Impact of Trail commission on your Mutual Fund Returns

There are a number of ways by which we grow our money drop by drop to build at least a lake of wealth for future consumption. After taking care of Wealth protection by way of insurance we recommend delving into Wealth creation keeping Asset Allocation in mind and investing in Debt and Equity to create a long term corpus that will not only help meet our financial goals but also let us indulge in a little bit of luxury if the corpus permits, as an incentive for such long term savings.

The Equity part of the portfolio can be built with direct stock investing or through Mutual funds the latter being the preferred route for a major part of the population as the effort involved in selecting buying and tracking individual stocks not only needs acumen and eye for detail but also time and temperament that many lack. Thus Mutual funds are the preferred route for growing money.

Of the several expenses that one pays to the AMC to manage a scheme there is a lurking element called Trail commission that not many are aware of. Trail commission, put simply, is the loyalty fees paid to the distributor for marketing and bringing the business. This is completely justified because the advisor/distributor has shown the way for a customer to invest in the fund, at times even discussing in length why that particular scheme is a fit for a portfolio [Planners must do this anyways!]. Thus it is right that the distributor gets paid the trail commission. There is a class of investors who go directly with the AMC. Many of them might get tips from newspapers, magazines, blogs and forums and also invest by word of mouth/recommendation received from friends and family and may choose to go DIRECT as well. The AMC charges a trail commission for such DIRECT customers as well. So how do the AMCs do it?

Trail commission can be between 0.2 to 0.8% (no limits but usually sub 1%) for equity funds and much lower for Debt and Liquid funds. Each quarter the AMC deducts the trail commission from the NAV of the scheme. So if the NAV today is 100 and tomorrow due to market movement the NAV raises by 50 paise to 100.50 and a Trail commission of 0.15% (Assuming annual trail of 0.6%) is applied the final NAV is 100.3493 which will be rounded to 100.35. An unsuspecting user would assume that the NAV went up only by 35 paise while the trail has slowly eaten away some returns. Miniscule – one may think. Not really, if you consider this over the long term. Look at the attached spreadsheet here for the actual impact. This can reduce your corpus by over 11% even assuming a MF growth rate of 12% over 25 years and trail commission of 0.15% each quarter. For an initial investment of 2 lacs and continuing a SIP for Rs. 10000 over 25 years the final corpus can get reduced by ~ 25 lacs which would still be decent money after 25 years. Discounting at a long term inflation rate of 8% this amount would be worth 3.65 lacs in today’s terms – not a small amount in any sense. Imagine this money being charged for the thousands of investors!Work out the numbers yourself for your SIP amounts by clicking the excel spreadsheet  here.

Source: Outlook Money Dated 21 March 2012

Outlook Money recently organized a Mutual Fund round table and posed my question to the MDs and CEOs of several Mutual funds who had attended the meeting. You can see the responses right here. Bluntly put the answers have been wishy-washy as you can see for yourself avoiding a sensitive topic in the Mutual Fund world – on one end it says it is impossible to segregate investors and at the other end it says that these funds anyway return higher than compared to the trail being cut. Both arguments don’t hold water for obvious reasons. The AMC perhaps has not done anything to earn this DIRECT customer and it is not justified charging a trail commission to this investor.

In this highly technical world when AMCs can track down right at the point of transaction initiation if the folio’s broker needs to be paid a transaction commission of Rs.0, Rs. 100 or Rs. 150 it is not a difficult task to find out customers who are DIRECT investors. Also just because the fund returns higher one need not necessarily have to pay a trail – something that will be used for the AMC’s marketing expenses. In fact more the return more the trail as well as you saw in the spreadsheet above!. The trail commissions are the customer’s money and AMCs know this.

Is there a solution out? Perhaps yes.

Option 1 – Retain the NAV + Reduce the units held for customers charged with trail commission.

This way the DIRECT investors will see the full value of NAV retained. The customers going through a distributor will see few units shaved off their portfolio reflecting the trail that was paid. This will lead customers to ask questions on the Account statement. Honestly speaking if the Distributor has done the due diligence they deserve this but any money ‘taken’ from someone usually cause rankles. They will all want to switch to DIRECT mode making the MF industry unattractive for distributors.

Option 2 – Decrease the NAV + Increase the units held for DIRECT customers

This is the best of both worlds. This way the DIRECT investors will see the NAV slashed but compensated in the form of new additional units. The customers going through a distributor will see the NAV reduced but as is today many would not even notice while the DIRECT customers do not get penalized.

We as informed investors must write to SEBI and AMFI about this practice. It is not that they don’t know this but perhaps when there is a rise in volume of such requests from informed investors it might be considered and deliberated.

Would the AMCs listen?

Welcoming all your views on this!

LIC Jeevan Vriddhi – A Quick look

I know it has been a long break since I posted previously but I just got a little busier with drafting Financial Plans for several of our readers. Thanks all for your continued patronage.

I am publishing here a product review this time about the new talk of the town LIC Jeevan Vriddhi  (http://www.licindia.in/Jeevan_vriddhi_sales_brochure.htm). All LIC policies get this status by default!

Though I recommend shunning LIC’s and other Endowment policies in general and one time premium paying policies especially, when my spouse asked me earlier today to take a look at this plan I agreed. I worked out the numbers for Jeevan Vriddhi and was in for a pleasant surprise (compared to LIC standards) which is when I decided to write about this plan in the justgrowmymoney blog. Do note I evaluated this policy purely from an investment perspective. The policy is in no way an Insurance product. Take a Pure term policy in the first place. Any additional coverage provided by this plan is just that – additional. 

