What is the impact of ultra-low monetary conditions in developed countries on Asia? Some economists, including Ben Bernanke, chairman of the US Federal Reserve Bank, have blamed Asian countries, particularly China, for consuming too little and saving too much, which has led the US to, willy-nilly, run up huge current account deficits.
Others have attributed the global imbalances—the huge current account surpluses in China and the corresponding deficits in the US—on the artificially low value of the Chinese currency.
But the fact remains that these global imbalances have been accompanied by low interest rates in the US, which has led to a huge expansion of global liquidity.
This paper attempts to understand how these low interest rates in the West have affected emerging and developed economies in Asia. It explores the linkages between the global and domestic monetary gaps— defined as the gap between the actual real rate and the neutral real rate—and their effects on output growth, inflation and net saving rates for Asian countries.
The authors use data from 20 Asian countries for the period 1980-2008. They find that ultra-low real interest rates in the West have led not only to increased output growth in emerging Asia, but also to high inflation and large current account surpluses.
The authors find that loose monetary policy in advanced economies is partly responsible for the widening savings-investment gap in Asia. This is because expansionary monetary policy leads to capital flows to emerging economies, which can be used to finance investment. Moreover, world output growth, again partly the result of accommodative monetary policies, leads to higher exports from emerging economies, and therefore, higher output.
The authors find, however, that easy monetary policy in advanced nations increases output more than it does investment in emerging economies. It, therefore, reduces the investment rate. With the savings rate remaining as before, the result is that the net savings rate (savings rate minus investment rate) rises. Bernanke calls this excess of savings over investment the savings glut, but the authors show that its main reason is the expansionary monetary policy in the West.
Other findings include: International reserve holdings tend to reduce domestic investment for all Asian country groups, possibly reflecting excess accumulation of reserves at the expense of lower investment, and financial integration tends to stimulate savings and investment in the advanced economies of Asia but not for emerging Asia.
Finally, the authors find what they call a feedback loop between the monetary policy of advanced economies and the impact on emerging nations in Asia. They say low interest rates lead to funds flowing out to emerging Asia, and the first line of defence when dealing with these capital inflows by policymakers in emerging economies has been to intervene in the currency markets. They prefer to intervene rather than let their currencies appreciate.
These interventions have led to the build-up of international reserves, which fuel vast quantities of dollars into international capital markets and lead to low returns on US securities. This in turn leads to low real interest rates in the US, completing the feedback loop.
The authors say the easy global monetary condition is partly responsible for the current account surplus in Asia and “unwinding the global monetary gap will help reduce global imbalances”. In other words, it’s only once the West starts raising real interest rates that we’ll see an end to global imbalances.
Saturday, October 9, 2010
5 ways to take control of your money
It may seem to you that you are in control in most situations. May be true till you start thinking of money and dig deeper till you hear yourself saying ``I know where my money is going.`` Do you spend time worrying about money and how you never know where it is being spent? Well, join the band wagon as most of us are still trying to see what money means to us and how we should manage it better.
5 simple things you can do to take control of your money life:
1. Budget: Prepare a budget for the month/ year and stick to it. Do not prepare strict budgets, allow for some splurging and some emergency fund as well. An annual budget would help; as you could add the festival expenses or any other annual expenses that you have.
2. Control debt: Leave the credit card at home when you go shopping. Well you may be wondering if you just read it correctly. Cash shopping once in a while is good, as most people feel the pinch when they pay hard cash and not when the credit card is swiped. Make your payments on the cards prompt and in full. Don`t take personal loans (as it has the highest rate since it is unsecured) for buying assets that depreciate (like TVs, music systems) which means personal loans for shopping is a strict No.Whether it is for your Jimmy choos or the latest Touch Screen phone you want to update to.
5 simple things you can do to take control of your money life:
1. Budget: Prepare a budget for the month/ year and stick to it. Do not prepare strict budgets, allow for some splurging and some emergency fund as well. An annual budget would help; as you could add the festival expenses or any other annual expenses that you have.
2. Control debt: Leave the credit card at home when you go shopping. Well you may be wondering if you just read it correctly. Cash shopping once in a while is good, as most people feel the pinch when they pay hard cash and not when the credit card is swiped. Make your payments on the cards prompt and in full. Don`t take personal loans (as it has the highest rate since it is unsecured) for buying assets that depreciate (like TVs, music systems) which means personal loans for shopping is a strict No.Whether it is for your Jimmy choos or the latest Touch Screen phone you want to update to.
3. Don`t leave it in the bank: Money left in the bank is equal to money spent...you may ask how? Well, with net access and ATMs giving you the latest balances every minute, you tend to keep seeing the money and then, spend it. Instead invest in short term/ liquid mutual funds which are highly liquid; encashable at a day`s notice. What you don`t need for the next 2 years+, start investing in longer tenure say 6-18 month FDs which are multiple(ie. Some amount in each tenure FD) so that you don`t have to break FDs if you need the money, it matures automatically.
