whereas volumes reflect the emotions of market participants. It shows the intensity of traders’ emotional and financial commitments. To read these emotions reflected through volumes, Joseph Granville, the reigning market guru of USA in the late 1970s, introduced the concept of on balance volumes (OBV) in his book New Strategy of Daily Market Timing. Granville colourfully described volumes as “the steam in the boiler that makes the Choo Choo go down the tracks.” OBV is a running total of daily volumes. It is calculated in two steps. First, each day’s total volume is deemed as being positive or negative depending upon the closing price for the day. If prices close higher, the total volume is positive; if prices close lower, total volume is negative. In the second step, each day’s positive or negative value is summed up in a running cumulative total. A new high of OBV shows the power of bulls and a new low shows the strength of bears. As crowds exhibit mob mentality, volumes often precede the price changes, which gives us clues about the future direction of the market. Accumulation/ Distribution Astute trader and technical analyst Larry Williams introduced the concept of accumulation and distribution (A/D) in his book How I Made Million Dollars. It is designed as a leading indicator, which gives clues in advance for predicting market direction. A/D tracks the relationship between opening and closing prices along with volumes. Unlike OBV, A/D credits a fraction of volumes to bulls and bears. A running total of each day’s A/D creates a cumulative A/D indicator. It is calculated by using the following formula: A/D = ((Close-Open)/(High-Low))*Volume Opening trades are often dominated by amateur traders, who place their orders based on the overnight news flow or information gathered by them. The outburst of their emotions result in opening ticks on the bourses. Unlike amateurs, professionals who are active throughout the day usually dominate the market at closing time. A/D tracks the outcome of the battle between professionals and amateurs. It ticks up when professionals are more bullish than amateurs and ticks down when professional are more bearish than amateurs. Distribution of security is said to have taken place when price is making a new high and the A/D indicator is failing to make a new high. As it is a bearish sign, traders prefer to sell. Accumulation of the security is indicated when the security is making a new low and the A/D indicator is failing to make a new low. It is a bullish sign, which results in buy orders. Open interest It takes one bull and one bear to create a futures or options contract. A person who is convinced that prices are heading high will initiate long positions and a person who is convinced that prices are heading down will initiate short positions. Open interest (OI) refers to the number of contracts held by buyers or owed by short sellers on a given day. It is a zero-sum game in which for every winner there will be a looser. OI increases when a new buyer initiates long positions from a new short seller. OI falls when a trader who is already long trades with someone who is already short. OI remains unchanged when a new bull buys from an existing bull who is getting out of his long positions. OI remains unchanged when a new bear sells to an existing bear who is squaring off his short positions. If OI is increasing in an uptrend, it represents aggressive new buying and is a bullish sign. On the contrary, if OI is rising in a downtrend, it represents new short selling and is a bearish sign. Declining OI in an uptrend represents short covering but not fresh buying. Hence, it is a bearish sign. However, declining OI in a downtrend suggests liquidation of losing long positions and is treated as a bullish sign. Put-call ratio A person who is bearish on the markets buy put options. Similarly, a person who is bullish on the markets buys call options. Put-call ratio (PCR) is arrived at by dividing the total number of puts with the total number of calls. A high PCR suggests that more number of people are betting for the downward direction of the market; that the majority of market participants are bearish. A low PCR, on the other hand, reflects the optimism in the crowd. In practice, PCR acts as the best contrarian indicator as the market moves in opposite direction to what the crowd expects. Thus, a high PCR is favourable for future market direction. Apart from the above indicators, there are other indicators and oscillators like relative strength index, moving average convergence and divergence, new high and new low index, Herrick Payoff Index, etc which help us in gauging market psyche. The writer is technical analyst, Darashaw & Co,Mumbai. Views are personal.
Gold ETFs make golden sense0 commentsIt pays to keep buying a unit or two at regular intervals Sandeep Shanbhag This week I am finally going to do something I should have done a long while ago —- simultaneously thanking and apologising to readers of this column. The thanks are for your overwhelming response week in, week out. The apologies are for not being able to reply to all those who write in; the sheer volume of emails makes it physically impossible to do so. However, please do keep writing in and I will try and respond as best as I can. There is yet another advantage to your email feedback. It provides me with subject matter to write on. For example, if I find that there is an issue or matter that several readers have raised, all of them can be answered at one time by way of an article on the subject. Previous write-ups on PPF, tax return forms and HRA, etc are cases in point. And this week’s article too is a result of reader feedback from last week. To recap, last week we constructed a financial plan for the Mehta family, which helped them provide for their daughter’s education, marriage as well as their own retirement. Among other suggestions, it was recommended that the Mehtas provide for the anticipated gold requirement for their daughter’s marriage by accumulating units of a gold exchange traded fund (ETF) each month. In this regard, several readers wrote in requesting more elaboration on the concept of an ETF and how this instrument may be used to buy gold bullion. Well, ETFs are essentially mutual funds listed on the stock exchange. You can buy and sell them just like you would buy and sell a share. In the case of a gold ETF, the underlying asset is standard gold bullion. In other words, a gold ETF is just like any other mutual fund scheme —- only difference being that instead of being invested in equity shares, the monies collected are invested in gold. Generally, the price of one unit represents approximately one gram of gold. Since these are passively managed funds, the NAV will basically track the price of gold in the open market. Currently, Benchmark, Kotak, UTI, Reliance and Quantum mutual funds offer gold ETFs. SBI MF had an ongoing new fund offer, which closed on April 28. Now, in a country where gold worth over Rs 70,000 crore per annum is sold in the form of jewellery, coins, biscuits and bars, the total assets under management of these schemes amount to just around Rs 750 crore. This suggests that investors are either unaware or uncomfortable buying gold in the electronic form. It requires a shift in mindset, which shouldn’t really be difficult considering we already own other equally valuable assets in a similar form. Think of the money in your bank. Whether you have Rs 10,000 or Rs 10 lakh or over a crore, the physical cash (hopefully) is not lying in your safe —- your bank passbook indicates the amount you own. Similarly, there was a time, not too long ago, when physical share certificates needed to be delivered and stored. Then we shifted to electronic holding and an investor’s life was never more convenient. Now, similarly, gold too can be held in the dematerialised, electronic form, which is a safer and more efficient way to own it. For starters, there is no doubt on the purity —- you can’t get purer gold even if you tried and you don’t even have to depend on human honesty or scruples. With a gold ETF, impurity risk is non-existent. Security is of course taken care of by the fund, unlike in the case of jewellery or other forms of physical gold where the threat of theft always looms. As for denomination, as mentioned earlier, one can literally buy one gram at a time. Indeed, with Quantum, you can even buy half-a-gram at one time. Though a traditional systematic investment plan, as we understand it, is not possible in the case of gold ETFs, one of my friends has been diligently picking up 5 grams of gold per month and by now he is already the proud owner of 70 grams of highest quality of gold. When it comes to selling back, the making charges of jewellery cannot be recovered, in fact, it is generally bought back at a discounted price. Coins and bars also suffer from similar problems. Units of gold ETFs, on the other hand, can be sold by either a call to your broker or with a few clicks of your mouse if you have an online trading account. Free of wealth tax and subject to long-term capital gains tax of 10% as against 20% in case of physical gold, tax benefits round off the manifold advantages of holding gold in the electronic form. Gold prices have spurted by almost 26% over the last year, leading to an almost corresponding rise in the net asset values (NAVs) of the gold ETFs. However, investors shouldn’t look at gold on the basis of returns in a particular period. This investment is essentially as a hedge against inflation and its quality of negative correlation with other asset classes like stocks, fixed income securities and commodities during uncertain times. When markets are erratic and times unpredictable, the wise thing to do is to step up exposure to an asset that would infuse a semblance of stability and strength to the portfolio. And the cleanest, simplest and the most efficient way to do this is by investing in a gold ETF. Given the debasement many countries are subjecting their currencies to, one cannot help but feel that at the end of the day, bullion would prove to be more valuable than the billions. The writer is director, Wonderland Consultants, a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com.