Highlights:

• 1 time premium plan
• 10 year term
• Some guaranteed returns provided in LIC website (link provided above)
• Life cover is 5 times of premium. Minimum premium 30,000 no maximum premium.
• Incentives for higher premiums (50k-99k -> 1.25%, 100k+ 3%)
• Loan available after 1 year. Surrender value after 1 year is 90% of amount paid.
• Service tax of 1.545% for Endowment plans is applicable (not mentioned explicitly in the link above!)
• Loyalty additions at the end of the term may be decided by LIC. I am assuming this to be a very insignificant amount because the guaranteed payout is large. [This hidden return in a Debt investment is one of the several reason I shun Endowment policies]. Hence I have made this zero in my calculations. You may make this to be Rs.1 or Rs. 2 per thousand for EACH YEAR for comparison purposes.

What is in it for Investors:

The guaranteed rate of return ranges from 4.53% to 6.93% [This is for the case with NO incentive. If someone pays 1lac the range of returns are 4.84% to 7.25%). The numbers do not appear to be very impressive at the first glance and it is easier to shun this off as another LIC Endowment plan but we need to look a little beyond the obvious.

I have also assumed there are no Tax savings in the year of investment by investing in this policy because I recommend anyone to maximize PPF before looking at this plan in which case the tax savings under 80C are already in place.

Let us look at some numbers for LIC Jeevan Vriddhi. (Detailed Calculations here – Sneak peek at Jeevan Vriddhi)

Assume a 30 year old in the 30% tax bracket pays a premium of 1 lac. The initial outgo will be 1.545% higher due to service tax => 101545. The Sum Assured is 5 lacs. The guaranteed payment is 199985. The rate of return turns out to be 7.01%. There are 2 considerations here:

1)      If someone at Age 30 takes a pure term plan for 5 lacs the cost should approximately be  Rs. 1000 per year (Just like the premium does not increase proportionally between a sum assured of 50 lacs and 1 crore it would not decrease proportionally when you take a term plan for just 5 lacs). There is a notional income flow of Rs. 1000 every year. Plugging this in a IRR calculator will show that this increases the returns to 7.81%. The notional income flow is higher for people 40+ as their insurance costs are higher as well. Do note the calculation in the spreadsheet link provided above do not take into consideration this cash flow as it may differ for each individual. 

2)      This is a controversial one related to DTC. According to the current tax laws the maturity proceeds are tax free. However per DTC if the Sum Assured is not 20 times the premium paid then the final corpus is taxable. Now if and when DTC comes in to effect will it affect existing investments? At least as per the current draft it will. However LIC’s primary business (besides bailing out State run companies!) of selling endowment plans would suffer a massive massive blow if such a proposal is made a law. Again in general taxation laws are usually prospective so such proposals may be applicable for future investments and would not  tax previous investments. There is a lot of gray area here that is anybody’s guess. So assuming DTC will not tax the proceeds the return of 7.81% is equivalent of a 10 year CAGR of 11.1% taxed at 30% – not bad for a Debt investment. By ignoring the Rs. 1000 cash flow I mentioned earlier the tax adjusted return still comes out to be 10.02%.

I agree you can as well lock in a FD for 10 years today at the 9.5% range. However you will miss out on the Life cover, which, however insignificant (Say even 5 lacs), still makes your money work harder. Do note I have assumed the loyalty additions are zero so in the event there is some addition at the end consider it as a freebie!

Should you buy this?

Is this not why you read this review until now?! There is no one size fits all because the final returns are determined also by the Initial premium paid, tax bracket and age (Financial Planners never commit, do they!). Consider these points and your specific tax situation and age before making a final call.

-          The final return on this Debt plan appears to be decent for some Tax brackets and age levels not for all.

-          Even where this plan gives decent FD like returns they STILL lag PPF/EPF returns over the same duration. The proceeds from the latter are guaranteed to be tax free. So if someone has not exhausted PPF it makes less sense to invest in LIC Jeevan Vriddhi! Just go and maximize PPF before even thinking about investing in this plan.

-          In the Debt scheme of things PPF/EPF obviously rank at the highest level followed by the new (restarted) era of Tax Free bonds. REC is coming up with an issue of Tax free bonds in about 1 week at 8.13%. But note that the annual interest is paid out and not reinvested and you may or may not find reinvestment avenues at such rates in future. The returns are nevertheless very good. After these bonds come in the hierarchy Liquid/Debt funds where you can park your money to grow at a rate marginally better than FDs if you opt for a Dividend option that is taxed at ~ 15%. This again is beneficial only for folks in the 20% and 30% tax bracket. Returns on Jeevan Vriddhi come somewhere between the Tax free bonds and Liquid funds depending on your individual situation.

If someone says they are not willing to consider any LIC plan and can manage their Debt portfolio otherwise I would not disagree. As I said before Jeevan Vriddhi is one plan from LIC that is at least worth considering analyzing to be included in one’s debt portfolio.

Whether it makes the cut to enter your Debt portfolio is a combination of several factors including your current Asset allocation, liquidity situation, the premium chosen, age and tax bracket amongst other things.

Welcoming your views on this.

Update on Apr 1, 2012:

Per the Union Budget that was presented in Mar 2012 maturity proceeds from policies where the Sum Assured is not at least 10 times the premium paid will be taxed at maturity.

