CPSE ETF: a Perspective on the Follow-on Fund Offer (FFO)

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What is CPSE ETF?

The Central Public Sector Enterprises (CPSE) Exchange Traded Fund (ETF) is a route for divestment of part of Government’s stake in certain CPSEs. The ETF route was an innovation against the conventional method of sale of shares to investors i.e. either the IPO route or the Offer for Sale (OFS) route. CPSE ETF New Fund Offer (NFO) was launched in March 2014. Units were listed in April 2014 on NSE and BSE. Further Fund Offer (FFO) was launched in January 2017 and another one (FFO2) was launched in March 2017. Response to the NFO and FFOs have been good i.e. higher than the issue size. The combined AUM is Rs 11,500 crore. CPSE ETF is executed by Reliance AMC. 

Composition

There are 11 stocks across sectors. In terms of weightages, the top five companies are NTPC Ltd (19.59%), Coal India (19.17%), Indian Oil Corporation (18.98%), Oil & Natural Gas Corporation (18.92%) and Rural Electrification Corporation (6.19%). The 11 stocks are across sectors e.g. oil, power, mining, petroleum products, finance, etc. The composition has been changed recently; they have dropped Gail India, Container Corporation of India and Engineers India. The ones added are NTPC, NLC Ltd and SJVN Ltd. 

Sectors:

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6 out of 11 companies in CPSE being sector leaders or near monopolies:

  • ONGC & Oil India – Leadership in Oil production

  • Coal India – Monopoly in coal supply

  • Indian Oil Corp. – Leader in fuel distribution & Petrochem

  • Bharat Electronics – Leader in Defence

  • NTPC – Leader in coal-based power generation


Energy Companies: Attractive Valuations

 

  • Total installed capacity of power stations in India stood at 344.69 GW as of August 2018. Coal-based power generation capacity in India, which currently stands at 196 GW is expected to reach 330-441 GW by 2040. 

  • India’s per capita power consumption is 1/4th of the world average and thus there is a lot of scope for growth

 

Oil PSUs: Consumption at Attractive Valuations

Petroleum products (Petrol & Diesel) consumption demand remains strong and is structural. And given the limited capacity additions on the global refining capacity, GRMs environment is expected to remain healthy. 

 

Infra & Engineering: Leadership with MOAT

  • Big opportunity in Government Capex, Logistics & Defence 

  • Market leaders in respective sectors 

  • Excellent balance sheet with net cash, with ability to grow significantly

  • All of the above points towards a good growth opportunity going forward


Concept of CPSE Index

For ease of tracking the composition and performance of the ETF, there is a Nifty CPSE Index, specifically for this purpose. The Index comprises 11 stocks with weightages as discussed earlier. The weightages are a function of the free-float market capitalisation of the constituents.  

 

Attractive Valuation and Superior Dividend Yield – Compared to Other Broader Indices 

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Performance

Market sentiments about PSUs have been negative for some time. Performance of CPSEs in general and the CPSE Index in particular, has been poor. Over the last 3 years till 31 October ’18, CPSE ETF has yielded a return of 5.97% annualized against Nifty total returns index (TRI) of 10.22% annualized. Since inception, CPSE ETF return has been 8.17% annualized against Nifty TRI of 11.47% annualized. 

 

Valuations

The poor performance by itself is a positive. Valuations are that much more attractive now, and makes a case for investment with a long term horizon. As on 31 October ’18, the price-earning (PE) ratio Nifty, on the basis of FY18 earnings, is 25.4. As against this, the PE ratio of Nifty CPSE is only 9.5. This represents a 63% discount against Nifty PE level. Similarly, the price to book value (PB) ratio of CPSE at 1.3 times is at a 62% discount to Nifty PB ratio of 3.5 times. However, the Return of Equity (RoE) is at a similar level; 14.1% of CPSE against 14% of Nifty in FY18.   

 

Forthcoming FFO 

Context: Disinvestment target is between 6,000 – 12,000 crore even though current valuations are low.

 

After the earlier ones i.e. FFO and FFO2 of 2017, the next one i.e. FFO3 is scheduled for the last week of November ’18. As discussed earlier, performance of CPSEs so far has been poor but that makes the valuations (PE and PB ratio) that much attractive and that ROE is at a similar level as the broad index. On top of that, dividend yield of CPSE is superior, even after accounting for the relatively lower price level of CPSEs. Dividend yield of Nifty CPSE index is 5.25% against broad Nifty dividend yield of only 1.27%, as on 31 October ’18. While investors can purchase the ETF anytime, there is a discount available during the FFO period. 

  

Conclusion

For investors looking at the value proposition of CPSEs over the long term through passive management along with the cost saving, there is a case to look at CPSE FFO3. The recurring fund management charges of CPSE ETF are nominal against the actively managed funds, even after considering SEBI’s revised TER norms.   

  

Positives:

  • Attractive valuations

  • Dividends by the CPSE companies are yet to be announced. This is a great opportunity

  • Strong Business models of constituents

 

Watch out for:

The recent negative performance. 

However, as explained earlier, the low valuations make it an attractive investment option.   

 

 

How to earn better post tax returns using bond funds

Article published on Moneycontrol on 11 January 2017. Please click here for the link

This article explains how bond funds can be used to optimize post tax returns on fixed income portfolios.

Joydeep Sen

For investment decisions, tax efficiency is something investors always look at. Though tax efficiency is an essential ingredient of an investment operation, it should not be the sole norm of picking an investment. Today we will however try to understand how to optimise tax incidence on your fixed income portfolio using bond funds.

Fixed income investments are routed mostly through the mutual fund route. Investors prefer mutual funds because mutual fund offers the advantages of liquidity and accessibility. You can sell mutual fund units to fund house and get your money quickly. The minimum investment in bond fund starts at Rs 5000 which makes it affordable for even the small investor. In terms of tax efficiency, provided you have a horizon of three years and invest in the growth option, debt oriented mutual funds are much more tax efficient than bank fixed deposits. Let us see how.

Interest on bank deposits is taxable at the slab rates, and at the highest tax bracket it is taxable at 30% plus 15% surcharge (if you earn more than Rs 1 crore per year) plus 3% cess = 34.54%. Otherwise, at the highest tax bracket, it is at 30% plus 3% cess = 30.9%. Investment in debt mutual funds, for a horizon less than 3 years, may be either (a) in the growth option, which is taxable as short term capital gains (STCG) at the slab rates as discussed above or (b) in the dividend option, where there is a dividend distribution tax (DDT) applicable, @ 28.84% for individuals and 34.5% for corporates.

The tax efficiency kicks in for a horizon of more than three years. It is taxable as long term capital gains (LTCG) with the benefit of indexation. As an illustration, let us say the initial investment value is Rs 100, the fund returns are 8% CAGR i.e. Rs 100 becomes Rs 125.97 over 3 years and the cost inflation indexation (CII) is 4.5% per year. By virtue of CII, the purchase cost gets indexed to Rs 114.12. Hence, the taxable component is Rs 125.97 minus Rs 114.12 = Rs 11.85. At a LTCG rate of 20% plus 15% surcharge (if you earn more than Rs 1 crore per year) plus 3% cess i.e. 23.69%, the tax is Rs 2.81 and the net return is Rs 25.97 minus Rs 2.81 = 23.16. For investors earning less than Rs 1 crore per year, tax will be little lower. If it were a bank deposit, it would be taxed at 34.54% and the net return would be Rs 17 instead of Rs 23.16.

In mutual funds, for investments in growth option of debt oriented funds, there is another avenue for tax planning. For investors who have short term or long term capital loss, short term capital gains from mutual funds can be set off, leading to tax efficiency. For example, if there is short term capital loss from equity, it can be set off.

Within the mutual fund space, let us now look at other categories of funds, with some deviation from conventional fixed income funds, but which are relevant for fixed income oriented investors. There is tax efficiency in (a) Arbitrage Funds and (b) Equity Savings Funds. Let us understand the nature of these funds.

Arbitrage Funds play with the price differential, known as arbitrage, between equity shares in the cash market and stock futures market. This is done for 65% or more of the portfolio, and the balance is invested in money market instruments. These funds are technically equity funds and enjoy the tax efficiency, which is no LTCG tax for a holding period of more than 1 year, no dividend distribution tax, only STCG tax for holding period of less than 1 year, which is 15% plus surcharge and cess. To be noted, though these are technically equity funds, there is no directional call on the equity market. That is to say, equity stock prices may move up or come down, but arbitrage funds derive their income from the stock - futures arbitrage. The break-even return, for a return of say 6.25% from arbitrage funds, at a tax rate of 28.84% (which is the DDT rate for individuals in debt funds) is 6.25% / (1-28.84%) = 8.78%. In the current situation, a return of 8.78% or higher from debt funds is ambitious.

Equity savings funds are a different breed altogether. There is exposure to equities, unhedged, to the extent of 25% to 45% of the portfolio. There is an arbitrage component as well, like arbitrage funds. Put together the long unhedged component and the hedged component make up at least 65% of the portfolio. This makes it technically an equity fund and the tax treatment is that of an equity fund. The difference between Arbitrage Funds and Equity Savings Funds is that in Arbitrage, there is no open position in equities as it is completely hedged, whereas in Equity Savings there is unhedged exposure to equities of 25% to 45% of the portfolio – which makes the later a bit risky bet. Conservative fixed income investors can look at Arbitrage Funds for an allocation in the portfolio. If you are willing to take a bit more risk with your money consider investing in equity saving fund.

In our next article, we will discuss tax implications of investments directly in bonds.

Author is an independent financial advisor.

Know the tax treatment of gains on bonds before investing

Article published on Moneycontrol on 19 January 2017. Please click here for the link

Bonds offer interest and capital appreciation to investors. It is better to know the basis of taxation and the rate of tax.