4. Insurance: If a person has dependants, he/she must take life insurance. The type, quantum and term will depend on the requirements of the person as that is unique to him/her. However, it does make sense to take life insurance early on in one`s life for 2 main reasons- it is affordable now and scaling down is easier later rather than scaling up and that his/ health is good today, may develop conditions later where he might get rated up later on.
5. Equities: A small portion of your monthly savings can start going to equities via SIPs in diversified equity mutual funds. The start can be as small as Rs 500; being young you have time on your side, which gives this money time to compound. The power of compounding is one of the best gifts you can give yourself. This should stay invested for 5 years+ so that you actually see growth here.
Follow a few simple steps, to attain financial freedom..
4. Insurance: If a person has dependants, he/she must take life insurance. The type, quantum and term will depend on the requirements of the person as that is unique to him/her. However, it does make sense to take life insurance early on in one`s life for 2 main reasons- it is affordable now and scaling down is easier later rather than scaling up and that his/ health is good today, may develop conditions later where he might get rated up later on.
5. Equities: A small portion of your monthly savings can start going to equities via SIPs in diversified equity mutual funds. The start can be as small as Rs 500; being young you have time on your side, which gives this money time to compound. The power of compounding is one of the best gifts you can give yourself. This should stay invested for 5 years+ so that you actually see growth here.
Follow a few simple steps, to attain financial freedom..
Time to rebalance your portfolio
Stock market has crossed 20,000 marks and everybody is looking for an all time new high in the coming months. At this juncture many people, who made good profits, will be very happy, and who failed to participate in the rally, will be seriously looking to invest in the shares or in mutual fund schemes. Before investing or staying invested, one should ask, whether this is the right time to enter or stay invested or to wait for correction or book profit. Most of the investors will be confused as what to do at this stage. The following are some assessment, which one should consider before taking final call.
Current facts of market:
1) Market has already moved up by 150% from the bottom of 8,000 marks without major correction in last 18 months.
2) GDP growth was above 9% for the year-end March`06 to March`08 when market touched 21000 and for current year it will be around 8% to 8.5%.
3) Current market PE is near to 24, giving some alert signals.
Let me first clarify that neither I am trying to time the market, nor I am predicting market movements to go up or down. I am just trying to highlight the basic principles of financial planning, i.e. ART
A - Asset Allocation
R - Risk Appetite
T -Time horizon.
R - Risk Appetite
T -Time horizon.
Asset Allocation plays a major role in deciding your returns over a period of time. Your portfolio returns more depends on asset allocation than fund performance. Asset Allocation means balancing between risk and reward by investing in different kind of asset class such as Equity, Debt and Liquid instruments. In simple words it means do not put your all apples in one basket. Invest according to your risk appetite, time horizon and defined future goals, but never forget your asset allocation on any given point of time. Different asset class has different levels of risk and returns.
Thumb rule is that 100 minus your age, you should invest in high-risk asset class such as equity and real asset. The sum equal to your age should always go to fix or debt instruments such as Bank FDs, Postal Schemes PPF and Debt or Liquid Funds. Asset Allocation once decided should be followed seriously and accordingly should be rebalanced periodically. Rebalancing is the process of restoring your portfolio back to its original asset allocation. Rebalancing generally should be done every year or when you get some good profits from one asset class like today. You should also rebalance it 2 to 3 years prior to reaching your goals.
Let us take an example:
Mr. Hitesh aged 40 years has decided to invest, as per his asset allocation, in the ratio, 60% in Equity, 35% in Debt and 5% in liquid funds. He has invested Rs. 10 lacs last year on 01.09.2009. Accordingly he has invested 6 lacs in equity, 3.5 lacs in Debt and 0.5 in liquid instruments.
After one year his value in Equity has gone up to 9 lacs (50% growth), 3.78 lacs in debt (8% growth) and 0.52 lacs (4% growth) in liquid funds. His total investment has rose to 13.30 lacs giving him over all return of 33% on his total portfolio. Now his investment is 68% in equity, 28% in debt and 4% in liquid funds. This clearly shows that he has more investment in equity compared to his original asset allocation and need to book profit and allocate the profit to debt and liquid funds.
He has to book profit up to 1.02 lacs from equity and has to reallocate 0.88 lacs to debt and 0.14 lacs to liquid funds. This will again bring him to his original asset allocation at his age. One should also keep in mind that after 5 years, you have to change your asset allocation and has to decrease equity exposure and increase debt allocation. In Hitesh case, at age 45, his asset allocation will be 55% equity, 40% debt and 5% liquid.