LIC Jeevan Vriddhi provides 5 times coverage. Hence any investment made from April 1, 2012 will be taxed at maturity. Hence I recommend a STRICT NO-NO for anyone (except perhaps age group 8-12) to take this policy.

Asset allocation – Your oneway ticket to Wealth generation

We have gone through some exciting wealth preservation strategies in our pursuit of Financial independence so far. Taking Insurance: this lets us retain a bulk of the wealth in the event of an unforeseen mishap. Saving money outflows directly correspond to growing money. In our pursuit in this direction let us see how to grow money further.

Asset allocation is how you divide your investments between different asset categories like Equities, Debt, Gold, Real Estate and Cash. Again here, there is no one-size-fits-all and is usually tied to a person’s risk tolerance, personal and financial situation and many other factors which in combination determine one’s Investor profile. Asset allocation is probably one of the simplest tools readily available for investors that it is even termed as ‘Almost a Free Lunch’ in the investing world.

Asset allocation is by far the most important part of anyone’s investment portfolio. In a study in 2000, Kaplan and Ibbotson inferred that almost 90% of the Portfolio variability is directly attributed to Asset Allocation. If this were true only 10% of a portfolio performance is due to the individual holdings while 90% of it is determined by how one has allocated their money. This goes to show the importance of asset allocation.

It is a well known fact that Stocks and Bonds move usually in opposite directions. During the onset of a bear market due to the volatility in equity returns investors start flocking to Bonds. Hence as the appetite for equity starts to fall (along with its return) the yield on bonds go up. Thus if a portfolio is composed of Stocks and Bonds then when the stock component falls the bond component gains (not equally!) thus protecting the downside. It is very much required to hold debt in almost all portfolios, as studies have clearly shown. This forms the crux of Portfolio Management.

Rebalancing

Let us say someone started with a 60% Equity and 40% Debt allocation at some point in time. Over a period of time since both equities and debt will often provide different returns the asset mix will shift. Every once in a a while (atleast one a year) one has to do what is called as ‘rebalancing of a portfolio’ to bring the portfolio back to its original asset allocation. If the Equity portion of a portfolio has gained one sells some equity and moves it to Debt to retain the original allocation and vice versa.

Determining optimal Asset Allocation

There is no direct answer to this.  A combination of primary factors below will allow one to arrive at optimal asset allocation:

• Risk tolerance: The lower one’s risk tolerance the lower their equity allocation.
• Financial situation: If all investment evaporates can one still keep up their standard of living. How long can they survive?
• Time horizon: The longer time one has toa financial goal the more equity one can hold.

 A thumb rule is that the allocation to Debt must be the same as your age. A 30 year old can have 30% Debt and 70% Equity while the Debt exposure will need to be about 60% for a 60-year-old person. REMEMBER: This is just a thumb rule.

 Research based historical inferences

A lot of studies have been undertaken in much of US and Europe to prove that Asset allocation significantly determines the wealth generated over a long period of time. I have attempted here to do a research on the Indian markets to confirm whether such a theory holds good.

Research Background

• I have created a group of portfolios ranging from 100% Equity to 100% Debt and compared the performance of the portfolios during a period of time. I have ignored Real Estate and Gold for simplification purposes.
• The period of study is this millennium, from 3-Jan-2000 to 9-Dec-2011.
• Nifty closing for this period has been taken. It is assumed that the rebalancing is done once a year on Dec 31^st. The Initial allocation alone happens on 3-Jan-2000.
• The average Bank FD return in India for this period is assumed to be 8% (Range: 7.25% to 11%)
• Taxes and Brokerage expenses/Investment fees have been ignored in the study
• Rebalancing: A Hypothetical amount of INR 100,000 is assumed to have been invested on 3-Jan-2000. With a 60/40 Equity/Debt allocation one starts with INR 60,000 in Equity and INR 40,000 in Debt. For easier calculation purposes I have declared equity units to be allocated (like an ETF). At a Nifty closing of 1591 on 3-Jan-2000 there are 37.68 units of Nifty available. At a Nifty closing level of 1263 on Dec 31, 2000, the Equity portfolio has fell from INR 60,000 to INR 47615 (Which is 37.68 units * Closing value of 1263). The Debt portfolio at the end of that year @ 8% growth is INR 43,200. The overall portfolio value now is INR 90815. This is again split into 60/40 between Equity and Debt. It is assumed we are able to reinvest Debt at 8% throughout this period.
• The rebalancing process continues at the end of each year until Dec 9, 2011, the time the research results were being collated

Key observations

An allocation of 100% to Nifty and 100% allocation – Both have underperformed several of Asset allocation models as outlined in Exhibit 1. This must ring a bell for 2 classes of investors:

• The overzealous who want to invest 100% in Equity
• The ultra conservatives invested in full in Debt (like FDs)

 Both these models have underperformed a simple Index fund + FDs combo by about 100 to 300 basis points at the 70/30, 60/40 allocations. As diversification from 100% Equity starts to 90/10 and beyond the return of the portfolio increases steadily, peaking around a 60/40 allocation and then falling off. Even a 25% Equity allocation + rebalancing has marginally beat the market. [NOTE: It is not to be construed that 60/40 is the ideal allocation]. The important idea to take away from here is that Asset allocation + Rebalancing plays a significant role in wealth generation.