Why’s China buying so much copper?0 commentsEither its economy is on revival path or it is trying to spend its forex reserves Vivek Kaul. Mumbai Late on Tuesday morning, as I had just finished chasing the pigeons out of my house, there was a knock on the door. “Hi, it’s me,” she said as I opened the door. “Not going to office today?” I asked. “Don’t feel like. It’s nice to take a weekday off once in a while.” “Yeah, even I don’t feel like going to office today,” I said “Well, then let’s discuss the economy. I feel China has started to revive again,” she said, making herself comfortable on the couch. “And why do you say that?” “Because copper prices have risen almost 50% to $4,700 per tonne on the London Metal Exchange in the last three months. China’s copper imports in the first two months of the year are up 71% vis-à-vis last year to 451,400 tonnes.” “But what has copper got to do with Chinese economic recovery?” I asked. “Guess you did not study your science properly in school. Copper is a metal that is used from making everything from water pipes to electrical wires and electronic products. China’s State Reserves Bureau has been buying copper in good amounts over the last three months and this has led to an increase in the price of copper. Why would they buy copper unless they plan to use it in some form of industrial activity? Some experts are of the view that an increased demand of copper means Chinese industrial output is picking up again. Industrial output for the month of March picked up 8.3% annualised, after 3.8% in the first two months,” she said. “Interesting. But I have another theory for this. China has foreign exchange reserves worth $1.95 trillion. Of this, nearly 85% is invested in the United States in one form or another. China is buying copper to lower its dependence on the US, given the perceived weakness of the US dollar and financial securities issued by the US government. In fact, if experts are to be believed, it has bought much more copper than it is likely to use this year. And copper is not the only metal it is buying. It is also buying metals like aluminium, nickel, titanium and zinc, the entire idea being to build a storehouse of real physical assets instead of having a major portion of the foreign exchange reserves invested in financial securities issued by the US government. I’d say they are trying to follow the ageold investment adage, “Don’t put all your eggs in one basket.”” “Fair enough. But how do you explain the rally in the Chinese stock market? The Shanghai Composite Index has gone up by more than 25% in the last three months. The market is rallying primarily because it expects the Chinese economy to start picking up in the next few months and that in turn will lead to global economic recovery. How about that?” she asked. “Madam, hold your horses. If economics was that precise a science, all these problems wouldn’t have happened in the first place. The Chinese stock market has rallied despite company profits being 37% lower in the January-March period this year, compared with the same period last year. So there is a little more to the rally than the expectation that the economy will do well in the days to come. And the answer in most cases lies in the money supply numbers. Chinese money supply is now around 25% higher than it was a year ago, which clearly means the People’s Bank of China, which is the Chinese central bank, is printing more yuan. This has been the fastest growth in money supply in the last 12 years. And where is most of this money going? It is going into buying stocks and is being fuelled into the property market, to firm up prices.” “So are you saying the Chinese are trying to rebuild the bubble they burst last year?” “Yeah, that is way I look at it. The story gets even more interesting if we look at the amount of lending the banks have been indulging in. For the first three months of this year, Chinese banks have lent 4.6 trillion yuan ($585 billion). This is larger than the fiscal stimulus of 4 trillion yuan that the Chinese government has planned. If we combine these numbers, what we get is a number that is equal to 30% of the Chinese gross domestic product (GDP). With all this lending and spending, the Chinese government hopes the economy will be back on its feet again.” “And how is that?” “Well there is something known as the “wealth effect” in economics. If stock markets and property markets continue to go up, people will start to feel more wealthy. They would then go out and spend more money on buying goods and services. This, in turn, will benefit local Chinese companies and entrepreneurs. By doing this, China is trying to break its dependence on exports, which currently constitute nearly 40% of its GDP. Exports in March fell 17% and in February by nearly 25%, which indicates an attempt to kick start the domestic consumption exercise. But this won’ be a miracle cure because the Chinese dependence on exports as a way of earning money is not going to go overnight.” (The example is hypothetical) k_vivek@dnandia.net References: A ‘Copper Standard’ for the world’scurrency system?, Ambrose Evans-Pritchard,April 16, 2009, www.telegraph.co.uk; New Bubbles Brewing in Shanghai and Wall Street, Gary Dorsch, April 14,2009, www.safehaven.com; Jury still out on China’s exports dependence, G
Of stories, rupee-dollar rate & gold0 commentsThere’s no saying for sure which way a particular asset class will move Vivek Kaul. Mumbai Human beings are suckers for stories. You, me, everybody. We need stories to make a decision and stories to not make a decision as well. If there is no story, we create stories in our mind to justify a decision. So much so, in the rare case that a decision is made without there being a story, we rush to create a story to justify it. On the same lines, every bull market has a story going because people won’t invest otherwise. And there is a story behind the bull market in gold. So what’s the story behind the price of gold going up? To put it in a few lines, the US government owes the world much more than it can ever hope to repay. Depending on which estimate you believe, the figure varies from $50 trillion to $70 trillion. Also, the US has been printing dollars big time to tide over the current financial crisis. As the US prints more dollars, the supply of dollars in the market will increase. Experts feel this, over a period of time, will lead to the value of the dollar against other currencies going down. Expecting this play out, some international investors have been moving their money out of the US dollar and buying gold; they don’t consider the US dollar a safe haven anymore. And because of this, the price of gold had been shooting up. Over a two-year period, gold in dollar terms has given an absolute return of around 35%. Over the last one year, though, investments in gold in dollar terms have made a loss of 3.7%. Around a year back, gold was selling at around $917 an ounce (one troy ounce = 31.1 grams). Currently, it is selling at around $883 an ounce The rupee-dollar-gold game Though gold hasn’t given any return in dollar terms in the last one year, it has given a return of around 20% in rupee terms. Now how is that possible? A year back, gold was selling at $917 an ounce. Back then, one dollar was worth 40 rupees. So to buy one ounce of gold, one would have needed Rs 36,680 (917 x Rs 40). One ounce is equal to around 31.1 grams. So one gram of gold, a year back, would have cost around Rs 1,180 (Rs 36,680/31.1 grams). This means 10 grams of gold (typically the way the price of gold is expressed in India), would have been Rs 11,800. Now, one year down the line, one dollar is worth 50 rupees. One ounce of gold now costs $883 an ounce. In dollar terms, this would mean a loss of 3.7% vis-à-vis a price of $917 an ounce last year. But in rupee terms, the game changes. One ounce of gold would now be worth Rs 44,150 ($883 x 50). This means, 10 grams of gold would cost Rs 14,200, a gain Rs 2,400 (Rs 14,200 – Rs 11,800), or around 20% (Rs 2,400 expressed as a percentage of Rs 11,800). Gold is priced in dollars in the international market, like most other commodities. Even though it has given negative returns internationally in the last one year, the Indian investor in gold has made money due to the fact that one dollar is now worth Rs 10 or 25% more in rupees than it was one year back. The other currencies The entire premise of investing in gold is built on the back of the US dollar collapsing. But over the last few months, it has come to light that other economies of the world and hence their currencies aren’t in great shape either. The British pound, the Japanese yen and the euro have been falling against the dollar, instead of it being the other way around. As the weaknesses of the big economies of the world is getting exposed, money is moving from there into financial securities issued by the US government and hence effectively to the US dollar. This is the primary reason the dollar has held up against other currencies. Also, if the dollar is going to fall, which other currency can replace it? The world still hasn’t come up with an answer to that question. An appreciating rupee could be show spoiler… For an Indian investor, one spoiler could be an appreciating rupee. As mentioned earlier, gold is currently at $883 an ounce, and one dollar is worth 50 rupees. This means, 10 grams of gold currently cost around Rs 14,200. Now let us assume that a year down the line, gold continues to stay at the same price, but the rupee appreciates and one dollar is worth 40 rupees. This would mean 10 grams of gold would cost Rs 11,350, or a loss of 20%. When will money be made? For an Indian investor, to make money out of gold, any of the following four things need to happen: a) The price of gold in dollar terms goes up; the rupee also depreciates against the dollar. This is the best case scenario. b) The price of gold in dollar terms goes up; the rupee continues quoting at the same rate to the dollar as it is right now. c) The price of gold in dollar terms goes up; the rupee appreciates against the dollar, but it doesn’t appreciate as much so as to knock of the gain in dollar terms. d) The price of gold in dollar terms falls; the rupee depreciates against the dollar, so as to knock off the fall in price in dollar terms. If any of these four situations plays out, the Indian investor in gold will make money. But for any of these four situations to happen, a different set of dynamics will be playing out. If forecasting the price of gold is difficult, forecasting which way the foreign exchange markets will head is even more difficult. And you thought investing was simple business. Conclusion The dollar-gold story seems fairly plausible (like most good bull market stories are) right now and chances are it will play out. But in financial markets, as in most other things in life, one can never be sure. Bottom line: all investment is but speculation. Disclosure: The author has investments in a mutual fund, which invests in gold mining companies.
