The mutual fund sector operates under stricter regulations as compared to most other investment avenues. Apart from offering investors tax efficiency and legal comfort, how do mutual funds compare with other products?
Fixed deposits are unsecured borrowings by the company accepting the money. Credit rating of the fixed deposit programme is an indication of the inherent default risk in the investment.
The moneys of investors in a mutual fund scheme are invested by the fund manager in specific investments under that scheme. These investments are held and managed in trust for the benefit of the scheme’s investors. On the other hand, there is no such direct correlation between a company’s fixed deposit mobilisation, and the avenues where it deploys these resources.
A corollary of such linkage between mobilisation and investment is that the gains and losses of the mutual fund scheme (after deducting costs) entirely flow through to the investors. Therefore, there can be no certainty of yield, unless a named guarantor assures a return or, to a lesser extent, if the investment is in a FMP type of structure. On the other hand, the return under a fixed deposit is certain, subject only to the default risk of the borrower.
Both fixed deposits and mutual funds offer liquidity, but subject to some differences:
>> The provider of liquidity in the case of fixed deposits is the borrowing company. In mutual funds, the liquidity provider is the scheme itself for open-end schemes, or the market in the case of closed-end schemes.
>> The basic value at which fixed deposits are encashable is not subject to market risk. However, the value at which units of a scheme are redeemed entirely depends on the market. If securities have
gained in value during the period, then the investor can even earn a return that is higher than what she anticipated when she invested. Conversely, she could also end up with a loss.
Early encashment of fixed deposits is always subject to a penalty charged by the company that accepted the fixed deposit. Mutual fund schemes also have the option of charging a penalty on “early” redemption of units (by way of an “exit load”). If the NAV has appreciated adequately, then despite the exit load, the investor could earn a capital gain on her investment.
Bank fixed deposits are similar to company fixed deposits. The major difference is that banks are more stringently regulated than are non-bank companies. They even operate under stricter requirements regarding Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) mandated by RBI.
While the above are causes for comfort, bank deposits too are subject to default risk. However, given the political and economic impact of bank defaults, the government as well as Reserve Bank of India (RBI) try to ensure that banks — at least the public sector banks — do not fail.
Further, bank deposits up to Rs. 1 lakh (including interest) are protected by the Deposit Insurance and Credit Guarantee Corporation (DICGC), so long as the bank has paid the required insurance premium of 10 paise per annum for every Rs. 100 of deposits. The monetary ceiling of Rs. 1 lakh is for all the deposits in all the branches of a bank, held by the depositor in the same capacity and right.
Suppose an investor’s dues (principal plus interest) from two failed banks are as follows:
- Bank A, Branch 1 on own account Rs. 70,000.
- Bank A, Branch 2 on own account Rs. 40,000.
- Bank A as legal guardian for minor Rs. 80,000.
- Bank B on own account Rs. 90,000.
The benefit through DICGC would be as follows:
Bank A on own account :
Rs. 100,000 (as compared to the dues of Rs. 70,000 plus Rs. 40,000, i.e. Rs. 110,000 from both branches put together).
Bank A as legal guardian of minor:
Rs. 80,000 (since it is in a different capacity and within the Rs. 100,000 limit).
Rs. 90,000, since it is within the Rs. 100,000 limit in a different bank.
As in the case of fixed deposits, credit rating of a bond or debenture is an indication of the inherent default risk in the investment. However, unlike fixed deposits, bonds and debentures are transferable securities.
While an investor may have an early encashment option from the issuer (for instance through a “put” option), liquidity is generally through a listing in the market. Implications of this are:
If the security does not get traded in the market, then the liquidity remains on paper. In this respect, an open-end scheme offering continuous sale / repurchase option is superior.
The value that the investor would realise in an early exit is subject to market risk. The investor could have a capital gain or a capital loss. This aspect is similar to a mutual fund scheme.
It is possible for an astute investor to earn attractive returns by directly investing in the debt market, and actively managing the positions. Given the market realities in India, however, it is difficult for most investors to actively manage their debt portfolio. Further, at times it is difficult to execute trades in the debt market even when the transaction size is as high as Rs. 1 crore. In this respect, investment in a debt scheme would be beneficial.
Debt securities could be backed by a hypothecation or mortgage of identified fixed and / or current assets, e.g. secured bonds or debentures. In such a case, if there is a default, the identified assets become available for meeting redemption requirements. An unsecured bond or debenture is for all practical purposes like a fixed deposit, as far as access to assets is concerned.
The investments of a mutual fund scheme are held by a custodian for the benefit of investors in the scheme. Thus, the securities that relate to a scheme are ringfenced for the benefit of its investors.