The counter-argument goes something like this: Some diversified Mutual funds have easily returned about 15+% CAGR over a period of time So would it not be better to invest in 100% Equities and just buy such sound Mutual funds and sit. There are 2 problems here. One is, since past performance is not an indicator of future performance, it is difficult to zero in on a fund that can outperform the market so consistently. Again, such MF portfolios are likely to be more volatile than a balanced portfolio. Hence, however convinced one is about the fund selection, if one has to experience wild swings over a period of time with the Portfolio swaying big time say, -50% or more, it is highly likely someone is going to exit the fund altogether as has happened in the recent falls of Jan 2008 and Jan 2011 (and in any fall, historically, across countries). These two are powerful reasons for diversification and asset allocation.

I have attempted a similar study like the one we saw in the Nifty example just above – this time rebalancing with one of the Top diversified Mutual Funds in India, HDFC Top 200. Many funds that were on the same pedestal as this fund for a significant part of the decade have rolled off subsequently, just showing that a good fund selection is very difficult and risky more so to be fully invested in.

NOTE: This is neither an endorsement for HDFC Top 200 scheme nor a denouncement + There is no guarantee such returns can necessarily be sustained in the future (Disclosure: I have a SIP running in HDFC Top 200-Growth since Jan 2010).

The results are not vastly different (see Exhibit 2) in that a rebalancing at 90/10 allocation still marginally beats a fully invested portfolio in the MF over a period of 11 years reinforcing that a Portfolio rebalance still can beat a full allocation to equity.

Though a detailed study on the impact of taxes on bond yields and MF fees and expenses has not been carried out a cursory plugging in of the numbers in the attached spreadsheet will help establish that the results are not too different in that the yields spreads between a full allocation to equity and a rebalanced portfolio will decrease on one side and that every 100 basis point (1%) increase in the Bond/FD yield will make a larger set of Portfolio Asset Allocations beat both the Market and diversified Mutual Funds in general.

Closing note: Asset Allocation is such a powerful tool with which it is possible to join hands with any of the best performing MF scheme and even beat it over a period of several years by combining the MF with Debt and rebalancing at least once a year. This very simple tool can be used to protect wealth already generated by moving the equity earned income to Debt and also vice versa, by purchasing more of Equity when the markets are beaten down. No wonder this strategy is referred to as ‘Almost a Free lunch’ because an investor has the complete choice in determining their allocation no matter what the markets do and where the markets head.

The next step in this exciting journey of growing money is to ensure we arrive at an Asset allocation, following the thumb rule to begin with and stick to it and rebalance – increasing your chances manifold to grow your money!

About the author: Anand Balakrishnan is a CFA Level II candidate and a Certified Personal Financial Advisor (CPFA). He also contributes at Seeking Alpha – http://seekingalpha.com/user/689315/instablog.

Sources/References: http://www.nseindia.com/ and www.hdfcfund.com. Market emotions image sourced from http://www.arborinvestmentplanner.com/.

Pursuing Financial Freedom: Step 2 – Getting Insured

 The foundation of a successful financial plan lies in ensuring that risks are eliminated,mitigated or transferred. Insurance can fulfill one or more of the above functions. Insurance can broadly be divided as Life insurance and Non-Life insurance. We saw that the first step in achieving financial freedom is buying a Term Insurance.  The next step is to ensure we have adequate non-life insurance (Don’t grow impatient. I promise we will discuss things like ‘growing money’ soon).

 Health Insurance Plan (HIP/Mediclaim):

• Health insurance protects the policy holder and his/ her family against any financial contingency arising due to a medical emergency. This policy provides for reimbursement/cashless treatment of hospitalization/domiciliary treatment expenses for illness/disease or accidental injury. 3^rd party administrators (called TPA) administer the policy.
• Medical expenses incurred during period of 30 days prior to and period of 60 days after hospitalization are covered. Any one illness will be deemed to mean continuous period of illness and it includes relapse within 45 days from day of discharge from the hospital.
• Normal exclusions include all diseases/injuries which are pre-existing at the time of taking the cover. Most policies now cover pre-existing diseases as well after a specified period of time (usually 4 years).
• HIP may have various limits and sub-limits for every aspect of hospitalization. For example: Insurer may say that room rent per day shall not exceed 1% of total coverage. So if your coverage is 5 Lacs room rent per day up to Rs. 5000 shall be reimbursed.
• HIP may have co-pay. For example: The first 20% of the bill is paid by the insured and the rest is reimbursed by the insurer. This will reduce frivolous claims and keep overall costs lower for the population.

• HIP is now portable. So you can move to another insurer with certain entitlements earned with the previous insurer. Assume you have taken a HIP today and paid some premiums (say for 3 years until 2014) and you decide to port this policy to another company with similar coverage. With the new company you don’t have to wait for 4 years afresh to start covering pre-existing illnesses (as in the past). Your pre-existing illnesses will now be covered after 2015 itself. This is a great relief as many companies typically increased insurance premiums even when no claim was made. Since people wanted to ensure preexisting illnesses were covered they had no choice but to stick around with the previous insurer. A right step that IRDA has taken and something we as consumers must know.
• Employer provided Health insurance is good but not sufficient, how much ever that plan covers. One should have their own HIP. Multiple reasons: Employer reducing benefits as part of cost cutting, Change of employers, Loss of job, being in-between jobs, taking a break in job to pursue higher education (say, a MBA), taking a sabbatical etc. Trying to buy a health plan when any of the above happen is not a prudent idea and may expose the individual.
• Family floater is a great cost saver but is risky. Assume a family of Husband, wife (Both in early 30s) and their kids taking a family floater insurance with the husband as the proposer. Assuming the proposer passes away some 30 years later. At this point the policy cannot be renewed any further. If the wife now intends to take a fresh cover it is going to cost a fortune regardless of the fact she was covered for 30 years and even if she has had no major ailment in that duration. Hence I would recommend each spouse take an individual health plan for themselves and when they have kids convert one of those plans into a floater policy only covering themselves and the kids. The other spouse must remain with the individual plan. When kids become majors they will need to have their own HIP.
• Ensure you provide honest details about your health when taking health insurance. Insist on a medical test (most companies anyway do) so you claim has lesser chance of being rejected in future because the insurance company is supposed to have done a full evaluation of the health status (that DOES NOT preclude you from providing information in full) – this just gives you an upper hand case in case of a conflict.
• Tell everyone in the family where the Medical insurance cards are. I would recommend everyone has a copy of the card with them. Also make a note of the list of hospitals in your area covered by your plan.
• Claims must usually be filed within 45 days of hospitalization [Even for employer covered plans]. Ensure you are not lazy and do the paperwork in time.
• Go for Health insurance plans where the settlement rate is higher. Chances are your claim will also be settled. Also choose HIP that lets you renew at least until you are 80 years old or more.

