Ways of Investing – Are we ourselves becoming financial experts?

Well I am neither old nor experienced enough to write about the various ways in which people invest.  But even in the short span of time from when I started investing, the way we invest have changed considerably.

I am speaking about the past 10 years. Year 2001 was the first year since when I started investing.  Being from  a middle-class background, for my family investing was parking money in fixed deposit and be satisfied with the interest earned.  Investing in stock market was fear about.  The only equity investment parents made (and that too of small quantity) was in the IPO of Reliance Petroleum Limited way back in 1977 and kept it intact till 2005.  Besides these there were hardly any other investments.

My first investment was in some bonds (I am not able to recollect the name of the institution).  I went to the neighborhood investment agent who took my application and returned me few rupees in cash as pay back commission.  I was happy that I have earned from the first day of investment!  My first mutual fund investment was in the year of 2003.  A lump sum in one of the infrastructure funds, which was advertised heavily and was hot investment during those times.  I kept making such investments without thinking how will it help me in achieving my ‘long term monetary goals’ and without knowing whether these investments are within my ‘risk-tolerance’ limits.  Terms such as long term goals and risk tolerance were new to me during those times.  Then, the basis for investment was primarily for tax benefits or the lure of hefty dividends up to 300% in mutual funds within 15 days of investment.  All these investment were driven by agents or so called financial advisors who would market the investments which earned the highest commission for them. 

The scenario has changed now.  We all are lucky to be living in this era of internet and information age.  We are well informed about such agents.  Hence we invest directly online through internet where various intermediary sites help us in investing by just a click of the mouse or through online facilities provided by mutual fund houses and banking channels.

However in all these free and easily available options, we have started assuming that we can choose the right investments for ourselves.  We feel that we have done adequate research about the investment.  Before investing in a stock, we review its past financials, we diligently go through free analyst reports available, we check the stock price underperformance vis-à-vis sensex in past one year and then we conclude that this stock is suitable for investment.  Similar process is carried out for other financials products such as ULIPs and mutual funds which give hefty dividends within weeks of investing.

Just think are we correct in investing this way?  Are these investments suitable for us?  Though they may be good form of investment, do they suit my risk profile?  Before taking any investment decision, the answers to these questions are more important than the right valuations and these questions need to be asked before each and every investment which we make.

This is why financial planners are important.  They help us in understanding our monetary goals, assist us in making realistic goals and identify investments which suit our risk profile and which will not be a burden 20 years down the line.  Further these planners bring discipline to our investing.  They are the managers of our finances and ensure that it is timely, efficiently and effectively deployed.

Ask yourself.  How many of you have ever met a financial planner who would help in charting your goals, assessing your risk and suggesting suitable investment plan?  Alternatively, how many of you would have made investment through an agent who would give you cash-back of small percentage of amount which you had invested in insurance plans, PPF or mutual funds?  I am sure that majority of people would not have met planners but would surely have availed service of ‘pay back’ agents.

If these advisors play such an important role in our wealth building, then why are we complacent with managing the investment ourselves?  Are we thinking ourselves to be a financial expert or is it because to avail their services we need to pay them, instead of they paying back us.

 

If this is the reason, think again.  Do not view their charges as expenses.  View it as an investment which will help you in growing your wealth.  It is an investment which flows back to you multifold over a period of time.

Do have a reality check with your finances.  Are you happy with your current portfolio?  Are you reasonably sure that your current investment pattern will help you in achieving your future goals?  If your answer to any of these questions is NO, then a good financial planner is your best friend.

I invite you to share your experience in investing and comments on this post.

Infra bonds – Is the advertised yield really true?

Many people are aghast by the yield on Infra Bonds advertise by the companies and do not believe the same to be true.  In line with the basic principle of this blog - to make investing simpler - this article will try to clarify various doubts which many of my readers and investors have about these Infra Bonds.  Readers may also like to visit my earlier post on Infra Bonds.  

