Know Your Enemies

The road to investing success can be likened to a battlefield.  There are people and entities out there, who want a share of our money, and may stop at nothing to get that.  There are also other obstacles that, if not overcome, can harm our aspirations, and even leave us financially crippled.  These people and obstacles are the enemies that I allude to.  What makes things tough is that some of these people give the impression of being friends, not foes, and that some of the obstacles are simply hidden from plain sight. This post is intended to put a spotlight on a few of these enemies.

Taxes and Inflation

There is a quote of unclear origin that goes thus: “The way to crush the bourgeoisie is to grind them down between the millstones of taxation and inflation.”  The author may as well been talking about investors.  Consider this: if the rate of inflation were to be 8%, for someone paying 30% as taxes, to merely break-even against the combined impact of taxes and inflation, he/she would have to earn a return of 11.43% p.a. on his/her investments.  To see any growth in the true value of his/her money, such an investor would have to earn a return greater than that.

Of the two, inflation is the bigger threat.  It is inescapable, and carries a greater impact.  For example, on an investment return of 9% p.a. over a period of 10 years, having to deal with an inflation rate of 8% p.a. is equivalent to paying taxes each year at the rate of almost 90%. Inflation is also more stealthy: taxes are mostly visible as we pay them, year after year, whereas inflation creeps up on us from behind and eats into our purchasing power. 

Equity funds can help fight inflation.  These are also highly tax-efficient.  Opting for debt funds over bank deposits (or most other debt instruments) can bring down one’s taxes, provided one is willing to hold these for over 3 years.  Amongst debt funds, open-end schemes carry one significant advantage over closed-end schemes: one can defer one’s taxes as long as one wants to.  Obviously, selecting the right equity and debt funds is important. Knowing how much of each to have in one’s portfolio (i.e. the asset allocation) is crucial.

The Financial Services Industry

In his investment classic, ‘The Four Pillars of Investing,’ William Bernstein had this to say about the financial services industry:

“Investors tend to be touchingly naïve about stockbrokers and mutual fund companies: brokers are not your friends, and the interests of the fund companies are highly divergent from yours. You are in fact locked in a financial life-and-death struggle with the investment industry; losing that battle puts you at increased risk of running short of assets far sooner than you’d like. The more you know about the industry’s priorities and how it operates, the more likely it is that you will be able to thwart it.”

In the introduction to this blog I referred to the noble purpose that the mutual fund industry serves.  Yet, as I have pointed out (for instance, here), many, if not most, fund houses have indulged in dubious practices.  Worse, there has been a tacit collusion between some unscrupulous fund houses and their distributors to legally make money off investors in a manner that raises questions of ethics and morality. 

Just to be clear, their intentions of ill-will should not make us stay away from investing in mutual fund schemes.  The reasons for investing remain as compelling as ever.  It is important that while doing so, we be aware of this and take adequate precautions to protect our interests.  Gathering information and perspectives is a vital part of being prepared to deal with these enemies.  As you do so, be sure to distinguish facts from opinions.  Verify facts, if necessary.  Question the opinions till you feel satisfied.  In addition, as I suggested in this post, ask questions of those whom you engage with: advisors, representatives of fund houses, or anyone else.  Trust only those whose integrity you feel comfortable about, and whose competence you see little basis to doubt.

The Person in the Mirror

Yes, you read that right.  According to Benjamin Graham, regarded by many as one of the greatest minds in investing, “the investor’s chief problem—and even his worst enemy—is likely to be himself.”  In case this makes you wonder, there is a large body of evidence that illustrates that most of us make flawed investment decisions.  Research also shows that our natural behavior leads most of us to be poor investors.   To put it in the quaint prose of William Bernstein: “Most of what we fondly call ‘human nature’ becomes a deadly quicksand of maladaptive behavior when allowed to roam free in the investment arena.” 

Our awareness of this fact, while an important step, still leaves us with significant challenges.  If we are fortunate to have access to the services of a good financial advisor whom we can trust, then we may have far less to worry about. Good financial advisors not only steer their clients clear of the pitfalls of their flaws, they also act as a behavioral coach.  Of course, good financial advisors are few and far between.

