Sunday, August 24, 2008

The new Rage in safe investing : FMP vs Bank deposits

Its the talk of the town folks - to FMP or to FD is the question. The stock market showing signs of behaving what it always does in the long run, i.e. being rational and correcting the exuberance of the past 5 years of heady growth, Every retail investor is looking to run and hide with safer avenues and that has traditionally been bank fixed deposits.

I have always had my reservations on bank fixed deposits and this has been from years ago even when fixed maturity plans (FMP expanded just so you know ) were an unknown entity, Finally mutual fund institutions have found a new way to lay their hands on your money and provide "safe and secure" returns to you. Welcome to the world of Fixed maturity plans or FMPs. Think of this as a mutual fund equivalent of an FD (is it really an equivalent? we will talk about that soon) where the returns nowadays match a fixed deposit.

What are they

These instruments are essentially debt mutual funds which are typically close-ended with a maturity period ranging from one month to five years. FMPs are typically setup by the fund manager by purchasing debt instruments that align with the fund's maturity period so that they can protect the returns and meet market expectations

Why are they touted to be better

The key to FMP's fame is the tax treatment viz a fixed deposit. Since these are debt mutual funds, they enjoy all the benefits that a debt fund gets, ie.

Short-term capital gains

Short-term capital gains on debt-oriented funds are added to income and taxed as income tax.

Long-term capital gains

Long-term capital gains on debt-oriented funds are taxed at higher of the two i.e.10% without indexation and 20 per cent with indexation. To help understand the benefits, the following table below illustrates the comparison between Bank deposits, FMPs both dividend plan and growth plan.

The last row shows the returns for various options

The detailed spreadsheet that shows the calculations is found here on google docs

Essentially three things stand out here
  1. FMPs are far superior to bank deposits in terms of net returns
  2. When buying FMPs less than one year always prefer the dividend option
  3. When buying FMPs greater than one year, always pick the growth option
  4. If possible try to get double indexation benefit by buying FMPs at the very end of a financial year that redeems at the very beginning of a future financial year

Given that FMPs are superior and everybody is rooting for it (if you looked at the recent spam that you have received from your favorite financial institutions, its FMP galore. So what are the key problems?

What are the pitfalls

There are a few underlying assumptions in the spreadsheet above that I want to call out so that you can understand the key issues with FMP.

  1. Returns: The above sheet assumed that banks and FMPs return the same returns. While that is helpful to compare apples to apples, the real truth is that returns in an FMP is neither guaranteed nor secure. The Hindu carried a dated but detailed article on how FMPs fare with respect to bank deposits and they concluded that short term FMPs really do fare badly. I had personally tried out one FMP for 4 months and received a fabulous 7.7% returns in 4 months which is > 20% annualized.
  2. Risk : FMPs typically invest in commercial paper of many businesses. Commercial papers have various CRISIL/ICRA ratings and FMPs announce their intent on investment spread across various ratings in their prospectus. An aggressive FMP can put your capital at risk in a bad economic situation where the business can default on payments thereby putting principal at risk.
In conclusion, not to sound as an alarmist, FMPs obviously if chosen well, can be a superior tool as compared to a debt fund. As in all investments, caveat emptor or "Let the buyer beware". Ensure that you read the FMP offer document to understand their investment strategy.

1 comment:

VJonDalalStreet said...

This is a good comparison of the types of investment and definitely FMPs look better in term of return.

But in the current global financial turmoil, I would suggest one should prefer to safe the erosion of their capital and avoid taking risks.

Ofcourse going forward, say few quarters from now, one can again look again in FMPs who invest in the so called AAA or AA+ ratings given by those rating agencies who have basically missed the entire rating concept :-)