Rebalancing your portfolio:
| Details | Equity | Debt | Liquid |
| 2009 | | | |
| Amount | 6 lacs | 3.5 Lacs | 0.5 Lacs |
| % | 60% | 35% | 5% |
| 2010 | | | |
| Growth | 50% | 8% | 4% |
| Amount | 9 Lacs | 3.78 Lacs | 0.52 Lacs |
| Rebalancing Portfolio | | | |
| % | 68% | 28% | 4% |
| Change | 8% | -7% | -1% |
| Amount | 102000 | -88000 | -14000 |
| Action | -102000 | 88000 | 14000 |
| Net Investment | 7.98 Lacs | 4.66 Lacs | 0.66 lacs |
This rebalancing of portfolio will always keep Hitesh in win-win situation. Market movements will less affect him, whether market goes up or down. It is always advisable to rebalance the portfolio as per asset allocation.
Before taking any investment decision one must do some homework and exercise and check ART first. If you are confused and unable to take any decision, just follow the basics.
1) Book Profit if you are getting extra ordinary profit.
2) Continue your current SIPs.
3) Do not put a lump sum amount rather split it to SIP.
4) Rebalance portfolio as per your asset allocation.
2) Continue your current SIPs.
3) Do not put a lump sum amount rather split it to SIP.
4) Rebalance portfolio as per your asset allocation.
Asset allocation and rebalancing your portfolio is a key to success and financial freedom.
Where are the opportunities? Source: Business Line (03-OCT-10)
Stocks of non-banking finance companies (NBFC), which took a massive hit during the credit crisis, have rebounded smartly from their lows in March 2009. Taking stock today, which segments of the business appear overheated and which offer further investment opportunities? Our analysis suggests that while infrastructure financing NBFCs offer growth opportunities and their housing finance counterparts may deliver stable growth, investors should also book profits in some of the segments that have run up too far.
Benign liquidity conditions, regulatory support by RBI , revival in the economic activity boosting credit demand and improving asset quality benefited NBFCs immensely. Additionally, the capital raised over the last year and a half also helped some of them reduce leverage .
Apart from rising economic activity, banks` wariness to lend to some segments of borrowers worked in favour of these NBFCs. Securitisation also revived, augmenting their fund raising base.
Our analysis showed that 24 NBFCs with a market capitalisation of more than Rs 10 billion, gained between 123 to 1400% from the March 2009 lows, with the majority of stocks trebling in value and almost the entire universe outperforming the broader market.
However, investment companies such as Tata Investment Corp, JSW Holdings and Network 18 Media, given the underlying stocks` under- performance, continue to trade below their January peaks. Here, we review NBFCs spread across three major segments (infrastructure, mortgageand asset financing) and take a look at their stock performance vis-a-vis business growth, current valuations and growth prospects.
Infrastructure financing
Power Finance Corporation (PFC), REC and IDFC are the largest listed players in the infrastructure financing space and are among the better performing stocks as the demand for credit from infrastructure did not cool off over the last two years despite overall slowdown in capex activities. The stock of IDFC, however, hasn`t gone back to its January 2008 peak levels, as its loan book grew the slowest and has very high business linkages with equity markets which hasn`t entirely revived.
The loan books of IDFC, PFC and REC grew at annual rate of 10%, 24% and 30% respectively over the two-year period ended March 2010, leading to an annual net profit growth of 22%, 39%, and 52% respectively. Apart from rising loan book, fall in interest rates, shrinking corporate spreads and high liquidity also led to cost declines and consequent improvement in margins for these NBFCs.
As of June 2010, cumulatively, these three NBFCs` loan books grew at 7.5% sequentially, indicative of the high demand for infra-loans. The current price-to-book value of PFC, REC and IDFC are close to three times, re-rated from the March 2009 lows of 1.1-1.5.
During this period, IDFC and REC raised capital, despite which they are trading at such a high price-book value. Going forward, with a major chunk of Rs 20,000 billion of funding requirements yet to be met in the 11th Five Year Plan (2007-12) and another Rs 41,000 billion projected to be spent in the 12th Plan , the loan book growth may continue to be spectacular. The asset-liability management of these NBFCs will also be better in future as they are allowed to raise long-term resources at lower costs thanks to their infrastructure financing status. In our view, investors can hold on to these stocks with a two-three year horizon for good returns.
Mortgage financing
Among the housing finance company stocks, HDFC, LIC Housing Finance, Dewan Housing and Gruh Finance have all climbed above their January 2008 peaks. To revive the housing loan segment, regulations such as re-financing and interest subvention were introduced and, as the economy revived, housing demand improved steadily, especially as property prices and rates of interest were low.
Housing finance companies maintained their market share over the last two years despite stiff competition from banks. The total loan book of major housing finance companies expanded by 20% annually in 2008-10, when scheduled commercial banks` home loan growth was in single digits.