Investment in both equity and mutual funds is subject to market risk.
An investor holding an equity security that is not traded in the market place has a problem in realising value from it. But investment in an open-end mutual fund eliminates this direct risk of not being able to sell the investment in the market. An indirect risk remains, because the scheme has to realise its investments to pay investors. The AMC is, however, in a better position to handle the situation. Further, on account of various SEBI regulations, such illiquid securities are likely to be only a part of the scheme’s portfolio.
Another benefit of equity mutual fund schemes is that they give investors the benefit of portfolio diversification through a small investment. For instance, an investor can take an exposure to the index by investing a mere Rs. 5,000 in an index fund.
Life insurance is a hedge against risk — and not really an investment option. So, it would be wrong to compare life insurance against any other financial product.
Various insurance policies are available to meet different needs of investors. Broadly, there are policies that offer only risk cover (term plans) and others which have an element of savings accumulation (endowment). Some insurance plans give the impression of being mutual funds in nature, on account of the choice of portfolio given to the insured, and quantification in the form of units (unit-linked insurance plans).
High front-end costs, largely on account of distribution expenses, impact the net return on the savings component of endowment policies and unit linked insurance plans.
Transparency levels in the insurance industry, although improving, are still below the standards set by mutual funds. For instance, an insurance plan may say that NAV is protected or that you will get the highest NAV over 7 years. Such statements cannot be taken at face value.
Suppose out of Rs. 100 invested by you, Rs. 40 is taken away towards various insurance, selling and administrative costs. Then, only the balance 60 will be part of the savings portion. You may be allotted 6 units at Rs. 10 against this. NAV protection / highest NAV would be only on this savings portion, i.e. after 40% (in this illustration) has been taken away towards costs. In comparison, the costs in the mutual fund industry are restricted to 2.5%, plus a small element on amounts mobilised from locations other than the Top 15 in the country.
Pension, as we all know, is a sum of money that some people (pensioners) are entitled to after they retire from regular employment. Pension schemes can be:
>> Defined benefit schemes, where the pensioner gets a benefit that is linked to the average salary she was drawing around the time of retirement. The benefit may also be inflation indexed. People who worked for the Indian government and public sector companies traditionally earned pension in the form of a defined benefit.
>> Defined contribution schemes, where the pensioner contributes a stipulated percentage of salary during her working years. The post-retirement corpus then depends on the contribution during the working years, and the return that those contributions earned. Provident fund schemes in the organised sector in India are of this nature.
>> The National Pension System (NPS) offers an alternative defined contribution scheme, where the investor has the option of varying the investment amount each year. The minimum annual investment is Rs. 6,000. This corpus created over a period is used to buy an annuity from an annuity provider. This annuity is the pension that will be received post-retirement.
In a defined benefit scheme, the organisation paying the pension takes a huge risk. Its liability is committed, irrespective of how much there is in the kitty. As the kitty dwindles, the organisation seeks to cover its liability to past employees, by recovering correspondingly higher amounts from current employees. Thus, current employees end up subsidising the pension of past employees.
When the number of current employees in organisations reduces (with rationalisation, automation, etc.) while the number of retired employees increases (with higher life expectancy), the former take up increasing burdens. Over a period of time, the entire pension system becomes inequitable and risky.
People in India can subscribe to the NPS, which is a defined contribution scheme. Dedicated pension fund managers (PFM) are responsible for investing on behalf of the scheme. Investors have a choice regarding mix of debt and equity for their portfolio, and the PFM(s) who should manage it for them.
NPS is a good vehicle for the accumulation of long-term savings. The government has enforced an extremely low cost structure for NPS. This costeffectiveness can be the basis for better returns for NPS subscribers as compared to insurance and mutual funds (it also depends on how well the portfolios are managed). Fewer product choices make it easier for investors to compare and decide between schemes and pension fund managers. Centralised record keeping and Points of Presence (POPs) all across the country add to the convenience for NPS subscribers.
Despite recent increases in the cost structure, NPS continues to be a costeffective product. Persistence charge was recently introduced. Although the amount is nominal, its recovery through cancellation of units is rather nontransparent. Investors who track the performance of their NPS fund manager through NAV may miss out on the impact of the levy. Hopefully, such measures are not a harbinger of a switch towards the high cost and low transparency insurance model.
Under the Income Tax Act, 1961, a separate deduction of Rs. 50,000 from income is available for contributions in NPS. Withdrawals from the NPS are tax-exempt upto 40% of the corpus, provided the pensioner has attained the age of 60.