UNIT 1 - Investment Alternatives material.pdf

Investment Alternatives Choices Galore LEARNING OBJECTIVES After studying this chapter you should be able to Describe the features of ﬁnancial assets, both marketable and non-marketable. Understand the features of equity shares. Determine the suitability of mutual funds for your needs. Explain various kinds of insurance products. Understand the different types of retirement products. Know the pros and cons of investing in real assets and precious assets. Describe the basic features of derivatives. A bewildering range of investment alternatives is available. They fall into two broad categories, viz., ﬁnancial assets and real assets. Financial assets are paper (or electronic) claims on some issuer such as the government or a corporate body. The important ﬁnancial assets are equity shares, corporate debentures, government securities, deposits with banks, mutual fund shares, insurance policies, and derivative instruments. Real estate and precious objects are represented by tangible assets like residential house, commercial property, agricultural farm, gold, precious stones, and art objects. As the economy advances, the relative importance of ﬁnancial assets tends to increase. Of course, by and large the two forms of investments are complementary and not competitive. For sensible investing, you should be familiar with the characteristics and features of various investment alternatives before you. This chapter describes various investment alternatives. Since the emphasis of this book is on ﬁnancial assets, they will be discussed in greater detail. Although the discussion is fairly up to date, the rapid changes in the world of investments leads to the creation of new investment alternatives. If you understand the basic characteristics of major investment alternatives currently available, you will have the background to understand new alternatives as they appear. 2.2 Investment Analysis and Portfolio Management 2.1 DEPOSITS A good portion of the ﬁnancial assets of individual investors is held in the form of deposits like bank deposits, post ofﬁce deposits, company deposits. A distinguishing feature of these assets is that they represent personal transactions between the investor and the issuer. For example, when you open a savings bank account at a bank, you deal with the bank personally. In contrast, when you buy equity shares in the stock market you do not know who the seller is and you may not care. The important types of deposits held by investors are brieﬂy described below: Bank Deposits Perhaps the simplest of investment avenues, by opening a bank account and depositing money in it one can make a bank deposit. There are various kinds of bank accounts: current account, savings account, and ﬁxed deposit account. While a deposit in a current account does not earn any interest, deposits in other kinds of bank accounts earn interest. The important features of bank deposits are as follows: Deposits in scheduled banks are very safe because of the regulations of the Reserve Bank of India and the guarantee provided by the Deposit Insurance Corporation, which guarantees deposits upto Rs 100,000 per depositor of a bank. The interest rate on ﬁxed deposits varies with the term of the deposit. Interest is generally paid quarterly. Bank deposits enjoy exceptionally high liquidity. Banks now offer customers the facility of premature withdrawals of a portion or whole of ﬁxed deposits. Such withdrawals would earn interest rates corresponding to the periods for which they are deposited, at times with some penalty. Loans can be raised against bank deposits. A tax savings ﬁxed deposit is a bank term deposit which has a tenure of 5 years or more and which enjoys tax beneﬁt under section 80 C of the IT Act. Post Ofﬁce Savings Account A post ofﬁce savings account is similar to a savings bank account. Its salient features are as follows: The interest rate is 4 percent per annum. The interest is tax exempt upto Rs. 3500 in case of single accounts and Rs.4000 in case of joint accounts. The amount of ﬁrst deposit should be at least Rs. 20 for an ordinary account. Withdrawals are subject to keeping a minimum balance of Rs.50 in an ordinary account and Rs.500 for a cheque facility account. There is no limit on maximum deposit. Post Ofﬁce Time Deposits (POTDs) Similar to ﬁxed deposits of commercial banks, POTDs have the following features: Deposits can be made in multiplies of Rs. 200 without any limit. The interest is calculated half-yearly and paid annually. The interest is calculated quarterly and paid annually. Investment Alternatives 2.3 No withdrawal is permitted upto six months. After six months, withdrawals are permitted. However, on withdrawals made between six months and one year, no interest is payable. On withdrawals after one year, but before the term of deposit, interest is paid for the period the deposit has been held, subject