This may come as a surprise as many banks came up with teaser loans, but the growth in the loan books of some banks led to fall in the others, reducing the pressure on housing finance companies. They also maintained margins despite pressure on yields (due to teaser loans) as they brought down operating costs and cost of funds.
Even as HDFC saw its price-book value expand from 2.5 to 5 times, it was LIC HF, Dewan Housing and Gruh Finance that enjoyed the highest re-rating. The re-rating of LIC Housing and Dewan Housing was due to their non-metro focus, which improved their market share in the total loan book. Loan book growth was at 31% and 45% compounded annually over the two years ended March 2010. Over the years, not only have the volumes increased, but also the ticket size of loans, boosting the overall loan book size of the housing finance companies.
Going forward, the demand for loans may improve given the 24.7 - million unit shortfall in housing expected in Eleventh Plan. According to Crisil estimates, mortgage loans from NBFCs and banks will grow at 14.7% compounded annually over the five years ending FY15.
Our preferred picks in this segment are HDFC (diversified business income across various segments of finance) and Dewan Housing (low valuation and improving presence , thanks to tie-up with banks). Investors can book profits in LIC Housing and Gruh Finance, which are trading at stiff valuations, limiting the upside.
Asset-Financing
Auto financing companies were hit the most during the fall, because of their high dependence on growth in vehicle sales, which headed south during the latter half of FY-09 and early FY-10. However, the rebound also has been spectacular, thanks to stimulus efforts. Sundaram Finance, Bajaj Auto Finance and Mahindra Financial Services benefited from the revival in the vehicle sector.
Commercial vehicle (CV), two-wheeler and car volumes grew 38%, 26%, and 26% for the year ended March 2010 after a muted performance a year ago. Bajaj Auto Finance saw its loan book grow by 94% in the last 15 months after a slowdown in 2008-09.
Similarly, Sundaram Finance and Mahindra Financial, which saw moderation in 2008-09, have improved their loan book growth for the year-ended March 2010.
The current price-to-book value of Mahindra Finance, Bajaj Finance and Sundaram Finance stands at 2.2 to 3.5 times, up from 0.3 and 1.4 times the value in March 2009.
The Society of Indian Automobile Manufacturers estimates that car and utility vehicle sales will grow at 13% in the current year with CV sales growth moderating to 19% and two-wheeler sales increasing to 9-10% as the base effect kicks in. With the rate of growth getting normalised, the upside in these stocks may moderate. Investors can hold on to Sundaram Finance and Bajaj Finance.
Rising competition
Shriram Transport Finance (STFC), Manappuram General Finance and the recently listed SKS Microfinance are all trading at a high valuation premium to other NBFCs due to lack of peers for such businesses in the listed space.
These three have a presence in very high margin (albeit risky) businesses and make margins of more than 8 per cent.
STFC is a commercial vehicle financier but predominantly finances used vehicles, in which it is almost a monopoly in the organised space.
SKS and Manappuram, despite facing competition from their peers have advantages of scale as well as a first-mover edge in certain geographies, helping them attract more borrowers and keeping the high growth rates ticking.
STFC is up 218% since its March 2009 lows and 92% from the January 2008 market peak, while Manappuram ended up being the star performer amongst the large NBFCs, with more than 900 per cent in gains since March 2009 and 777% gains from market peaks. SKS, which listed in August, has already gained 35% in the last 45 days.
The current price-to-book values of STFC, Manappuram, and SKS are 4.2, 7 and 5.5 times respectively.
The loan book growth for STFC, Manappuram and SKS during the last two-year period was 22%, 222% and 101% respectively.
Given their current valuations they have to clock exceptionally high growth in earnings over the next few years to justify these prices.
Despite huge untapped potential left in these segments, competition is also on the rise.
In addition, there are individual business risks relating to vulnerability to a downturn and asset quality due to a low-income focus.
Therefore, it is safer for investors to stay away from these stocks at this juncture.
Overall, we continue to be bullish on infrastructure financing companies, thanks to their growth prospects, and on investment companies such as Bajaj Holdings, Tata Investment Corp, JSW Holdings as they are trading at significant discounts to their investment book value.
The nuts and bolts of price-earnings ratio Source: BUSINESS LINE (03-OCT-10)
Price to Earnings ratio is jargon used by equity research analysts, experts in valuation, stock brokers, fund managers, as well as present and prospective investors.
Let us take a look at the nuts and bolts of this valuation metric and its variants.
What does it measure?
P/E multiple measures the number of times the share of a company is priced in the stock market compared with its earnings. It is the market price per share/earnings per share.
For example, the P/E ratio of State Bank of India is 20.7 times, if we consider the trailing to market earnings per share of Rs 153.5. This is known as Trailing P/E Ratio.
Note that the higher the P/E, the longer it would take for investors to earn their money back.