For most of us who don’t have access to a good financial advisor, it will be an uphill task correcting our flaws on our own.  A good starting point would be to acquire knowledge about the nature of these flaws.  There is one resource, in particular, that I would like to recommend in this regard.  This is a series of videos that were aired on the program, ‘Nightly Business Report’ on PBS in the US over 2009-10, under the title: ‘Your Mind and Your Money.’  Most, if not all, of the episodes have been uploaded on YouTube, and can be accessed by searching on the PBS channel.

To sum up, the enemies listed here may not be adversaries in any traditional sense but we would do well to treat them as such.  To quote Gerald Loeb in his book, ‘The Battle for Investment Survival’: “Your best weapons against the forces that tend to clip your fortune are knowledge and experience.”

Why retired investors need mutual funds

Let me tell you about a 60-year old gentleman, whom I recently met.  He had just stepped into retirement, had a retirement fund of 1 crore and, to start with, needed an income of 65,000 p.m. I take this example because I think this is reasonably representative of the retired people I have met.  Most retirees that I have met (who have retired around the age of 60), have had retirement funds that were between 100 and 200 times their desired monthly income at the start of retirement- this individual had a retirement fund that was about 154 times that.  Additionally, like most retirees that I have met, he was keen to invest his money in an option that carried an assurance of a fixed return, preferably from the Government, or a Government-owned entity. 

After a bit of looking around, he had short-listed monthly-interest paying deposits across three banks, which were offering a rate of 9% p.a.. If he invested his entire fund, he would get 75,000 p.m. from these deposits.  Leaving aside taxes, it was his opinion that the bank deposit would be more than adequate for his needs.  So certain was he of his choice that his only question to me was regarding the tenure of the deposit, “Should I go for a 5 year deposit, or should I go for a 10 year deposit?”

As I saw it, he was, most likely, in for an unpleasant surprise. 

The biggest challenge for any retired investor is to deal with inflation (or price rise). While inflation impacts us throughout our lives, its impact is arguably most severe during the years of retirement.  In the above example, if we were to assume an annual inflation rate of 6% (which is a reasonable assumption), that would mean that to maintain the same quality of life a year later, he would need a monthly income of 68,900.  Two years later, the monthly income would have to go up to 73,034.  Five years later, it would have to go up to 86,985.  Ten years later, it would have to go up to 116,405.  

While the deposits are not designed to match such increases, in the first couple of years, these would generate a surplus (over the required monthly income), which could be reinvested and used in later years.  However, this wouldn’t last too long.   If the surplus were to be reinvested at the same rate of 9% p.a., then somewhere in the seventh year of retirement, it would run out.  The only way to survive from the income from the deposits would be to cut his monthly expenses by a third.

But let’s go back to the start.  In this example, to adequately counter the impact of inflation, the deposits should have generated a monthly income of just over 110,000 p.m. (this calculation assumes the person lives till the age of 90).  To get that kind of income each month, this person would have had to invest about 1.47 crore (@ 9% p.a.).  In other words, on this count alone, he should have had a retirement fund that was about 226 times the monthly income needed at the start of retirement.

Even so, this would still leave the issues of taxes to contend with.  Secondly, there would still be the very realistic possibility of inflation being higher than 6% p.a. (a number of people may regard my assumption on the rate of inflation as being unrealistically low).  If we were to consider taxes and a higher rate of inflation, then one would need a much bigger retirement fund. 

In my estimate, anyone retiring at the age of 60, and relying on bank deposits for monthly income, should have a retirement fund that is at least 300 times the monthly income needed at the start of retirement.  My experience also suggests, as I mentioned earlier, that most Indians entering retirement do not have a fund of that size.  Therein lies the case for mutual funds.

Having a slice of equity funds in one’s portfolio is a great way to counter the impact of inflation.  Having debt funds instead of fixed deposits (or other debt instruments) carries two advantages: a. it allows for efficient withdrawals i.e. you can withdraw the exact amount that you need, exactly when you need it and b. it offers greater tax efficiency i.e. you can defer the incidence of taxes and even bring down the amount of taxes needed to be paid.  Thus, using debt and equity funds together, it is very possible to enjoy the quality of life one aspires for, with a smaller retirement fund compared to what would be needed if one invested only in options with assured returns.