Joydeep Sen

Returns from investments in bonds come from interest receipts and capital appreciation. The bulk of the returns come from interest payments which is fixed, as against capital gains, which is uncertain and a relatively smaller component of the overall returns from a bond. Price appreciation is not only a relatively smaller component but also, till it is booked, it remains on paper only. The interest (technically known as coupon) inflow is taxed at the marginal slab rate, which at the higher end is 30% plus surcharge (as applicable) and cess. Price appreciation is taxed as capital gains; long term if held for more than one year for a listed bond and three years for an unlisted bond. For listed bonds held for more than one year, long term capital gains tax is 10% plus surcharge (as applicable) and cess.

If the cash flows from the issuer of the bond to the investor is treated as capital appreciation instead of coupon, there would be tax efficiency. In zero coupon bonds, where there is no interest payment in the interim from issue to maturity, there is a case for treating it as capital appreciation. There are certain notified zero-coupon bonds, issued by NABARD and REC, where the differential between maturity price and issue price is treated as capital appreciation and taxed accordingly. Hence in the NABARD and REC notified bonds, entire price appreciation is treated as LTCG for a holding period of more than one year. This generates considerable tax efficiency, taxation rate being 10% as against 30%.

For other non-interest paying bonds, which may also be termed as zero coupon or ‘redemption at a premium’ or ‘issue at a discount’, gains are taxed as interest rather than capital appreciation. Going by provisions of the law, for plain vanilla non-notified zero coupon bonds, the differential between issue price and maturity value is taxable as interest. However, investors in such bonds may get in touch with his/her tax consultant as there may be scope for generating tax efficiency in non-coupon paying bonds by treating it as capital gains, based on precedence.

Capital gains can be set-off against capital loss. LTCG from selling a listed bond after a holding period of more than one year, can be set off against long term capital loss from say debt mutual fund or unlisted equity. While as per theory it can be set off against long term capital loss from debt mutual fund, it is highly unlikely that over a holding period of 3 years debt would give negative returns. Loss from unlisted equity is a more probable method for setting off.

For companies subject to MAT taxation, everything is subject to the MAT rate of taxation, which is 18.5% plus surcharge (as applicable) and cess. Hence the impact of coupon flows is not as much as it is taxable at a lower rate than 30% (plus surcharge and cess) for other investors. For capital gains, there is no special attraction for making it long term as the tax rate is anyways higher than 10%. Companies subject to MAT taxation need not consider zero coupon bonds; they may settle for regular coupon paying bonds, either listed or unlisted.

In tax-free PSU bonds, the coupon payments are tax-free, only the capital appreciation is taxable. These bonds being listed, the holding period required for treatment as long term capital gains (LTCG) tax is one year. Investors in tax-free PSU bonds should hold for one year, unless there is a cash flow requirement, to avail of LTCG taxation of 10% (plus surcharge and cess) against STCG rate of 30% (plus surcharge and cess). To reiterate, this is only for the price appreciation aspect as the coupon receipts are tax-free. The favourable tax-treatment of tax free bonds has made investors opt for tax free bonds. Falling interest rates further push up the prices of these bonds. Both these factors are responsible for premium pricing these bonds enjoy.

The way to look at tax-free PSU bonds, for comparison purposes, is to look at the ‘pre-tax equivalent’. As an illustration, let us say the yield on a tax-free PSU bond is 6.1% and taxation rate is 30%, no surcharge, and 3% cess i.e. 30.9%. The approximate ‘pre-tax equivalent’ in this case is 6.1% / (1-30.9%) = 8.83%. The concept is, if one invests in a taxable instrument, assuming no LTCG, tax is payable on the coupon at 30.9%. On the same plane, the comparable yield level for a tax-free PSU bond is 8.83%, which is attractive in the current market situation where the yield level on top-rated PSU bonds is approx 7%.

For purchase of a bond in the secondary market (as against primary market) and sale in the secondary market, the purchase price will include accrued interest for the period from the last interest payment date to the transaction date. The transaction should be documented accordingly, specifying the price as such and the accrued interest component. While selling the bond, the tax on price appreciation as capital gains will be on the ‘price’ component and not the accrued interest part. This clarity will help investors in filing proper tax returns. 


Author is an independent financial advisor.

Want fixed income? Try arbitrage funds, they attract no dividend distribution tax

Article published in Financial Express on 20 January 2017. Please click here for the link

Arbitrage funds attract no dividend distribution tax and no LTCG tax for holdings beyond one year

The term arbitrage refers to simultaneous purchase and sale of assets to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms.

Price differential

Arbitrage funds play on the price differential between equity shares in the cash market and stock futures market. Typically, the price at which a stock is sold in the stock futures market is higher than the price at which it is purchased in the cash or spot market. The price difference represents the ‘cost of funds’ for the remaining number of days between the date of transaction and ‘expiry’, which is the last working Thursday of the month.

The concept of ‘cost of funds’ is that a trader is deferring a transaction from the current date to the last Thursday of the month. For this deferment, some other trader is stepping in and conceptually ‘funding’ it. When a trader in the market is purchasing a stock in the stock futures market, the arbitrage fund manager is selling the stock at a price higher than the cash market, and this price differential represents the ‘cost of funding’.

The definition of an equity fund, for tax treatment purposes, is 65% or more of the portfolio, which is measured as an average of last one year, on the first and last working day of the month. For 65% or more of the portfolio in an arbitrage fund, the fund manager purchases equity stocks and sells the same stock in the futures market. The sale position in the stock futures market is a little higher than the purchase position, which is the fund’s earning. The balance is invested in money market or debt instruments.

Tax efficiency

These funds are technically equity funds and enjoy the tax efficiency of an equity fund over debt funds. There is no long term capital gains tax for holdings of more than one year, no dividend distribution tax and short term capital gains tax for holdings of less than one year is 15% plus surcharge and cess. Arbitrage funds are suitable for fixed income oriented investors. Conservative fixed income investors can look at arbitrage funds for an allocation in the portfolio, since there is no open position in equities as it is completely hedged.

For the purpose of comparison of returns with fixed income funds, it is to be seen like this: Let us say you are an individual and the DDT rate is 28.84%. Let us assume the debt fund generates a return of 8.78%. Hence your net return is 8.78% minus 28.84% of that, i.e., 6.25%. An arbitrage fund being free of DDT needs to generate only 6.25% return to match the debt fund. Now, a return of 6.25% from arbitrage fund is likely, but a return of 8.78% from debt fund is ambitious in the current context. Hence arbitrage funds look attractive.

There is a variant of arbitrage funds floated recently by an AMC, where 20-25% will be hedged against Nifty Futures (and not stock futures) and the fund manager will purchase stocks that may not exactly match the Nifty basket. The purpose is to outperform Nifty through selection of stocks. If the fund manager outperforms Nifty, this fund will outperform conventional arbitrage funds.

Joydeep Sen

The writer is an independent financial adviser and has authored books on fixed income.

Fixed income investment: Here’s how investors can bond with the best

Article published in Financial Express on 20 February 2017. Please click here for the link

Fixed income investments happen mostly through the mutual fund route, and rightly so, because of the advantages of accessibility and liquidity.

Joydeep Sen

Fixed income investments happen mostly through the mutual fund route, and rightly so, because of the advantages of accessibility and liquidity. However, investors need to be aware of the avenue of direct exposure in bonds, for the sake of wider choice.

Tax-free bonds
The biggest drawback of the direct bond route is lack of liquidity in the secondary market. This problem is, however, not there in one segment of the bond market: Tax-free PSU bonds. These bonds are rated top notch, i.e., AAA, and have implicit government support.

The interest payments on these bonds are free of tax, but there would be capital gains tax if you sell before maturity at a profit. The method for dealing in these bonds is similar to that of dealing in equity shares: You have to have the basic set-up with your stock broker. These bonds are listed in the capital market segment of exchanges, and hence can be dealt with in a manner similar to that of equity stocks.

Returns on these bonds are attractive, even at current levels after a rally and yields having come down from higher levels earlier. In market parlance, the yield is referred to as YTM, which stands for yield to maturity. In simple terms, the yield is the return you would get, if you hold the bond till maturity, expressed as compound annualised interest rate. The YTM on tax-free PSU bonds currently is around 6.1%.

The proper perspective to look at the yield on tax-free bonds is the ‘pre-tax equivalent’ and compare it with a taxable instrument, though technically it is tax-free. Taking the tax-free bond yield at say 6.1% and the tax rate at 30.9%, the pre-tax equivalent comes to 6.1% / (1-30.9%) = 8.83%. The yields available in the market for taxable AAA rated PSU bonds is much lower than 8.83%, hence it makes sense to buy these bonds.

Taxable PSU bonds

The other option is taxable PSU bonds / private sector bonds / bonds rated AAA or lower. Primary issuances of bonds happen from time to time as issuers access the market for raising resources, and you can purchase these for relatively small amounts as well.

It is advisable to go with higher rated bonds, AAA or at least AA, to reduce the credit risk in your portfolio. The issue of liquidity becomes relevant again: If you want to sell in the secondary market before maturity, while it is possible to sell, liquidity in instruments rated less than AAA is on the lower side. Best scenario is if you can hold the bond till maturity.

In the secondary market, the ticket size for negotiated deals is on the higher side as the market is wholesale in nature. It is possible to trade relatively small quantums as well, for instance, when a desperate seller is on the exchange, offering a high YTM to encash his holding. However, to take advantage of such offerings, you need to actively track the website of the exchange and need guidance from your debt broker.

You may purchase tax-free AAA rated PSU bonds from the secondary market, as these issuers are not coming with primary issuances as of now, and subscribe to primary issuances of AAA / AA rated issuers, preferably for a tenure matching your cash flow requirements.

