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No free lunches in financial markets

Deepali,34,had tried to invest in equities. She had bought stocks when the Sensex was at 12,000. Unfortunately,the Sensex then fell to 8,500.

Written by Veer Sardesai |
January 18, 2010 12:39:09 am

Deepali,34,had tried to invest in equities. She had bought stocks when the Sensex was at 12,000. Unfortunately,the Sensex then fell to 8,500. Deepali had panicked and sold off her investments. She was aware that wealth can be created in the stock market if one remains invested for a period of five to 10 years. Deepali did not mind committing funds for the long term. But her risk-averse nature could not stomach the short-term volatility of stocks. She had therefore decided that stocks are not for her. She would invest in Public Provident Fund (PPF) and bank Fixed Deposits (FD) which give an assured return.

Her close friend Sakshi,33,knew of Deepali’s attempts at investing in the stock market. So,when she saw an advertisement proclaiming “Highest NAV Guaranteed”,she immediately informed Deepali. Both of them felt excited about the new unit linked insurance plan (Ulip). This 10-year plan guaranteed that the investor would get the highest net asset value (NAV) of the first seven years on redemption. They believed it meant that their stock market investments were protected from any downside. Even if the Sensex dropped from 12,000 to 8,500 they would not be affected.

Disabuse yourself of false notions

The two friends came to us to discuss this newfound product. I felt sorry to have to temper their excitement. The reality was very different from their belief. “There is no such thing as guaranteed returns from stock market investments. It does not matter whether you invest directly or an insurance company does it for you,” I said.

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“But it states so in the ad,” Deepali replied.

“Not quite. Let me explain,” I said.

India is not new to assured-benefit schemes. Giants like UTI and LIC have launched schemes in the past that offered assured yields. They have all failed and had to be bailed out. Fortunately,in those days most of these institutions were run by the government. The mutual fund industry has learned its lessons and Sebi,the stock market regulator,has banned mutual funds from launching assured-return schemes.

The current schemes have been launched by insurance companies over whom Sebi’s diktat does not run. If these schemes try to invest the entire amount in equities,there is hardly any possibility of them being able to keep their promise. US 64 had to shut down in 2002 because it could not deliver on similar expectations. Any scheme that invests the entire amount in the stock markets can guarantee the highest NAV at redemption if and only if the stock markets rise continuously for those seven years. This is an unlikely scenario and one that has never been witnessed earlier. But if it did happen,even Deepali’s direct stock-market investments would deliver the highest NAV benefit!

The catch

The new Ulip schemes do assure you the highest NAV. However,it is we who assume that they are taking about investing the entire corpus in stocks. If one reads their offer document,one will find that they will invest between 0 and 100 per cent in equities. The remainder will be in fixed-income instruments like bonds. This means that they have the right to invest all the funds in fixed-income instruments. Just like a cumulative bank FD that appreciates in value every year,the Ulip will also appreciate annually. At redemption your bank FD will also be redeemed at the highest value it has ever reached. The Ulip will do the same. Any bank can therefore always advertise redemption at highest NAV on a fixed deposit!

“You mean these schemes will invest only in fixed income instruments?” asked Deepali.

“They certainly haven’t stated that all the funds will continuously be deployed in the stock market,” I replied. Deepali nodded. In reality,they will probably invest a small amount in stocks while the rest will be invested in fixed-income securities.

How does it work?

There is a simple approach by which the highest NAV can be guaranteed to investors. Suppose I have Rs 100 and I can invest it in a FD at 10 per cent per annum. I now invest only Rs 91 in the FD. Including accrued interest,at the end of one year I will receive Rs 100.10 (Rs 91 plus Rs 9.10 as interest). This indicates that the Rs 9 from the original capital can be deployed in any risky investment. Should this risky investment fail I lose Rs 9. But since I have earned Rs 9.10 as interest,my capital is unaffected! The risky investment in the above example can be the stock market. These guaranteed-return Ulips are likely to be run in a similar manner. If they overexpose themselves to equities and lose money,investors will lose,their only hope being that someone will bail the insurance company out.

In conclusion,do not expect that “guaranteed-return Ulips” will give you earnings commensurate with the stock market. To make stock market profits you have to bear the risks associated with the stock markets. Remember that risk and return go hand in hand and that there are no free lunches in the financial markets. If you want assured benefits,invest in products such as a bank FD or PPF. Deepali and Sakshi nodded in agreement. They said their goodbyes and left.

The author,a certified financial planner,is the chief executive of Sardesai Finance.

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