Month: April 2012

I write about ULIPs very rarely, but in the last year or so, several people have commented that under some circumstances ULIPs are a suitable investing option, and when Roopa posted a comment inquiring about the ICICI Pru SmartKid Premier ULIP in the Suggest a Topic page, I thought it’s finally time to read up on this and do a review of this product.

Insurance and Investment

ICICI Pru’s Smart Kid Premier is a ULIP that combines life insurance and investment, and the way it works for the life insurance part is that you choose whether one or both parents have to be insured, and based on that on the death of the parent – the insurance policy pays you out. This is called the single life or joint life option under the plan.

The insurance pays out a sum assured and it also waives off the future premiums that you would have had to pay under the policy, and you continue to get benefits as if the premiums had been paid.

And how much is the sum assured using this option?  The minimum sum assured is the higher of these two amounts:

• Ten times the annual premium or
• 0.5 x policy term x annual premium

These two options exist because you can decide on a plan where you pay for only 5 years but the plan has a term of 10 years.

So, if you took out a policy with a premium of Rs. 50,000 per year for 10 years, then then sum assured will be Rs. 5 lakhs in this case. Goes without saying that this cover is a lot less than what you get from a term insurance, but then there is no investment angle in term insurance either. Now, let’s get to the investment aspect of this policy.

ICICI Pru Smart Kid Premier Investing Style Options

After they have taken away some money as expenses towards the plan, the remaining sum can be invested in a choice of funds based on three different strategies that you can opt for.

1. Fixed Portfolio Strategy: This is the first of the available strategies, and if you select this strategy, you will have the choice of actively managing your portfolio, and you can pick and choose from 8 funds that they have on offer.

The 8 funds they have on offer are the following:

Fund Name	Asset Allocation
Opportunities Fund	Equity: 80% Debt: 20%
Multi Cap Growth Fund	Equity: 80% Debt: 20%
Bluechip Fund	Equity: 80% Debt: 20%
Multi Cap Balanced Fund	Equity: 60% Debt: 40%
Income Fund	Debt: 100%
Money Market Fund	Debt: 100%
Return Guarantee Fund	Debt: 100%
Dynamic P/E Fund	Invests in the ratio of debt and equity based on the P/E range of the market

I think the name is a little misleading for this strategy because nothing is fixed here, and you have to actively manage which funds you are going to buy into.

 2. Life Cycle Based Portfolio Strategy: The second strategy that you can choose is the life cycle based portfolio strategy and in this strategy the fund moves around your money from an equity based mutual fund to a debt based mutual fund according your age. So, if you are between 26 and 35 years then the fund will have 75% of your money in the multi cap growth fund, and 25% in an income fund, but when you reach the age of 36 – that ratio will be changed to 65% and 35%. So as you get older, more of your money comes out from the equity fund and moves in to the debt fund.

3. Trigger Portfolio Strategy: In this strategy, 75% of your money is invested in the multi cap growth fund and 25% is invested in an income fund. If the equity market rises then part of your profits are redeemed and the money is invested back in the income fund so that any downward movement doesn’t eat into your profits. If the market goes down then new money is used to invest in more equity funds such that they can maintain a 75% – 25% ratio.

To sum up whate we have seen so far, the insurance is ten times your premium and then after they deduct expenses, they allow you to choose one of these three strategic investment options. The next question is how much are the expenses of this plan.

ICICI Pru Smart Kid Premier Expenses

Just like other ULIPS, there are charges under several different heads in this one too, and I’ll list them down in this section.

Premium Allocation Charge: 2% of the premium in the first year will be deducted under this charge, so if you took a policy out for Rs. 50,000 then Rs. 1,000 will be deducted from the policy during the first year for this charge. This will be zero from the second year onwards.

Fund Management Charge: 1.35% per annum will be deducted from the fund value you invest in all the funds except for the return guarantee fund where it is 1.50% and the money market fund where this percentage is 0.75%.

Policy Administration Charge: 0.47% per month will be charged from the premium as this expense from the first year to the time you are paying the premium. When you stop paying the premium (but the term still continues) this will become 0.10% every month.

