Foundation — Performance data, tax-saving products, pooled vehicles and ULIPs

A salaried woman has Rs 1,50,000 to place for her section 80C deduction. She has three doors in front of her, and they lead to very different rooms.

The ELSS door opens in three years. The workbook says 3 years lock in; post that can be withdrawn at any time — the shortest lock-in of the three by a wide margin. But the room is entirely equity: risk of loss of invested capital is HIGH, as the entire investment is in equities, with no guaranteed returns, and capital gains taxed at 12.50%.

The PPF door opens in fifteen years, with a small window from year five: lock in for 15 years from inception of the account; partial withdrawal possible after 5 years. The room is safe — LOW risk, as it is a SOVEREIGN RISK — and the returns are tax free, though the rate is dependent on the G-sec rate and can fluctuate for every quarter.

The NPS Tier 1 door does not open until she turns sixty. And if she forces it early, premature withdrawal requires using 80% of the withdrawal amount for purchasing an annuity. Even at sixty, only 60% of the corpus can be withdrawn tax free; the balance 40% has to be used to buy annuity product(s), and the annuity received is fully taxable.

The lesson is that the tax deduction is identical and the products are not remotely comparable. She should choose by when she needs the money and what risk she can bear — and the deduction, exactly as Chapter 17 said of insurance, is a reduction in cost rather than a reason to buy.

Three people travel the same route every morning. One takes a shared taxi: cheap, fixed route, and everyone in it goes to the same place. Another hires a car for herself: expensive, but it goes where she asks and waits when she wants.

That is the structural difference between a mutual fund and a PMS, and everything else in the table follows from it.

A mutual fund is a POOLED investment vehicle, where investments are in a POOLED ACCOUNT with UNITS allocated to each investor, and therefore it is a COMMON investment for all investors in a scheme. A PMS holds securities in the INDIVIDUAL INVESTORS' DEMAT ACCOUNT, and therefore can be CUSTOMIZED to meet the needs of an individual investor.

The price of that customisation is visible in the minimums: Rs 1,000 for a mutual fund, Rs 50 lakhs for a PMS, Rs 1 crore for an AIF Category 3.

But there is a second price, and it is easy to miss. A mutual fund's concentration is REGULATED BY SEBI to ensure some amount of BROAD BASING of investment; a PMS is NOT REGULATED BY SEBI on this, and can be and NORMALLY IS a CONCENTRATED PORTFOLIO.

So an investor moving from a fund to a PMS is not merely buying a more personal service. They are stepping outside a diversification rule that was protecting them — which may be exactly what they want, provided they know it.

And the AIF Category 3 is a third thing altogether: a POOLED vehicle like the fund, but one that undertakes DIVERSE OR COMPLEX TRADING STRATEGIES including investment in LISTED OR UNLISTED DERIVATIVES, meant for a High Net worth Investor looking for COMPLEX OR LEVERAGED investment strategies.

Two hotels charge Rs 9,000 a night. The first prints a bill showing room Rs 7,200, breakfast Rs 900, taxes Rs 900. The second prints one line: Rs 9,000.

If you want to know whether the room is good value, only the first bill lets you find out.

The workbook makes exactly this complaint about ULIPs. Maximum charges are regulated by IRDAI — so it is not that they are unregulated. The problem is the mechanism: INSURANCE (MORTALITY) AND OTHER CHARGES ARE DEDUCTED FROM FUND VALUE MAKING POST EXPENSE RETURN CALCULATION DIFFICULT.

The investor sees a fund value that has already had the insurance cost taken out of it. They cannot tell whether a disappointing number reflects a poor investment year or a heavy mortality charge, and those two facts call for completely different responses.

The difficulty compounds because of the next row: ULIPs have LOWER DISCLOSURE STANDARDS AND LESS AVAILABILITY OF VALUE ADDED COMPARISON SERVICES from independent media, while mutual funds have TRANSPARENT DAILY/PERIODIC DISCLOSURES that many independent media track.

So the investor can neither decompose their own product nor compare it against others — and that is the real argument, quite separate from cost, for the Chapter 17 conclusion that term policy plus PPF will invariably beat an endowment product for the same money. When insurance and investment are bought separately, each can be priced, compared and replaced on its own merits.

A man retires at sixty with Rs 1,00,00,000 in his NPS Tier 1 account. He assumes the money is his.

Most of it is. 60% of the corpus can be withdrawn tax free, after reaching the age of 60 years — Rs 60,00,000, with no tax.

The balance 40% has to be used to buy annuity product(s) from an Insurance company — Rs 40,00,000, which he does not receive. It buys a monthly income instead. And the annuity(ies) received from the Insurance company is FULLY TAXABLE.

Three facts, and all three are examined: 60 per cent tax free, 40 per cent compulsory annuity, annuity income fully taxable.

Now consider the same man at forty-five, wanting his money. Premature withdrawal requires using 80% of the withdrawal amount for purchasing annuity from an Insurance Company. Leaving early doubles the annuitisation from 40 per cent to 80 per cent.

Whether the rule is good or bad is not the question a candidate is asked. What matters for advice is that NPS Tier 1 is the least liquid product in the tax-saving table — lock in till the age of 60 years — and that its risk is the only one in the table the investor controls, since it is moderate by default but can be made low if so desired by choosing a higher proportion of Government securities.

So NPS is not a single product with a single risk level. It is a container whose contents the subscriber chooses, locked until sixty, with a compulsory annuity at the end.