to a penal deduction of 2 percent. A POTD account can be pledged. An investment for a 5 year time deposit qualiﬁes for tax relief under Section 80 C. Post Ofﬁce Monthly Income Scheme (POMIS) A popular scheme of the post ofﬁce, the POMIS is meant to provide regular monthly income to the depositors. The salient features of this scheme are as follows: The term of the scheme is 5 years. The minimum amount of investment is Rs.1,500. The maximum investment can be Rs.4,50,000 in a single account or Rs.9,00,000 in a joint account. The interest rate is 8.2 percent payable monthly. A bonus of 10 percent is payable on maturity. There is no tax deduction at source. There is a facility of premature withdrawal after 1 year but before 3 years with 2 percent deduction and after 3 years with 1 percent deduction. Company Fixed Deposits Many companies, large and small, solicit ﬁxed deposits from the public. Fixed deposits mobilised by manufacturing companies are regulated by the Company Law Board and ﬁxed deposits mobilised by ﬁnance companies (more precisely non-banking ﬁnance companies) are regulated by the Reserve Bank of India. The key features of company deposits in India are as follows: For a manufacturing company the term of deposits can be one to three years, whereas for a non-banking ﬁnance company it can vary between 25 months to ﬁve years. A manufacturing company can mobilise, by way of ﬁxed deposits, an amount equal to 25 percent of its worth from the public and an additional amount equal to 10 percent of its worth from its shareholders. A non-banking ﬁnance company, however, can mobilise a higher amount. The interest rates on company deposits are higher than those on bank ﬁxed deposits. Company deposits have to be necessarily credit-rated. Depositors don’t get any tax beneﬁt on company deposits. However no income tax is deducted at source if the interest income is upto Rs. 5,000 in a ﬁnancial year. Companies offer some incentives like facility for premature withdrawal or free personal accident insurance cover to attract deposits. 2.4 Investment Analysis and Portfolio Management 2.2 GOVERNMENT SAVINGS SCHEMES Government of India offers a number of small savings schemes to individual investors. These schemes are offered through the post ofﬁce and select banks. The important savings schemes are: Public Provident Fund Scheme, Senior Citizens’ Saving Scheme, and National Savings Certiﬁcate. Though the interest rates on these schemes are ﬁxed at present, the government may eventually link them to some market related benchmark rates. Public Provident Fund Scheme One of the most attractive investment avenues available in India, the Public Provident Fund (PPF) Scheme has the following features : Individuals and HUFs can participate in this scheme. A PPF account may be opened at any branch of the State Bank of India or its subsidiaries or at speciﬁed branches of the other nationalised banks and post ofﬁces. Though the period of a PPF account is stated to be 15 years, the number of contributions has to be 16. This is because the 15 year period is calculated from the ﬁnancial year following the date on which the account is opened. Thus, a PPF account matures on the ﬁrst day of the 17th year. The subscriber to a PPF account is required to make a minimum deposit of Rs. 500 per year. The maximum permissible deposit per year is Rs 1,00,000. Deposits in a PPF account can be deducted before computing the taxable income under Section 80 C. PPF deposits currently earn a compound interest rate of 8.6 percent per annum, which is totally exempt from taxes. The interest, however, is accumulated in the PPF account and not paid annually to the subscriber. The balance in a PPF account is fully exempt from wealth tax. Further, it is not subject to attachment under any order or decree of a court. The subscriber to a PPF account is eligible to take a loan from the third year to the sixth year after opening the PPF account. The amount of loan cannot exceed 25 percent of the balance standing to the credit of the PPF account at the end of the second preceding ﬁnancial year. The interest payable on such a loan is 1 percent higher than the PPF account interest rate. The subscriber to a PPF account can make one withdrawal every year from the sixth year to the ﬁfteenth year. The amount of withdrawal cannot exceed 50 percent of the balance at the end of the fourth preceding year or the year immediately preceding the year of withdrawal, whichever is lower, less the amount of loan, if any. The withdrawal can be put to any use and is not required to be refunded. On maturity, the credit balance in a PPF account can be withdrawn. However, at the option of the subscriber, the account can be continued for three successive block periods of ﬁve years each, with or without deposits. During the extensions the account holder can make one withdrawal per year, subject to the condition that the total amount withdrawn