The writer is an independent financial adviser and has authored books on fixed income

Go for balanced funds for risk adjusted returns

Article published in DNA on 23 March 2017. Please click here for the link

We tend to evaluate performance of funds by returns only, which is what is relevant for the investor. For analytical purposes, however, the parameter is not just the returns, but risk-adjusted returns i.e. Funds having moves more than the market index will outperform the peer group during a bull phase but will lose more than the market in a bear phase.

Balanced Funds have equity allocation ranging 65% to 70%. For an investor positive on India's growth story, the choice is between focused equity fund on one hand and a balanced fund with 65%-70% allocation to equity and 30%-35% to debt, on the other hand. Though in the long run, returns from equity are higher than debt, debt component adds stability to returns during phases of market volatility. In the long run, adding up the phases of relative underperformance against focused equity funds and outperformance in bear periods, balanced funds deliver good risk-adjusted returns.

To look back at performance as a straight line and not as per bullish and bearish phases, over the last one year till 3 March, Crisil Balanced Funds - Aggressive Index shows a return of 16.5%, lower than Nifty 50 return of 18.9%. Over last five years, balanced funds return is 10.6% compound annualised per year, similar to Nifty return of 11%. The unique selling point is that over last 10 years, this category has yielded 9.7% compound annualised per year against Nifty return of 9.5%. This, along with the 30%-35% allocation to debt and consequent lower volatility. Hence, it offers the best of both worlds, competitive returns over the long term along with lower volatility.

The appeal of balanced funds can be gauged from the assets that are being built up in this category. The assets under management (AUM) in this group of funds, which was Rs 26,400 crore as on 31 Mar 2015, moved up to Rs 39,000 crore on 31 Mar 2016 and is currently at Rs 71,000 crore on 31 Jan 2017. While equity assets have grown as well over this period, growth in AUM of balanced funds has been faster. The AUM of equity funds has grown from approximately Rs 3.67 lakh crore on March 2015 to approx Rs 5.65 lakh crore in January i.e. the current AUM is 1.54 times that of January 2015. As against this, the AUM of Balanced Funds has grown to 2.7 times, from Rs 26,400 crore on March 2015 to Rs 71,000 crore currently.

Since the market is peaking and quite a few positives have been discounted at current levels, balanced funds are suitable for investors who want to benefit from the India growth story but prefer a relatively lower volatility, leading to better risk-adjusted returns over the holding period.

The writer is independent financial advisor and author

Bond investments through secondary market can offer you a better deal

Article published on Moneycontrol on 23 March 2017. Please click here for the link

For retail investors intending to purchase bonds in lot size of say few lakh rupees, when there is no primary issue available or the primary issue is not matching up to the risk-return profile expected, one should go for purchases in the secondary market.

Joydeep Sen

For fixed income oriented investments, the preferred avenue is mutual funds. For direct investments in bonds, it is advisable to invest in tax-free bonds as these are more liquid and yields are attractive. However, the investor should be aware of the options on the table, to take an informed and judicious decision. In this article, we will discuss the options for direct investment in regular taxable bonds. Taxable bonds with attractive yields and decent credit quality are particularly suitable for tax-free investment entities (e.g. tax-free Trusts) and companies subject to MAT rate of taxation. The reason is, the ‘pre-tax equivalent’ for a tax-free bond at a tax rate of say 30% is approx 6.15% /(1-30%) = 8.79% whereas at a tax rate of say 20%, it is 6.15% /(1-20%) = 7.69%.

The secondary market being wholesale and less liquid, trades happen mostly on the ‘phone market’ i.e. transactions are negotiated and finalized over phone with bond dealers. The size of these trades are in HNI lots, mostly upwards of Rs 1 crore. It may be in lot size of less than Rs 1 crore also, if the client is an HNI. For retail size investments, primary market is a suitable route as investments can be made in retail as well as HNI lots. The limitation of the primary route is that it is subject to availability, as and when an issuer comes up with a bond issue.

For retail investors intending to purchase bonds in lot size of say few lakh rupees, when there is no primary issue available or the primary issue is not matching up to the risk-return profile expected, one should go for purchases in the secondary market. The process of purchasing a bond from the secondary market, from the investor’s perspective, is similar to purchase of a tax-free bond. S/he has to have a trading account with a stock-broker and place the purchase instruction. There are bonds listed in the NSE capital market segment and BSE debt market segment, and as per the client instructions, the broker will execute the purchase / sale order.

The bond market is not as liquid as the equity market and the purchase / sale order may not be executed the same day as you place it. The investor has to be patient and repeat the order next day. The segment that is relatively more liquid in the secondary market for bonds is tax-free PSU bonds. Next in terms of liquidity are other (i.e. taxable) AAA rated bonds. Bonds rated less than AAA have relatively low liquidity and it is here that the investor needs to be patient. The lack of liquidity in the secondary market is one of the reasons Mutual Funds is the preferred route for debt investments.

The arguments in favour of direct bond investments vis-à-vis the Mutual Fund route are (a) saving of costs: in mutual fund the recurring management expenses are charged every year whereas in bonds it is a one-time transaction cost, which also is on the lower side and (b) matching of investment horizon with maturity of the instrument. In mutual funds, FMPs come with a defined maturity date but the tenure is mostly 3 years or little more than 3 years. In direct exposure to bonds, the investor can do ‘laddering’ of maturity as per cash flow requirements at tenures of say 2 years, 4 years, 6 years, 8 years and so on. To achieve this, you have to purchase bonds of desired maturities.

The credit risk of bonds has to be kept in mind while investing. Either it should be rated AAA or if it is a less-than-AAA rated bond, the issuing corporate should have goodwill to evoke confidence. It is advisable to stick to bonds rated AA and above from the credit risk perspective. A rated bonds also are investment grade, which is defined as BBB and above, but go for an A rated bond only if you are sure about the goodwill of the Issuer.

In the table below, we see some of the bonds that are available in the secondary market:

 

Source: NSE, BSE Stock Exchange & Phillip Capital Fixed Income Research

Please note, the bonds mentioned above are for illustration and guidance purposes, and is not an exhaustive list or recommendation to buy or sell. What we observe above is the difference in yields due to market perception about the issuer. Both Mahindra & Mahindra Financial Services and India Bulls Housing Finance Limited are rated AAA, but there is a differential of approx 0.45% in yield. Similarly, both L&T Infra and Edelweiss Housing Finance are rated AA, with a differential in yield of approx 0.62%. To re-iterate, you can settle for higher yields if you are comfortable about the issuer.

For wholesale market lots, which is more than Rs 1 crore, the negotiated yield level for the deal would be more or less in line with prevailing yield levels in the market. In retail lots illustrated above traded at NSE and BSE, which is in Rs lakhs, yield levels may be higher, depending on the desperation of the seller. The yield levels in the table are higher by approx 25 basis points (0.25%) than comparable levels in the institutional market. Sometimes the yield differential is even higher and savvy investors have to monitor the websites of NSE & BSE to avail of such opportunities. To be noted, for retail lots at NSE and BSE, the quoted price includes the accrued interest, which is referred to as ‘dirty price’ whereas in wholesale deals, the ‘clean price’ and accrued interest is calculated separately.

Author is an independent financial advisor.

RBI Monetary Policy Committee: Need for better communication

Article published on Moneycontrol on 30 March 2017. Please click here for the link 

In India, the initiation of the committee process was expected to make policy rate decisions more scientific, more debated and bias-free.

Joydeep Sen

Before the formation of the Monetary Policy Committee (MPC), the RBI policy rate formulation used to be a one-man decision, that of the Governor. There was a Technical Advisory Committee (TAC) meeting held before the Policy Review meeting, but the advice of the TAC was not binding on the Governor. Globally, most central banks take decision through the committee process. In a study conducted by Mahadeva and Sterne in 2001 found that of the 94 central banks in their sample, 79 take decisions in a committee.

In India, the initiation of the committee process was expected to make policy rate decisions more scientific, more debated and bias-free. The conceptualization of the committee process was done by the Government during the tenure of Dr Raghuram Rajan. He supported the committee process, stating the benefits: (a) multiple heads are better than one (b) it takes the pressure off one individual and (c) scope for mistakes is that much lower. The implementation of the MPC happened immediately after the tenure of Dr Rajan; the Policy Review meeting held on 4 Oct 2016 was the first ‘committee’ meeting. It is a 6-person committee, comprising 3 persons from the RBI (including the Governor) and 3 external economists nominated by the Government.

However, the way the committee has functioned so far has not been upto expectations of market participants. There have been three committee meetings so far, and in all the three meetings, voting has been 6-0 in favour of the decision taken. While there is nothing wrong in unanimity, the point of debate is that we are not in a phase of secular uptrend or secular downtrend of interest rates. Complete unanimity implies a lack of healthy difference of opinion, expected during a juncture of change from ‘accommodative’ to ‘neutral’ policy stance, that too in a situation of after-effect of demonetization and inflation being broadly within target. The rationale given by the committee members for the decision taken, as published in the Minutes and stated during the post-meeting media interactions, at times does not give a solid argument in favour of the decision.

What, then, is the solution? The committee should be maintained, but the process should be strengthened. To address the confusion in the market about the future outlook of the MPC, we should have a system of projected signal interest rates. The projections would not be binding on the RBI and would be subject to change along with change in economic variables.

To draw a parallel, in the US, the Fed FOMC issues a policy statement following each regular meeting that summarizes the Committee's economic outlook and the policy decision at that meeting. The US Fed schedules eight meetings per year. In four of these meetings, participants submit individual economic projections in conjunction with four FOMC meetings. A compilation and summary of these projections (without attribution) is circulated to participants, and a detailed summary of the economic projections (the Summary of Economic Projections, or "SEP") is included as an addendum to the minutes that are released three weeks after the meeting. The SEP is popularly known as the ‘dot plot’ because the projections are shown as dots in a graph.