Mortality Charges: These will also be deducted monthly and they have a table for this that they refer to for determining how much will be reduced. Naturally, if the life of both parents is covered the mortality charges will increase (not by double though).

Switching Charges: You have four free switches in a year, and I think this refers to switching between portfolio strategies, anything over this will be charged Rs. 100 per switch.

Miscellaneous Charges: Policy alterations will be charged at Rs. 250, and I’m not quite sure what type of policy alterations this includes.

How do these expenses affect returns?

The policy brochure has got the following illustration which shows you sample returns at 6% and 10% for two policy terms which are net of all charges, service tax and education cesses.

• Age at entry: 30 years
• Annual Premium Amount: Rs. 50,000
• Mode of Payment: Yearly
• Coverage Option: Single life
• Choice of Portfolio Strategy: Fixed (Money invested in Dynamic P/E fund)
• Premium Payment Option: Regular

	Term = 10 years		Term = 15 years
	Returns at 6% p.a.	Returns at 10% p.a.	Returns at 6% p.a.	Returns at 10% p.a.
Fund Value at Maturity	Rs. 5,94,574	Rs. 7,43,261	Rs. 10,03,955	Rs. 14,12,382
Effective Return Rate	 3.13%	7.1%	 3.56%	 7.57%

I have added the last row of the above table myself, and the effective return rate is how much you are effectively getting if the fund performs at 6% or 10%. Since the amount above that is net of expenses – it is not actually based on 6% or 10% but is arrived at after deducting all the expenses.

So, in the first option you just get a return of 3.13% if the fund actually performs at 6%, and if the fund performs at 10% then you just get 7.1%, and in the 15 year term you get 3.56% and 7.57%.  I think this shows fairly significant expenses and an insurance of ten times annual premium doesn’t make these kind of expenses attractive enough.

Conclusion

Having reviewed this tells me that  ULIPs aren’t as bad as they once used to be and some people may actually find use for them if they want to boost their insurance coverage for example. But as far as I’m concerned, I don’t see any compelling reason to buy this policy, and I would much rather buy a term plan and make other investments according to whatever plan and preferences I have. That way I can buy whatever mutual fund I want instead of being limited to the ones offered through this plan and can also make changes mid way.

 

Google announced an unusual move today where they introduced a new class of shares that have no voting rights at all. Google already had two classes of shares – A shares that have one vote per share and B shares that have 10 votes per shares.

The founders own the bulk of the B shares and that gives them the ability to issue new stock without diluting their control over the company. The new class of shares they have issued is called the C class, and these shares won’t have any voting rights at all.

The way they are going to issue these new shares is to give a stock dividend of one C class share to each owner of a A class share, so everyone who owned one Google share will now own two shares – one class A and one class C.

Just like a regular split, or bonus issue – the stock price should drop by about half but in this case since the class C shares don’t have voting rights, they should trade at a lower price than the class A shares. Whether this will really happen or how deep the discount will be is anybody’s guess.

In an Indian context, this can be used to understand the concept of DVRs or Differential Voting Rights shares. Differential Voting Rights also mean that the owner of one class of share will have different voting rights from the owner of another class of shares.

Tata Motors is the most famous example of DVRs in India because it was the first one to issue DVRs, and it trades at a big discount to the Tata Motors ordinary share, something that it has done for quite some time. In the case of Tata Motors  – one DVR share has only one tenth the voting right of an ordinary share.

Currently, the Tata Motors DVR trades at Rs. 158, while the ordinary share trades at Rs. 285. The Financial Express had a story about this wide gap last year and how this was expected to close down, but for some reason this gap doesn’t seem to close.

The Tata Motors DVR also pays a higher rate of dividend than the ordinary share, and has a fairly good dividend yield as well.

These DVR type shares are a lot more common in the tech companies in the US than they are in India as Indian companies have probably not felt the need for protecting themselves against dilution of equity, and they’d much rather conserve cash than give it away in the form of higher dividends.