during a 5-year block does not exceed 60 percent of the balance to the credit of the account at the beginning. Investment Alternatives 2.5 Senior Citizens’ Saving Scheme (SCSS) Meant for Indian citizens who are 60 years of age or more, the SCSS has the following features: It is a 5-year deposit on which interest is paid on a quarterly basis. On maturity, the tenor can be extended by 3 years. The maximum amount that can be invested by an individual, singly or jointly with another holder, is Rs. 15 lakhs. The deposits have to be in lots of Rs. 1,000. SCSS deposits are eligible for tax deduction under Section 80 C of the Income Tax Act. The interest rate is 9 percent, payable quarterly. Interest is taxable. SCSS deposits are not transferable, but premature withdrawal is possible after one year with penalties. National Savings Certiﬁcate Issued at the post ofﬁces, National Savings Certiﬁcate (VIII-Issue) offers the following features: It comes in denominations of Rs.100, Rs.500, Rs.1,000, and Rs.10,000. It has a term of 5 years. Over this periods Rs.100 becomes Rs.150.90.Hence the compound rate of return works out to 8.6 percent. The investment in NSC can be deducted before computing the taxable income under Section 80 C. There is no tax deduction at source. It can be pledged as a collateral for raising loans. A new savings instrument, namely 10-Year National Savings Certiﬁcate (IX-Issue), 2011, has been issued with effect from 1st December 2011.The major highlights of this scheme are as follows: Investments in the Certiﬁcate will earn interest at the rate of 8.7 percent p.a. compounded semi-annually. On investment of Rs. 100, the depositor will get Rs. 234.35 on maturity of the Certiﬁcate in 10 years. This Certiﬁcate will be available in the denominations of Rs. 100, Rs.500, Rs.1000, Rs.5000, and Rs.10,000. There is no upper limit for investment in the Certiﬁcate. Deposits upto Rs. 1 lakh are deductible before computing taxable income under Section 80 C. The Certiﬁcate can be transferred from a post ofﬁce where it is registered to any other post ofﬁce and it can be pledged as a security. 2.3 MONEY MARKET INSTRUMENTS Debt instruments, which have a maturity of less than one year at the time of issue, are called money market instruments. These instruments are highly liquid and have negligible risk. The major money market instruments are Treasury bills, certiﬁcates of deposit, commercial paper, repos, and CBLO. The money market is dominated by the government, ﬁnancial institutions, banks, and corporates. Individual investors 2.6 Investment Analysis and Portfolio Management scarcely participate in the money market directly. A brief description of money market instruments is given below. Treasury Bills Treasury bills are the most important money market instrument. They represent the obligations of the Government of India which have a primary tenor like 91 days and 364 days. They are sold on an auction basis every week in certain minimum denominations by the Reserve Bank of India. They do not carry an explicit interest rate (or coupon rate). Instead, they are sold at a discount and redeemed at par. Hence the implicit yield of a Treasury bill is a function of the size of the discount and the period of maturity. Though the yield on Treasury bills is somewhat low, they have appeal for the following reasons: (a) They can be transacted readily and there is a very active secondary market for them. (b) Treasury bills have nil credit risk and negligible price risk (thanks to their short tenor). Commercial Paper A commercial paper (CP) is a short term unsecured money market instrument. CPs can be issued by corporates, primary dealers (PDs), and all-India ﬁnancial institutions under the umbrella limit speciﬁed by the Reserve Bank of India. CPs can be issued for maturities between 7 days and one year from the date of issue. CPs are sold at a discount and redeemed at par. Hence the implicit rate of interest is a function of the size of discount and the period of maturity. Certiﬁcate of Deposit A certiﬁcate of deposit(CD) is a negotiable money market instrument issued by a bank or an eligible ﬁnancial institution for a speciﬁed time period - while banks can issue CDs of maturities from 7 days to one year, ﬁnancial institutions can issue CDs of maturities of 1 year to 3 years. CDs are issued in dematerialised form or as a Usance Promissory Note. CDs are issued at a discount on face value or on a ﬂoating rate basis. CDs are a popular form of short-term investment for mutual funds and companies for the following reasons: (i) Banks are normally willing to tailor the denominations and maturities to suit the needs of the investors. (ii) CDs are generally risk-free. (iii) CDs generally offer a higher rate of interest than Treasury bills or term deposits. (iv) CDs are transferable. Call Money Market Call money notice market is a market for unsecured lending or borrowing of funds. Participants