The risk in investing for future tax benefits

There are some risks related to investing that are not widely talked about but which, I believe, one would do well to take note of.  One such risk is that of a change in tax laws (some consider this as part of what is known as, “regulatory risk”).  In a way, the recent Budget proposals to amend the way gains from debt funds are taxed, have put this risk in the spotlight.  In this post, I propose to offer my thoughts on this risk.

Tax benefits can come at three levels – on the amount we invest, on the dividends we get, and on the gains we make (or the amount we get) when we exit.  A change in tax laws that may adversely affect the latter two is what we most need to watch out for.  Depending on the nature of such a change, one may end up having to pay far more taxes than one planned for, or worse, the achievement of a financial goal may be in jeopardy.  Consider the recent proposals, for instance.  Someone who invested in an FMP with a tenure of less than 3 years could well end up paying 3 times the amount of tax originally envisaged, or even more (unless, of course, the fund house is able to extend the tenure of the fund).  On the other hand, what if, this amount was needed to fund a financial goal that cannot be deferred, such as one’s child’s higher education?

History provides us enough evidence of the unpredictability of tax laws.  Once upon a time, all long term gains (including those from equities) were defined and taxed in the manner that has now been proposed for debt funds.  Till 1999, dividends were taxable.  Some of these changes have been pleasant, some not so.  Some proposals never advanced beyond being proposals.  But at no point, was there any way of knowing for certain what would happen in the future. It remains to be seen as to whether the current proposals will become a reality and, if so, in what shape.  Time will tell what other changes may happen.  Given that this risk may not be identical across all kinds of investments, makes a case for diversification.  As I suggested in an earlier post, diversification can minimize the impact of unpleasant surprises that may affect any single investment or category of investments.

Investing is always fraught with uncertainty.  There are very few, if any, assurances that can be said to be carved in stone.  Taxes, too, as history shows, aren’t quite the certainty that some have suggested.

A wake-up call for the mutual fund industry

I refer to the Budget proposals made yesterday, specifically the ones to amend the way gains from debt funds will be taxed.

I guess the objective would have been to plug an area that was impacting tax collections.  One has to admire how perfect a choice this is- high on impact, and low on collateral damage, with some potentially interesting side effects to boot.  For me, the most interesting of these would be the impact this has on the mutual fund industry.

Mutual funds were originally envisioned as a means to help retail investors build long-term wealth. Yet, over the years, the industry did little to justify its existence for this purpose. It chased corporates and high net-worth individuals, ignoring the masses.  It unabashedly marketed FMPs as a way to get around the taxes that other debt instruments would involve.  In short, the industry constantly looked around for easy, short-term profitability. 

Sure, exceptions were (and are) there, but as a whole, the industry has taken little pride in the nobility of the purpose for which it existed.  If the Budget proposals do become a reality, this will, in my opinion, be the biggest wake-up call the industry has ever had.

Are debt funds still worth investing into?

Short answer: Yes, but…

In the first post of this blog, a couple of months ago, I mentioned three categories of investors for whom there was a compelling case to consider investing in mutual funds.  Yesterday’s Budget proposals for a change in taxation of gains from debt funds don’t negate the points I made in that post.  However, for investors with a proposed investment tenure of less than 3 years, the case to consider a debt fund is now considerably weakened. 

Some time ago, I undertook a study that covered the period 2007-2013, over which I compared the returns from debt funds with a cumulative term deposit with State Bank of India.  I looked at the calendar year returns and at the rolling 2 year (calendar year) returns.  The fund data was taken from Value Research.  No exit loads were applied. The data covered 370 debt funds, of which 153 were in existence in 2007 (and for which data was available for each year since).  Here are some findings:

1 year returns:

The best calendar year in terms of the number of funds outperforming the deposit was 2008, when 81% of the funds did so.  The worst year was 2009 when 6% of the funds did so.

Of the 153 funds in existence since 2007, no fund beat the return from the deposit in all 7 calendar years.  3 funds outperformed the deposit in 6 of the 7 years, while another 27 did so in 5 of the 7 years.  There were 58 funds which outperformed the deposit in 2 years or less (including 6 funds which did not surpass the returns from the deposit in any single calendar year.)