A high PE, therefore, indicates that investors expect the company`s earning power to go up. Low P/E shares, on the other hand, are generally low-growth or mature companies. They often have long records of earnings stability and regular dividends, and are usually relatively safe investments.
Alternatively, we can compute the Historical P/E Ratio for SBI by dividing its current market price by its last year [2010] EPS; the 2010 EPS for the company was Rs 144.37. The historical price to earnings ratio, therefore, would be about 22. While these two are the most commonly used P/E ratios - as both are based on actual earnings and hence the most accurate - it is forward PE that holds more relevance to investors when evaluating a company.
Forward P/E multiple
Forward P/E multiple reveals the number of times the price of the stock is traded in the market compared with its estimated next year EPS.
For instance, if we expect a 15% increase in the earnings of SBI, then the forward PE would be 19 times (i.e. 3181/166). When you compare the stock`s trailing P/E with its forward P/E, you may find the stock more attractive on a forward PE basis, as it is lower than the trailing PE due to higher earnings growth expectations.
There are also times when we need to predict the P/E for future, when it is over and above one year. Without getting into the technicalities of earnings projection, let`s suppose that the EPS of SBI is expected to be Rs 300 after five years.
Then the future P/E Ratio for the stock would be about 11 times. This is much lower than both historical and trailing price to earnings ratio.
Note that the P/E multiple comes down drastically due to the steep increase in the forecast EPS; the opposite holds true for a steep decline in the forecast e EPS number.
All the variants of P/E are based on the same numerator (i.e. market price per share) but use different denominators (i.e. earnings per share- historical, trailing, forward and future). You can also consider taking the 6 -12 months median market price of the share for computing the price to earnings multiples. Doing this may help you avoid the problem of outliers to a greater extent.
Determinants of P/E Ratio:
The P/E multiple of a company is determined by many factors but the key determinants are (a) Expected Growth Rate (b) Current and Future Risk and (c) Current and Future investment needs.
Companies with a higher expected growth rate in business normally trade at a higher P/E multiple, as the earnings are expected to be more attractive in future. When the estimated EPS is higher, the forward P/E is lower compared with the current P/E. So, when the market gets this information, the share price goes up as then investors would be willing to pay a higher price for the stock. Therefore, companies with higher growth rates trade at higher P/E multiples.
However, companies perceived as risky usually trade at lower multiples, as the market expects fluctuations in their operating results.
For instance, companies with higher operating leverage (higher proportion of fixed costs to total costs) and higher financial leverage (higher debt/equity ratio) are perceived to be riskier, by the market.
P/E ratio is also affected by the reinvestment needs/requirements of a company. For example, a company with higher reinvestment needs is perceived as riskier, as it would then require the company to borrow more funds. This may lead to a higher financial leverage or earnings dilution for existing shareholders depending on the method adopted to raise funds.
What should investors do now?
Investors usually ask `What should we do?` either after the market has zoomed upward or when it has crashed. When markets are somnolent, investors too hibernate. In the latest instance, the fact that the broad indices are close to breaching their old highs has prompted the question whether to book profits and re-enter at lower levels. Before seeking the answer from ``market experts`` let us ask ourselves some questions : We call ourselves ``investors``. But why are we investing? Is it in order to have the financial ability to meet some goal in the distant future and will this goal not be achieved if we do not invest ? Or are you doing it for the excitement of ``investing`` in stocks and cannot afford to be left behind when the others are at it? If we answer in the affirmative to the first option it means that our goals should decide our investment tenure and not the market levels. If it is the latter, you will be eternally confused even after meeting the best ``market expert`` because your objectives were never clear in the first place. None of us know where the market will be a few days, weeks or months from now Did you know in July 2010 that we would cross 20000 in September 2010? If you did not, what gives you (or the market experts) the confidence to predict the level two months from now? Of course, if you had been investing to meet some financial objective (say a down payment on a house) six months down the line, and you have attained the requisite amount today itself, it makes sense to take some money off the table. However, this money should never enter the market again. It should be parked in debt funds for a year and then used to pay for the house. If your goals are many years down the line, just stay put. Do not tinker with your portfolio. The next question to you is ``The index has gone up but how much has your net worth increased?`` You may feel justified in feeling frustrated when your friends circle is apparently rolling in the moolah by speculating in the derivatives segment or by purchasing the latest `tip` and your (assumingly) fundamentally sound stocks have barely moved. This may make you envious and instigate you to jettison the good stocks and jump onto the bandwagon that your friends are riding. Well, this may be a sure-fire way of inviting grief. Warren Buffett has apparently implied in jest that ``of all the seven sins, envy is the worst, because it only makes you miserable. At least one enjoys while committing the other six sins.`` Your decision to buy, sell or switch stocks should not be dictated ONLY by the level of the index. Each stock has a rhythm of their own. They will move when they have to. The only thing within our control is to make a proper choice BEFORE investing and periodically reviewing that choice. Of course, if you switch from an overvalued stock to an undervalued one it is justified. But switching to dubious stocks merely because they are ``hot`` is an invitation to disaster. The final question is ``Who are you relying on for an expert opinion?`` Is it your broker, is it business channels or is it your newspaper/magazine? Everyone will try to instill you to do ``something``. That is because their well-being depends on your actions. Everytime you transact, your broker earns a commission and the more tips and ``expert comments`` TV channels and magazines give, the more viewers/readers they hope to attract which in turn could lead to higher advertising revenue. In the entire ecosystem, the retail investor is treated like the plankton on which the larger organisms thrive. Avoid this situation by closing your ears when the din gets too loud. In this market it is easy to be ``seen`` as an expert by making frequent appearances on mass media. However, the real experts are not seen too often as they are too busy trying to make sense of the market mayhem and make some money in the process. As you may have noticed, the answers to many of our questions are contained within ourselves. Take time to introspect. Seek within and you shall find..... |