 Critical illness insurance

 This policy provides for a lump sum benefit to be paid if the named insured contracts certain specified diseases such as Stroke, Heart attack, cancer etc. There is no payment on death. Payment is usually subject to a minimum survival period of 30 days after the diagnosis. With the current lifestyle it is imperative that one takes critical illness insurance. This will ensure that any loss of income associated with the illnesses can be mitigated.

 Personal Accident Insurance policy (PAIP):

 This policy offers compensation in case of death or bodily injury to the insured person, directly and solely as a result of an accident, by external, visible and violent means. Although usually sold as riders with Term plans, PAIP can also be purchased separately.

 Motor Insurance:

 Motor insurance covers: A) Destruction to motor vehicle of the insured and the motor vehicle of the counterparty in an accident and B) Other damages caused to the counterparty (bodily injury/death etc.).   In India the insurance of one’s own motor vehicles against damage is not compulsory but the insurance of third party liability arising out of the use of motor vehicles in public places is. Thus having a motor insurance is mandatory to drive a motor vehicle. 

• If the damage to the vehicle is just a scratch/bump etc. do not file a claim because you lose your NO CLAIM BONUS (NCB) status. The increased premium outgo in future may not be justified.
• Maintain your vehicle in top shape so accidents due to vehicle mal-function can be reduced greatly

Property Insurance:

The insurance covers one’s property against mishaps like natural disasters, societal vandalism and terrorist attacks. One must insure their properties, starting with their primary residence. Land need not be insured as it is indestructible. The buildings on them, however, are susceptible and need to be insured in line with market value.

If you live in a seismic zone or closer to the coast it is better to take property insurance. Small business owners definitely need to insure their establishments and godowns. No point scrimping money here.

Keyman Insurance:

A keyman, as the word suggests is the ‘key man’ in a business context – say a CEO or a sales executive of a firm. A company can take ‘Keyman insurance’ so should something untoward happen to the key person the company will be compensated monetarily for the potential loss of business caused by the absence of the keyman.

While this appears on the outside to be suitable for large organizations this is more so applicable for small firms run by a handful of people, really. A large firm can find near suitable replacement in the market for a higher cost if need be. Small businesses and family businesses will benefit by the keyman insurance. Obviously a detailed cost benefit assessment needs to be done in taking this insurance.

Income Protection Insurance:

Income protection insurance ensures that one has an income stream to rely on in case of short-term or long-term inability to work. Income protection is designed specifically to cover one in the event of a significant loss of earnings caused by illness or injury. However, some short-term policies also build in cover for unemployment or redundancy. The cover is usually for a few months from the time an unfortunate event has occurred. Generally such plans are a no-no regardless of how sweet talked we are about the benefits . A PAIP (Personal Accident Insurance policy) and an emergency fund that will allow one to subsist for at least 6 months, part of sound financial planning, should be your immediate reach when such an event occurs.

 A closing note: “Discussing insurance in itself is not very interesting”- I have had this feedback several times. Déjà vu. However, Insurance forms the basis of financial planning. In the context of a home: Insurance is akin to the safety measures taken for a home – like adding dead bolts to the door, a second iron grill door etc. Home decoration and luxury amenities can be compared to growing money by investing. Safety of the home is of paramount importance than the amenities, I am sure all you will all agree.

 What we have done so far is ‘justsavemymoney’. We will next move on to topics where each one can ‘justgrowmymoney’.

Housing Development Finance Corporation [HDFC] – Research report

Housing Development Finance Corporation [HDFC] – Download here

Recommendation: Strong BUY| Date: 13-Nov-2011| CMP:668| 30 month target: 1000

Disclosure:  I am long HDFC since May 2011 at a starting price of 663. I personally hold 9% of my entire portfolio in HDFC. I don’t intend to open/close positions in HDFC over the next 20 business days.

This is a completely independent research. No compensation has been received from any entity in preparing this report.  All data in this report is based on data available from HDFC Financial Statements in their website and from BSE/NSE websites. Sources where appropriate are cited.

This research report is unique for the following 2 reasons:

1) Most recommendations you see provide a short term price target – sometimes 1 month target or even 1 week targets. My recommendations also involve price and time targets but over a longer duration. Rationale: Obviously I don’t know where the markets will be in the next “any period” and invariably all the stocks almost follow the market fluctuations over any long duration. However over a longer duration the likelihood of the fundamentals and the performance of a company being recognized by market forces are much higher which will reflect in the share price.