The US Fed gives projections on GDP growth, unemployment and inflations. We also have a similar system: the RBI shows a ‘fan chart’ on projections of GDP and inflation. What we do not have is projections on interest rates, in lines of the SEP or ‘dot plot’. What we need to have is the projection of interest rates, namely the signal repo rate of the RBI, of the six committee members. The publication of the projections may be without attribution to the individual members, as it would make them more comfortable.

The benefit of this move will be that currently, market participants glean through the projections on GDP and inflation, and statements of the individual committee members on the rationale of the decision taken, to gauge the rate outlook. However, there are communication gaps on the future outlook of the committee - what they have in mind and the way it is perceived by the market. The rate projection (dot plot) will make it more objective, doing away with the uncertainties of interpretation of the published language.

The author is an independent financial advisor.

Rating agency default study: What is in it for investors?

Article published on Moneycontrol on 20 April 2017. Please click here for the link

Till date, no long term instrument rated AAA by CRISIL has ever defaulted. For instruments rated AA, the average 3-year default rate is less than 1 percent, which means if you hold an instrument rated AA+ or AA or AA- for 3 years, on an average, the incidence of default has been less than 1 percent.

Joydeep Sen

There are some dark clouds on the horizon: banks are ‘stressed’ with stressed assets, credit offtake from banks by the corporate sector is stagnant due to idle capacities, GDP growth rate in the demonetisation quarter coming in at 7.1% but market participants sceptical about it. In this backdrop, it is interesting to see what message CRISIL’s latest Default Study conveys to us.

Interestingly, CRISIL’s definition of default is any missed payment. That is to say, if an interest payment is not serviced on due date, it is treated as default. In 2016, the overall default rate was 4.2%, similar to 4.1% of previous year, but that is due to high proportion of firms rated less than investment grade. Of the 13,000 firms rated by CRISIL as on December 2016, more than three-fourths had rating of BB or lower, which is less than the investment grade rating of BBB and above. From one perspective, default by companies rated junk should not be alarming; most of the cases of default of 4.2% in 2016 were from sub-par companies. However, from another perspective, more than three-fourths of firms approaching CRISIL for rating being categorized as speculative grade is a cause for concern. Eight years ago, a fifth of the 900 companies rated by CRISIL was BB and lower. The deterioration over eight years shows the pressure on the corporate ecosystem.

In the gloomy scenario discussed above, the saving grace is that the default rate on instruments rated AAA is zero. Till date, no long term instrument rated AAA by CRISIL has ever defaulted. For instruments rated AA, the average 3-year default rate is less than 1%, which means if you hold an instrument rated AA+ or AA or AA- for 3 years, on an average, the incidence of default has been less than 1%. This is not alarming. Even on papers rated BBB, which is just investment grade, the 3-year average default rate is 5%.

The other relevant information from the rating agency is the upgrade-downgrade ratio, which compares the number of upgrades with the number of downgrades in the year. In fiscal 2016-17, the ratio was 1.22; there were 1335 companies upgraded against 1092 downgraded. This is positive as more companies were upgraded. The ratio is similar to 1.29 in 2015-16. There is another variant of this ratio called debt-weighted upgrade ratio, where it is not just the number of companies but the number of companies weighted by the amount of their debt. This ratio is 0.88 in 2016-17, much better than 0.31 in 2015-16. The reason this ratio is lower than the simple number ratio of 1.22 is that companies downgraded are bogged down by large quantum of debt, as compared to companies upgraded, and this pulls down the weighted ratio. The significant improvement in this ratio over previous year shows that the problem of bad debt is bottoming out. This also implies that the NPA problems saddling banks are old legacy issues.

Now that we have seen the rating agency perspective, which shows things are stable to marginally improving, let us now look at what it means for investors. For investors investing directly in bonds, once a company goes into default grade, it is a dilemma. While the logical advice is to sell it off, practically, once the bad news is out, there would not be any buyer or a buyer would quote an excessively high yield i.e. low price. To play it safe, investors should stick to AAA rated bonds where the historic default rate is zero, or at most AA rated instruments where the average default rate is less than 1%.

It is advisable for investors to take the mutual fund route for investment in bonds, as the bond market is largely wholesale, dealing in big lot sizes. Mutual funds offer liquidity in the form of redemption with the AMC, affordable investment sizes, and professional investment management. The credit quality of the portfolio of the fund can be gauged by looking at the credit ratings of the instruments in the portfolio. Since rating of AAA or AA gives us comfort, as discussed above, conservative fixed income investors may confine to funds mandated to invest in highly rated bonds only. The default rate of 4.2% in 2016 was mostly due to companies rated below investment grade junk, where a mutual fund would not invest anyway.

Fixed income oriented investors who have a slightly higher risk appetite may allocate a part of the portfolio to corporate bond funds of reputable AMCs that invest in a combination of AAA, AA and A rated securities, for the higher interest accrual from the credit exposures, as there is a professional team tracking the A and AA rated companies.

Author is an independent financial advisor.

Asset allocation: Looking to book profits in equity now? Here’s why you should shift to short term bond funds

Article published in Financial Express on 28 April 2017. Please click here for the link

It has been proven that portfolio allocation leads to long-term optimum results on investments. Awareness among investors is gradually increasing on the imperative of allocation.

It has been proven that portfolio allocation leads to long-term optimum results on investments. Awareness among investors is gradually increasing on the imperative of allocation. Another aspect of portfolio management, which is equally important but not widely followed, is portfolio rebalancing. A classical argument of the investing community against the fund management community is that hardly anybody gives the exit call at market peak and the argument from fund managers is that it is difficult to call the peak as the market is by definition uncertain. The other side of the coin is, hardly any investor buys at market bottom, though fund managers give the ‘buy’ call.

A partial solution to the issue is portfolio rebalancing when the market seems to be peaking or bottoming. This is not about calling the exact top or bottom, but following a discipline when the market is running ahead. Let us take an example; our investor in this example follows an allocation ratio of 60:40 i.e. 60% in equity and 40% in fixed income. When the market crashed in March 2009 with Sensex touching 8160 after forming a peak of 20376 in December 2007, his equity allocation must have been significantly lesser than 60% due to erosion in market value, depending on time of entry. If he did a portfolio rebalancing by purchasing equity stocks, he would have purchased cheap.

This is not about calling the bottom of the market; even if it was done when the market was on the way down towards 8160, he would have benefitted. Similarly, when the market peaked in January 2011 with Sensex at 20,561, it was time to rebalance the portfolio by booking profits in equity. If he did it sometime towards end of 2010, it would have been good for him. Now let’s come to the present day context. Let’s say the investor with a 60:40 equity: debt allocation, constructed his portfolio sometime in August 2013 when the Sensex was at approximately 18,000. Given the current Sensex level of around 30,000, his allocation of `60 to equity has now become 30000/18000 X 60 = `100.

Assuming a return of 8.5% in fixed income, his allocation of `40 to debt has now become approximately `54. On the total portfolio value of `100 + `54 = `154, the allocation to equity has now become `100/154 = just under 65%. Hence on an intended allocation of 60:40, the current allocation is not very skewed. However, there is a case for periodic review, to revisit the risk appetite and horizon of the investor.

If the equity component is a dedicated long-term investment, then it may be left as it is, unless the market runs up significantly in the near to medium term. Otherwise, depending on the risk appetite and horizon of the investor, if the market runs up fast in the near to medium term, partial profit booking and rebalancing in favour of 40% in debt may be considered.

Rebalancing faces a psychological hurdle: shifting from a high return avenue (this is giving me 15% return!) to a low return avenue (expectation from debt is only 7.5%!). On the other side, when the market is bottoming, one tends to hold on (it will become even cheaper after a few days, I will buy then). This is where you have to separate your emotions from your financial investments.
The other question in rebalancing is, identifying the next best avenue. There is an expectation that it should have a similar return. To be noted, the next avenue should have a negative correlation with the existing one, i.e., expected to move in opposite direction in similar market conditions. That is where you are diversifying your portfolio.

In the current context, if you are booking profits in equity and coming to fixed income, do not take the risk of a long bond fund as the interest rate cycle is likely to be stable for the time being, with the rate cut cycle having come to an end. Rather be in conventional short term bond funds and wait for the next significant change in market fundamentals.

The writer is managing partner, Sen & Apte Consulting Services LLP

Which hybrid mutual funds should you choose?

Article published in Mint on 4 May 2017. Please click here for the link

To compare between balanced funds and equity savings funds, as long as you have an adequate investment horizon and risk appetite, balanced funds may be the better choice

The India growth story remains attractive, but the market is in a fair valuation range. The decision to allocate towards equity is easier when the market is at a relatively cheap valuation level. At this juncture, it is advisable to do a judicious allocation to equity and debt according to the risk appetite and horizon of the investor. The allocation to equity (high volatility-high return) and debt (low volatility-low return) can be done either a) through focused allocation to equity and debt funds, or b) through hybrid funds where the fund manager maintains the ratio between equity and debt. Here’s a look at the parameters that one should compare between the two categories of funds.

Balanced funds, which are a type of hybrid fund, maintain a minimum 65% allocation to equity, which is required for equity taxation rules—if the equity component is less than 65% on a one-year average basis, the fund is treated as a debt fund and taxation would be adverse. Most balanced funds have 65-70% equity allocation.

The other category of hybrid funds is equity savings funds, with allocation to debt, equity and arbitrage, i.e., equity cash-futures hedged exposure. They have an overall 65% allocation to equity to maintain the equity taxation; 30-40% is open or unhedged exposure to equity; and 30-35% is hedged with matching sale position in the stocks in the futures segment.

In the cash-futures hedged component, the returns come from the price differential in the scrip between the cash segment and futures segment of the exchange, and not from stock prices going up.

The strategy behind equity savings funds having 30-40% ‘actual’ exposure to equity, is conceptually a step-up over monthly income plan (MIP) funds, which have 15-20% exposure to equities. But participation in equity upside from the growth in the Indian economy is limited to 30-40% in equity savings funds against 65-70% in balanced funds. So, from this perspective, balanced funds offer better participation, as long as you have an adequate investment horizon.