Pension funds must look beyond returns criteria Source: Business Line (07-OCT-10)
| The primary mandate of pension funds is to create financial returns for its beneficiaries. Typically, trustees appointed by the employer or other plan sponsors bear the legal responsibility for controlling the assets of a pension fund. However, trustees of pension funds often delegate the investment related decision-making to professional fund managers and an agreement between the trustees and the fund manager governs their relationship. This agreement usually makes fund managers effectively subject to the same prudential investment obligations as trustees. Moreover, fund managers often have a contractual obligation to provide service or advice that enable trustees to meet their fiduciary duties. Extra-financial criteria Thus any breach in fiduciary duties by pension fund trustees/managers is liable to make them compensate beneficiaries for the losses attributable to this breach of duty. This understanding of fiduciary duty has often restricted pension funds from taking extra-financial criteria into account in the investment process. However, if extra-financial criteria have a material bearing on the financial performance of the companies, then, on the contrary, not including them into the investment making process may actually be a breach of fiduciary duty. While it is true that the environment, social and corporate governance (ESG) factors are more likely to become material in the medium to long term, but so are the investment horizons of the pension funds. Not a static concept Fiduciary duty is not a static concept. Fiduciary duties of pension funds have evolved over a long time to reflect the modern investment practices. They are again undergoing a change to capture the impact of ESG factors on corporate financial risk and return. Today, the financial world is learning, though in hard way, that good ESG performance can in fact lead to better financial performance. Since failure to consider and incorporate ESG-related information is not prudent in the financial sense of the word, it should not be treated as prudent in the legal sense either. Therefore, if correctly formulated and applied, then while discharging their fiduciary duties trustees/managers should include rather than exclude ESG factors into investment process. A regulation to enable pension funds to lawfully take ESG factors into account if it has a material impact on corporate financial risks and returns can go a long way to dispel the notion that inclusion of extra-financial criteria into investment process is a breach of fiduciary duty. In fact, such a suggestion was put forward by the lawmakers as early as in 1993 in Canada where the Manitoba Law Reform Commission recommended that the province amend its legislation to permit trustees to consider non-financial criteria in their investment policies. More recently, in 2005, Canada Pension Plan (a contributory, earnings-related social insurance programme managed by the federal government) revised its investment policy to include ESG factors to the extent that they affect long-term risk and return. Interestingly, the CPP Investment Board`s ?overriding? responsibility continues to be - maximising investment returns without undue risk?. But the fact that the CPP Investment Board has begun to recognise the materiality of ESG issues without any amendment to its legislative charter is noteworthy. Even a report by United Nations Environment Programme (UNEP) in 2005 suggested that investment manager`s fiduciary duties should not necessarily preclude or overly hamper inclusion of ESG factors into the investment process. Legislative requirement Another way by which pension funds could be encouraged to include ESG factors into their investment process is through legislative requirements for fund trustees/managers to publicly report on their policies in this respect. The first such initiative took place in the UK where in July 1999 the government issued a regulation requiring pension fund trustees to disclose their ESG policies. Since then many other European countries have enacted similar ESG disclosure requirements for pension funds in their respective countries. Thus, fiduciary duties of pension fund trustees/managers do not restrict them from including ESG factors into investment consideration. However, due to prevalent conservative understanding/practices, it is unlikely that pension fund trustees/managers will include ESG factors into the ambit of fiduciary duties voluntarily. Even European countries needed regulatory intervention. Therefore, inclusion of ESG criteria by PFRDA (Pension Fund Regulatory and Development Authority) into the investments guidelines of fund managers will in no way undermine the fiduciary duties of pension fund trustees/managers. On the contrary, this will only help the pension fund investment managers improve investment practices and ignoring them may prove costly as was discovered by the Norwegian Government Pension Fund Global, which disclosed in its second quarter report that it has lost more than 1 billion on its 1.75% stake in oil giant BP in the wake of the Deepwater Horizon oil spill in the Gulf of Mexico. (The author is Head and Senior Economist at Crisil. The views are personal) |
FMP: Route to fixed income
Series of fixed maturity plans (FMPs) have been launched by fund houses in the recent months. These offerings clearly indicate that the FMPs which were once exclusively reserved for corporate and high net-worth individuals (HNIs) are now competing with traditional fixed deposits (FDs) for retail investors` money. With lower risk as compared to equities and other debt funds, FMPs as a portfolio construction tool are often a viable product. In this article, we discuss FMP as an investment avenue, its pros and cons, compare it over fixed deposits and understand why investment into FMPs makes sense in current scenario.
