Tuesday, August 26, 2008

Lump sum vs SIP in ELSS

Every fund house has been touting the benefit of SIPs for quite some time now and how it is relevant for long term asset building. I firmly believe that is the right direction in terms of building an asset. One thing that does stand out is the fact that we have a concept called as ELSS in India. ie. Equity linked savings scheme. Essentially this is a equity based mutual fund that allows for tax saving.

So what is the implications of doing a SIP on an ELSS. Well here are the gotchas

  1. ELSS has a 3 year lock-in. So that if you do a SIP on this, each installment will have a lock in for 3 years. So your SIP will become your SWP :)
  2. If you pick a dividend reinvestment option, each time a dividend is issued by the fund house, that would get invested on that day back into the ELSS which will result in a 3 year lock-in of that dividend.
  3. All your gains will be taxfree (considering today's tax rules) since this will qualify for long term capital gains tax on equity which is currently 0%
Hope this information helps you make the right decision on SIP with ELSS.



This post was written by Vivek Venugopalan on the blog Personal Finance in India - The not so obvious stuff

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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.

Saturday, August 23, 2008

Back after a long Haitus

Well folks, I thought I will resume my posting after a long haitus. Thanks for being patient with me and also sending me feedback, comments and encouragement during these days of absense. will keep you posted :)