 

There is another risk in equity savings funds—which is just a possibility with no timeline to it—on the taxation aspect. The arbitrage component is not a real exposure to equity price movement and if someday the favourable tax treatment to these funds as equity funds is withdrawn, taxation would be akin to debt funds. Nobody knows whether this will happen or not, but the tax treatment is based on a provision in the rules and not on the effective 65% exposure to equities.

In a debt fund, there is a dividend distribution tax (DDT) of 28.84% for individual investors and 34.61% for others. There is no DDT in equity funds. In the growth option in equity funds, there is no long-term capital gains tax either after a holding period of one year. In debt funds, there is short-term capital gains tax at the marginal slab rate up to 3 years of holding. Long-term capital gains tax, after 3 years, is lower but not nil as in equity funds.

The industry exposure to the two categories of funds gives us a perspective on what to prefer. The assets under management (AUM) of balanced funds is around Rs77,000 crore as on end-February 2017. As against this, the AUM of equity savings funds is about Rs5,700 crore. Though the latter type of fund is relatively new as a category and balanced funds have been around in the market for decades, the vast difference in investor preference does tell a story.

Now let us look at performance. It is not an apple-to-apple comparison as the extent of effective equity exposure is different. But we still need to look at performance since we are deciding between the two categories of funds. Over the past one year (till 24 March 2017), returns from a basket of 25 balanced funds was 19.2% on an average. Over the same period, average returns from a basket of 12 equity savings funds (the number of funds in this category is lesser) was 12.6%. To look at a longer period, over 3 years, average returns from 23 balanced funds was 17%. Three-year returns from five equity savings funds (number of funds with 3-year performance) was 10.4% on an average. This reiterates that ‘open’ equity exposure being lower in equity savings funds does not provide the return upside.

To summarize, it is better to do a focused allocation to equity and debt funds, but in that option, the debt funds would be relatively tax inefficient. To compare between balanced funds and equity savings funds, as long as you have an adequate investment horizon and risk appetite, balanced funds are better by virtue of better risk-adjusted returns versus equity funds, higher exposure to equity than equity savings funds and meaningful participation in the equity market, and cleaner tax efficiency than equity savings funds.

Joydeep Sen is managing partner, Sen and Apte Consulting Services LLP

Why investors must keep InvITs on their radar

Article uploaded on Moneycontrol on 15 May 2017. Please click here for the link

An InvITs is a pool of money for investing in infrastructure projects and distribution of the earnings to the unit holders.

Joydeep Sen

When it comes to investment options, the more the merrier. Initially it may cause some confusion, but once you get a hang of it, you have one more dish if it suits your palate. Infrastructure Investment Trusts (InvITs) are one such new avenue. SEBI issued InvIT guidelines way back in September 2014, but the first product hit the market now, in May 2017. Real Estate Investment Trusts (REITs) are yet to take off.

An InvITs is a pool of money for investing in infrastructure projects and distribution of the earnings to the unit holders. An InvIT issues units that are listed at the Stock Exchange. In that sense, InvITs are like exchange traded funds (ETFs) of mutual funds. The difference is, in a mutual fund, the underlying portfolio of shares or bonds change in value every day and there is an NAV declared every day. An InvIT invests in the projects which are identified as special purpose vehicles (SPVs) that are not valued everyday but once in six months for publicly offered InvITs. Both InvITs and mutual funds are regulated by SEBI.

InvITs are set up as a trust and registered with SEBI. An InvIT involves four entities: Trustee, Sponsor, Investment Manager and Project Manager. The trustee, who oversees the role of an InvIT, is a SEBI registered debenture trustee and he cannot be an associate of the Sponsor or Manager. ‘Sponsor’ means promoters and refers to any company or body corporate with a net worth of Rs. 100 crore which sets up the InvIT and is designated as such while applying to SEBI. Promoters or Sponsor, collectively, have to hold at least 25 percent in the InvIT for minimum three years. Value of the assets owned/proposed to be owned by InvIT shall be at least Rs 500 crore. Minimum issue size for initial offer is Rs 250 crore. InvITs are allowed to add projects in the same vehicle in future so that investors can benefit from diversification as well as growth in their portfolio.

Given the challenging phase of infrastructure in the country today, InvITs may provide an alternate source of funds. Several existing infrastructure projects which are under development in India are delayed and ‘stressed’ on account of varied reasons like increasing debt finance costs, lack of international finance flowing to Indian infrastructure projects, project implementation delays caused by various factors like global economic slowdown, cost overruns, etc. InvITs may offer a source of long-term re-finance for existing infrastructure projects. InvITs may help in attracting international finance into Indian infrastructure sector. These would also enable the investors to hold a diversified portfolio of infrastructure assets.

The first InvIT in India, floated by IRB, which specialises in road assets, closed its public offer on 5 May ’17 and was subscribed approx 8.5 times i.e. received an enthusiastic response. India Grid Trust (power transmission assets) followed. There are more in the pipeline: MEP Infrastructure (toll assets), Reliance Infrastructure (toll assets) and IL&FS Transportation Networks (road assets).

Rating agency ICRA points out in a report that, led by roads, renewables and transmission sectors, there is a potential for InvIT issuances worth Rs 20,000 crore capital over the next 12-18 months. CRISIL states that InvITs are innovative new vehicles that can play a crucial role in meeting India’s huge infrastructure requirements, estimated at Rs 43 trillion over next 5 years. An InvIT can invest in infrastructure projects or a company with at least 90% of its assets comprising infrastructure projects. These would include projects for roads and bridges, ports, airports, metros, electricity generation / transmission, telecommunication services, oil pipelines, irrigation, etc.

Among Asian markets, Singapore is a success story for listed Trusts. In Singapore, there are 39 listings with a market capitalisation of approx USD 70 billion, but the bias is on REITs than on InvITs. Over a period of time, India may go the Singapore way, but the initial experience of investors from REITs and/or InvITs, from the one InvIT getting listed and others in the pipeline, should be sanguine.

There is a debate on whether an InvIT, by nature of investment, is equity or debt as it has features of both. It is somewhere in between; loosely, debt-plus or equity-minus in terms of risk return profile. The equity-like features are that the units are listed, can change hands like equity stocks, there is periodic valuation of the projects akin to periodic results of companies and economic factors like higher GDP growth or higher inflation would lead to expectation of higher revenue and hence higher price of the units at the Exchange.

The debt-like feature is there is periodic pay-out of the earnings of the InvIT from the underlying SPVs, which is not exactly like contractual coupon pay-out on bonds but somewhat comparable as the valuation gives a perspective on how much to expect. It is a hybrid instrument with a somewhat predictable cash flow yield (akin to debt) and potential appreciation with growth of the economy (akin to equity).

Taxation wise, an InvITs is a pass-through vehicle. There is a mandate to distribute at least 90 percent of net-distributable cash flows. Interest component of income distributed by trust to the unit holders would attract withholding tax @ 10 percent for resident unit holders. Interest income is taxable in the hands of the unit holder. Dividend income is exempt in the hands of the unit holder and there is no dividend distribution tax.

At this point of time, InvIT is not a retail product, the minimum primary application amount being Rs 10 lakh and the minimum secondary transaction amount being Rs 5 lakh. The restriction is imposed because there is no track record and lack of awareness. The major risk factor, as we understand from the IRB offer, is reduction in traffic, but there is a risk mitigant in the form of concession agreement and compensation payment in case of termination of contract.

There is a liquidity risk as well, in the secondary market the units may not be traded every day as the investor base is not wide at this point of time. May be over a period of time, with the development of this market, SEBI would look to easing the threshold amount for REITs and InvITs. As of now, investors should keep it on the radar and participate through the mutual fund route, who have a better understanding of the risk factors and can handle secondary market liquidity issues.

Author is an independent financial advisor.

How do mutual funds compare with bank deposits on tax front?

Article uploaded on Moneycontrol on 19 May 2017. Please click here for the link

Bank deposits and fixed income mutual funds differ with each other on a key parameter.

Joydeep Sen

Two deployment avenues are to be compared on the parameters of safety, liquidity, returns, ease of access, etc. Apart from these, another relevant aspect is tax efficiency i.e. for comparable risk-return profile investments, net-of-tax return expectation may be considered for comparison.

Bank deposits and fixed income mutual funds differ with each other on a key parameter. Bank deposits have ‘contractual’ returns i.e. the returns are known upfront and would not vary. Mutual funds are market-driven investments, dependent on movements in the underlying market. Having said that, liquid funds, though theoretically market-driven, are stable in performance with negligible mark-to-market movements. In that sense, liquid funds are comparable with bank deposits.

Returns from bank deposits, either savings or term, are taxable as interest at your marginal slab rate. The marginal slab rate for most investors would be 30 percent, which is the bracket for income more than Rs 10 lakh per year. On top of it, there is a surcharge of 10 percent / 15 percent applicable if you earn more than Rs 50 lakh / Rs 1 crore per year. Not to forget, there is a cess of 3 percent. Hence, in the income bracket of Rs 10 to 50 lakh, the tax rate is 30.9 percent and for people earning more than Rs 1 crore per year, the rate is 35.5 percent. However, if you are in a lower tax bracket of 5 percent or 20 percent, you pay a lower tax on your bank deposits.

In mutual funds, there are two options, dividend and growth. In the dividend option, there is a dividend distribution tax (DDT), which is deducted by the asset management company (AMC) on behalf of the investor and submitted to the government. The dividend received by the investor in a liquid fund or a debt fund is tax free in his/her hands, but comes after DDT, irrespective of the tax bracket of 5 percent or 20 percent or 30 percent. The DDT rate for individual investors, in liquid / debt funds, is 28.84 percent. Hence, if you are in the highest tax bracket (30 percent plus), mutual funds are slightly more tax efficient over bank deposits. If you are in a lower tax bracket (5 percent or 20 percent) then apparently bank deposits are better, but there is a way out, discussed below.