2) If I ever change my recommendation due to a future performance of the company or relevant regulatory changes I will provide an update. Also readers can feel free to discuss up this stock directly with me if the stock hits a 10% price band (up or down) from the recommended price.

Housing Development Finance Corporation [HDFC] is a financial conglomerate with its presence in the entire gamut of financial services including banking, insurance (life and non-life), asset management, real estate venture capital and more recently education loans. Housing Loans however account for about 52% of the revenue for HDFC.

For the recent quarter ended September 30, 2011, HDFC reported a profit before tax (PBT) of Rs. 1,337.70 crore – an increase of 18% vis-a-vis the corresponding quarter of the previous year. The corresponding Profit after tax (PAT) is Rs. 970.70 crores, an increase of 20%. For H1 2011 the loan approvals and disbursements grew at about 19%.

 Two remarkable areas of performance:

 1) Growing in tough times: The home loans rates have been raised every other quarter over the last 12-18 months. However HDFC has been able to maintain its growth at a healthy rate of 20% without any major compromise in its asset quality. The funding costs have been higher however the margins @ 4.3% and spreads @ 2.3% have remained relatively stable year-on-year.

 2)NPAs: In spite of the increase in the home loan rates over the last several quarters the total Non Performing Assets (NPAs) amount to 0.82% of the loan portfolio-an improvement from 0.86% the figure as on last year [Compare this with public sector banks where the average NPA hovers around 2.3%] . HDFC has been aggressively reducing its NPAs now for 27 quarters in a row. This shows that HDFC has been exercising the due diligence in ensuring the provisioning for NPAs do not impact its performance. Since HDFC primarily deals with collateralized lending, with the home being the collateral, the exposure is also limited.

 The dampeners:

 1)      Loan approvals moderated to 13.3% y-o-y from 28% y-o-y as compared with the previous year

2)      Inflation has been quickly eroding the purchasing power especially over the last 18 months. Oil prices are on the rise and this will impact almost every sector in the country where goods have to be transported. If the major consumption items account for a significant amount of the take home pie the appetite to service a new home loan will reduce. Thus it is very much possible that the plans for purchasing a house may be postponed. While the RBI has signaled that there may not be another rate hike it continues to monitor inflation. If inflation is unabated interest rates can further rise causing prices to spiral upward.

3)      Property prices have remained relatively stable or have been trending up across most of the country. Realty firms have been holding onto a number of finished units in the metros for several months now without reducing the rates. Several small players may be unable to do so for a very long time with the current spiraling financing costs. This can in turn lead to a minor correction in property prices in some regions. Even if this happens in a few pockets, if people get into servicing a loan worth more than their property the inclination to service the loan could fall. This could lead to increase in NPAs. While the reasoning appears farfetched the increasing costs of borrowing could lead us here.

 Outlook:

 We can expect that the revenues of HDFC will increase by about 21% CAGR until Mar 2015. HDFC should be able to maintain margins due to its ability to raise debt cheaper than most of it peers owing to its strong credit. The earning CAGR during this period can be about 19.4% (see exhibit below). The current leading PE based on projected net income for year ending Mar 2012 is 23.6 (CMP/projected EPS = 668/28.4= 23.6). The net income projection for the period Apr 2014 thru Mar 2015, considering further dilution in equity at 1 crore per year, is 47.6.  At this growth rate the markets should be willing to pay a PE of 21 which translates to per share price of Rs. 1000 over the next 30 months, a compounded annual growth of 17.6% over this duration.

 Though there may be short term fluctuations in the market and in this stock due to the Euro zone crisis as this report is being prepared the company has sound fundamentals and shown strong performance in dampening conditions over the past 12 months which could lead to a price discovery in the next 18-30 months. Investors with a long term view can get into the stock at the current levels as the price level appears attractive.

Pursuing Financial Freedom: Step 1 – Buy a Term Insurance

Insurance is Risk planning – to mitigate the impact of a risk. A Financial Plan, however well made, can hit a nasty roadblock if the inevitable things [like death] are not planned for. Insuring one’s life will support the dependents financially long after one is gone.

When it comes to Life Insurance in India there is no dearth for options to purchase from – Endowment Plans, Money Back Plans, Whole Life Plans, ULIPs, Term Plans etc.

Most of us who started our working careers in the 1990s and early 2000s invariably hold a money back plan/endowment plan where:

• A Sum Assured is defined at the beginning of the plan. This is the death benefit.
• You pay a fixed annual premium usually for a duration of 15, 20 or 25 years
• At the discretion of the insurer a bonus amount is declared every year (usually between Rs. 40 and Rs. 50 per 1000 of Sum Assured) starting Year 6. Additional discretionary bonus may be declared from time to time (none of this is known when you take the policy!!)
• In both these types of plans you get back the total premium paid at the end of the policy term.
• If you outlive the term of the policy you get the sum assured + Accrued bonus + Discretionary bonus. In Money Back plans you get some percentage of the  Sum Assured usually every 5 years. In Endowment plans you get the entire premium paid lumpsum at the end of the policy.

