Fixed Maturity Plans....(Returns)Lock Kiya Jaye

Whenever, we think of fixed returns, the first investment avenue that comes to our mind is the traditional fixed deposit (FD). We often tend to follow these investment avenues as they are considered safe and provide fixed returns. But Fixed Maturity Plans (FMPs) is another avenue which should be considered before we make an investment decision especially when you need tax efficient and inflation adjusted returns. Let us explore what FMPs are and how they score over a bank FD.

What are FMPs?

FMP's are equivalent to a Bank FD in a mutual fund but unlike FDs it cannot offer a fixed return. However, by nature the returns on the FMP are locked as all the investments are held to maturity. As the name suggests, the maturity of securities in portfolio equates with maturity of the FMP. FMP's fall under the closed ended debt category of mutual funds which has exposure only to fixed income securities for different maturity periods. The primary objective of a FMP is to generate income and protect fluctuation in the capital due to interest rate variations. They are also known as fixed tenure funds and fixed horizon funds.

FMPs have exposure to high quality bonds (generally AAA/AA rated). Being a debt fund, the portfolio is more tilted towards fixed income securities like certificate of deposits (CDs), commercial papers (CPs), corporate bonds, pass through certificates (PTC), government securities etc. The exposure across different debt instruments makes it more attractive and reduces the portfolio risk.

FMP's come with different maturities like 1 month, 3 months, 6 months, 1 year till 3 years. The different maturities provide an option to investor to choose an FMP as per their investment horizon.

Also one important point to note here is that unlike other debt funds, the fund managers need not undertake the review of portfolio because the instrument in portfolio matures with the tenure of the scheme. Thus, the expense gets reduced to a great extent.

How FMPs score over FDs:

The biggest difference between a Bank FD and an FMP is the Income Tax Arbitrage opportunity available. FMPs (if you have opted for Growth option) is taxed as capital gains and if you have opted for dividend option, it attracts Dividend Distribution Tax (DDT). The below illustration explains how one can optimize their tax liability:

Investment of Rs.1,00,000 in FMPs & Bank FDs for period of 1 year

	Bank FD Rs.	FMP Rs.
Investment  Amount (A)	1,00,000	1,00,000
Returns (% per annum) (assumed)	9%	9%
Time Horizon	367 days	367 days
Maturity Amount (B)	109049	109049
Interest/Capital Gain (C) = (B-A)	9049	9049
Cost after inflation – with indexation  (100000 )*924/852  (D)	NA	108450
Net Taxable Income – with indexation (E) = (B-D)	-	599
Tax Payable (assumed 30.9%) on Bank FD (F)	2,796	-
Capital Gains (@ 10.3% of (C) – without indexation	-	932
Capital Gains (@ 20.6% of (E) – with indexation	-	123
Post tax Return (C – F)	6253	8926
Post Tax Return (%age)	6.25%	-
Post Tax Return- with indexation (%age)	-	8.93%

*Cost Inflation Index (CII) for 2011-12 -785 and for 2012-13 -852, it is assumed cost inflation will rise by 9% as in the past.

Capital gains tax is 10% without indexation or 20% with indexation whichever is less

On a pre tax basis one is not able to make out which investment avenue is better, but as seen in the above example the impact after reducing taxes is indeed very significant. An investor can get 42% more return than a FD.

FMPs are best suited for investors (especially  above the 20% tax bracket) who are looking for a risk free investment avenue.

To conclude, although bank FDs offer guaranteed returns and FMPs cannot, there is merit to investing in FMPs vis-a-vis FDs due to higher tax efficient returns offered by FMPs. However, there is one limitation with regard to liquidity. Even though these are listed on the Stock Exchange, there is no liquidity and typically the investor has to hold the investment till maturity. In the present scenario, owing to higher inflation, interest rates are high, this will gradually decrease hence time is ideal to lock your investments in FMP's


Ninad Kamat CFPCM
www.letsmakeaplan.in
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Data Source: Juzer Gabajiwala Director- Ventura Securities
Image Source: Onemint.com

Inflation............the invisible enemy

It is quite understandable that not all investors are alike. Some are like the Virat Kohli's of the cricketing world, seeking to reap maximum investment returns (scoring aggressively) for their efforts. Yet, some are like "The Wall" Rahul Dravid who guard their nest eggs (have a solid defence) with a keen eye and firm hands, lest there be some unexpected loss of wealth. For this second group of investors, fixed deposits or savings accounts appear to be sure-fire ways to achieve their investment goals. However as an “invisible” but omnipresent enemy, inflation presents a great challenge to this notion.