In the growth option of mutual funds, the gains are taxable in the hands of the investor, as per the marginal slab rate, for short-term capital gains, defined as a holding period of up to three years. So, if you are in a lower tax bracket (5 percent or 20 percent) it is advisable to opt for the growth option of mutual funds because DDT rate is 28.84 percent irrespective of your tax slab. One additional tax benefit possible in growth option of mutual funds is that of set-off.

Short-term capital gains can be set off against short-term capital losses. Hence, if you have any short-term capital loss, it can be used to set off your short term capital gains from mutual fund investments, which is not the case with bank deposits. For guidance on short-term capital losses, you may consult your chartered accountant.

Now, let us look at a case of net of tax returns in bank deposits vis-à-vis liquid funds. The assumptions are (a) for a tenure of less than 7 days return from bank is 4 percent as fixed deposits are for 7 days and longer (b) for 1 month, return from bank is 5.5 percent and (d) return from liquid fund is 6 percent.

 

As we see in the table above, as the amount of investment and period of investment goes up, the utility of liquid fund over bank deposits goes up accordingly. The differential becomes more significant if (a) the comparison is with bank current account where there is no interest or (b) growth option of mutual fund where the investor has a tax set-off.

After SEBI allowed fund houses to provide instant redemption in liquid funds up to Rs 50,000 or 90 percent of folio value, to individual investors, retail investors can use the mutual fund route more efficiently. Even otherwise, you get your redemption proceeds on T+1 day i.e. the day after you submit the redemption request, at the NAV of previous day. The proceeds usually come in the morning of T+1 day so that you are in a position to deploy the money i.e. there is no loss of one day’s earning in the MF route.

(Author is an independent financial advisor)

Time to review your allocation to equities

Article published in Financial Express on 24 May 2017. Please click here for the link

Reviews should happen at regular intervals, but modifications in the portfolio should be done only when the event is significant.

The environment around us is always abuzz with events. These events may have some impact on our portfolio, and we need to be aware of it. We need not reshuffle our portfolio at each and every event. The reason is, at any point of time, there are multiple events happening, some with a positive push and some with a negative pull. Reviews should happen at regular intervals, but modifications in the portfolio should be done only when the event is significant. One such occasion for review is the completion of three years of the current NDA regime. We will discuss here, what has happened in the markets over these three years and what is the likely course over the next couple of years.

Reforms undertaken
A lot of market-positive reforms have been initiated by the government. The markets have discounted these measures and have surged ahead. Taking the Nifty 50 companies PE ratio as an indicator, it has moved up from 19.6 in May 2014, measured on the historical EPS of the companies, to 24 now. Going forward, it is expected that the good work will continue. Calling an election outcome is risky, but it seems, given the popularity ratings, that the current NDA regime would win the general elections after two years and retain power for another five-year term.

From this perspective, the market-positive environment is expected to be intact for the medium term. The India growth story is as strong as ever. To be sure, equity is a long-term proposition, unless you are a trader for short-term gains. From the PE ratio perspective, valuations are little stretched by historical PE standards, but nobody has the last word on what should be the ideal PE ratio. There may be a PE re-rating as well.

Review equity allocation
What you should do now is, review your allocation to equities. Having said that the long-term India growth story remains intact, it does not hurt to book profits, only that there may be an opportunity cost i.e. you may be giving up a part of the gains, had you been holding on. If you had earlier decided on an allocation of say 60:40 in favour of equities, equity allocation would have gone up anyway by virtue of better returns. It would now be, say, 65:35 in favour of equities.

Close your eyes, take a deep breath, and assure yourself that whatever equity allocation you decide today, is for the long term and any mid-term correction i.e. volatility would not bother you. To the extent you are sure, continue the equity allocation for another 5 to 10 years, assuming the NDA government and the good work is here to stay, fundamentals are positive and domestic investment in equity, which is very low currently (approx 4% of overall savings) would pick up gradually.

To the extent you are hesitant about your equity exposure, reduce your equity allocation in favour of fixed income. As an example, if you are at say 65:35 in favour of equities, bring it down to say 50:50. It may sound like an antithesis because equity is delivering sanguine returns. However, to the extent you are cashing out, you are taking that much money home. The profits booked in equities should be deployed in fixed income. Within fixed income, invest in short-term bond funds, since this category of funds is more stable in returns than long-term bond funds/dynamic funds /gilt funds. The purpose of cashing out from equities is to reduce potential volatility, hence it is not advisable to venture into long-term bond funds.

Even though long bond funds gain more when interest rates come down, it is not advisable to expose this part of your portfolio to relatively higher volatility. There are certain factors conducive to lower interest rates, like inflation being lower than expected, it is unlikely that the RBI monetary policy committee would reduce interest rates. The panel has taken a stand of ‘neutral’ monetary policy, implying they will not reduce rates unless there is a compelling case. If and when equity markets show a meaningful correction, you may enhance your allocation to equity, but with a long term view.

-Joydeep Sen, the writer is managing partner, Sen & Apte Consulting Services LLP

Debt Funds: Short or long? Why portfolio maturity matters

Article published in Financial Express on 31 May 2017. Please click here for the link

In the current context you would be hearing from your adviser to shift to short term bond funds, which have a portfolio maturity of two to four years, from longer maturity bond funds.

Joydeep Sen

In the current context you would be hearing from your adviser to shift to short term bond funds, which have a portfolio maturity of two to four years, from longer maturity bond funds. The rationale is that the RBI Monetary Policy Committee is unlikely to reduce interest rates further, even though inflation is lower than expected.

Interest rate
If interest rates remain stuck in a range, shorter maturity bond funds would be more stable in performance and will do better than long bond funds. When you are doing a shift from a 10-year portfolio maturity fund to a 2-year maturity one, or even if you are holding on to a long maturity fund, you are consciously aware of the strategy of the fund. The context here is, the cases where you may be unknowingly holding on to a long portfolio maturity fund, which may be volatile if and when interest rates move up.

Where it tends to get ignored is in hybrid funds. In a focused long maturity or short maturity fund, you tend to take note of it. In a hybrid fund, you take note of the overall strategy of the fund and portfolio allocation to debt or equity as per mandate of the fund and fund manager’s view on market movements. You tend to ignore the portfolio maturity of the bond component of the hybrid funds’ portfolio. Let us look at a few examples, which will give you clarity. MIP funds have 75-85% allocation to debt and 15-25% allocation to equity.

They generally declare dividend every month, hence the name ‘monthly income plan’ (MIP). These funds give a small exposure to equity to otherwise fixed income oriented investors. The debt component is generally kept conservative, like a short term bond fund, so as not to take any undue volatility risk in the debt component.

Normally, a range of two to five years of maturity is similar to the strategy of a short term bond fund. As per latest data, in a universe of 37 MIP funds, 18 funds have portfolio maturity less than five years but seven funds have their debt component maturity more than eight years. This kind of portfolio maturity, i.e., more than eight years is comparable to a long bond fund or dynamic bond fund.

There is nothing wrong in having a long portfolio maturity and the fund manager may have a positive view on the market; i.e., s/he may expect interest rates to come down. The point is, if you are doing a shift from long bond to short bond funds, you should be aware what kind of portfolio maturity you are exposed to in your MIP fund. It should not get ignored just because it is a hybrid fund.

Another category of hybrid funds is equity savings funds. In these funds, up to 35% is in debt, 30-40% is invested in equity and another 30-40% is in arbitrage; i.e., buy position in equity cash market and sell position in the same stock in equity futures market. In this category, the market risk is taken in the open or unhedged equity component and the debt component maturity is mostly in the range of one to five years.

However, in a universe of 10 equity savings funds there is one fund with a portfolio maturity of more than 12 years. There is a category of funds called arbitrage, wherein 65% of the portfolio is in equity cash-futures arbitrage and 35% is in money market or debt instruments. There also you need to check on a similar logic.

The whole reason why you are reviewing your portfolio is to avoid undue volatility as interest rates are expected to be on a long pause now and may move up later as and when the situation warrants. If you are continuing in a long bond fund in which you had invested earlier, it’s a conscious decision. The same logic applies to your hybrid fund exposures as well.

The writer is managing partner, Sen & Apte Consulting Services LLP.

For fixed income, return expectation is not the only parameter

Article published in Mint on 8 June 2017. Please click here for the link

With lower inflation, returns from short-term bond funds would be enough to beat inflation and generate real positive returns

When it comes to shifting from one investment category to another, particularly from a high-return category (say, equity) to a category of lower-return expectations (say, fixed income), there is a natural aversion to the latter and most would prefer to stay with higher returns. However, that is not the right approach to deploying your money. We will discuss why.

At the current juncture, in the fixed income space, your adviser must be telling you to stay with short-term bond funds, that is, not to venture into long-bond funds as the interest rate cut cycle seems to be bottoming out. The return expectation from short-term bond funds is relatively muted now, particularly with interest rate cuts being largely over. The difference in returns expectation looks all the more stark when you see equity returns at, say, 15%, and in single digits for short-term bond funds.

The essence of diversifying your portfolio is that the two or more investment categories should ideally have a negative correlation, that is: when one asset goes up, the other should not go up as much. It may seem inimical to you because ideally you would want all your investments to move up uniformly.

However, these are market-driven investments and the purpose of diversification is to avoid a situation in which your entire portfolio, or both the components of your portfolio, are not doing well. If you invest in only one asset class, there would be certain phases when this asset would not perform so well, and your entire investment would be dependent on a particular set of market forces. If you diversify, a part of your investments into a different asset class would benefit from these very set of market forces, and you are better off to that extent. In the long run, you are optimising your returns. When you are allocating a part of your portfolio to, say, short-term bond funds against 100% allocation to equity, you are reducing volatility in your portfolio to that extent. That is to say, you have to look at the overall perspective. Hence, when you are shifting a part of your money from equity to fixed income, you are not reducing your returns as such but moving that component from one ‘box’ to another ‘box’ that suits your profile, risk appetite and the horizon of investments.