Let do some numbers here. Annual Premium: 30,000 Sum Assured (SA): 6 Lacs, Premium Term: 20 Years. Assuming TOTAL Bonuses of 60 per 1000 of Sum Assured (an over estimate) ==> We accrue 36,000 for the 6 Lacs of SA every year. So at the end of Year 20 one gets: Sum Assured (6 lacs) + Bonuses (36000*15=5.4 Lacs) = 11.4 Lacs. Let’s calculate the Internal rate of return (IRR). In an Excel spreadsheet fill (30000) from cells A1 to A20. This is the Cash outflow. At the beginning of Year 21 (ie, end of year 20) the cash inflow is 11.4 Lacs. Enter this is Cell A21. In Cell A22 use the formula=IRR(A1:A21) and hit ENTER. Voila, your rate of return is 6%.

2 Major drawbacks here:  Primary one being Sum Assured for the duration is only 6 Lacs + Accrued bonus (Say ~ 10 lacs). The covered amount is way too low to offer any meaningful ‘Insurance’. The other one being the return on the money is just 6% obviously unacceptable in India as on date. Enter Term Plan and we may have a better solution here.

ULIPs:

ULIPs are heavily front loaded with so many charges and provide barely any real insurance like Endowment plans. Although they participate in Equity the returns they generate must way exceed that of a normal Mutual Fund to generate any final decent return. Given that only a handful of funds have ever beaten the market over any long term  globally and given that the Life coverage is usually lip service ULIP is definitely not a recommended product. Just like drinking and driving do not mix so do insurance and investment.

Term Plans:

• A Sum Assured is defined at the beginning of the plan. This is the death benefit.
• You pay a fixed annual premium for a duration you choose (Maximum of 35 years available now)
• If you outlive the policy term the Insurer keeps all the premiums. If not the SA is paid to the nominee/legal heirs

Let do some more numbers here. Annual Premium: 10,000 Sum Assured (SA): 50 Lacs, Premium Term: 20 Years.  You take the remaining Rs. 20,000 (given we were ready to invest 30,000 in the Endowment Plan) and invest in Diversified Mutual Funds. Even assuming a very modest long term return of 10% [Just put =FV(10%,20,20000,0,1) in an excel cell] you will see you get an amount of 12.6 Lacs. The future value will increase exponentially for any increase in the expected return. In the case of this Term Plan the Sum Assured is reasonably large to support one’s dependents after their death.

Any calculation back and forth will establish beyond doubt that Term Insurance Plans are what really constitute LIFE INSURANCE and we see they are very cost effective. You may not find too many agents selling/pushing Term Insurance plans because historically the commissions are lower than selling an Endowment plan/Money Back plan.

Term Plan basics:

• Rule of thumb: The coverage must be 8 to 10 times your annual income.
• Take a Term Plan few years into your work life and for the longest possible duration. If you take one at 25 years of age for a period of 35 years then your cover ceases at 60. It is likely your dependents have all settled by then and you have a retirement corpus built for your spouse.
• The earlier you take a Term plan the cheaper it is. Don’t wait to get married and have kids to take a term plan. Yes it is general knowledge that unless you have something to protect you don’t need insurance. However the insurance premium for a 25 year old and 30 year old vary (10% at least) and adds up to a decent sum over the life of the policy. So load up that policy sooner.
• As you start earning more and more in life add additional cover
• It is a no frills attached policy. You don’t like it/You don’t need it – just stop paying the premium and the policy will lapse.

Are Term Plans reliable:

IRDA regulates the insurers and there are several capital adequacy parameters that are monitored regularly. In the absolute worst case that an insurer falls sick IRDA can force it to be merged with another entity for sustainability. All policies issued will be honoured, as long as all information provided in the policy proposal document is true. There are several online term plans available as well today which are even cost effective as the agent sales commission on such policies is virtually zero. If you have decided to take insurance from company A it does not matter for claim processing in future whether it was a policy sold online or not – no worries there as well.

Takeaway: Reducing the rampant misspelling of financial products in the market by educating the readers is one of the major objectives of this blog. Choosing a Term Insurance is a step in that direction and is indeed the most important step in your overall Financial Planning. Let buying a Term Insurance Plan in 2011 be your first action item in your pursuit to Financial independence.

The Road to Financial freedom – Let’s begin

A journey of a thousand miles begins with a single step.

Welcome to this exciting journey on achieving your Financial Independence. Let us try to cover the first mile in Financial Planning in this post. I sure want to keep the posts shorter to make an interesting fast read but this post will consume some 5 minutes at least to wade through, no more. Just keep going – I guarantee you will like it!

Financial Planing is the process of meeting one’s life goals through the proper management of personal finances. As like any project/undertaking Financial Planning follows the Deming’s PDCA cycle [Plan-Do-Check-Act] . We will discuss in detail about creating a Financial Plan in this blog.

1. Create a detailed Financial plan
2. Execute the Financial Plan
3. Monitor your progress at least once a year (recommended every 6 months) if you are in the right track. Also identify any changes in personal/financial life – Eg: New dependents, a huge change in your take-home pay, job loss etc. and any changes in goals (you want a larger home or a car)
4. Make changes to your Financial plan to realign your plan to your goals

Creating a Comprehesive Financial Plan: Start by answering the following:

• Where am I today (How much assets and liabilities do I have)
• Where do I want to go (How much will I need for my future needs: Include eveything from Family expenses in future, Kids’ education, Buying a Car, Expensive Vacations, Entrepreneurship dream project cost/opportunity cost, Kids’ marriage expenses and most importantly your own retirement and lastly how should my wealth be distributed posthumous)
• The ‘How do I get there’ is really your Financial Plan

Estimating future expenses: Once you have an exhaustive list of your goals you need to estimate their future costs. Do remember that Inflation eats away your buying power. A Balcony/Box ticket for a movie cost Rs. 40 about a decade ago however you almost cannot find a ticket priced below Rs. 100 (and most likely pushing Rs. 150) in most of the multiplexes today. Hence in estimating future expenses you need to ensure that your expenses are adjusted for inflation. A long-term inflation rate of 6% to 7% is acceptable but estimate it on the higher side to be conservative. The table below lists the impact of inflation on a few things.

