CategoryMutual funds

I recently visited icici and HDFC bank for some personal work and some of the sales folks at these branches went into a sales pitch, pushing their respective unit linked plans. These unit linked plans are a combination of an Insurance policy and mutual funds. The key highlights of these plans are

Highlights
– An annual ‘premium’ payment towards the plan for around 15 years.
– An option to pick from a range of 100% equity to 100% debt plans
– If the primary holder passes away, the nominee get the insurance amount in addition to the accumulated value of the mutual fund component (varies by plan)
– A max total insurance cover of around 12.5 lacs even if the annual premium exceeds 2.5 lacs
– 40% premium charge in year 1, 30% charge in year 2 and 2% thereafter.
– A plethora of other charges some of which are not very clear unless you dig further such as mortality charge, admin charge etc
– A 1.25% fund management charge

Now these sales folks are well intentioned and all that. But frankly my initial feeling was that anything this complicated and convoluted cannot be very good. Lets look at some math

For ex : I invest 2.5 lacs per annum for 15 years in a 100% equity option. So around 1.75lacs are deducted in year 1 and 2 combined and around 5000 rs per annum thereafter. The rest would be invested in a mutual fund of choice.

The insurance component

Lets look at the insurance component first. A pure risk policy (which is what the above is) is currently priced at around 4000-6000 p.a premium for a duration of 15 years. So clearly the insurance component is overpriced.

There is a bumper component which is paid at the end of the policy term which equates 70-80% of the premium. If you look at it in another way, this equals the 70% you pay upfront at the start of the policy.

So in a nutshell, the company is taking 70-80% of the annual premium from you and holding it interest free for 15 years. At an interest rate of around 9% per annum that is 3.6 times your annual premium !!

The 2% annual deduction would get you a similar pure risk policy with all the attendant benefits including tax deductions.

Mutual fund component

Lets look at the mutual funds component – Nothing special here. The company is taking 60% of your premium in yr 1, 70% in year 2 and 90% in yr 3 and onwards and investing it on your behalf for 15 years. At the end of 15 years, you redeem based on the NAV then.

What are the negatives here ?
– For starters my money could be locked for 15 years – a big negative if the performance turns out to be poor.
– The brochures, which I have seen show very average performance for all the concerned funds (most of them, barely beating the index before charges and actually underperforming the index after the fund management fees).
– A plethora of charges I noted earlier, get deducted from the mutual fund component. There is not much clarity in the brochures on the quantum of total charges, but I don’t expect it be less than 1% of the total (maybe more).

Conclusion
A pretty bad investment option. The insurance component is way overpriced !!. The mutual fund component has nothing special in it and has a load of charges attached to it, which will reduce your returns substantially in the long run. I will not be surprised if the banks are getting a hefty commission or good fee from these kind of plans.

My initial feel was that anything this convuluted and complex is a nice way for the bank or AMC to make good money off the fees and leave the investor with poor returns

Recommendations
Buy a low cost pure risk policy for the insurance cover. These policies do not pay anything if you survive ( A happy outcome !! as I have survived) and have a very low premium. For the mutual fund component invest in a low cost index fund or ETF or a decent mutual fund (if you can find one).
Finally, buy something nice for yourself or your spouse/friend with the money you save and send me a gift for saving you this money (just kidding !)

I got the following comment on my previous post and thought of putting my response to it in a post as I think it would help in putting my approach and thoughts on mutual fund investing in perspective.

“Low risk, low gain” is fundamental philosophy found true in every walk of life. I am surprised Why people like you, who can take risk after calculated move on the stock market, purchase mutual fund by paying hefty fee to suited gentlemen who musroom on CNBC and other TV channel giving alwyas buy advice in the time of Market going up and up? Find them when the market goes down……They will vanish.
Its my feeling that Mutual Fund is for those gullible masses who wants return on their capital but have no knowledge of stock market .Not like people like you, because why take risk on somebody feeling when you can take for yourself? That too by paying astronomical fee .

I do not agree with the above comment in entirety. True, there are several mutual funds which end up serving the asset management companies and their managers. A lot of these guys are just airheads who come on CNBC and other channels and spout useless drivel. Frankly I rarely watch these channels, they are at best a distraction and noise and just a form of entertainment. However, I would not sweep all the mutual funds with the same brush.

I consider mutual funds to be an important component of my portfolio in addition to stocks and other forms of investments. The reasons are as follows

– Low cost mutual funds with a good, consistent history are a good way of investing in the market and getting above market returns (the low cost and consistent history part is crucial). By selecting a mutual funds based on specific criteria (which I will post shortly), I can try to avoid the type of risks mentioned in the comment above.