Allocation is easier for fresh deployment as there are lesser mental blocks. You have to see which ‘boxes’ suit you and you must put your money into those ‘boxes’ proportionately. Ask your adviser why that investment avenue is suitable for you, and not just ‘what is the returns expectation’. For example, equity is to build wealth over a long horizon, but may be volatile in the interim period. To fulfil that objective, large-cap equity funds may be more suitable. If your objective is to achieve gains over the medium term, your preference would be promising mid-cap funds. In the fixed income space, the logic behind recommending short-term bond funds over long-term bond funds is that scope for gains from interest rates coming down is unlikely, rather, if interest rates move up, long-term bond funds would underperform. The objective here is goal-based investment with relatively lower risk-return profile.

 

Having discussed the logic of suitability over expected returns, let us now see if it is possible to enhance returns to a certain extent. It is possible to achieve relatively better returns than short-term bond funds through:

a) credit-play corporate bond funds that have a higher portfolio running yield, provided you are comfortable with the credit exposures in the portfolio;

b) tax-free bonds where the ‘pre-tax equivalent’ yield is still attractive, depending on your tax bracket;

c) preference shares with decent yield, defined dividend rate and tax efficiency but relatively low secondary market liquidity; and

d) structured debentures (only if you understand them fully), where interest rate is contingent upon a movement in the equity market but they behaves like coupon-bearing bonds due to a pre-defined range of interest. But you will need the minimum investment size required.

 

Another factor working in favour of fixed income instruments, and which counters the bias of lower-return expectations, is the relatively lower inflation. We are in a phase of structurally lower inflation from the double-digit numbers at one point. The measure of inflation is now based on a basket of consumer prices (CP), and this is better than the wholesale basket followed earlier. CP inflation was 3.8% in March 2017. Even if it moves up, it is expected to be in the range of 4.5-5% over the next 1 year or so. Thus, even if short-term bond funds yield relatively lower returns than the last couple of years, which was helped by the rate-cut cycle, it would be enough to beat inflation and generate real positive returns.

For the ‘alpha’ (higher returns) in your portfolio, stay put in equities with a long horizon.

Joydeep Sen is managing partner, Sen and Apte Consulting Services LLP.

Looking to invest in bank perpetual bonds? Beware of risks

Article published on Moneycontrol on 15 June 2017. Please click here for the link

The ICRA rating rationale states that rating for the Basel III compliant Tier I bonds is four notches lower than the Basel III complaint Tier II bonds of the bank as these instruments have the following loss absorption features that make them riskier.

Joydeep Sen

We had discussed earlier that Bank Additional Tier I (AT1) Perpetual Bonds are gaining traction in the market. The increasing interest is seen in both the institutional investors i.e. mutual funds, corporate treasuries, PMS providers and the individual investors i.e. high networth individual investors. In the recent past, some events have taken place in this segment of the market, which investors and prospective investors should be aware of. These events are negative, but the segment as a whole remains robust and the events have led to better price discovery i.e. higher yield on the bonds issued by those banks.

The most prominent event is the downgrade of AT1 Perpetual Bonds issued by IDBI Bank. The facts are as follows: on 23 May ’17, ICRA downgraded these bonds from A to BBB-. Other instruments were downgraded as well; certificates of deposit (CDs) were downgraded from A1+ to A1, infrastructure bonds were moved from AA- to A, Basel III compliant Tier II bonds were moved from AA- to A. On the same day, CRISIL downgraded IDBI AT1 Perpetual Bonds from A- to BBB+.

What went wrong? The ICRA rating rationale states that rating for the Basel III compliant Tier I bonds is four notches lower than the Basel III complaint Tier II bonds of the bank as these instruments have the following loss absorption features that make them riskier:

The bank has the full discretion at all times to cancel distribution or payments and the cancellation of discretionary payments shall not be an event of default

and

The minimum capital conservation ratio applicable to banks may restrict the bank from servicing these Tier I bonds in case the Common Equity Tier-I (CET-I) falls below the limit prescribed by the RBI.

This is already known; to be noted, the differential between Tier I and Tier II bonds is usually two notches but in this case it is four notches. The rationale also states, “despite a capital infusion of Rs. 1,900 crore in March 2017 by the Government of India, the sharp deterioration in asset quality and consequent increase in credit costs resulted in the bank’s CET-I (including Capital Conservation Buffer) being lower than the required regulatory level as on March 31, 2017. For FY2017, IDBI Bank reported a net loss before tax of Rs. 8,618 crore and net loss after tax of Rs. 5,158 crore as against net loss after tax of Rs. 3,665 crore in FY2016.

As the losses during FY2017 far exceeded the capital infusion by the GoI, the CET-I (including CCB) was lower at 5.64% as on March 31, 2017 as compared with 7.98% as on March 31, 2016. High levels of losses has also significantly eroded the bank’s distributable reserves, which the bank can use to service the coupon on its AT-I bonds. As per the terms of the AT-I instruments, the bank will be constrained from servicing the coupon on these bonds, unless it reports profits and improves its CET-I levels (including CCB) above regulatory levels by divestments of non-core assets and raising fresh capital before the coupon payment dates.” The other weakness, as stated are “weak asset quality profile with gross NPAs at 21.25% and net NPAs at 13.21% as on March 31, 2017” and “large exposure to infrastructure sector (~20% of total exposure as on March 31, 2017), which is prone to cyclical downturns, leading to asset quality pressures”.

However, there are certain strengths as well: majority shareholding of Government of India (approx 74%) and its standing as a developmental financial institution. The CRISIL rating rationale states “strong expectation of support from GoI:

GoI is the majority shareholder in public sector banks (PSBs) and the guardian of India's financial system. The stability of the banking sector is of prime importance to the government, given the criticality of the sector to the economy, the strong public perception of sovereign backing for PSBs, and the severe implications of any PSB failure in terms of political fallout, systemic stability, and investor confidence in public sector institutions. CRISIL believes the majority ownership creates a moral obligation on the government to support PSBs, including IDBI Bank.

As part of the Indradhanush programme, the government has pledged to infuse at least Rs 70,000 crore in PSBs between 2015 and 2019, of which Rs 25,000 crore was infused in fiscal 2016 and Rs 16,410 crore in fiscal 2017. The government infused Rs 6,284 crore in IDBI Bank in the five fiscals through 2016, and Rs 1,900 crore in March 2017. Furthermore, under the Indradhanush plan, the government has committed that all PSBs will maintain a safe buffer over the regulatory minimum.” The other comfort factor, again from the CRISIL rationale, is “IDBI Bank has an established market position, supported by a large asset base of Rs 361,768 crore as on March 31, 2017. Advances of Rs 190,826 crore accounted for 3% of the banking system advances. While the bank has moderated growth, it is likely to remain among the 10 largest banks in India.”

The other issue in the recent past, in this segment of the market, was the NPA discrepancy of Yes Bank and Axis Bank. Yes Bank's recent annual report highlights the large divergence visible on NPAs as per Reserve Bank of India (RBI) audit and bank reported numbers for FY16. In contrast to the 0.76% NPLs reported by Yes Bank in FY16, the RBI audit pegged them at 5% of loans. Similarly, according to the RBI, at Axis, NPAs were higher at 4.5% of loans (vs 1.78% reported) and at ICICI Bank they were at 7.0% (vs 5.85%). Detailed disclosures on NPAs will be available in their annual reports. In the case of Yes Bank, management has indicated that during the course of FY17 these accounts have seen repayments and improvements and, therefore, the NPA outstanding for March 2017 is now lower at Rs 1000 crore (1% of FY17 loans). Also, given the growth in loan book and also the recent capital raise, the March 2016 RBI NPA of Rs 4900 crore is now down to 3.7% of loans and 22.3% of net worth.

Now let us look at the market reaction. The following table shows the indicative yield level on the AT1 Perpetual Bonds of the Issuers, in February (i.e. the previous article), recent highs on adverse events and current levels after the rally on RBI Policy on 7 June.

Indicative Yield levels

 

Data Source: Phillip Capital India Fixed Income Desk

Conclusion: For individual investors interested in AT1 Perpetual Bonds, who can trade in lot size of Rs 10 lakh or more through the bond dealing houses offering these papers, should be aware of the risk, discussed above, and settle for a yield that is not the highest. The reason is, where the yield is on the higher side, market participants are indicating that an IDBI Bank like case is a possibility. Otherwise, the stability in yields indicates that the market is confident about these bonds.

The writer is an independent financial advisor.

Your mutual fund investment tax efficient? Here are 3 steps to ensure utmost efficiency for your portfolio

Article published in Financial Express on 20 June 2017. Please click here for the link

Ensuring that your mutual fund portfolio has the utmost tax efficiency is essential. Fund taxation depends on the nature of the fund and holding period. But decide your investments on merit, then look for tax efficiency, if available.

Tax efficiency is something much sought after by investors, and rightly so. However, to be noted, tax efficiency should not be a fundamental parameter for your investment decisions. Decide your investments on merit, then look for tax efficiency, if available.

Equity mutual funds

Equity oriented mutual funds are more tax efficient; dividends are always tax free and in the growth option, it becomes tax free after one year of holding by virtue of it becoming eligible for long term capital gains (LTCG) taxation.

The only tax incidence in equity mutual funds is short term capital gains tax (STCG), which is up to one year of holding, at 15% plus surcharge and cess as applicable. We will discuss the STCG aspect of equity funds in a while. Clearly, efficiency is generated by either investing in the dividend option of an equity fund or in the growth option, which is taxable as capital gains, with a horizon of more than one year.