A ready-made shirt costs Rs 900 and fits most people reasonably. A tailored shirt costs Rs 2,400 and may fit better — or may not, depending on the tailor.

The workbook draws the comparison in three rows. An actively managed fund is one where the fund manager seeks to generate additional return (ALPHA) over the chosen benchmark by ACTIVELY CHOOSING SECURITIES from among the investment universe. An index fund aims to REPLICATE the returns from the chosen benchmark by investing in the securities in the benchmark IN THE SAME PROPORTION.

On cost: active is HIGHER as the fund manager is actively involved in the decision-making; index is LOWER COST.

And the return row contains the sentence that decides the argument: active funds attempt to get higher returns, NET OF THE HIGHER MANAGEMENT COST. Net of — the extra return must first pay for itself. A fund that beats its benchmark by 0.8 per cent while charging 1.2 per cent more has not helped the investor at all.

The index fund makes a smaller promise and is judged differently: its attempt is to track AS CLOSELY AS POSSIBLE the benchmark return. Beating the index is not the objective, so failing to beat it is not a failure.

This is the cleanest comparison in the chapter because the two products are being judged against different tests — one against its benchmark plus its own cost, the other against its benchmark alone.

A family wants Rs 5,00,000 of gold exposure. Four routes exist, and the workbook sets them side by side.

Physical gold can be bought at the prevailing price at the moment, but it attracts GST, carries purity concerns — though some of it has been removed due to hallmarking — and brings safety and storage costs. It produces no income and is taxable as capital gains.

Gold funds price at NAV at the end of the day, and Gold ETFs can be bought at the moment like a share. Both buy physical gold, so GST cost is incurred on purchase and added to the cost — however, it is accounted as an asset and NOT LOADED AS COST. In both, purity is ensured by the fund house, and safety and storage costs are in-built into the fund management charges. Both can be exchanged with physical gold at a nominal cost. Neither pays any income.

Sovereign Gold Bonds are different on almost every row. Each issue is priced based on price prevailing on last 3 days. There is NO GST. There are no purity concerns as no physical gold is bought, and no safety or storage costs. They cannot be exchanged with physical gold. And uniquely, they pay 2.50% p.a. interest payable semi-annually.

The tax row is where SGBs stand apart most sharply: NO TAX IF REDEEMED WITH RBI, but taxable as capital gains if sold in the market before maturity, and the interest is taxable as per the Income Tax Act.

Liquidity is the price of that advantage. SGBs are redeemable on their anniversary dates after 5 years, with last redemption after 8 years; they can be sold in the stock market in the interim but liquidity is MODERATE.

So the family faces a genuine trade: the bond pays interest and can be tax-free at redemption, but it ties the money up. The ETF is liquid and quick but pays nothing and is always taxable.

A railway station advertises an express ticket counter. In theory it is the fastest way to buy a ticket. In practice, at that particular station, it is open irregularly and the price posted there is not quite the price you pay.

The workbook is unusually blunt about Indian ETFs, and the candour is worth noticing.

On the positive side, an ETF price is available on a MINUTE TO MINUTE basis like any other security, while an index fund price is the NAV that is available on END OF DAY basis. And ETF management costs are comparatively LOW.

But then: there can be BROKERAGE and DEMAT and other charges involved in BOTH BUY AND SELL, as well as the DIFFERENCE BETWEEN THE BUY AND SELL QUOTES on the exchange. That spread adds to the cost when buying and reduces the final sale value.

And the liquidity row is the sharpest sentence in the chapter: liquidity depends on the market and in fact, EXCEPT FOR A COUPLE OF ETFs, LIQUIDITY IS VERY POOR ON THE INDIAN STOCK EXCHANGES. THERE IS A BIG DIFFERENCE BETWEEN THE NAV OF THE UNDERLYING SECURITIES AND THE QUOTED PRICES. ALSO, THERE IS A RELATIVELY LARGE DIFFERENCE BETWEEN BUY-SELL QUOTES.

Against that, an index fund has management costs NOMINALLY HIGHER but NORMALLY NO OTHER COSTS, and is available from the AMC on end of day basis.

So the theoretically cheaper product may be the more expensive one in practice, once brokerage, demat charges and a wide spread are counted — and that is a lesson about reading a total cost rather than a headline expense ratio.

A man lends Rs 2,00,000 to his neighbour twice. The first time on a plain promise. The second time against the neighbour's scooter, with papers.

Same neighbour. Same ability to repay. Completely different position if things go wrong.

That is the whole of 19.2.12, and the workbook frames it precisely — the comparison applies if both are offered by the SAME company.

Risk: company deposits are UNSECURED, so even if from the same company the risk level is relatively HIGHER. Debentures will normally be SECURED, so even if from the same company the risk level is relatively LOWER.

Return follows risk, exactly as theory requires. The deposit tends to be slightly HIGHER than debentures from the same company for the same period; the debenture tends to be slightly LOWER than company deposits from the same company for the same period.

Liquidity is where it becomes interesting. The deposit has a redemption facility provided by the company, though NO INTEREST CAN BE PAID IF REDEEMED WITHIN A YEAR. The debenture depends on the market, WHERE LIQUIDITY IS ALWAYS AN ISSUE.

So neither is simply better. The deposit gives up security to gain a little yield and a company-provided exit; the debenture gains security and gives up both. An investor who understands only the interest rate is comparing one number out of three.