Investors beware,’tis a sucker’s rally0 commentsOptimism that concerted govt action will save world economy may be premature Vivek Kaul. Mumbai “The more I think about it, the more interesting it becomes that sentiment has turned bullish so quickly. When bear markets really bottom, sentiment is so negative that it really feels like the blood is not only in the streets, but that we are haemorrhaging from every orifice with nary a tourniquet in sight. That hasn’t happened yet.” —Richard Russell, one of the world’s most revered investment letter writers, who has been publishing Dow Theory Letters since 1958 “You have become a scaremonger,” she said. “Yeah. But isn’t one man’s scaremonger another man’s realist?” I asked. “I was looking at some numbers and realised that most stock markets around the world have rallied big time since the beginning of March. Take the Bombay Stock Exchange Sensex, which has risen by more than 20%. The Dow Jones Industrial Average, the oldest stock index in the world, has given a return of 11% since the beginning of March. And here you are, going on and on as if the world is about to come to an end.” “Ever heard of a term called ‘dead cat bounce’?” I asked. “I thought we are discussing the stock market. Why are we suddenly talking about cats?” “Let me explain. A dead cat bounce is a term used to describe rallies in a bear market. It comes from the notion that even a dead cat bounces if its falls from a great height. Most bear markets are characterised by these dead cat bounces. Take the Great Crash of the stock market that happened in October 1929 and which ultimately led to the Great Depression. Between 1929 and 1932, Dow fell by around 90%. But during that period, there were six rallies in which the stock market gave a return of more than 20%. Every time there was a renewed sense of optimism among the investors, but each time the rally went kaput and the market touched new lows.” “Rather interesting. But what makes investors get back into the market time and again?” she asked. “I think it is a matter of hope. When everything was rallying, investors believed nothing could go wrong. That is why the world over stock markets went up and so did property prices. Over the last 15 months, the process has reversed. Stock markets have fallen with a thud, and so have property prices. But investors still have an iota of hope left in them. So every time stock prices go up a little, investors come up with stories that they tell themselves, to convince themselves that everything will be fine, and that the good old days will be back. The business media picks this up, and builds on it. If you have realised, anchors of business news channels have been smiling a lot more in the last few days.” “So what is the story investors are telling themselves this time around?” “That combined government action will save the world, and its financial markets. The latest episode in this story is the meeting of the leaders of the Group of Twenty (G-20) which happened last week. They announced a $1.1 trillion stimulus for the International Monetary Fund (IMF) and other international institutions. This has made investors across the world happy. They don’t realise that the financial meltdown has destroyed investment capital of around $50 trillion. So what difference is a little over a trillion dollars going to make? Also, as one journalist put it, 20 leaders of G-20 spent 220 minutes in London, discussing the crisis, which means each leader had precisely 11 minutes to put across his point of view.” “Eleven minutes?” she interrupted. “Actually, it was much lesser, considering there were ten other leaders from organisations like the IMF, Association of South East Asian Nations and the Financial Stability Forum, etc also attending the meeting. So, there were thirty leaders and a total of 220 minutes to discuss the entire issue, which means a little over seven minutes per leader. Not a huge amount of time. Hence, expecting them to come out with anything substantial in such a short period of time would be outright foolish.” “What of the economy? Isn’t that supposed to recover in the days to come?” “Ultimately everything recovers; the question is —- when? That nobody really knows, and at best, the so-called experts are guessing. Let me give you the example of Japan. Exports for March are down 49% from the same time a year back. Exports to the US, Japan’s largest trading partner, collapsed by 58.4%. Industrial production was down 9.4% in February and the economy contracted 12.1% in the first three months of the year. All this is forcing companies to cut jobs and salaries. Salaries have come down by 3.5% from a year back. Investors in Japan have ignored all the negative news and the Nikkei-225 index has rallied 17.8% since the beginning of March. They are betting on an export-led recovery in the second half of the year. The Japanese economy may be an extreme example, but the situation is no different in other parts of the world as well, with the economy contracting and massive job losses.” “You are scaring me even more now.” “Maybe, but that is the way I see it. Also, a point to remember is that as more and more people lose their jobs all over the world, there will be more loan defaults, and a further slowdown in spending, which will impact corporate profits. This, in turn, will lead to more job losses and a further slowdown in spending. An important point to remember is that till now, the United States has the main source of demand for the world economy. And the American consumer is clearly not in a mood to buy either goods or services right now.” “What are you hinting at?” she asked. “Stock market performance ultimately rests on hopes of future corporate performance. And if investors don’t buy goods and services, companies can’t make profits. Meanwhile, investors are stuck with delusional optimism. By the time they come out of it, they would have lost a few dollars more. Or should I say rupees? P T Barnum, an American showman, once famously said, “There’s a sucker born every minute.” Rallies in bear markets are sucker’s rallies. Now can you tell me what people who invest only on the basis of such rallies are called?” k_vivek@dnaindia.net (The example is hypothetical) References: Speculators Return to Commodities, Aussie and Canadian Dollar, Gary Dorsch, ww.safehaven.com, April 2, 2009; Junkets, Boondoggles, and Faith, Gary North, www.lewrockwell.com, April 4, 2009; G20 leaders get 11 minutes each to save capitalism, www.marketwatch.com, April 2, 2009; A Sucker’s Rally and Bear Market Surprise,Bill Bonner, April 7, 2009, www.dailyreckoning.com.
Why the G-20 plan is plain hogwash0 commentsOnly $500 bn of the $1.1 tn package announced is new money; rest is already committed Vivek Kaul. Mumbai “In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.” —Eric Hoffer “So we are finally going to save the world, eh?” she said, with a cup of coffee in her hand. “Save the world?” I asked, putting my overtly sweet cup of coffee on the table. “Yeah. The Group of Twenty (G-20) which met in London recently has announced a $1.1 trillion stimulus for the International Monetary Fund (IMF) and other international institutions.” “So?” “I feel that money will rescue the world.” “You know what. You are talking like a politician who feels that just by allocating money to a problem, a problem is solved.” “What do you mean by that?” “Well. First, the $1.1 trillion is not all new money as it is made out to be. Around $600 billion of it has already been committed, long before the announcement. So the real plan is of the size of $500 billion and not $1.1 trillion. To get this new $500 billion, the IMF will print $250 billion as special drawing rights, its own form of currency. Of the remaining, China has said it will chip in with $40 billion. No one really knows where the remaining money will come from. From what I have read in the media, the US will chip in with a major share.” “You sure keep track of things. But why did politicians come up with $1.1 trillion, when the fresh money coming in is less than half of that?” she asked. “At times, it is very important for politicians to come up with a big number to show the world they are doing something. To give you a sense of proportion, it is nowhere near the $14 trillion the US has spent trying to get its financial system up and running again. Or take the UK, whose external debt stands at nearly $9.6 trillion, a large part of it spent to rescue the financial system in the country.” “What are you trying to say?” she interjected. “That if such huge amounts of money barely made a difference to their respective economies, the chances of the G-20 stimulus making any are rare. To elaborate, unemployment in the US reached the highest in 25 years. In March, companies axed 6.63 lakh workers, taking the number of unemployed to 1.3 crore or 8.5% of the total workforce. In the UK, unemployment has risen to its worst since 1971, with the number of unemployed reaching 2.03 million at the end of February.” “But what is the link between the financial system and the job losses?” “It’s like this. Countries have been rescuing banks so they can continue to lend. When they continue to lend, people continue to borrow. People continue to borrow and buy goods that companies make and services they provide. This helps companies earn money and thus keep people employed. The fact that companies are firing people means they are not earning enough, which in turn means that people are not borrowing and banks are not lending. This is despite the fact that governments the world over have pumped money into these banks.” “But why is that happening?” “The reason is psychological. When people see others around them lose jobs, the first thing they do is start saving for the rainy day. Economists call it the “paradox of savings.” As Bill Bonner, an economist and an investment letter writer, wrote recently, “When an economy goes into a downswing, people save money. This causes prices to fall… making savings more valuable. Then, people save even more. Instead of circulating, money goes into pockets, vaults, and mattresses; saved for a rainier day… and lower prices.” Banks don’t lend because a large portion of what they had lent over the last few years has gone bad. And they don’t have enough confidence in people returning the money they lend. So basically, money does not have enough velocity these days and so any plan that assumes people will borrow and spend money, will not work.” “What do you mean by money not having enough velocity?” “Let us say you earn Rs 50,000 per month. You save Rs 20,000 and spend Rs 30,000. Now, this Rs 30,000 is an income for a group of people. They in turn save Rs 12,000 and spend Rs 18,000. This Rs 18,000 is income for another group of people. And so it goes on. Basically, your spending creates income for others. In a scenario like today, you might decide to save Rs 30,000 and spend only Rs 20,000. This means income that others derive from your money will go down. So the velocity of money will come down, which in turn means companies will earn lesser money, which in turn means more people will be fired, and which will further lead to lesser money being spent. This is a clear case of where rational decisions at an individual level lead to an irrational decision at a broader level.” “Very interesting. I think I should start saving more. But tell me something, where is the US going to get the money for the G-20 plan?” “Very good question — given that the US owes the world a lot of money, where will they get this money from? But the answer is straight forward — they will print it.” “Oh, simple indeed. Tell you what? I have been thinking on a rather fundamental point. Most things sold in the international market are ultimately related to the US dollar. Be it apples, gold or even oil. Everything in the world is linked to the dollar. But what is the dollar linked to?” she asked. “Think it over some more,” I said. “Oh, my coffee’s gone cold.” k_vivek@dnaindia.net (The example is hypothetical) References: The Dollar’s Days are Numbered,Bill Bonner, www.dailyreckoning.com, March 30,2009; Humpty-Dumpty Fiat Sat on the Wall….You Know the Rest!, Rob Kirby, www.news.goldseek.com, April 3, 2009; Brown’s illusory G20 deal, FraserNelson, www.spectator.co.uk, April 2, 2009.
