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Are you ready to pay for guarantees?

Are you ready to pay for guarantees?
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First Published: Mon, Jun 13 2011. 10 02 PM IST
Updated: Mon, Jun 13 2011. 10 02 PM IST
To make sure that the money you invest comes back to you while you get to dabble into the markets sounds good. But there are a few costs that such a guarantee may entail—performance and features and in some even high charges. We found that out by scanning capital protection products among mutual funds and unit-linked insurance plans (Ulips). Read on to know whether they work for you.
Mutual funds
The highest that any capital protection fund has delivered in the last one year is just 5.88% (Franklin Templeton Capital Safety 5 Yrs), according to data from Value Research, a mutual funds tracker. The least was 3.09% (Sundaram Capital Protection Oriented Series I 5 Yrs).
Compare this with the rate of inflation for 2010-11, which has been above 9%, and your real rate of return turns negative. The real rate of return is the nominal rate of return minus the inflation rate. A 9% inflation rate means what you could buy for Rs 100 a year back now costs Rs 109, but your investments have returned only around Rs 106, giving a negative return of Rs 3.
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Even bank fixed deposits (FDs) have fared better than capital protection funds over the past one year, though FDs’ real returns are in the negative zone, too. A year ago, banks were offering interest rates of around 6.5-7% for a year.
The trend is similar even on a longer time horizon of three years. Take a look at these figures: Franklin Templeton Capital returned 7.93% in the last three years, the highest among all capital protection funds. SBI Capital Protection Oriented Fund Series I clocked the least with 4.30%. An FD taken in June 2008 for three years would have given around 8.5-9.5% this year.
Why poor performance: In their bid to protect the investors’ initial capital, these funds predominantly—at least 70-80%—invest in bonds. The performance of bonds is inversely related to interest rates movement. In a rising interest rate scenario, bonds tend to perform badly. With the Reserve Bank of India (RBI) raising policy rates by 100 basis points in the last six months, bond performance has suffered, hitting capital protection funds in turn.
“Capital protection funds also invest part of their corpus in equities and since equities have hardly yielded any return in the last one year or so, that too has impacted the performance of these funds,” says Kartik Jhaveri, founder and director, Transcend Consulting (I) Pvt. Ltd, a Mumbai-based private wealth management firm. These funds are closed-end and if you stay the course rather than exiting early, your returns would get better. You will have to pay an exit load if you leave the fund before its term and that may drag your return down.
Fees charged: The fee, or expense ratio, these funds charge are as per the industry standard—1.5-2% per annum.
Ulips
In Ulips, capital guarantee products became popular post 1 September 2010, when the regulator introduced cost caps on Ulips. While some Ulips promised to return all the premiums paid on maturity, it was the capital guarantee in the form of highest net asset value (NAV) that caught the fancy of investors.
Says Sanjeev Pujari, appointed actuary, SBI Life Insurance Co. Ltd: “Ulips giving highest NAV guarantee capital in the initial stages but when the fund value looks up it is the fund value that is guaranteed subsequently.” While the lure of highest NAV is strong, the fine print can change the story.
A capital guarantee fund within a Ulip has the flexibility to swing between equity and debt since their exposure to equity is 0-100%. The highest NAV guaranteed fund has the same flexibility—even as it may look like an equity fund, it is capable of turning completely into a debt fund in order to protect your capital. Usually in a bullish market, this plan will deliver on the mirage it creates: guaranteed return at the highest NAV of an equity fund. However, if the markets turn volatile the highest return is not of a fund that consists of only equity. To protect your upside in a volatile market, the insurer will lock in your gains in debt options. If the markets continue to fall, the insurer will shift more and more into debt, which gets reflected in your NAV.
Performance: As the markets continue to stay volatile and more money gets allocated to debt, the fund performance will mirror the returns of a balanced or a debt product, which will get reflected by a much sober NAV. Adds Pujari: “These are like balanced funds, but with no fixed asset allocation. Typically, the returns from these are similar to that of balanced funds.” The biggest risk here is that the entire corpus can get shifted to debt if the market crashes. It becomes difficult to move back to equity specially towards the end of the tenor as the focus then would be on preserving the highest NAV. While all this may sound a simple case of rejig the portfolio, the process is actually carried out by a complex software throwing out a constant debt-equity ratio.
Cost: It is not the returns alone that hurt. These plans charge you extra for offering the guarantee. Worse, there are no regulatory caps on how much the insurer can charge you. Mortality charge and charges on account of a guarantee are outside the regulatory caps purview. Depending on your age, the sum assured you choose and the charge for the guarantee, the advantage of a capital guarantee can actually turn against you.
Here’s an example: Canara HSBC Oriental Bank of Commerce Life Insurance Co. Ltd’s Insure Smart Plan is a 10-year term product that guarantees the highest NAV over the fund’s initial seven years. For this guarantee, it charges 0.35% per annum of the fund value; this is over and above the fund management charge. Assuming you pay Rs 1 lakh for five years for a sum assured of Rs 15 lakh—it has a limited premium paying term—and your fund grows at 10%, the plan will return around Rs 8.3 lakh: a return of 6.45% in 10 years. According to the regulator, the difference between the gross yield and the net yield can’t be more than 3 percentage points, but here the returns have come down on account of the cost on guarantee, which is not within the regulatory caps.
Features: A Ulip offering any kind of capital guarantee typically does so only on maturity. So in case you wish to surrender your policy or in case of death, the guarantee will not be available. Also, these policies come for shorter terms, usually 10 years, and with a limited sum assured to help the insurer manage the guarantee.
What you should do
Capital guarantee products are for risk-averse investors. But even in the conservative and safer investment stable, there are better products to use. There is Public Provident Fund that gives 8% risk-free return, though its horizon is 15 years. For shorter duration, you could consider fixed deposits if you are in the lower tax bracket. With returns on one-year commercial papers around 10.5% as on 13 June, you can easily earn around 9.5-10% in fixed maturity plans.
But if you can stomach some risk, then investing in equity over at least 10 years will automatically insulate your capital. You can choose a mutual fund with a good performance track record. In the long-term, equities tend to be less volatile and give returns that leave inflation behind by a comfortable margin.
Graphic By Sandeep Bhatnagar; illustration By Shyamal Banerjee/Mint
abhishek.a@livemint.com
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First Published: Mon, Jun 13 2011. 10 02 PM IST