in this market include banks, Primary Dealers (PDs), development ﬁnance institutions, insurance companies, and select mutual funds. While banks and PDs can borrow as well as lend in the call market, other participants can only lend. The call market is predominantly an overnight market. Repos A “repo” involves a simultaneous “sale and repurchase” agreement. A “repo” works as follows. Party A needs short-term funds and Party B wants to make a short- term investment. Party A sells securities to Party B at a certain price and simultaneously agrees to repurchase the same after a speciﬁed time at a slightly higher price. The difference between the sale price and the repurchase price represents the interest cost to Party A and conversely the interest income for Party B. A “reverse repo” is the opposite of a “repo” – it involves an initial purchase of a security followed by a Investment Alternatives 2.7 subsequent sale. It is a safe and convenient form of short-term investment. From the above it is clear that there are two legs to the same transaction in a repo / reverse repo. The duration between the two legs is the “repo period,” which is predominantly a one day period. Collateralised Borrowing and Lending Obligations (CBLO) The CBLO market is a money market operated by the Clearing Corporation of India Limited (CCIL) for entities that have no access or restricted access to the inter-bank call money market. CCIL members can borrow or lend funds against the collateral of eligible securities which include central government securities and such other securities as speciﬁed by CCIL from time to time. Borrowers in CBLO market are required to deposit the eligible securities with the CCIL based on which CCIL determines the borrowing limits. CCIL matches the borrowing and lending orders received from the members and notiﬁes them. Though the securities provided as collateral remain in the custody of the CCIL, the beneﬁcial interest of the lender is recognised through proper documentation. 2.4 BONDS OR DEBENTURES Bonds or debentures represent long-term debt instruments. The issuer of a bond promises to pay a stipulated stream of cash ﬂows. This generally comprises of periodic interest payments over the life of the instrument and principal payment at the time of redemption(s). This section discusses the following types of bonds or debentures: central government securities, state development loans, savings bonds, private sector debentures, PSU bonds and preference shares. Central Government Securities Debt securities issued by the central government are popularly called G-secs. They may be in the form of Treasury Bills (discussed earlier) or Dated Government Securities (discussed here). Issued by the RBI on behalf of the Government of India, dated G-secs generally have a ﬁxed maturity (2 to 30 years) and a ﬁxed coupon (interest) rate and pay interest semi-annually. For example, 8.50 percent GOI 2024 matures in 2024 and carries a coupon of 8.5 percent payable semi-annually. G – secs are issued in the following four forms: A promissory note payable to the order of a certain person. A bearer bond payable to a bearer. A stock which is registered in the books of RBI for which a stock certiﬁcate is issued or which are held to the credit of the holder in the Subsidiary General Ledger (SGL) Account maintained in the books of RBI and transferable by registration in the books of RBI. An agent, on behalf of his constituent (i.e., investor), can open a second SGL account with RBI called the Constituents’ Subsidiary General Ledger account (CSGL Account). A bond which is held in a Bond Ledger Account (BLA) with RBI or an agency bank in which the government securities are held in a demat form. The investor 2.8 Investment Analysis and Portfolio Management in a BLA receives a Certiﬁcate of Holding from RBI/agency banks. The Public Debt Ofﬁce (PDO) of the RBI, Mumbai acts as the registry and central depository for the government securities which may be held either in the physical form or demat form except for all RBI regulated entities who have to necessarily hold and transact these securities in demat form only. A physical stock certiﬁcate is registered with PDO and can be transferred only by executing a transfer form which need to be registered with the PDO. Securities in demat form are maintained in SGL and CGSL accounts. An investor can use the depositories NSDL or CDSL also for holding their demat government securities. G – secs qualify as SLR (statutory liquidity ratio) investments, unless otherwise stated. They are held mainly by banks, ﬁnancial institutions, insurance companies, provident funds, and mutual funds. However, traditionally they have not appealed to individual investors because of long maturities and illiquid retail markets. State Development Loans State Development Loans (SDLs) are debt securities issued by the state government. RBI manages the issue of these