Saving for your child’s future? Try mutual funds0 commentsYou can go for equity, debt, or a mix of the two depending on your risk appetite ICRA Online Research Desk An average Indian investor is in a tizzy when it comes to choosing investments, because for every spending need of his, there is a plan structured to help him save. Planning for children’s education as well as other social responsibilities pertaining tochildren are possibly the most urgent requirements of parents. Here too, the Indian investor by and large opts for the traditional options of long-dated fixed deposits, bonds, insurance policies etc. Earlier, parents had the comfort of investing in assured-returns plans offering double digit rates of guaranteed return. However, over the past five years, these rates have halved and an efficient ‘assured-returns plan’ is also difficult to come by. Today, in order to get that extra buffer in returns, one needs to look outside the traditionally offered investment options. Investing in mutual fund plans for a child’s benefit is one way to alleviate the low-interest-rate blues. Mutual funds as an investment destination for planning the future of one’s children have been hitherto an underutilised option. For one thing, these plans haven’t received the usual aggressive push by the average financial planner. Nevertheless, these funds offer an efficient and convenient option of investing. Structure At the very outset, we need to make a distinction between a child plan offered by an insurance company as against one offered by a mutual fund house. In case of the former, there is a clear insurance cover on the life of either the parent or the child, whereas in case of mutual funds, the insurance cover offered can at times be misleading. In most of the schemes, the insurance cover offered is only a personal-accident cover; hence if the insured, i.e. the premium payer, passes away due to natural causes, an insurance claim will yield nothing. At the same time, there are a handful of schemes that offer life insurance to the applicants. However, the applicant has to make a minimum number of consecutive payments towards the plan. Such a life insurance cover may not suffice, as it only exempts the unit holder from further subscription payment and the claims are credited to the beneficiary’s account with restrictions imposed on the amount of claim. Therefore, it is important to gain clarity on the insurance component offered. At the very basic level, a child plan is very similar to a balanced fund, which has a portfolio of both equity and debt instruments. Therefore, one of the biggest benefits these funds offer is that of automatic rebalancing of the equity and debt components. So if due to market appreciation, the equity component begins to start growing, the fund manager will book profits at systematic levels to ensure an optimum balance. A further analysis of this special category reveals that the investment patterns in the funds are not exactly identical for all schemes; they are either equity-oriented or debt-oriented by asset allocation. For example, plans such as HDFC Children’s Gift Fund—Investment Plan, ICICI Prudential Child Care Plan—Gift Plan, LIC Children’s Fund, Principal Child Benefit—Career Builder Plan have a larger equity allocation than other child plans. While schemes such as HDFC Children’s Gift Fund—Saving Plan, ICICI Prudential Child Care Plan—Study Plan, SBI Magnum Children Benefit Plan, Tata Young Citizens Fund and a few more can be categorised as debt-oriented as they have invested in the debt segment more aggressively over the past two years. One can also switch from the equity-oriented to debt-oriented fund as you get closer to your financial goal. For instance, ICICI Prudential offers two separate plans. While the Study Plan is managed as a debt-oriented fund (investing up to 75% in debt and the balance in equity), the Gift Plan is more skewed towards equity (up to 60% in equity and the balance in debt). An asset management company (AMC) recommends the Gift option if your child is in the 1-13 years age bracket, while the Study Plan owing to its lower equity exposure, is more suitable if your child is in the 13-17 years age bracket. Similarly, HDFC Mutual Fund, Franklin Templeton Investments and UTI Mutual Fund also offer distinct plans. Can I exit? First and foremost, these plans are not for the short- or medium-term investor. You ought to look at an investment time horizon of more than 10 years to reap the true benefits of a child plan. In case an early redemption is inevitable, you should be mindful of the exit load charged by these plans. The entry load is not a big concern as these are either nil or within 2.25%. Given the long investment horizon, an entry load of even 2.25% will not pinch. Also, in most cases, the exit load is for a period of less than seven years, so if you end up withdrawing your investments after that, you don’t need to worry about the exit load. Performance Comparing the performance of the two categories, we notice that over the long term, equity-oriented child plans have performed better than their debt counterparts. Specifically, this difference can be seen in HDFC Children’s Gift Fund —Investment Plan (which is equity oriented) and Savings Plan (debt oriented). The difference arises in the asset allocation, which leads to the difference in their returns. The investment plan has posted returns of 11.96% from March 2001 till March 26, 2009, while the savings plan has given a return of 9.69% during the same period. Similar has been the case with the ICICI schemes. Over the more recent period, of course, the debt-oriented schemes have outperformed their peers. Among all the equity-oriented schemes over the past five years, Principal Child Benefit—Career Builder Plan and Future Guard Plan have delivered close to 14% compounded annualised. The returns comparison of the schemes also reveals that a high equity allocation doesn’t necessarily lead to better returns. A look at LIC Children’s Plan shows that in spite of maintaining a moderately aggressive portfolio, the scheme has lost much more than its more aggressive counterparts. On an average, despite equity allocation of 58% over the past two years, the scheme has lost 33%, much more than ICICI Prudential Child Care—Gift Plan, which has lost 21% over the two-year period on an average equity allocation of 74.94%. What to expect This brings us back to the often repeated ‘risk profile’ of the investor. But, irrespective of the degree of your risk appetite, the fact remains that preservation of capital is extremely important for parents when they are setting aside funds for their children. In this respect, these funds do not offer capital guarantee. In fact, many of them have posted losses over the last one year. A look at the five-year performance should give you a better idea of what sort of returns to expect over the long haul. Another word of caution: Don’t expect these schemes to deliver superb returns over the short- and medium-term. The risk-reward positioning of these schemes is such it is unlikely that you will see a phenomenal return trail in good times. Also, to squeeze the maximum benefit, investing early is the key. The earlier you start, the longer your investments have time to grow and greater is the power of compounding. The longer time frame also allows you to choose a more aggressive equity-oriented plan so that one can ride out the volatility. Moreover, the exit load of child plans should help in instilling a discipline and prevent early redemptions.