As far as retail investors are concerned, I don’t see how voting rights make much difference to them, and if you are the kind of person who likes to pick stocks and is looking for some stocks with good dividend yields that you can hold for long – the DVR space might offer some opportunities.

The topic of Futures and Options has come up quite frequently in comments and emails but I’ve never done a post on them till now because the posts got too long. I can remember deleting at least two drafts because they got too unwieldy, and complex.

I’ve tried to give it another shot, and simplify it by breaking it into parts. Here is the first part with some very basic and easily digestible information on futures and options.

Two Types of Derivatives

There are two types of Derivatives commonly traded in the market – Futures and Options, and within Options there is further a Call option and a Put option.

The price of these derivatives is based on an underlying asset, and the price of the derivative usually moves in tandem with the price of the underlying. The underlying is usually a stock or an index in the context of investing in a stock market.

So, that means the price of Infosys futures or Infosys options will depend on the price of the Infosys shares. But if that’s the case then why don’t people simply buy the stock or the index fund?

Why Buy Futures or Options?

While there are other reasons, I think two big reasons are leverage and taking short positions. Options and Futures give you a lot of leverage and you can make (or blow up) a large amount of money in a short period of time with the same amount of capital than you can with a regular cash position.

The second reason is to take short positions, or profit from declines in the price of a share or commodity. If you want to take a bet that a particular company will do badly, and then profit from it then you can’t do it very easily in the cash market.

But you can sell a future, call option or buy a put option to take a short position in the stock or index.

The third common reason I hear is hedging risk, and while I agree that it is a big reason for institutional investors, I just can’t see how retail investors can efficiently hedge with derivatives. The notional values of derivatives is often too high, and the expiry periods too short to act as an efficient hedge for small investors.

Who should buy Derivatives?

I think the big difference between buying derivatives and buying a share in the cash market is that your investment can go to zero a lot more frequently in the derivatives market than in the cash market, and only those people who have a high risk appetite and who can stomach losing a lot of money should invest in derivatives.

I think you should also be fairly clued in on the market to make these kind of leveraged bets, but if you asked me what “fairly clued in on the market” means I would find it very difficult to define that.

That being said, they can be quite profitable as well because they give you the ability to profit from short positions and add leverage.

I think the bottom line is that you should only invest that amount of money in derivatives that you are comfortable in losing. They aren’t for everyone, and not everyone should dabble in them.

I’ll stop this post here, and in the next part of this series build on what it means when  you say the price of a derivative depends on the underlying.

This post is from the Suggest a Topic page. 

• Part 1: Introduction to Futures and Options
• Part 2: How do Futures Work?
• Part 3: How do Options work?

Prat had an interesting question on how a share price is calculated on the stock exchange at any given point, and his question had more to do with the mechanics of share price calculation, and not on value or demand and supply etc. which is what is commonly talked about.

So, when you see that the price of Infosys is Rs. 2,850 – how was the price calculated at that given time?

The calculation of prices is completely automated, software driven, and anonymous at both BSE and NSE, and the price is calculated by electronically matching bids and offers for a particular share recorded an electronic limit order book (ELOB).

When you place an order to buy a share at a certain price that is called your “bid” and when you place an order to sell your shares at a certain price that’s called your “ask”.

The ELOB contains all the bid – asks for a particular share and the system matches the best bids and asks to execute an order. The price at which a transaction is executed is called the last traded price (LTP) and that’s what you see on TV screens.

From the NSE’s website – let’s take a look at an example ELOB to understand this process.

An example of an order book for a stock at a point in time is detailed below:

Buy			Sell
S.No.	Quantity	Price	Quantity	Price	S.No.
1	1,000	3.50	2,000	4.00	5
2	1,000	3.40	1,000	4.05	6
3	2,000	3.40	500	4.20	7
4	1,000	3.30	100	4.25	8

If you look at the above table, the left side are the bids and the right side are the asks. As it stands – there can’t be any transaction because the highest price that the buyers are willing to pay is lower than the lowest price at which the sellers are willing to sell. However, if you come in and put up a market order to buy 3,000 shares – your order will be executed and you will get 2,000 shares at Rs. 4.00 and the remaining 1,000 shares at Rs. 4.05.