Reference here is made to L&T Infra Bonds since it is the only Infra bond which is open for subscription right now.  In no way it encourages or discourages any one to invest in the said bond.  Investment has to be made in line with the risk profile and investment objectives of an individual.

1. Is the tax-adjusted yield of 17.20% advertised really true (for Series III L&T Infra Bonds having 7.50% interest rate)?

This yield is based on certain assumptions:

a. You opt for the buyback option at the end of the 5 years.

b. You are able to take the benefit under Section 80 CCF of the Income Tax Act.

c.  You are in 30.90% tax bracket.  In case you are in lower tax bracket, the tax-adjusted yield will definitely be lower (further cover in detail below).

d.  It further assumes that you are investing the annual interest earned at the rate of 17.20% p.a.  Well I know this can never be achieved.  But this is the assumption behind the calculation.  In case, you assume that you are able to invest the annual interest earned at the rate of say 7.50%, then the tax-adjusted yield drops to 15.75%, which is still a good rate on investment.

2.  Why are they not adjusting the tax-adjusted yield of 17.20% for the tax which I will be required to pay on the interest earned? 

The interest earned on Infra Bonds is taxable in the hands of investor.  The tax-adjusted yield of 17.20% does not take into account any tax payable on annual interest received.  Adjusting for the same, the post-tax tax-adjusted yield comes to 14.23% for the above series bond.  Generally no one highlights post-tax tax-adjusted yield on investment.  Have you ever seen a bank saying that the interest rate on its 1 year Fixed Deposit is 5.4% p.a. (post tax) and not 7.75% (which is the interest rate)? 

Post-tax tax-adjusted yields for the entire series bond are as follows:

 

Series	Tax-adjusted yield	Post-tax tax-adjusted yield
Series 1	15.23%	12.16%
Series 2	13.59%	11.07%
Series 3	17.20%	14.23%
Series 4	15.75%	13.25%

The above yields are again for person in the tax bracket of 30.90%.  In case a person is in lower tax bracket, the yield will be different and lower from the above.  The table below provides details of post-tax tax-adjusted yields for entire series of L&T Infrastructure Bonds at different income tax slabs.

SERIES	Tax Slabs
	30.90%		20.60%		10.30%
	TAY	PT TAY	TAY	PT TAY	TAY	PT TAY
Series I	15.23%	12.16%	12.31%	10.45%	9.86%	9.00%
Series II	13.59%	11.07%	11.36%	9.71%	9.44%	8.63%
Series III	17.20%	14.23%	13.42%	11.62%	10.23%	9.40%
Series IV	15.75%	13.25%	12.58%	10.96%	9.86%	9.07%

TAY - Tax-adjusted yield

PT TAY - Post-tax tax-adjusted yield

3. Why the yield on Cumulative option (Series 2 or 4) less than the yield on Annual option (Series 1 or 3)?

Generally, all consultants advise us to go for cumulative option since it is more beneficial. If that being the case, then why the yield on cumulative option is less than the yield on annual option? This is due to the inherent assumption in calculating the yield on the investment. The calculations assume that in the annual option, you are able to re-invest the interest earned at the tax-adjusted yield rate (i.e. @ 15.23% for Series 1 and @ 17.20% for Series 3), whereas in the cumulative option you automatically reinvest any interest earned at the rate of 7.75% for Series 2 and at the rate of 7.50% option for Series 4.

Reinvesting at higher rates may be impossible, and hence the effective yield on Series 1 and Series 3 will be lower depending on how you re-invest the interest earned.  In case you do not invest at all, the yield will be further low.

4. If the re-investment is crucial, then in which option should I invest - Annual or Cumulative?

In case you are able to re-invest the funds at rate greater than interest rate offered (7.50% or 7.75% depending on the Series in which you invest in), you should opt for the annual option. In case, you are unable to do so, or you do not wish to go in for micro-management of investing the interest every year, you can opt for cumulative option.