Make retirement easy, go for MF pension plans0 commentsIf you don’t intend to withdraw money before the age of 58, then these funds are meant for you ICRA Online Research Desk Another eight days to go and still haven’t found a perfect fit for your tax planning needs? There is one more option that might just strike a chord with you. It’s a mutual fund that offers the ease of planning your pension and in the bargain meets all the requirements of Section 80C of the Income Tax Act under which you can enjoy a rebate of up to Rs 1 lakh. The need for planning your pension cannot be underscored enough, but you need to be smart enough to start setting aside money today itself, step by step. Most of you would be familiar with some investment options facilitatedby Central Board of Direct Tax (CBDT), which qualifies for tax rebate, under Sec 80C up to Rs 1 lakh per annum (p.a.).For example: infrastructure bonds,national savings certificate (NSC), public provident fund (PPF) and of coursethe tax planning schemes as well as insurance plans. Though Indian investors are aware of the pension schemes offered by insurance schemes, the pension schemes operated by mutual funds are less known. However, currently, there are only two schemes that were launched in the 90s. Since then, there haven’t been any pension plans launched by mutual funds. 1. UTI-Retirement Benefit Pension Fund (UTI-RBP) by UTI Mutual Fund launched in 1994 2. Templeton India Pension Plan by Franklin Templeton Investments; launched in 1997. The fund managed by these pension plans is not a small amount with the two schemes managing Rs 600 crore. Let us look into some features of these schemes: How does one step in and step out? Investors can start to invest a minimum of Rs 500 monthly. A unit holder of the scheme has to ensure that he invests an aggregate sum of at least Rs 10,000 before he completes 52 years of age for UTI-RBP, while investors have to make a minimum investment of Rs 10,000 by the time they reach the age of 58 for Templeton India Pension Plan. While, there is no upper limit up to which any amount can be invested in the scheme in any year, it may be noted that under current tax laws only a sum up to Rs 1,00,000 along with other specified investments is entitled for tax benefit in a year under Section 80(C) of Income Tax Act, 1961. The redemption procedure with these funds like most other pension plans is a little tricky. Investors under UTI-RBP can withdraw money, but they have to maintain Rs 10,000 balance in their folio after withdrawal. Redemption of units is possible at any stage after investment subject to different loads levied (as given in Table 1). In case of UTI Mutual Fund’s offering, one can opt to invest without the benefit of tax rebates under Section 80(C) and by doing so you can withdraw money at any time subject to exit loads. Those who take advantage of the tax rebate cannot withdraw money before the stipulated three-year lock-in period. Investors can also opt for systematic withdrawal plan (SWP) by which they get money in hand at regular intervals i.e. monthly/ quarterly/ half-yearly/ annual intervals. In case of Templeton India Pension Plan investors can redeem a minimum amount of Rs 1,000, subject to a three-year lock in period from the date of investment. An investor can withdraw his full holdings after reaching the age of 58. Investors also redeem units prior to reaching the age of 58 and after completion of three-year lock-in; however, exit load will be levied. In this scheme also investors have the option of SWP with alternatives of monthly/ quarterly/ half-yearly/ annual intervals. While the exit loads may seem steep, they will enable investors to be more disciplined. What is the risk level? Equity linked saving schemes can invest even 100% of their net assets into equity market. However, for mutual fund pension plans investment into equity market is restricted to 40% of their net assets and the rest they can invest into debt market. On the whole it is the equity component that one needs to be slightly wary of because this market segment is where the risk is higher. The debt segment is comparatively less risky than equity market. Having said that, investors need to realise that since these schemes are positioned for the very long term, one need not be overtly concerned of the equity component, as in the long term equity is believed to outperform all other investment classes. The two pension plans have kept an equity allocation on an average of 28.49% and 34.81% respectively over the past one year. Other investment avenues, which one can opt for with tax benefits such as public provident fund (PPF), national saving certificate (NSC) and five-year fixed deposit (FD) are the pure debt products, which deliver fixed returns. However, the pension plans offered by insurance companies have the option of flexible asset allocation from where investor can choose pure equity or a mix of equity and debt or even pure debt. But, one ends up paying for this flexibility with the higher costs built into these products in the first few years of the investment plan. How much do pension funds cost? For load structure for the funds, see Table 1: A 2.25% and 1.5% entry load is not very high and if you invest directly, without the help of a financial planner you can save on this load as well. How did they perform? This equity market meltdown has left investors shaken. As a result they are apprehensive about investing into equity linked saving schemes and are searching for a place to hide. To this extent, mutual fund pension plans did well in capping the losses in this prolonged bearish phase and in turn emerged as an option to which a long-term investor can look for saving taxes under Section 80(C). Over the period of past one year, ELSS category plummeted 40.89%. On the other hand pension plans owing to their much lower equity allocation fell by only 10.55% in the same period. Hence, the complete risk averse investor needs to be aware that these schemes can in fact deliver negative returns in the short time frame of a year. Those who are spoilt by the ‘guaranteed return’ syndrome might be better of looking elsewhere. If we take longer time frames i.e. of three years and five years, ELSS category delivered compounded annualised returns of (-) 4.95% and 9.68% respectively. While, during the same period, balanced funds, which usually have equity allocation in the range of 65-75%, had generated compounded annualised returns of (-) 4.28% and 10.19% respectively. Whereas pension plans generated compounded annualised returns of 1.68% and 8.50%, respectively, reflecting decent performances even in the longer time frames, given the impact of equity market meltdown. However, this picture drastically changes when we considered the performance period as of December 31, 2008 indicating the dominance of bulls. ELSS category had generated compounded annualised returns of 45% and 52% respectively over the period of past three years and five years respectively as of December 31, 2008. During the same period, pension plans had generated compounded annualised returns of 19% and 20%, respectively. Other options available under Section 80(C) such as PPF, NSC and five years FD provide returns in the range of 8- 9%. Conclusion Amongst the various investment avenues under Section 80(C), ELSS is the most risky and could also be the best in terms of returns when bulls drive the market. ELSS redemptions are also tax free. While mutual fund pension plans are less risky than ELSS owing to their mix allocation of equity and debt with bias towards debt, withdrawing before reaching the age of 58 years would mean paying an exit load in the range of 1-3%. And returns are also taxable. However in the case of PPF, NSC and five-year FD, minimum lock-in period is five years and returns of NSC and five-year FD are taxable. Returns of PPF are tax-free. PPF, NSC and five-year FD used to give returns in the range of 8-9% and they are the least risky amongst the various investment avenues. So, investors, before choosing any of the investment avenues under Sec 80(C), need to check the parameters such as asset allocation, lock-in period, expenses, tax treatment of the gains and the most important thing is to know your own risk appetite. Another piece of advice is that look at these pension plans for what they are. If you intend withdrawing money before you reach the age of 58 then these funds in the first place are not meant for you.
US is doing the very things that led to the crisis0 commentsBy trying to get banks to lend and consumers to borrow again, the government is betting heavily on spending Vivek Kaul. Mumbai This idea to increase the money supply byprinting money is the Single Stupidest Idea in the whole history of economics for the last 4,500 years. —Richard Daughty “You know what? Ben Bernanke, the chairman of the Federal Reserve of the United States, the US central bank, is running up the printing press again,” she said walking into my house, and making herself comfortable on the sofa. My new neighbour was getting rather bold, I thought but decided not to be discourteous. “Yeah, I read it in the papers last week,” I said. “The plan is to print $1.15 trillion and spend that money in various ways, hoping to revive the US economy.” “That is so, so stupid, I think. What do you say?” she asked. I couldn’t hold my angst any longer. “Yeah, it’s stupid. But couldn’t discuss this another time? I was about to take my Sunday afternoon nap.” “Oh, come on. This Sunday you can spend some time with me. OK, now tell me about this new plan in a little more detail.” “OK,” I relented. “Of the $1.15 trillion that the Fed plans to print, $300 billion is to be used to buy back the debt issued by the US government. The idea is to buy back the securities, so that banks have money which they can go out and lend. But the bigger point is that the government is also extinguishing its own debt. Typically, when we take a loan, we have to earn to be able to repay that money. But a government can print money to repay a loan. And that is what the plan seems to be. This is clearly not a healthy trend, given that the US owes the world around $54 trillion, and this number is growing. Printing money can cause its own problems. Still, the US doesn’t quite have another way out.” “Why do you say that?” “Well, after years of negative savings, the Americans are saving now. The current savings rate stands at 3% of the gross domestic product (GDP) of $14 trillion, which works out to $420billion. In the years to come, the savings rate is expected to go up to 10% of the GDP, thehistorical rate of saving in the US, but the GDP is likely to contract, as people lose jobs andincomes decline. Thus, in absolute terms, the savings are not going to be very different from what they currently are. Hence, if the US saves $420 billion a year and uses all of it to repay debt, even after 10 years, it would have repaid only $4.2 trillion, and this after we assume that the overall debt does not go up. That’s why I think the US has no other way to repay its debt than printing dollars.” “Interesting. But that was an explanation for only $300 billion. What of the rest?” “Of the remaining money, $750 billion willbe used to buy up mortgage backed securities (MBS) issued by housing-related government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.” “What is a mortgage backed security?” she butted in. “Banks first give out home loans, also called mortgages in the US. Then they agglomeratesimilar loans