	Rate of Inflation	2001	2011	2031	2041
Movie Ticket	11.6%	INR 40	INR 120	INR 1,076	INR 3,226
College Tuition Expense	6.00%	-	INR 2,000,000	INR 6,414,271	INR 11,486,982
Monthly Expense	6.00%	-	INR 25,000	INR 80,178	INR 143,587

Not all expense items change at the same pace as Inflation but this is a very decent estimate of your future cost. Once you have identified your current cash flows and have estimated future expenses adjusted for inflation you have to identify how to invest your money.

Investing your money:

There is definitely no magic wand here (and we will cover several parts of this section, mentioned in italics, in separate posts in the coming days). Depending on one’s life goals the corpus one needs to invest and the returns one needs vary greatly for every individual. There is no one-size-fits-all solution. However what I am proposing here is a brief outline of how to go about investing.

Empirical studies have shown 2 things:

1)      Equity markets have outperformed Debt markets over the long run
2)     The asset allocation between Equity and Debt plays a far more significant role in building wealth than just security selection.

Investing in Equities is not everyone’s cup of tea. Hence the easiest way to take part in Equities is via Mutual Funds. Just to get through making a Financial Plan let’s assume here that you are able to pick the right Mutual Fund schemes. If you have had one or two instances of your schemes faring worse (i.e the Mutual Fund scheme fared poorer than the market) do not hate MFs all together.

A mix of equity and debt is recommended across age groups with the tilt towards debt becoming higher as you grow older. This way a steady stream of income will bear the shocks of the equity portfolio. Rule of thumb here: The allocation to debt should be equal to your age. Thus a larger corpus is allocated to debt as you grow older. The main things to notice when investing in Debt instruments are:

Returns: If the return offered is too good to be true, chances are it is. When Bank FDs quote at 10% and some entity offers 11% it may appear reasonable but if someone guarantees you 18% return it is most likely a Ponzi scheme or a bogus scheme

Liquidity – Though there is a risk at maturity that you may not be able to invest the proceeds at the same higher rate as before, shorter maturity debt (say, 2 – 4 years) carry the element of liquidity so you may choose to utilize the maturity proceeds differently.

Planning for the inevitable:

A)    Term Insurance: The untimely death of the earning member of a family will expose one’s heirs to a lot of uncertainty.  Apart from the emotional trauma from the loss of a loved one they may also be in for a financial trauma if there is no proper planning on one’s part. There may be loans outstanding that need to be settled. Future income/cash flows could have been planned for further investment to meet financial goals, which will now stop. Human Life is precious and has infinite value, no doubt. However human life needs to be insured for an amount, the thumb rule being 7-10 times of one’s annual income, so the planned goals can be met in the event of their untimely demise. There are a whole lot of variants of life insurance. But the most cost effective one is buying a Term Insurance. Simply put, you pay a premium every year (usually) through the life of the policy. In the case of an unfortunate event the Sum Assured is paid to the insured’s nominee. If the insured survives the duration of the policy the policy ceases to exist. There are tons of other variants that return some portion of your investment if you outlive the policy. Though such plans appear to be a better option very simple calculations will clearly show that Term Insurance is the best option. So, go for a Term Insurance. Having a Term Insurance is by far the most important step in your overall financial planning.

B)    Health Insurance: The Health care costs are soaring every year. Having a Health Insurance pay for your treatment is the best way to mitigate the financial impact of an illness. Health Insurance and a Critical Care Illness plan are a must

C)    Unforeseen risks: Murphy’s laws are always at work. A job loss is an unforeseen risk. A sudden business risk or a business opportunity may materialize and you may need some urgent funds to deploy. For such events a contingency fund ~ 6 months of your monthly expenses ~ should be created and kept liquid (Eg: Short term debt funds, Savings account etc.).

Taxation and Estate: The tax code of any country gives you certain concessions on how different classes of income can to be treated and what taxes need to be paid. Your income can be made tax efficient so more of your income stays in your hand within the legal ambit.

Estate planning is best understood as a process of making proper arrangement for the protection and preservation of a person’s total assets for the benefit of his or her family and loved ones. Creating a Will detailing how to distribute/utilize one’s assets will ensure that there is no direct conflict after the lifetime of the maker of the will

 Putting it all together – Here is our Financial Planning in a nutshell: 

• Take stock of your current assets and liabilities
• Define what you need to achieve financially over the next few decades including during your retirement
• Decide how to invest your money in achieving those goals. A mix of equity and debt is recommended across age groups with the tilt towards debt becoming higher as you grow older.
• Make sure you have adequate Term insurance – This is by far the most important step in your overall financial planning. Well, even if you don’t have a plan or never intend to create one just ensure that you have a Term Insurance policy in place so your family is supported.
• Make sure that you have a Health Insurance in addition to what your employer provides
• Create a contingency fund to meet any emergency. If you happen to exhaust the fund rebuild it!
• Ensure you optimally utilize all the tax concessions you may be eligible for
• Plan for the proper transfer of your estate. It is never too early to make your Will.

************ Thus begins our journey to Financial independence ************

So, in your opinion what is the most important take away from this entire post? Share them through your comments below.