5. How does it compare with other investment options?

Infra Bonds are attractive only due to one reason – the benefit they offer under section 80 CCF. Otherwise there are many other opportunities available which are more beneficial. Also you need to consider the security and liquidity issue before taking the final call. These bonds are not as secured as fixed deposits and the earliest you can liquidate is the first working day after the 5th year.

Given below is the comparison of L&T Infra bonds with SBI fixed deposit for 10 years, 10 years Government of India Bonds and L&T Finance Debentures which were issued for 10 years @ 10.40% and remaining period on which is approx 9 years and current price Rs. 1082 for Rs. 1000 bond. Remember that except for L&T Finance Debentures, others are not apple to apple comparison, but will help you to make investment decision (technically though L&T Finance Debenture is also not the accurate comparison!).

Tax Slabs	SBI FD	GOI Yield	L&T Finance Debentures	L&T Infra Bond Series II
0%	7.8%	8.1%	9.1%	13.6%
30.9%	5.4%	5.6%	6.0%	11.1%
20.6%	6.2%	6.5%	7.0%	9.7%
10.3%	7.0%	7.3%	8.1%	8.6%

As you can notice even at lowest tax bracket, the lowest of the yield of L&T Infra Bond is higher than Bank Fixed Deposit, Government of India Yield and L&T Finance Debentures.

To conclude, in case you have already exhausted the Section 80C benefits and you have additional funds to invest from your debt portfolio which you are planning to invest for long term, you should invest in these bonds to the extent of Rs. 20,000 only and not a rupee more.

Comments are deeply appreciated on the above.

Are all ETFs same for investment?

Generally whenever one mentions Exchange Traded Funds (ETFs), people assume it to be a replica of the index, which in Indian scenario means the replica of Sensex or Nifty. However, it may not always be true. There are ETFs which track the subset of the index or a particular sector (eg. Banks) or even a commodity (eg. Gold). This post will guide you to understand ETFs and how to choose one.

ETFs available for investments:

One can invest in any of the following ETFs (I have chosen only those ETFs which are more than one year old):

Schemes	Asset Size (Rs. Cr)	1 Yr Returns	3 Yr Returns	Expense Ratio
Nifty ETFs
Nifty BeES	400	21.3	5.7	0.5
ICICI Pru SPIcE Plan	1	19.7	5.5	0.8
Kotak Sensex ETF	21	20.0	n.a.	0.5
Nifty Junior ETFs
Nifty Junior BeES	185	34.1	13.0	0.5
Banks ETFs
Nifty Bank Benchmark	19	28.5	16.9	0.5
Bank BeES	39	29.3	19.0	0.5
Reliance Banking ETF	15	29.0	n.a.	0.35
Kotak PSU Bank ETF	16	38.1	n.a.	0.65
PSU Bank BeES	7	37.9	n.a.	0.75
Gold ETFs
UTI Gold Exchange Traded Fund	390	20.4	23.7	1.0
Reliance Gold ETF	321	23.2	n.a.	1.0
Gold BeES	1244	20.3	23.8	1.0
Kotak Gold ETF	167	20.3	23.7	1.0
Quantum Gold Fund	24	20.3	n.a.	1.0
SBI Gold Exchange Traded Fund	139	20.9	n.a.	1.7

n.a. - not available

Returns as of 22nd October 2010

When to invest in ETFs?

Equity ETFs are good in diversifying your investments, similar to mutual funds. However, they generally track the benchmark in which they invest and can not give superior returns as compared to the benchmark. Whereas, mutual funds are managed actively and in countries like India, are able to generate additional returns. Diversified equity mutual fund should ideally form one’s core equity holding and equity ETFs should supplement this investment. However, in case one is not comfortable in trusting fund manager’s performance, he can invest more in ETFs.

What to look for in ETFs before investing?

1. First you should determine the type of exposure you would like to have through ETFs. In case you want the exposure to index stocks, good way to invest will be through ETFs like NIFTY BeES. If you want exposure to mid cap stocks along with large cap stocks, you can invest in Nifty Junior BeES. Similarly, in case you want to invest in Gold, you can look at Gold ETFs.