and convert them into financialsecurities. These financial securities are sold to investors willing to buy them. Once the securities are sold, the major part of the equated monthly instalment (EMI) that the borrower pays to repay the home loan is passed on to investors who have bought the financialsecurities. This entire process is referred to as securitisation. Once a bank sells these securities, the risk does not remain on its books. Also, the money comes back immediately and the bank can give out more loans.” “But where do these GSEs come in?” “See, most banks do not have the wherewithal to conduct the entire process of securitisation themselves. So GSEs like Fannie Mae and Freddie Mac used to buy out entire loans from these banks. They would then issue securities against these loans and sell them to investors. But that was in the good old days when the buyers repaid. After a point when the defaults started, the GSEs were no longer in a position to keep buying loans and securitising them.” “And what did that do to the market?” “It killed the securitisation market. Once GSEs stopped buying loans to securitise them, banks realised that they would have to continue to hold loans on their own books. And they did not want to take that risk. That in turn killed the home loan market. Now, with this move of buying up $750 billion worth of GSE-backed MBS, the US Fed is hoping to revive the home loan market.” “I didn’t quite get that.” “See, the Fed is essentially telling the GSEs to buy out home loans from banks and securitise them, with an assurance that it will buy those securities. The US Fed is now getting into the home loan business, big time. This could push banks to lend again, so the GSEs can buy out these loans, securitise them and sell them to the US Fed. Also once the lending starts to happen again, housing prices might stabilise and even start to go up,” I explained. “But why is the US Fed trying to get home prices up and running again?” “The US consumer was using his home as an ATM machine by taking home equity loans. Home equity is essentially the difference between the market value of your house and the portion of the home loan taken to buy it, which is still to be repaid. So let us say the current market value of a house is $250,000 and the home loan to be repaid is $200,000, the home equity works out $50,000. The loan taken against this $50,000 is a home equity loan. As prices went up, borrowers encashed their homes big time and went on a spending spree. This inspired other buyers to take on loans much greater than their repayment capacity, hoping to cash in. Now, this could only go on till the housing prices were going up. Once the house prices started to crash, the home could no longer be used as an ATM. And once that happened, all the frenzied spending that the US consumer was indulging in came to an absolute standstill. Now, by trying to get the securitisation market going again, the hope is banks will start lending again and people will start borrowing again.” “But isn’t that ironical, given that it was excess borrowing that caused the problem in the first place?” she asked. “Yes it is. But that’s the way it is. Also, right now, the consumer is not buying the borrowing argument. Also, the $1.15 trillion that the Fed plans to print and spend is other than the $11.7 trillion it has already flushed into the system to rescue the American financial system. I am amazed that even with such an astonishingly high amount of money being printed, there has been no inflation. But in the days to come, inflation is bound to show up as the money starts to hit the system. In that situation, it will be interesting to see how the system holds up. You know, a ten year debt security issued by the US government currently pays a return of around 2.5%. Inflation on the other hand stands at 0.4%. So, basically, the real return is around 2.1%. Imagine if inflation were to hit 5%, which is possible given the amount of money hitting the economy. Investors will simply want to get out of the US government securities, because effective returns will get negative. Then they will get out of the dollar and the dollar will fall against other currencies.” “Pretty scary, eh,” she said. “Now, if you don’t mind, I will go take my Sunday afternoon nap.” (The example is hypothetical) k_vivek@dnaindia.net
Insurance can be a bad tax-saving bet0 commentsIn terms of returns, there are better options such as tax-saving FDs and MFs Vivek Kaul. Mumbai The phone rang. I didn’t pick up. The phone rang again. I didn’t pick up. I wondered why she was calling when it was all over between us. It was late in the night. The FM station was playing that immortal number from Umrao Jaan: “Har mulakat ka anjaam judai kyon hai? Ab to har waqt yahi baat satati hai humme.” There couldn’t have been a more apt expression for what I was feeling. The phone rang again. This time I picked up. “Tell me how I should go about my tax planning?” she asked. No ‘hello’; not a word about how I’d been; straight to business —- was this the woman I was sad to have parted ways with? “You tell me what you plan to do,” I shot back, feigning annoyance. “You know I pay around Rs 3,000 per month towards my employee’s provident fund. That works out to Rs 36,000 for the year. So if I want to make use of the full exemption limit of Rs 1 lakh available under Section 80C of the Income Tax Act, I need to invest Rs 64,000 more. I was thinking of investing in this unit linked insurance plan (Ulip). I understand Ulips are insurance policies that club insurance and investment. Usually the individual taking the policy has 4-6 choices while choosing his investment fund, ranging from an option that invests 100% in equity to one that invests 100% in debt securities. The policyholder gets an insurance cover for which the insurance company charges a mortality premium every month. Also, this cool dude I know, who also happens to be an insurance advisor, says my money will double in three years if I invest in the Ulip that he sells.” “What else has he promised you?” I asked. “I am not seeing him, if that is what you are asking,” she replied. “I wasn’t suggesting that. What else has he told you about Ulips?” “Oh. He has also promised that we can split the commission he earns. I invest Rs 64,000 in an Ulip and he gets a commission of 20% on that amount. Now that works out to Rs 12,800 (20% of Rs 64,000), which we split. Thus, I get Rs 6,400 back. In addition, I can stop investing in the scheme after three years if I want to. Just think! With Rs 6,400, I could buy myself that red designer dress I have looked up.” Now this was the first of its kind. A red dress would now say what tax-saving investment needs to be made. “Has your friend told you about the returns the Ulip has given?” “No, not really. Does it matter? Besides I want that red dress real bad.” “You don’t need to invest Rs 64,000 to buy that dress. Giving kickbacks or if I may put it euphemistically sharing a part of the commission is an age old trick used by insurance agents. This makes sure that people don’t ask the most significant question “How has the Ulip performed?” Now listen to me carefully. The expense structure of Ulips offered by different insurance companies is different. Therefore, there is no way an individual can figure out which is the best performing Ulip. And if you are investing your hard-earned money, you better get the best. Also, whether money doubles in three years or not depends on how the Ulip performs. There is no guarantee. Also, doubling money in three years would mean your Ulip must earn a return of 26% every year. Now, how can anyone guarantee that kind of return? Also, you need to realise that in the first two years, in order to pay huge commissions to insurance agents, Ulips have a very high premium allocation charge. This charge is made from the premium you pay, in order to pay the insurance agents and the remaining money is invested,” I replied. “For once, you make sense,” she said. “As far as investing for just three years is concerned, that is another point that is used to mis-sell Ulips. Most Ulips have a term of ten years or more. Ulips have a cover continuance option, which comes into picture after three years. If an individual who has opted for this option at the time of taking the policy is unable to pay premiums after the first three years, this option ensures that the policy continues. Agents have turned this into a mis-selling point. Also, individuals who stop paying premiums after three years lose out the most. Ulips have a very high expense structure in the first two to three years. So, less premium gets invested. After the third year, the expenses are low and only then more premium gets invested. Agents do this because their incentives are misaligned. They make the most of their commission in the first two years. So they sell the Ulip as a three-year policy. At the end of three years, they will be in a position to sell you a new policy and hence continue to earn higher commissions.” “I get the point. I guess you want me to look up some other investment avenue.” “That’s right, but don’t do so because I want you to. It doesn’t matter now. Split your money equally between a tax-saving fixed deposit with a bank and a tax-saving mutual fund, wherein you can easily figure out the best scheme going. Now if you would excuse me, I’ve got things to do.” k_vivek@dnaindia.net Give yourself the arbitrage fund advantage0 commentsThe category stands out for the tax advantage and stability in returns it offers ICRA Online Research Continuing our series of less popular equity fund categories that have done well in the current equity market meltdown, we talk about the arbitrage funds this week. Unlike the run of the mill equity fund, arbitrage funds skirt the ‘high risk’ tag that is synonymous with equity investment. But then again, the returns are also much lower and closer to those of debt-oriented funds. The obvious question, of course, is how these funds manage to keep the risk so low. We first look at the performance of these schemes, and then explain why it makes sense to invest in them. Performance The benefits of arbitrage schemes are best enjoyed during volatile markets, primarily due to the stability in the investment strategy of such schemes. To attain the returns with bare minimum risk, the asset allocation of arbitrage scheme is split mainly between equity and debt components. The basket of 10 arbitrage schemes has provided an average return of 7% over the past one year, which is lower than those of the ultra short term debt funds. Over the past two years, these funds have done better than the liquid fund category. However, if we consider the tax advantage that the equity oriented (discussed later in the article) arbitrage funds offer, the post-tax returns of arbitrage funds look much better. A look at the year-on-year performance, albeit short, gives us an idea of the kind of stability these funds offer. At this juncture, we must also speak about UTI Spread Fund, which has managed to clearly beat the category. Investors need to be forewarned that the scheme has since January 2008 been functioning more as a debt-oriented fund. From an average equity allocation of 68-70%, the scheme’s equity allocation over the past 15 months has been in the range of 0-22%. While this movement in the fund’s asset allocation has been noteworthy in producing results, it may have in the bargain lost its equity oriented tag. How arbitrage works The arbitrage gain is achieved by taking