securities. Each state is allowed to issue these securities upto a certain limit each year. The coupon rates on SDLs are marginally higher than those on G - secs for the same maturity. Public Sector Undertaking Bonds Public Sector Undertakings (PSUs) issue debentures that are referred to as PSU bonds. There are two broad varieties of PSU bonds: taxable bonds and tax free bonds. While PSUs are free to set the interest rates on taxable bonds, they cannot offer more than a certain interest rate on tax-free bonds which is ﬁxed by the Ministry of Finance. More important, a PSU can issue tax-free bonds only with the prior approval of the Ministry of Finance. In general, PSU bonds have the following investor-friendly features: (a) there is no deduction of tax at source on the interest paid on these bonds, (b) they are transferable by mere endorsement and delivery, (c) there is no stamp duty applicable on transfer, and (d) they are traded on the stock exchanges. In addition, some institutions are ready to buy and sell these bonds with a small price difference. Private Sector Debentures Akin to promissory notes, debentures are instruments meant for raising long term debt. The obligation of a company towards its debenture holders is similar to that of a borrower who promises to pay interest and principal at speciﬁed times. The important features of debentures are as follows: When a debenture issue is sold to the investing public, a trustee is appointed through a deed. The trustee is usually a bank or a ﬁnancial institution. Entrusted with the role of protecting the interest of debenture holders, the trustee is responsible for ensuring that the borrowing ﬁrm fulﬁls its contractual obligations. Typically, debentures are secured by a charge on the immovable properties, both present and future, of the company by way of an equitable mortgage. All debentures issues with a maturity period of more than 18 months must be necessarily credit-rated. Further, for such debenture issues, a Debenture Redemption Reserve (DRR) has to be created. The company should create a Investment Alternatives 2.9 DRR equivalent to at least 50 percent of the amount of issue before redemption commences. The company issuing the debentures can choose the redemption (maturity period) as well as the coupon rate. Further, the rate may be ﬁxed or ﬂoating. In the latter case it is periodically determined in relation to some benchmark rate. Debentures sometimes carry a ‘call’ feature which provides the issuing company with an option to redeem the debentures at a certain price before the maturity date. Sometimes, the debentures may have a ‘put’ feature which gives the holder the right to seek redemption at speciﬁed times at predetermined prices. Debentures may have a convertible clause which gives the debenture holder the option to convert the debentures into equity shares on certain terms and conditions that are pre-speciﬁed. Preference Shares Preference shares represent a hybrid security that partakes some characteristics of equity shares and some attributes of debentures. The salient features of preference shares are as follows: Preference shares carry a ﬁxed rate of dividend. Preference dividend is payable only out of distributable proﬁts. Hence, when there is inadequacy of distributable proﬁts, the question of paying preference dividend does not arise. Dividend on preference shares is generally cumulative. Dividend skipped in one year has to be paid subsequently before equity dividend can be paid. Preference shares are redeemable- the redemption period is usually 7 to 12 years. Currently preference dividend is tax-exempt. 2.5 EQUITY SHARES Equity capital represents ownership capital. Equity shareholders collectively own the company. They bear the risk and enjoy the rewards of ownership. Of all the forms of securities, equity shares appear to be the most romantic. While ﬁxed income investment avenues may be more important to most of the investors, equity shares seem to capture their interest the most. The potential rewards and penalties associated with equity shares make them an interesting, even exciting, proposition. No wonder, equity investment is a favourite topic of conversation in parties and get-togethers. Terminology The amount of capital that a company can issue as per its memorandum represents the authorised capital. The amount offered by the company to the investors is called the issued capital. That part of the issued capital that has been subscribed to by the investors is called the paid-up capital. Typically, the issued, subscribed, and paid-up capital are the same. The par value is stated in the memorandum and written on the share scrip. The par value of equity shares is generally Rs. 10 or Re 1. Infrequently, one comes across par values like Rs. 5, Rs. 50, and Rs. 1,000.There is a proposal to make the par value uniformly 2.10 Investment Analysis and Portfolio Management at Re 1. The issue