2. Second thing you need to do is compare the ETF returns with the benchmark. Your reason for investment in ETF is to ensure that you get returns similar to benchmark return. Hence, you should be wary of ETFs which consistently is above or below benchmark by significant percentage (more than 1% in this case). Tabulated below is the comparison of Index ETFs with the Nifty benchmark which is 20.5% for 1 year and 5.6% for 3 years. You can notice that generally they track the benchmark which is a positive sign (i.e. their tracking error is low). 

Similar analysis for Gold ETFs.

3. Next thing to check is the fund size. Greater the fund size, more comfortable you should be. Nifty BeES has the fund size of Rs. 400 crores as against Rs. 21 crores for Kotak Sensex ETF.

4. Last thing to check is the annual expenses which the fund house incurs to generate returns. Lower the expenses, better the returns. Hence look out for ETFs with less expense ratio. Nifty BeES and Kotak Sensex ETF have expense ratio of 0.5% p.a. where as ICICI Pru SpicE Plan has expense ratio of 0.8% p.a.

Keep these points in mind and start investing in ETFs.  Bachhat prefers Nifty BeES for exposure to index stocks, Junior BeES for mid cap stocks and Gold BeES for investment in gold.

As usual, comments appreciated.

ETFs – More findings from the research

Continuing my yesterday’s post on ETFs – their impact on your investments?, the research paper of Jefrey Wurgler, Nomura Professor of Finance, NYU Stern School of Business “On the Economic Consequences of Index-linked Investing” has other findings which I would like to highlight in this post.

On ETFs he says that 

“…the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs.” 

One can estimate the size of such funds from the following. 

“Standard & Poor’s reports that as of this writing (July 2010) there is $3.5 trillion benchmarked to the S&P 500 alone, including $915 billion in explicit Index funds. ETFs now amount to $1 trillion across all asset classes and indices. Russell estimates that $3.9 trillion is currently benchmarked to its indices. This gets us quickly to about $8 trillion in easily countable products.”

No doubt as ETFs continued to get popular in countries like India, they will start making impact on index stocks and their returns.

It further states that the stock which gets included in the Index changes its return pattern 'magically' and 'quickly'.  It begins to move closely with its other constituent stocks and less closely with the rest of the market.  In statistical terms, its co-variance increases with index stocks, thus increasing its beta.  This affects various corporate investment and financing decisions taken by this particular company (Remember Capital Asset Pricing Model (CAPM) where beta of the stock is one of the inputs for calculation of Cost of Equity).

Another interesting finding of its impact on the performance of active fund managers.
  

“the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index – it may actually be contributing to their underperformance."

Finally ending with his conclusion

"Indices and index-based investing are innovations that are here to stay and have rightly become central to modern investing.  The consequences are here to stay as well.  Research on the magnitude of the economic distortions they cause is needed, as are suggestions how regulators and market structures might reduce them."

ETFs – their impact on your investments?

Exchange traded funds or ETFs, as they are popularly known as, is one of the vehicles to invest your money in equity markets.  Since they invest in benchmark index in the same proportion as its constituents, their performance is similar to the benchmark they track and they have low tracking error as well as low operating cost.  All this making them as one of the important avenues of investment.  They are hugely popular in the developed countries and are slowly catching up in countries like India. 

In India, many fund managers are able to give returns exceeding the returns generated by the index funds and hence investors correctly prefer mutual funds more than the index funds.  However, as capital market develops, becomes more efficient and it gets impossible for fund managers to gain above normal returns, ETFs will become one of the prime vehicles of investment.

In countries like US where funds are available cheap, exchange traded funds have started blossoming because they invest in the indexes of emerging markets and give better returns. Since large sums of money is invested in ETFs which flows in to the stocks of the index, it should be interesting to know how this affects the performance of individual stock and of capital market overall.