advantage of the mispricing between the cash and the derivatives markets. For example, say the stock price of A Ltd is quoting at Rs 100. Let’s say the stock is also traded in derivatives segment (not all scrips are traded in the derivative segment), where its futures price is Rs 110. In such a case, one can make a risk-free profit by selling a futures contract of A Ltd at Rs 110 and buying an equivalent number of shares in the cash market at Rs 100. Now, when settlement day arrives, it wouldn’t matter which direction the stock price of A Ltd has taken in the interim. In other words, it is irrelevant whether the share price of A Ltd has risen or fallen, one would still make the same amount of money. This happens because on the date of expiry (settlement date), the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction, i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place —- first, buy stock; second, sell futures; third, sell stock; and fourth, buy futures. In this manner, irrespective of the share price, the investor earns the spread of Rs 10 between the purchase price of the equity shares and the sale price of futures contract. Asset allocation Generally, asset allocation is taken as a measure to judge the risk associated with the fund’s investment. Under normal circumstances, the indicative allocation will be in the range of 65-90% in derivatives including index futures, stock futures, index options and stock options, and the remaining 10-35% in money market and other debt instruments. On the other hand, when there is unavailability of arbitrage opportunities, investments will be in money market instruments. • Typical arbitrage opportunities When a company merges with or is taken over by another company, there could be arbitrage opportunities due to mispricing of the scrip. When the company announces the buyback of its own shares, there could be opportunities due to price differential in buyback price and traded price. At the time of dividend declaration, the stock futures or options market can provide a profitable opportunity. Generally, the stock price declines by the dividend amount when the stock goes ex-dividend. The mispricing across different indices can lead to arbitrage opportunities for the fund. Roadblocks in the strategy It is not all smooth sailing for these funds. There can be instances where the fund manager cannot find an arbitrage opportunity in the market. During a given time period the market may or may not provide any meaningful arbitrage opportunity. For this very reason, such schemes cannot assure returns; the returns totally and completely depend on available opportunity. In the absence of arbitrage opportunities, the fund manager is most likely to retain the money in liquid fixed income instruments. This would affect the returns of the funds and make them akin to a liquid fund. This eventuality has so far not arisen in the case of arbitrage funds in India, although these schemes are still quite young. There have also been cases where fund managers have refrained from taking arbitrage opportunities. All the transactions in the stock market involve payment of brokerage and security transaction tax (STT). These costs straightaway eat into the profits earned. Each leg of the transaction, i.e. buying stock, selling future, selling stock and buying future, will entail payment of these costs. Therefore, it is just not enough for an arbitrage opportunity to exist; the spread needs to be meaningful enough to cover the costs. Equity arbitrage fund vs debt funds Arbitrage funds are meant to be a long-term investment opportunity, even though they capitalise on short-term arbitrage opportunities. Fund managers will be the first to admit that attractive arbitrage opportunities are not easy to come by week after week, month after month. Arbitrage funds can fall in equity or debt category, depending on the exposure a fund has taken. If a scheme has an equity exposure of more than 65%, then it has an equity fund status, or else, a debt fund status. The fund will enjoy the same tax benefits that an equity fund has if it categorises as an equity arbitrage fund, that is, you pay no tax on capital gains, if these gains arise after a period of one-year. More than anything else, arbitrage funds enjoy an edge over debt funds mainly because of the tax benefit. To maximise this benefit, investors are advised to stick around for at least one year in an arbitrage funds. Also, some of these funds charge a considerable exit load for different tenures. Investors must check these details before committing money. Conclusion We would recommend these funds primarily for the tax advantage and stability in returns they offer. The returns here are fairly stable and in line with fixed income instruments. Chinese consumption can change the dollar game0 commentsBut, China’s dependence on the US consumer will take a long time going Vivek Kaul. Mumbai “At times, I wonder if we analyse too much. Or is it that we are where we are because that’s where we are meant to be?” she asked. “Have you lost your job?” I shot back, eager to stop the wave of philosophical mumbo-jumbo that threatened to break on me . “Not yet, but I can’t help pondering these days. Times are getting so difficult.” “Did you read the newspapers today? Zhou Xiaochuan, the governor of the People’s Bank of China (the Chinese equivalent of the Reserve Bank of India) has written in an essay that the world needs a new global currency. Though he hasn’t mentioned the dollar directly, that is what he has hinted at. In fact, just two weeks back, Wen Jiabo, the Chinese Prime Minister, said China had lent a huge amount of money to the United States and was concerned about the safety of its assets. “To be honest, I am definitely a little worried. I request the US to maintain its good credit, to honour its promises and to guarantee the safety of China’s assets,” said Jiabo.” “But how is this linked to the current crisis?” she asked. “Well, China has foreign exchange reserves worth nearly $2 trillion. Of this, an estimated $1.7 trillion has been invested in US dollar assets. To give you a breakdown, around $900 billion has been invested in financial securities issued by the US government, $550 billion to buy mortgage backed securities issued by the likes of Fannie Mae and Freddie Mac, $150 billion in financial securities issued by companies in the US and the remaining $100 billion in shares and short term deposits.” “So?” “So! Almost 85% of China’s foreign exchange reserves of $2 trillion is invested in the US. The two economies are highly interlinked. So, it is in China’s interest to see that the US dollar continues to be a strong currency. Instead, we see that its leaders are crying it down. Isn’t that something?” “Maybe. Can we have some detail?” “Sure. See, over the years, the US has been the biggest importer in the world. And the goods and services it has been importing have benefited countries like China. China earned dollars for its exports. These dollars found their way back into the US. As I said earlier, the Chinese invested these dollars to buy various kinds of financial securities issued in the US. So, basically, the Chinese were lending money to the US. The money lent was used by US citizens to continue buying goods and services from China. And so the cycle worked — the US shopped, China earned, China invested back in the US, the US borrowed, the US spent, and China earned again. It’s a classic case of ‘you scratch my back and I will scratch yours’.” “But has the cycle stopped working?” “Yes, by and large, and for the simple reason that Americans have stopped buying and as a result, Chinese exports have crashed. In February, Chinese exports fell nearly 26% from a year earlier. As a result, there have been massive job losses as well. Estimates suggest that nearly two crore people have lost their jobs. As Hillary Clinton, the US secretary of state said recently, “It would not be in China’s interest if we were unable to get our economy moving. Our economies are so intertwined.” Think of it, as long as the US keeps importing, China keeps chugging along nicely.” “I get you, but I’m sure the Chinese know all that. Why then are they making those statements?” “Well, because the Americans have been on a massive dollar-printing spree. Excessive currency printing leads to a currency losing value. And if the dollar loses value, who loses the most but the people who have their investments in financial securities quoted in dollars? According to an estimate by Merrill Lynch, investors in securities issued by the US government have lost an average 2.7% in 2009. That’s why they want the US to go a little slow on printing dollars.” “Does that mean China will stop buying financial securities issued by the US?” “I hope not. If China doesn’t buy these securities, the US will have to print more dollars in its attempt to rescue its financial institutions and get consumers to start spending again. That would only send the dollar value down further. And the Chinese can’t get out of these securities by selling them either, for then, the prices of these securities will crash and China’s own investments will suffer. It would be like shooting themselves in the foot. What’s worse, as exports to the US slow down, the Chinese will have lesser number of dollars to keep buying securities issued by the US government. And that may lead to the US printing more dollars. So there, the Chinese are stuck.” “But isn’t there a way out? Some people say Chinese consumption will save the world.” “I wish it was as simple as that. In fact, the Chinese government has also started printing money in the hope that people will spend and that will keep the economy growing at rates seen in the past. Chinese banks have lent 4.9 trillion yuan of new loans in the first two months of 2009, an increase of 35% year on year. But for the trend to sustain, the whole structure of the Chinese economy has to change from one focused on exports to one driven by domestic consumption. More importantly, China has been a country of savers, and it cannot be turned into a country of spenders overnight.” “What do you mean?” “I will give you an example from a recent article in The Financial Times. The article was on a violin factory, which made a third of the world’s violins. Almost all of these violins were exported. The factory would have continued to do well if the Chinese were to buy all the violins produced. But they are not. The factory can start producing something like furniture, which the Chinese would be interested in buying. But the changeover will take time because you would need to retrain workers, develop new distribution systems and so on.” “The hope is that Chinese consumption will revive global demand for commodities and lift the world out of recession. But that is a very simplistic argument. Much as people assume it would, China’s dependence on the US consumer won’t go overnight, though when it does, China won’t need to continue buying US financial securities.” “We live in interesting times,” she said. “Doesn’t that call for a cup of coffee?” k_vivek@dnaindia.net (The example is hypothetical) References: The Three Ways China May Deal With Growing US Debt, By William Patalon III and Jason Simpkins, www.moneymorning.com,March 25,2009; China announces stimulus plan,By Chuck Butler, www.dailyrecokning.com,March 5,2009; Central Banks Unleash NuclearOption, Gary Dorsch, www.safehaven.com,March 19, 2009; China - The Great Red Hope,Bill Bonner, www.dailyreckoning.com,March 12, 2009.