price is the price at which the equity share is issued. When the issue price exceeds the par value, the difference is referred to as the share premium. Note that the issue price cannot be, as per law, lower than the par value. The book value of an equity share is equal to: Paid-up equity capital Reserves and surplus Number of outstaanding equity shares Quite naturally, the book value of an equity share tends to increase as the ratio of reserves and surplus to the paid-up equity capital increases. The market value of an equity share is the price at which it is traded in the market. Rights of Equity Shareholders As owners of the company, equity shareholders enjoy the following rights: Equity shareholders have a residual claim to the income of the ﬁrm. This means that the proﬁt after tax less preference dividend belongs to equity shareholders. However, the board of directors has the prerogative to decide how it should be split between dividends and retained earnings. Dividends provide current income to equity shareholders and retained earnings tend to increase the intrinsic value of equity shares. Note that equity dividends are presently tax-exempt in the hands of the recipient. The company paying the dividend is required to pay dividend distribution tax. Equity shareholders elect the board of directors and have the right to vote on every resolution placed before the company. The board of directors, in turn, appoints the top management of the ﬁrm. Hence, equity shareholders, in theory, exercise an indirect control over the operations of the ﬁrm. In practice, however, equity shareholders – scattered, ill-organised, passive, and indifferent as they often are –fail to exercise their collective power effectively. Equity shareholders enjoy the pre-emptive right which enables them to maintain their proportional ownership by purchasing the additional equity shares issued by the ﬁrm. As in the case of income, equity shareholders have a residual claim over the assets of the company in the event of liquidation. Claims of all others – debenture holders, secured lenders, unsecured lenders, preferred shareholders, and other creditors – are prior to the claim of equity shareholders. Stock Market Classiﬁcation of Equity shares In stock market parlance, it is customary to classify equity shares as follows: Blue-chip Shares Shares of large, well-established, and ﬁnancially strong companies with an impressive record of earnings and dividends. Growth Shares Shares of companies that have a fairly entrenched position in a growing market and which enjoy an above average rate of growth as well as proﬁtability. Income Shares Shares of companies that have fairly stable operations, relatively limited growth opportunities, and high dividend payout ratios. Investment Alternatives 2.11 Cyclical Shares Shares of companies that have a pronounced cyclicality in their operations. Defensive Shares Shares of companies that are relatively unaffected by the ups and downs in general business conditions. Speculative Shares Shares that tend to ﬂuctuate widely because there is a lot of speculative trading in them. Note that the above classiﬁcation is only indicative. It should not be regarded as rigid and straitjacketed. Often you can’t pigeonhole a share exclusively in a single category. In fact, many shares may fall into two (or even more) categories. Peter Lynch’s Classiﬁcation1 There are different ways of classifying shares. Here is Peter Lynch’s classiﬁcation of companies (and, by derivation, shares). Slow Growers Large and ageing companies that are expected to grow slightly faster than the gross national product. Stalwarts Giant companies that are faster than slow growers but are not agile climbers. Fast Growers Small, aggressive new enterprises that grow at 10 to 25 percent a year. Cyclicals Companies whose sales and proﬁt rise and fall in a regular, though not completely predictable, fashion. Turnarounds Companies which are steeped in accumulated losses but which show signs of recovery. Turnaround companies have the potential to make up lost ground quickly. Asset Plays Companies that have valuable assets which have been somewhat overlooked by the stock market. Nature of Equity shares Benjamin Graham has described the nature of equity shares, referred to as common stocks in the US, very aptly: “Common stocks have one important investment characteristic and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the re-investment of undistributed earnings. However, most of the time common stocks are subject to irrational and excessive price ﬂuctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble, i.e., to give way to hope, fear, and greed.” 2.6 MUTUAL FUND SCHEMES If you ﬁnd it difﬁcult or cumbersome to invest directly in equity shares and debt instruments, you can invest in these ﬁnancial assets indirectly through a mutual fund. A mutual fund represents a vehicle for collective investment. When you participate in a scheme of a mutual fund, you become a part-owner of the investments held under that scheme. 