Debt mutual funds

Debt funds carry a higher tax burden. The eligibility period for LTCG taxation is three years, though as a category, debt funds are more stable than equity and the tax incentive for long-term investment orientation is required more for equities. Dividends from debt funds are subject to dividend distribution tax (DDT), which is 28.84% for individual investors and 34.6% for corporate investors.
The DDT rate is same for all investors, irrespective of tax bracket. Efficiency is generated by investing in the growth option of debt funds, rather than dividend option, with a horizon of more than three years. For investors in a lower tax bracket, growth option is better for any holding period as the taxation rate is lower.

Indexation in debt funds

The way LTCG works for debt funds is as follows: there is an ‘indexation’ allowed to compensate for inflation in the holding period, as per numbers announced by the government. The capital gains component after allowing for indexation is taxed at 20%, plus surcharge and cess as applicable.

There are cost inflation index (CII) numbers announced by Central Board of Direct Taxes for every financial year, having seen the CPI inflation for previous year. Let us see an illustration: the CII number for FY 2013-14 was 939 and that for FY 2016-17 was 1125.

Let’s assume you invested in a debt fund sometime in FY14 and redeemed sometime in FY17—just to recall—three years of holding period is required. The initial NAV of the fund was `10 and the final NAV was `12.25. The indexed cost of purchase will be 1125/939 X Rs 10 = Rs11.98. Hence the taxable component is only Rs 12.25— Rs 11.98 = Rs 0.27. The tax rate for LTCG is 20%; with a cess of 3% it comes to 20.6%. Tax works out to 20.6% of Rs 0.27 = Rs 0.055. Your net of tax return is `12.25 – `0.055 = `12.195, i.e., the tax incidence is low, post indexation.

STCG in debt funds

The difficult part is STCG in debt funds. This can be handled through set-offs, if it is available in your case. Short term capital loss (STCL) can be set off against STCG as well as LTCG, i.e., STCG can be set off against STCL. Having said that, in the current market conditions, losses are difficult to come by as asset prices across categories are rising.
Investors may get in touch with his/her tax consultant as there may still be scope for set-offs, if you have STCL from some other investment and it can be planned accordingly. The same applies for STCG from equity funds.

For companies subject to MAT taxation, everything is subject to the MAT rate of taxation, which is 18.5% plus surcharge (as applicable) and cess. Hence, the dividend option of debt funds is not advisable as DDT rates are higher as discussed earlier. The STCG rate is lower than it is for regular taxation companies and lower than the DDT rate.
For capital gains, there is no tax-efficiency-oriented attraction to hold it for three years as indexation benefit is not available. Everything being taxable at the flat rate, growth option is preferred and holding period can be anything from tax perspective.

Joydeep Sen is managing partner, Sen & Apte Consulting Services LLP

How to track bond funds: G-Sec yield is the correct benchmark, for long term ones, for money market, track yields of treasury bills

Article published in Financial Express on 3 July 2017. Please click here for the link

While the G-Sec yield is the correct benchmark for long-term bond funds, for money market funds track yields on treasury bills.

Joydeep Sen

Certain things seem easy to track, particularly in today’s age of information explosion through various websites and apps. However, in spite of availability of data, you need a proper perspective on what you are tracking, otherwise you will be misled. Tracking bond market For tracking the bond market, the most popular fall-back is the 10-year maturity Government Security (G-Sec) yield. This is the most liquid G-Sec, except during time periods when the 10-year benchmark G-Sec is changing, and there is good reason to track it. What we normally refer to as the 10-year benchmark yield indicates only the yield level at that point of time.

We try to gauge the movement by looking at the movement of the yield, i.e., up or down and the extent of the up-move or down-move. For clarity, it is not the returns from that security over the two dates. If you have investments in G-Sec funds / long bond funds with maturity somewhere around 10 years, you may refer to the 10-year G-Sec yield. If the portfolio maturity of your fund is even longer, say 15 or 20 years, you should refer to the 15-year or 20-year G-Secs also, to gauge the movement of yields over the two dates. Data source

The source of data on G-Sec yields is www.ccilindia.com. On the home page, click on RBI NDS – OM. It gives live data on traded level of G-Secs. The right-most column titled LTY shows the last traded yield. The relevant Gilt for you is the number of years from the current year. For example, the 10-year G-Sec matures in 2027 and the 20-year security matures in 2037. Since all G-Secs don’t get traded every day, you may refer to a nearer-maturity one as a proxy for the maturity you are looking for. If your context is to track a shorter maturity exposure, for instance, a short-term bond fund with portfolio maturity in the range of two to four years, then the 10-year G-Sec is not the right benchmark, due to the palpable difference in maturity.

The impact of relevant economic parameters like inflation, GDP growth, etc., is directionally similar across maturities in the yield curve, but the extent of the impact is different. The shorter end of the yield curve, say, less than one year maturity, is impacted more by banking system liquidity. If system liquidity is surplus, money market yields, defined as maturity less than one year, tends to be low and deficit liquidity pulls up money market yield level. That is to say, longer maturities like 10 or 20 years is influenced by both the view on economic parameters as well as system liquidity whereas the shorter end is influenced more by system liquidity, followed by economic parameters. Yields on treasury bills

For tracking the shorter end, relevant for money market funds, you may refer to yields on treasury bills (T-Bills) as this is the most liquid segment of the money market. You may refer to the source mentioned above for the latest traded levels on T-Bills of various maturities. Please take care of the maturity date; for example, a 364-day T-Bill was of 364 days maturity when issued, but the residual maturity as of today is relevant.

Coming back to the context of benchmarking, for your short-term bond fund with two- to four-year maturity, money market yields are not the correct benchmark as these are of less than one year maturity. The correct benchmark is corporate bonds of relevant maturity, but there is a challenge in getting the data. There are bond dealing houses and some mutual funds who publish daily market updates. If you are not privy to those reports, you may refer to G-Secs of corresponding maturity as a proxy.

The writer is managing partner, Sen & Apte Consulting Services LLP

Visit a fashion show to invest in financial products

Article published on Mint on 4 July 2017. Please click here for the link

Expecting a ‘garment’ kind of sales effort from your adviser makes it easier for her to mis-sell as you could end up buying something unsuitable for you

Sounds anomalous? That’s what it is meant to be. A staid title line probably wouldn’t have attracted your attention as much. Now if I say “people, do this”, you would probably not be interested and say “too much”. But pause for a while and think. When you buy any goods or services, you pay money and get them at that point of time. It could be something physical like a shirt, car or phone, or a service like a haircut or transport. When you invest in a financial product, you get nothing. You get a promise (like in debt) or an expectation (like in equity) of getting the money back in future, and getting back more to compensate for your current sacrifice.

What you should look for is how strong is the promise or expectation of getting your money back, how long can you spare the money (investment horizon) or if you suddenly require your money one day, how much do you expect to get back (liquidity). If you ask other things to your financial adviser, like what all products are there with her, you are expecting her to put on display a fashion parade of products.

An investment decision is different from buying a garment—this too is a matter of choice, but more a matter of suitability to your conditions. Expecting a ‘garment’ kind of sales effort from your adviser makes it easier for her to missell, because you would buy something you fall for, but it may not be suitable for you. While misselling is a problem and it does happen, if you ask the wrong questions, you are opening the door for it. This can also be termed as mis-buying. 

This is where investors go wrong. The foremost FAQ is about return expectation, “kitna dega(what is the return)?”; whereas this should come later. You may ask: returns is what I am investing for, why should that question come later? Let me give an analogy. Let’s say, higher returns while investing is the same as lesser expenses while spending. You want transport and you don’t have your car. You have a choice all the way from an auto-rickshaw at the lower end to a radio taxi service's at the higher end. The factors you would look for are:

Comfort: a sedan is more comfortable, while an auto-rickshaw is jerky and dusty;

 

Travelling time: Which one will take you faster;

Availability: Is the app faster than going to the road looking for an auto-rickshaw or a cab?;

Other comfort factors: Wi-Fi and all in radio taxis;

Safety: Especially for women;

Charges: What you pay upfront.

 

The point here is that even for a small one-time transport service, you consider so many factors apart from your expenses. If cost were the only factor, you would travel by public bus. 

When it comes to investing your hard-earned money, it should be more about suitability, followed by return expectations. In a fashion show, a colour or design may attract you; in a suite of financial products, a particular feature may appeal to you, for example, equity market being in a bull run, low inflation prompting the Reserve Bank of India to reduce interest rates, a portfolio management service provider who has given returns higher than peers in the industry in small-cap funds, and a structured debenture is giving a higher coupon if the equity market moves in a particular range. 

Let’s see what is buying right and what are the questions you should ask your financial adviser: 

Suitability: Any product, be it equity or debt or hybrid, for the allocation recommended in your portfolio, has a rationale. Ask your financial adviser for a brief, non-jargonized reason why this product is suitable for you. 

Volatility: Technically, volatility may be both on the upside (returns higher than expected for a while) and the downside (returns lower than expected for a while). Naturally, nobody has a problem with upside volatility. Ask your adviser, what is the expected maximum downside in an extreme adverse market event. This downside, technically called drawdown, should be acceptable to you. 

Risk profiling: Your adviser does you risk appetite profiling. Understand from her how she is classifying you—aggressive, moderate, conservative—and the basis thereof. 

Horizon: There is a recommended or optimum horizon for any investment. You should understand that, and not negotiate. High net worth individuals (HNIs) have a tendency to ‘negotiate’ this with the adviser but the investments are in the market, not in a term deposit of the adviser. 

Liquidity: You may be comfortable with the horizon, but in case you require the money earlier, the perspective should be clear from the beginning.

Any typical or particular risk: For instance, a credit-oriented fund will have relatively higher credit risk, which should be clarified. 

Some of the queries to be avoided are whether the product is ‘exclusive’ and who else has invested in it, because the market is for all and all individuals are unique.

 Joydeep Sen, managing partner, Sen & Apte Consulting Services LLP