Sshhhh... We offer mediclaim to senior citizens0 commentsState-owned general insurance companies are hush-hush about these policies Khyati Dharamsi. Mumbai Health insurance policies exclusively for senior citizens, launched by the public sector general insurance companies on a request by former president APJ Abdul Kalam, exist only on paper today. None of the four public sector general insurance companies is keen to promote these policies, which cater to the 60-80 years age bracket. The normal mediclaim cover, usually issued only up to 60 years, is either denied to people above 55 years or the premium hiked significantly. A senior official with a general insurance company conceded as much on the condition of anonymity. “We had floated these policies under pressure from the government. But we are not promoting them because there is an expectation of immediate claim. The health portfolio, which is already in losses, would suffer further.” National Insurance Company was the first to launch an exclusive mediclaim policy called Varistha Mediclaim for the 60-90 years age group, in December 2006. United India Assurance Company, Oriental Insurance Company and New India Assurance Company followed with their products, after P Chidambaram in his budget speech announced that the other three players have been asked to launch similar products. Star Health & Allied Insurance, another exclusive health insurer, also launched a policy called Senior Citizens Red Carpet. Insurance brokers DNA Money talked to said there weren’t many enquiries for mediclaim covers specifically for senior citizens. “Only 2-3 customers have come asking for the cover, which tells us that there is no awareness of such a product,” a major Delhi-based insurance broker said. Another insurance broker said, “Public sector companies do not sell it (senior citizen’s covers) because they know these are going to be loss-making proposals for them.” To add insult to injury, the agents are given miniscule or no commission in case they get a customer who is above 55 years. According to the Insurance Regulatory Development Authority (IRDA), of the five major types of insurance policies sold, the highest losses are incurred on health policies. As per the latest available figures, the incurred claims ratio of public sector general insurance companies on health in 2006-07 was 157.79% vis-à-vis 103.42% incurred by private insurance companies. According to an Irda report, New India had the highest claims ratio in health at 212.81%. The volumes recorded earlier have also reduced of late, say sources. It is also learnt that government, which was taking proactive steps to ensure insurers offered covers, has now shifted attention. A source said, “The central government used to ask for statistics during the initial days, but has stopped asking for figures now.” Currently, only two of the abovementioned players are issuing policies, say brokers. “In case a proposal comes, these companies are not denying covers, as was the case earlier with 55-plus age group. Insurers are doing proper checkups and noting down any pre-existing condition on the forms,” said Rahul Aggarwal, head of Optima Insurance Brokers. Asked why the covers may not be promoted, Aggarwal said, “One must understand that insurance, like any other business, is a for-profit one. If the government pushes the company to launch a product where one is sure to make losses, the organisation has no interest in it.” In any case, senior citizen’s policies shouldn’t be about subsidised premium alone, said Aggarwal. The policy should offer covers that are relevant to senior citizens, he said, adding, “Not many policies in the market are offered accordingly.” d_khyati@dnaindia.net Pension plans can be quite taxing0 commentsGiven the complexities, a combination of tax-savingMFs and PPF may be a better option Vivek Kaul. Mumbai Pension plans offered by insurance companies have gained tremendous popularity in recent years, though whether they really help the person retiring remains debatable. Also, this is that time of the year when investors are looking to save on income tax by making investments to that effect. Here are things you should keep in mind before you go around investing in a pension plan. The Webster’s English dictionary defines the word pension as “a fixed sum paid regularly, especially to a person retired from work.” What insurance companies sell as pension plans aren’t strictly pension plans. Individuals have a choice of kinds of pension plans: immediate annuities and deferred annuities. An individual putting money in an immediate annuity plan is assured of a regular payment from the insurance company. This payment can be monthly, quarterly, half-yearly or annually, depending upon the way the individual taking the policy wants it to be structured. Immediate annuity thus ensures that the policyholder gets a regular pension. But for a working individual buying a pension plan, it of course does not make sense to buy an immediate annuity. What the insurance company is interested in selling and the individual is interested in buying is the deferred annuity. In case of deferred annuity, the individual taking the policy needs to pay a regular premium. This premium is invested for a certain number of years. This phase is known as the accumulation phase. The money is being accumulated so that at the time of retirement, enough money has accumulated to earn a regular income. Once the accumulation phase is over, the money accumulated has to be used to buy immediate annuities either from the same insurance company or another insurance company. Hence, deferred annuities are like any other investment product, which let you invest and hence accumulate a certain corpus of money, depending on the returns they provide. Hence, the term ‘pension plan’ is a misnomer in this case. You can’t choose the best pension plan Almost all pension plans are structured like unit linked plans. After deducting various expenses such as premium allocation charge (used to pay high commissions to insurance agents) and policy administration charge, the amount remaining is invested in an asset class such as equity or debt or a combination of the two, based on the choice of the individual buying the pension plan. Now, since deferred annuities (or pension plans, as they are popularly known) are investment products, an individual should ideally be investing in the best performing pension plan. But as regular readers of DNA Money would know by now, trying to pick the best performing pension plan (like trying to figure out the best performing unit linked insurance plan) is next to impossible. The reason is simple. Different insurance companies have different expense structures and hence their returns are incomparable. So, why settle for a product category where you can’t even figure out the best deal available, the sales pitch of the agent or the company advertisement notwithstanding. Tax inefficiency of pension plans Earlier, investments into pension plans used to get a maximum deduction of Rs 10,000. Now, when an individual invests in a pension plan, he or she gets a tax deduction of a maximum of Rs 1 lakh, like they would do in the case of tax-saving mutual funds or even National Savings Certificates. But the tax law works differently when compared with regular insurance plans or tax-saving mutual funds, if the individual decides to get out of the plan midway or holds on till maturity. As stated earlier, pension plans are essentially investment products. A few years down the line, you might realise that the pension plan has not been performing well in comparison with other plans in the market. The logical thing to do would be to get out of the plan. But, there is a price to be paid. As is the case with most unit linked plans, the insurance company might charge a surrender fee. Also, given the current tax laws, the individual will have to pay tax on the entire amount the insurance company pays him. And after all this, when you enter a new pension plan, you will have to bear the high upfront charges, which is the bane of most unit-linked products. Now what happens at maturity? As per the current tax laws, the individual is allowed to withdraw one-third of the corpus tax-free. The remaining money has to be used to buy immediate annuities. This means that the individual will have to buy immediate annuities even when other kinds of investment might give him a greater return. What if he wants the entire corpus at maturity? The only way out is to surrender the policy. But again, the problem is that on surrendering the policy, the entire corpus will be taxed at the prevailing tax rates. Returns of immediate annuities As of now, the post-tax return on immediate annuities has been lesser compared with other sources of regular income, such as the Post Office Monthly Income Scheme, Senior Citizens Saving Scheme or even senior citizens fixed deposits. In addition, if on a later date, immediate annuities give a better return, an individual can always buy those rather than opt for other regular income generating options. So how do you build a retirement corpus? Pension plans aren’t the only way to build a healthy corpus for retirement, notwithstanding the fact that they contain the word ‘pension’. In fact, a combination of Public Provident Fund (PPF) and tax-saving mutual funds can work much better in this regard. The maximum amount that can be invested in PPF every year is limited to Rs 70,000. The remaining can be invested in tax-saving mutual funds. Those who are comfortable with more risk can invest more in tax-saving mutual funds and less in PPF. PPF account matures 15 years after the financial year in which the investment was started and can be extended thereafter. When you withdraw the accumulated corpus, it is totally tax-free. Same is the case with tax-saving mutual funds, which come with a lock-in of three years. Also, if the investor sees that his tax-saving mutual fund is not doing well, he can easily switch to another scheme. That flexibility, as we have already seen, is not available in case of pension plans. Individuals should not fall for the bogey used by insurance companies against mutual funds — that mutual funds are for the short term whereas insurance is long term. But, that is really not the case. Mutual funds are as long term as the investor wants them to be and come with the flexibility of the investor opting out of one scheme and moving on to another. Also, at the time of retirement, the individual has the option of buying an immediate annuity, if he wants to. k_vivek@dnaindia.net
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