What are FMPs?
An FMP as the name suggests is a mutual fund which has a fixed maturity period and invests in fixed income instruments like bonds, government securities, money market instruments etc. There are a few FMPs which also invest a small portion of their corpus in equities but they are exceptions to the rule. The tenure could be 30, 90,180, 365 days or more and they invest only in such securities that mature on or before the date of the maturity of the scheme. For instance, an FMP with tenure of 370 days will invest only in papers maturing within 370 days or less and hold them till maturity. They are closed ended funds and are listed on stock exchange. Hence, premature withdrawal is only possible through selling on the exchanges or on maturity the units can be directly redeemed from the fund house.
Pros and cons of FMPs
Tax advantage: The returns generated from FMPs if held for more than a year, are taxed as capital gain (10% without indexation and 20% with indexation) instead of marginal tax rate which could be as high as 30%. Also, FMPs enjoys double indexation benefit if held for two financial years. For e. g., suppose an investor invests in a 14 months FMP in the month of March, and holds the same till maturity i.e., till April next year, he would get the advantage of indexing his investment to inflation for two years.
Low volatility: FMPs invest in papers in line with maturity of the scheme and hold the same till maturity; hence they do not carry interest rate risk and provide stable returns with low volatility.
However, FMPs also suffer from certain limitations.
Less liquid: They cannot be pre maturely redeemed from fund houses and the only exit option is to sell them on exchanges, where FMPs do not have enough liquidity.
Less transparent: The returns are neither guaranteed and nor it is known in advance with reasonable certainty. The portfolios of FMPs are also not known before investment and as a result, fund managers may invest in low quality papers to attract higher yields at higher risk. In other words, the investment mandate is not as definitely spelt out as in other mutual fund products.
What are FMPs?
An FMP as the name suggests is a mutual fund which has a fixed maturity period and invests in fixed income instruments like bonds, government securities, money market instruments etc. There are a few FMPs which also invest a small portion of their corpus in equities but they are exceptions to the rule. The tenure could be 30, 90,180, 365 days or more and they invest only in such securities that mature on or before the date of the maturity of the scheme. For instance, an FMP with tenure of 370 days will invest only in papers maturing within 370 days or less and hold them till maturity. They are closed ended funds and are listed on stock exchange. Hence, premature withdrawal is only possible through selling on the exchanges or on maturity the units can be directly redeemed from the fund house.
Pros and cons of FMPs
Tax advantage: The returns generated from FMPs if held for more than a year, are taxed as capital gain (10% without indexation and 20% with indexation) instead of marginal tax rate which could be as high as 30%. Also, FMPs enjoys double indexation benefit if held for two financial years. For e. g., suppose an investor invests in a 14 months FMP in the month of March, and holds the same till maturity i.e., till April next year, he would get the advantage of indexing his investment to inflation for two years.
Low volatility: FMPs invest in papers in line with maturity of the scheme and hold the same till maturity; hence they do not carry interest rate risk and provide stable returns with low volatility.
However, FMPs also suffer from certain limitations.
Less liquid: They cannot be pre maturely redeemed from fund houses and the only exit option is to sell them on exchanges, where FMPs do not have enough liquidity.
Less transparent: The returns are neither guaranteed and nor it is known in advance with reasonable certainty. The portfolios of FMPs are also not known before investment and as a result, fund managers may invest in low quality papers to attract higher yields at higher risk. In other words, the investment mandate is not as definitely spelt out as in other mutual fund products.
FMP vs FD
FMPs are generally used by large investors and companies as an alternative to FDs. Though FMPs do not guarantee any returns, the indicative returns are based on the returns of similar duration bonds available in the market.
The main advantage of investing in FMP as compared to FD is tax arbitrage. For individuals that fall in the highest tax bracket and corporates, the interest on FDs is taxed at 30%. But, if FMP is held for more than 1 year and the investor chooses to treat all the gains as capital gain then he or she will be taxed at 10% without indexation and 20% with indexation. Even if the investment horizon is less than a year, investors can choose the dividend payout option where dividend distribution tax will be at 13.84% for individuals and 22.15% for corporates.