2 year returns:

The best two-year period in terms of number of funds outperforming the deposit was 2011-12, when 78% of the funds did so.  The worst two-year period was 2009-10 when 1% of the funds beat the returns from the deposit.

No fund surpassed the returns from the deposit over all 6 two-year periods.  2 funds outperformed the deposit in 5 of the 6 two-year periods while 18 funds did so in 4 of the 6 two-year periods.  The vast majority of the funds outperformed the deposit half the time or less.  14 funds did not beat the returns from the deposit in any two-year period.

There was no pattern that I could see across these numbers linking funds having a similar average maturity or credit quality or strategy. Looking at these numbers, I am inclined to believe that without the advantage of tax breaks, investing in a debt fund, hoping to beat the returns from a 1 year deposit or a 2 year deposit is quite like a shot in the dark.  I am also inclined to believe that for someone in the higher tax brackets, there is a case to consider allocating more to equity funds.  After all, the return required to outperform a deposit or a debt fund just went down. But maybe that’s a discussion best left for another time.  For now, consider it as food for thought.

Do you really need to invest in mutual funds?

If you fall into one of these three categories of investors, there is a cogent case for you to consider investing in mutual funds.

• You are presently working but will retire at some time in the future.
• You are retired and dependent on the income from your investments.
• You pay high taxes.

Let me elaborate on each of these scenarios.

Presently working, planning to retire:

Barring a miniscule minority, most of us who work, are dependent on the income from our profession. When we retire from our profession, we will be fully dependent on the income that we can passively generate from our investments. Whether we realize it or not, a key purpose of our working life is to acquire adequate wealth to passively generate the income we desire, post-retirement.

Let’s assume for a moment that one were to retire at the age of 60. If medical science continues to progress the way it has, there is a high chance of living up to the age of 90 or beyond. That means that the wealth that one has at the start of one’s retirement needs to see one through a period of 30 years.

The evidence suggests that for a lot of Indians working today, getting to that level of wealth will need them to earn a return on their current investments that is higher than what bank deposits offer. That limits the choice of investment options to stocks and real estate. Without getting into a debate at this point over which is a better choice, let me suggest that directly investing into both these options requires the kind of expertise which is beyond the capability of most investors. That’s where mutual funds come in. Currently there may be no real estate funds in India but there are a wide variety of equity funds available. Yes, building and nurturing a portfolio of equity funds, too, calls call for some degree of expertise but that is far less than what is called for building and nurturing a portfolio of stocks. Furthermore, there are many more financial advisors who possess and offer the expertise for the former, as compared to those who possess and offer the expertise for the latter.

Retired:

As mentioned earlier, individuals in this stage don’t have the luxury of being able to take much risk on their investments. Coupled with the need for assurance of return, such investors tend to choose debt instruments. These instruments carry one significant limitation: you are stuck with receiving a fixed amount for the entire tenure of the investment.

Why is that a drawback? Our expenses do not remain fixed: these tend to go up with inflation. Retired individuals, thus, need an investment option which can either generate the income they need (after adjusting for inflation), or give them the flexibility to draw upon their investment principal, as and when necessary. Open-end debt funds score on the second count. Combine these with a slice of equity funds, and you have a portfolio that could score on both counts.

The need for tax efficiency

To the extent that our money needs to be in debt instruments, we have the choice to opt for debt instruments like bank deposits, Post Office schemes, bonds, and the PPF, or go for debt funds. For individuals paying higher taxes, PPF and debt funds represent more tax efficient choices. The PPF is unique in that it offers both a tax rebate at the time of investment, and its income is completely tax free. It has two major drawbacks, though. There are restrictions on the amount you can invest, and it is not very liquid.

In this backdrop, open-end debt funds present an interesting alternative. These are highly liquid, and have no restrictions on what you can invest. Unlike other debt instruments, there is no assurance of ‘fixed income.’ There are debt funds, though, which have a high degree of predictability as to the return these will generate.

On tax efficiency, open-end debt funds score lower than the PPF. But relative to any other debt instrument these offer far greater tax efficiency. The tax efficiency comes in two forms: the rate of tax, and the ability to defer paying taxes until we withdraw.

I hope to further expand upon some of these issues in the weeks ahead. Nonetheless, feel free to email me if you have any questions or feedback on this post.