Jefrey Wurgler, Nomura Professor of Finance, NYU Stern School of Business has researched the Economic Consequences of Index-linked Investing in his NBER paper and has come out with interesting conclusions.  He says that “.. index-linked investing is distorting stock prices and risk-return tradeoffs, which in turn may be distorting the corporate investment and financing decisions, investor portfolio allocation decisions, fund manager skill assessments, and other choices and measures.  These effects may intensify as index-linked investing continues to grow in popularity.”

This conclusion is interesting in many ways.  As a particular stock forms part of an index, all the ETFs are required to buy that stock till its weightage in the index.  This pushes up the prices of that particular stock as it enters the index.  Conversely, if any stock is removed from the index, ETFs sell that stock leading to declining stock price.  Mr. Wurgler observes that “On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event, with the effect generally growing over time with index fund assets.  Stocks deleted from the index have tumbled by even more.”  Here the event being that particular stock included in the index.

Similarly, as the fund flow increases to ETFs, these funds buy the underlying stocks pushing up their prices and improving their returns which in turn attract more investments in ETFs (“return chasing feedback loop” as per Mr. Wurgler).

To conclude, ETFs are good investment vehicle, more particularly where capital markets are more efficient.  For countries like India, their importance will grow as the capital market becomes more efficient.  They can form small part of your equity portfolio with diversified equity mutual funds comprising larger portion.

As usual, comments appreciated.

L&T Infrastructure Bonds – How does it compare with IDFC Bonds

Yesterday, L&T Infrastructure announced public issue of its infrastructure bonds, investment in which will be eligible for tax deduction under section 80CCF of the Income Tax Act.  The issue size at Rs. 200 Crores with an option to retain oversubscription of Rs. 500 crores is smaller than IDFC Infrastructure Bond Issue size of Rs. 3400 crores.

Terms of the issue are as follows:

• Issue Open Date : October 15, 2010
• Issue Close Date : November 2, 2010
• Listing on NSE
• Credit Rating of CARE AA+ by CARE and LAA+ by ICRA
• Basis of Allotment : On first come first serve basis
• Tenure : 10 years

The bonds are issued in four series as given below:

Series	Interest Rate	Interest Payment	Buy Back Option	Tax Adjusted Yield*
I	7.75%	Annual	After 7 years	15.23%
II	7.75%	Cumulative	After 7 years	13.59%
III	7.50%	Annual	After 5 years	17.20%
IV	7.50%	Cumulative	After 5 years	15.75%

HTML Table

* Tax adjusted yield is assuming buyback at the end of the specified period

Comparison with IDFC Bond:

The yields for Series 3 and Series 4 are same as Series 3 and Series 4 of IDFC bond issue.  Investor will in indifferent in investing in either of these issues. However, Series 1 and 2 of L&T Infrastructure issue has the buy back option after a period of 7 years and is ideal for investors looking for investing beyond 5 years but less than 10 years horizon.  For those looking for investing for 10 years, IDFC bond issue is preferred since the coupon rate is 8%.

Suggested weekend readings (October 9, 2010)

Today we will look at few basic concepts which concern ourselves on a day-to-day basis.  A beautiful visual guide to help one understand inflation (link) and deflation (link) in simple terms. Source: Mint

A good article by Deepak Shenoy on how inflation can assist you in saving less than required (link). 

And a nice game teaching you personal finance lessons (link).

Enjoy the weekend.

IDFC Infrastructure Bonds - Correction

In my earlier post on IDFC Infrastructure Bonds, the tax adjusted yield was incorrectly calculated.

The effective yield for an individual in 30.90% tax slab is as follows:

Series	Coupon Rate	Tax Adjusted Yield
Series 1	8.00%	13.90%
Series 2	8.00%	12.07%
Series 3	7.50%	17.85%
Series 4	7.50%	15.75%

HTML Tables

Tax adjusted yield for Series 3 & 4 is assuming buyback at the end of 5th year.