1 Peter Lynch, One Upon the Wall Street, Penguin, 1990. 2.12 Investment Analysis and Portfolio Management Till 1986 the Unit Trust of India was the only mutual fund in India offering a small number of schemes. As the mutual fund sector was liberalised, new entrants came into the ﬁeld. At present, there are about 30 mutual funds offering over 1000 schemes. In India, the following entities are involved in a mutual fund operation: the sponsor, the mutual fund, the trustees, the asset management company (AMC), the custodian, and the registrars and transfer agents. Mutual fund schemes invest in three broad categories of ﬁnancial assets, viz. stocks, bonds, and cash. Stocks refer to equity and equity-related instruments. Bonds are debt instruments that have a maturity of more than one year. Cash represents bank deposits and debt instruments that have a maturity of less than one year. Depending on the asset mix, mutual fund schemes are classiﬁed into three broad types, viz. equity schemes, hybrid schemes, and debt schemes. Equity schemes invest the bulk of their corpus, 85-95 percent or even more, in stocks and the balance in cash. Hybrid schemes, also referred to as balanced schemes, invest in a mix of stocks and debt instruments. Debt schemes invest in bonds and cash. Within each of these broad categories, there are several variants as shown in the accompanying box. Schemes Galore I. Equity Schemes Diversiﬁed equity schemes Index schemes Sectoral schemes Tax planning schemes II. Hybrid (Balanced) Schemes Equity-oriented schemes Debt-oriented schemes Variable asset allocation schemes III. Debt Schemes Gilt schemes Mixed schemes Floating rate debt schemes Money market schemes Mutual funds in India are comprehensively regulated under the SEBI (Mutual Funds) Regulation, 1996. Some of the important provisions of this regulation are as follows: A mutual fund shall be constituted in the form of a trust executed by the sponsor in favour of the trustees. The sponsor or, if so authorised by the trust deed, the trustees shall appoint an asset management company (AMC). No scheme shall be launched by the AMC unless it is approved by the trustees and a copy of the offer document has been ﬁled with SEBI, The offer document and advertisement materials shall not be misleading. Investment Alternatives 2.13 No guaranteed return shall be provided in a scheme unless such returns are fully guaranteed by the sponsor of the AMC. The mutual fund shall not borrow except to meet temporary liquidity needs. The net asset value (NAV) and the sale and repurchase price of mutual fund schemes must be regularly published in daily newspapers. The investments of a mutual fund are subject to several restrictions relating to exposure to stocks of individual companies, debt instruments of individual issuers, so on and so forth. Costs associated with mutual fund investing such as initial expenses, loads (entry and exit), and annual recurring expenses are subject to certain ceilings. For most of the individual investors, mutual funds represent an excellent vehicle for investing indirectly in stocks, bonds, and cash. However, there are some disadvantages as well. The pros and cons of mutual fund investing are summarised below. Pros Cons Diversiﬁcation Expenses Professional management Lack of thrill Liquidity Tax advantages Comprehensive regulation Transparency 2.7 INSURANCE PRODUCTS2 The basic customer needs met by life insurance policies are protection and savings. Policies that provide protection beneﬁts are designed to protect the policyholder (or his dependents) from the ﬁnancial consequence of unwelcome events such as death or long-term sickness/disability. Policies that are designed as savings contracts allow the policyholder to build up funds to meet speciﬁc investment objectives such as income in retirement or repayment of a loan. In practice, many policies provide a mixture of savings and protection beneﬁts. Types of Insurance Plans There are three broad types of insurance plans, (or policies) term assurance plans traditional investment-linked plans and unit-linked insurance Plans, (ULIPS). Term Assurance Plans This is a pure protection policy, which provides a beneﬁt on the death of the policy holder within a speciﬁed term, say 5 years or 10 years or 20 years or whatever. Premiums may be paid regularly over the term of the policy (or some shorter period) or as a single premium at the outset. Generally, there is no payment if the policyholder survives to the end of the end of the policy. However, there are term 2 This section has been contributed by Dr K. Sriram. 