Inflation is taxation without legislation.

Milton Friedman

As an enemy of the saver, inflation is invisible in the sense that it does not physically steal from you; rather, it manifests itself in the form of higher prices, which renders a rupee today less valuable than a rupee tomorrow. In recent years, we Indians have felt the significant impact of this invisible enemy in areas like food, shelter, transport and even in terms of healthcare needs. 

To illustrate this point, consider a situation where you invest Rs.1 lakh of your money in a deposit which earns you 8 per cent a year. At the same time, the prices are also generally rising at the rate of 8 per cent a year. In such a situation, your compounding returns will just about keep pace with inflation.In effect, you have not become any richer. The rise in the amount of money you hold is just an illusion and is completely negated by a corresponding rise in prices.

But inflation may not be so kind as to stay at the level of the interest you are earning. What if it's more? And what if this goes on for a very long time. Suppose your returns are 8 per cent but inflation stays at 10 per cent and twenty years go by?

Your investment would grow to Rs.4.66 lakh but things that used to cost Rs.1 lakh would now cost Rs.6.72 lakh. Now, the purchasing power of your Rs.1 lakh is just Rs.69,000. Your investment has actually made you poorer! This is not a theoretical example- it actually happens to millions in India. In our country, over the past thirty to forty years, the inflation rate has been either the same or a little bit higher than many of the deposits that are available. Unfortunately, far too many people think of the two problems as unrelated.

THE IMPORTANCE OF SEEKING A POSITIVE “REAL RETURN”

Over the past decade, India’s inflation has averaged well above 7%, although price increases have been more prevalent in recent years. What this entails is the inability of savings and deposits to generate a positive “real return”, that is, a return which can offset the effects of inflation on one’s savings, a pre-requisite for the preservation of purchasing power.

ALTERNATIVE OPTIONS FOR SAVERS?

One alternative is to shift up the risk scale, moving a portion of one’s savings into fixed income funds. While not guaranteed like bank deposits, these funds offer investors the chance to beat inflation and earn a positive real yield, default risks are also spread out owing to the diversified nature of the fund’s holdings. In addition to this Tax benefits are also available. A good way to get accustomed to fixed income instruments is to begin investing in Liquid funds which have shorter duration and lower risk.

You could also consider investing in Equity, although drummed risky it takes just a little thinking to figure out that inflation is riskier. And to match inflation, and get real returns on top of that, you have to latch on to something that goes up with inflation anyway. This is not difficult because the value of goods, services and assets in the economy is inherently inflation-linked. And so risky or not, equity and equity-linked investments are the only game in town to protect yourself from inflation.

Conclusion

The common problem in India is the inability to account for inflation. People think in nominal terms and the future impact of inflation is awfully hard to internalise. The real solution to this is that we should become a low-inflation economy but since that's clearly not on the agenda, savers should always adjust for inflation mentally.

Ninad Kamat

CERTIFIED FINANCIAL PLANNER^CM

^{www.letsmakeaplan.in}

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Data Source: valueresearchonline.com
Image source: expresso.net

Great Conversations lead to Quality Decisions

Last week was again a very hectic and  exciting  one. We launched our 1st app on the Android platform, which is actually another means of accessing this blog. So you can now download the app from Google Play or you can search for Friday Financials in the Play store itself.

Then, during the weekend I was travelling to Mumbai for a training session on Digital Marketing organised by NetworkFP. On the train I met this gentleman who boarded at Karmali. After exchanging initial pleasantries, he talked about his amazing journey in the business of manufacturing lamp shades. I was thoroughly amazed by the sheer effort and hardships that he had to go through to make it a successful enterprise. He was now travelling to Mumbai to meet the management of Hypercity to extend and grow his business reach. I am sure that many of the entrepreneurs out there can share similar stories of their own success with great pride. 