– Mutual funds serve as a good benchmark for my portfolio. If my equity portfolio (stocks only) does not beat my mutual fund portfolio (net returns), then I am better off putting my money in well chosen mutual funds and not wasting time in picking stocks myself. In the end, investing is about the risk taken and the returns I get for it. I don’t define risk as volatility or loss of capital alone. Time spent on picking stock is also an investment for me and I see no reason to invest in stocks myself if my equity portfolio does not beat my mutual fund portfolio

– Mutual funds and ETF’s are also a quicker way of getting decent returns. I may not get the same returns as I would by picking stocks on my own, but I also end up spending considerably less time. This I say from experience.

I do not look at stock versus mutual fund investing. On the contrary for me it is stock and mutual fund investing.
Stock investing may give me higher returns, however I have to spend considerably more time on it. For every 10 stocks I analyse, I end up buying 1-2 stocks at best. Mutual funds may provide me lower returns, but I also end up spending much lesser time in selecting and tracking them on a regular basis. So in the end the returns I get compare fairly with the time and effort I spent on it. Investing for me is still a part time thing and not a profession (yet)

As I write this post, I have been investing in mutual funds for over 8-9 years. This is a post to show the experiences I have had with mutual funds and learnings from my mistakes and sucesses. So it is not a showpiece of my brilliance or of my stupidities (of which you will find more of in the narrative). It is just a gist of my experience and learnings

1999-2000: Time of confidence and on top of the world

It is mid 1999. I had already dabbled a bit in mutual funds. I had invested a small amount in UTI-Mplus 91 in 1995 at a discount to NAV (it was a closed ended fund then). The discount had closed and I had made over 20% per annum and was feeling more confident of investing in mutual funds. Also I had moved out of Unit 64 scheme in 1998 after I had read a few adverse reports about it and managed to avoid the losses.

So here I am in 1999, feeling confident and having a little bit of cash in my pocket. Towards the end of 1999 (right a the start of the bull run) I started investing in mutual funds (yes, got the timing right!)

This was my list of mutual funds at that time
Alliance new millennium fund
Alliance buy india fund
DSP meryll lynch opportunities fund
Kotak MNC fund
Kothari pioneer fund balanced and Internet opportunities fund
Prudential ICICI tech fund
Alliance 95 fund
Franklin index fund

So I was heavily invested in IT funds. Considering that I was in mutual funds and spread across several of them, I incorrectly assumed that I had diversified the risk.

2001-2002: What was I thinking ?!!

The tech carnage started in mid 2000 and several of my funds lost 80-90% of the value. The saving grace were the non IT funds. But those funds lost more than the index as they were also heavily wieghted in IT. So the herd mentality affects everyone at the same time.

Although it was easy to blame the mutual funds and their aggressive marketing (they advertised 100% gains for 3 month periods), I realised it was my greed and faulty logic which was the reason for my losses.

I had been reading buffett and other value investors since 1998 and was a firm believer in value investing, but allowed myself to be carried away by euphoria and greed.

By the end of 2002, my mutual fund portfolio was down 25% and I had already exited from several tech funds and moved into diversified funds.

My fund summary by the end of 2002 was as follows
Alliance new millennium fund
Alliance equity fund
DSP meryll lynch opp fund
Zurich equity (now HDFC equity)
Prudential ICICI tech fund
Alliance 95 fund
Franklin index fund
Pioneer ITI index fund

So as you can see, I had started moving out of tech funds and into index funds.

A few learnings

– avoid sector funds. If you want to invest in a sector, find some good stocks in that sector. Sector funds don’t diversify risk, only concentrate them
– A good portion of funds should be kept in low cost index funds. You are garunteed market returns in the case of index funds.
– Diversified equity funds are the best option as these funds allow the mutual fund manager the maximum flexibility, unlike the sector fund where the manager and the investor are stuck in the same sector even when the sector is sinking.

2002-2004: Fixing the portfolio

With the above learnings in mind, I took my losses and moved into diversified equity funds. I chose funds which had demonstrated long term outperformance.

My portfolio looked like this by 2004.

Alliance equity fund
Reliance vision
DSP meryll
Franklin templeton – Blue chip growth and Dividend
Templeton india growth fund
Prudential ICICI growth (switch from tech fund)
HDFC equity
Rest was index funds and Nifty BEES.

My portfolio by this time reflected the following approach

– reduce the number of funds in the portfolio. More funds do not provide diversification, they just reduce the reduce the return without reducing the risk
– Select funds with low expenses and a long term performance history
– Prefer diversified equity funds over sector and promotional funds (like an MNC fund or similar idea based funds).

2004-2007: Doing nothing (and reaping the rewards)

During this period my fundamental approach did not change drastically. I have kind of fine tuned a few aspects of my mutual fund approach, but the broad approach has remained the same and has worked quite well

A few changes during this period have been

– reduction of the number of mutual funds and consolidation into fewer high quality funds
– Regular investing through a Systematic investment plan, barring when I feel the market is extremely high
– Limit the total number of mutual funds to 4-5 at best and re-invest additional money in the same funds.

The net result of the above journey from the year 2000 to 2007 has been a net performance of around 23% per annum , which would be around 5-6% more than the market returns.

Next post : My approach to selecting mutual funds