Similarly if you wanted to sell 2,000 shares – the first 1,000 will be sold at Rs. 3.50 and the second thousand will be sold at Rs. 3.40.

The exchange gets you the best price that is available at that given time whether you are a buyer or seller and if you have placed limit orders then those orders will not be executed as long as someone matches that on the other side of the transaction.

At a high level, matching the bids and asks on a stock based on the volume at that time determines the stock price. I’m sure there are a lot of intricacies in this system, but I’m unable to write about them because I’m not familiar with them myself. If you have a link that goes deeper than this then please do leave a comment.

This post was from the Suggest a Topic page.

In part 1 of this series I wrote about the evolution of an investor to either a trader or a long term investor, and said that I favor long term investing to short term trading.

Then in the second part I wrote about the implicit assumption that a long term investor makes which is over a very long period of time the market will move upwards, and then also spoke about the nature of a share or stock. That nature I said was that a stock is a representation of the earnings of a company, and looking at it that way helps you stomach the volatility that exists in the market and deal with the daily ups and downs.

In this part I’m going to build on the two concepts I spoke about earlier and share a few thoughts on execution.

I invest regularly in the market throughout the year but I don’t have a SIP set up and I do this on my own. I invest very aggressively in the market when there is doom and gloom and put in as much as I can like I was doing last December, and during the Lehman crisis, and I slow down (but still keep investing) when there isn’t much doom and gloom but people are not over the top as well. The market right now resembles that situation and while I’m investing in the market the sums that go in the market aren’t as much as they were last December.

There are three big ideas behind this type of thinking – one is that in the long term I expect markets to edge upwards so even if they are down today I feel that they will be up 3, 4 or 5 years down the line and as long as no one forces me to sell the position – I can wait for the tide to turn and sell at that time.

The second big idea is that markets don’t move in a linear fashion, and no one knows when, why or by how much they will go up or down. You can’t simply stop investing with the fear that the market will go down more because there is no way to know when the tide will turn and by how much the market will rise then. If you sit on the sidelines when the market is down, then I’m pretty sure you’re sitting on the sidelines through most of the earnings that come about when the tide turns.

The past decade has shown us that up moves have been as violent as down – moves and that too at very unexpected times, so that’s why I like to stay invested in the market as much as I can. I hear a lot of people say that I’m going to start investing when the market turns and perhaps Santa whispers when the market is about to turn in their ears, but I am not one of those people.

Here is a chart that illustrates what I’m talking about.

 

The third big idea is that while you can’t time your in and out, you can try to calibrate how much you put in the market, and while that exposes you to additional risk – if you don’t have any loans and can stomach risk and volatility then it is possible to make this volatility work in your favor rather than give you jitters.

The big difficulty in doing this is it’s very hard to buy when everyone else is paring down and the general atmosphere is of doom and gloom. However, if you view a stock as ownership in a company (like I wrote in the earlier post) and if you believe that the company will survive the downturn – that gives you confidence to hold on and continue buying. Then when the tide turns you will be sitting on some good profits, and you won’t be rushed into investing in the market like the people who feel left behind by sudden market jumps, and the jumps are always sudden, so at that time you can moderate your investments.

I think people who are starting out can leave calibrating out of the equation and start with investing small sums monthly which they continue with even when the market is down. I say small sums because it doesn’t hurt as much when you see them in the red (which you inevitably will) and it makes it easier to continue investing small sums even when the market is falling. Within a three to five year period you will get a sense of where you stand as far as shares are concerned and whether you want to stay away completely from them (understandable) or want to go in very aggressively (also understandable) but whichever way you eventually turn to I’d recommend you follow this approach initially rather than buying and selling daily or weekly in an ad-hoc manner.

In the next part of this series I will write about some type of mutual funds that can be used to invest in equities regularly and execute this strategy.

• Part 1: How should beginners approach investing in the stock market?
• Part 2: How should beginners approach investing in the stock market?
• Part 3: How should beginners approach investing in the stock market?
• Part 4: How should beginners approach investing in the stock market?