Let us compare the yield for an investor who invests in an FMP versus an FD. Assume that both give a return of 7% for a one-year plan.
As we can see in the above table, even though the pre-tax rate of both the products is same, on post tax basis, the FMP yields 1.4% higher than FD. On the contrary, if FD has to give the same post tax return as FMP, the former has to give pre-tax return of 9%.
Development of FMP over years
After having enjoyed great popularity among investors for some years till 2007, FMPs went through a rough phase in the second half of 2008 and 2009, but now the product is coming back on the radar of investors.
FMPs are generally used by large investors and companies as an alternative to FDs. Though FMPs do not guarantee any returns, the indicative returns are based on the returns of similar duration bonds available in the market.
The main advantage of investing in FMP as compared to FD is tax arbitrage. For individuals that fall in the highest tax bracket and corporates, the interest on FDs is taxed at 30%. But, if FMP is held for more than 1 year and the investor chooses to treat all the gains as capital gain then he or she will be taxed at 10% without indexation and 20% with indexation. Even if the investment horizon is less than a year, investors can choose the dividend payout option where dividend distribution tax will be at 13.84% for individuals and 22.15% for corporates.
Let us compare the yield for an investor who invests in an FMP versus an FD. Assume that both give a return of 7% for a one-year plan.
As we can see in the above table, even though the pre-tax rate of both the products is same, on post tax basis, the FMP yields 1.4% higher than FD. On the contrary, if FD has to give the same post tax return as FMP, the former has to give pre-tax return of 9%.Development of FMP over years
After having enjoyed great popularity among investors for some years till 2007, FMPs went through a rough phase in the second half of 2008 and 2009, but now the product is coming back on the radar of investors.
As we can see from the above chart, from August 2004 to August 2007, assets under management (AUM) of FMPs went up from Rs 44.77 billion to Rs 679.62 billion. Due to the liquidity crisis in October 2008 and the subsequent regulatory changes, the AUM of FMPs fell to Rs 339.66 billion in 2009. However, with several rate hikes by the RBI and short-term papers trading at attractive levels, FMPs are now garnering fresh investments again and the overall AUM for FMPs has reached Rs 654.84 billion in August 2010. In addition to this, around 191 FMPs have been launched in the calendar year 2010 as compared to 76 FMP in the previous year.
Crisis of 2008 and regulatory changes
During October 2008, when the stock market went into a freefall, FMPs faced a huge credit crunch as several risk-averse investors wanted to redeem their FMP investments prematurely. Due to poor quality of papers and illiquidity in the debt market, few fund houses had to put a cap on the FMP redemptions. Also, due to the liquidation pressure on close-ended funds, RBI instituted a term repo facility for an amount of Rs 600 billion to enable banks to ease the liquidity stress faced by mutual funds (MFs) and non-banking financial companies (NBFCs).
Following this, SEBI announced measures to resolve the liquidity problem faced by mutual funds. It banned premature withdrawals in new FMPs launched by Mutual fund houses and compulsory listing of all close-ended products. This meant that even if investors wanted to get out of FMPs in spite of the costs of the exit penalties, the regulator ensured that the investors either sell the units on exchanges or wait till the FMPs matures, rather than asking for an early redemption.
Also, SEBI banned the practice of FMPs declaring indicative future yield and displaying indicative portfolios in advance. Presently, AMCs have to disclose the portfolio of such schemes, once the issue has closed and on a monthly basis on their respective websites. With all these measures, the industry did see some stabilization of AUM in FMPs.
Current scenario
On account of high inflation and reasonable growth, RBI has started tightening the monetary policy and raised policy rates. As a result, we have seen yields on debt papers going up in the last few months. This makes FMPs attractive investment avenue for investors in the mutual fund space, who are looking to park money in fixed income instruments.
Currently, the three-month commercial papers are offering yields in the range of 7% to 7.5% and one year certificates of deposit are providing yields in the range of 7.5% to 8%. So even though FMPs are not allowed to indicate returns, considering the current rate of papers trading in the bond market, three months FMPs could fetch a return of 6.5% to 7.5% post expenses whereas one year FMPs could give return of 7.5% to 8% post expenses.
Conclusion
Taking into account the current scenario of tighter regulation and tax arbitrage, we are of the view that FMPs provide an attractive investment option. With yields at such high levels, it could be a wise call to lock some portion of your fixed income investment at such levels.
However, investors should keep in mind that liquidity is negligible in FMPs so the investor`s investment horizon should be in line with maturity of the scheme. For the final call on selection of an FMP, an investor should look at the portfolios and the track record of the previous FMPs launched by the fund house.
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