But when I started talking to him about various aspects of his financial life it turned out that neither did he have a basic Life Insurance cover nor did he know anything about PPF or Mutual Funds. This is where I updated him about the necessity of a simple term cover. This was particularly important because not only his family but  his business was entirely dependent on him. Due to shortage of time we could not talk in detail, but he was quite convinced that the holistic approach of financial planning was the way ahead.

This conversation was high quality and both of us were left with something new, knowledge(him) and motivation(me).

Where does Financial Planning come into  the picture?

The recent past has opened us up to exploring our relationship with money in a much deeper sense. There is this sense that things are really “different” now, and that feeling is leading us to talk about the role of money and its meaning. In the past, not many conversations were centered around money. Traditionally it was the “breadwinner’s” job to shelter the rest of the family from conversations about money. That is changing.

Now it is really becoming a topic of national conversation. People are openly asking questions like:

Who and what can I trust?
What role does money play in my happiness?

These are deep questions.

One of the reasons that people don’t plan for their financial future is that a good financial planner requires us to talk about these things. Having the conversation will lead to intense discussions about trade offs, including what will I give up NOW for something in the future and trying to balance living today (however we define it) with our desire for freedom and the deep human need for security. Each of us have a different and unique answer to that balance. Balance for me might be very uncomfortable to you.

Great conversations are at the heart of the financial planning process.

Engaging in this conversation therefore forces you to think about things that you may have never considered consciously, but ultimately it leads to a much clearer and healthier relationship with money.

So what are the questions that you are asking yourself about money?

Oh!  And before I forget, please rate the app and also post feedback about any bugs/non functionality. 

Let's keep the conversation going.....

Ninad Kamat CFPCM
www.letsmakeaplan.in
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Sketches are sourced from Carl Richards of behaviourgap and are used with prior permission of the creator. They are subject to copyright.

Data Source: Behaviour Gap Newsletter

Risk profiling....Investing with a different perspective(Part III)

Continued from Part II

Now that we have updated ourselves with the different products available in the debt asset class let’s move on to the next asset class which should also be an important part of any portfolio(but largely overlooked & misunderstood by Indian Investors) - Equity.

This is one asset class where the results of the psychometric test (I feel) matter the most simply because in my experience  the volatility of stock markets more often than not touches our nerves the most.

Talking about Equity at a time when Indices are scaling newer high's is really exciting, (some of us might even experience goosebumps) but before you jump the gun it is very important to get your basics right. 

Equity - includes investments like Derivatives, Stocks, Portfolio management services and Equity mutual funds. For the sake of simplicity I will address only MF's in this post and will detail the other products at a later stage.

Advantages of an Equity mutual fund:

Diversification - This enables investors to spread out and minimize their risk up to a certain extent instead of buying individual stocks. By investing in a large number of assets, the shortcomings of any particular investment are minimized by gains in others.

Economies of scale -  Equity MF's buy and sell large amounts of securities at a time. This helps reduce transaction costs and bring down the average cost of the unit for investors.

Professional management - Equity MF's are managed by thorough professionals. Most investors either don’t have the time or the expertise to manage their own portfolio. Hence, mutual funds are a relatively less expensive way to make and monitor their investments.

Liquidity - Investor always has the choice to easily liquidate his/her holdings.

Simplicity - Investing in a Equity MF is considered to be easier as compared to other available instruments in the market. The minimum investment is also extremely small, where an SIP can be initiated at just Rs.100 per month basis.

Duration or holding period.

This will again purely depend on your financial goal and/or the present/future market conditions. 

Example:

If you have a long term goal like retirement, and are a new to investing in mutual funds, start an SIP in a balanced fund. This will help negate volatility and provide consistency return wise too. Once you are accustomed to the conditions you can switch to a higher risk product like a diversified Equity fund

Important tips.

When it comes to selecting an asset class, one should look for a customized portfolio. Your best bet is the right combination of growth, stability and income, keeping your financial goals and risk appetite in mind.

Don't just base your decisions on Past Performances, Invest in what you understand. Have a circle of competence, and stick to it. An investor needs to do very few things right as long as he or she avoids big mistakes, and staying within your circle of competence is one of them.

To invest better, become a student of human psychology. Learn how emotions lead to cognitive errors, so that you can avoid those errors and benefit when others make them.

Ninad Kamat

CERTIFIED FINANCIAL PLANNER^CM

www.letsmakeaplan.in

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