2.14 Investment Analysis and Portfolio Management assurance policies, which offer some proportion of premiums paid on survival to the maturity date of the policy. A popular variant of the term assurance policy is the decreasing term assurance policy under which the sum assured decreases over the term of the policy. This type of policy can be used to meet two such speciﬁc needs. First, it can be used to rapay the balance outstanding under a loan (like house mortage) in the event of death of the policyholder. Secondly, it can be used to provide an income for the family of the deceased policyholder from the time of death up to the end of the policy term. Traditional Investment-Oriented Plans Traditional investment-oriented plans combine insurance with investment. So instead of paying Rs 3,000 per year for a term insurance plan, the policy holder would have to pay say Rs. 30,000 per year. Out of this, Rs 3,000 would be allocated toward an insurance cover and the balance would be invested in a fund, after deducting administration charges. Traditional investment-oriented plans typically come in two formats. viz., "non-participating" format and "participating" format. In the "non-participating" format, the policy offers a guaranteed amount of money (the "sum assured") at the maturity of the policy. In the "participating" format, the "sum assured" is expected to be enhanced by payment of bonus (distribution of proﬁts made by the insurance company). Obviously, the premium payable for a "participating" policy is higher than that of a similar "non-participating" policy. The important types of traditional investment-oriented plans are money back plans, endowment plans, whole life plans, and children's plans. A money back plan provides lump sum amounts at periodic intervals. For example, if you buy a 20-year policy with an assured sum of Rs. 10 lakh, the policy may provide for part payment of the sume assured as follows: Rs 2 lakh at the end every ﬁve years for 15 years and Rs. 4 lakh (plus bonus in case of a participating policy) at the end of the 20th year. If the policyholder dies during the term of 20 years, the family will get the entire Rs. 10 lakh along with bonus, if applicable, regardless of intermediate payouts. An endowment plan offers a guaranteed amount of money (the "sum assured") at the maturity date of the policy in exchange for a single premium at the start of the policy or series of regular premiums throughout the term of the policy. If the policy holder dies before the maturity date then usually the same sum assured is paid on death. The policyholder may be allowed to surrender the policy before maturity and receive a lump sum (surrender value or cash value) at the time, on guaranted or non-guranteed terms. There is usually a provision to take a loan upto 90 percent of the surrender value. A whole life plan provides an assured sum on the death of the policyholder whenever that might occur. Basically it provides long-term ﬁnancial protection to the dependents. It is particularly useful as a means of protecting some of the expected wealth transfer that a parent would be aiming to make to his or her children when he or she died. Without this policy, the wealth transfer is likely to be very small if the parent died young. Such policies can also be a tax efﬁcient way of transferring wealth at any age depending on legislation (often reducing the liability to inheritance tax). A children's plan seeks to secure your child's ﬁnancial future by providing certain sums of monies at important stages of your child's life. For instance, at the age of 16 Investment Alternatives 2.15 when the child has just ﬁnished schooling and at the age of 21 when the child has completed graduation. Unit-Linked Insurance Plans A unit-linked insurance plan (ULIP) is an insurance-cum investment product that differs from the traditional investment-oriented plans in the following ways: In a traditional investment-oriented plan the policyholder does not know how the premiums are allocated toward insurance cover, administration charges, and investments. In a ULIP, the policy holder knows exactly how the premiums are allocated toward each part. In a traditional investment-oriented plan, the investment portion is invested only in debt securites and the policyholder does not know exactly how the investment fund is performing. In a ULIP, the policyholder is given the choice to invest in equity, or balanced funds. These funds are like mutual funds and their NAVs are declared on a daily basis. At end of the ULIP term, the policy holder receives the value of the units at the NAV on the maturity date. If the policyholder dies before the maturity period, the nominees will get the sum assured or the fund value whichever is higher. It appears that the charges on ULIPS are higher than those on traditional investment- oriented plans Charges include initial allocation charge (between 20 to 60 percent of the ﬁrst year's premium), regular allocation charge (between 2 to 10 percent of the following year's premiums), policy administration fees (Rs. 20 to Rs. 60 per month), and investement managment charges (1.5 to 2.5 percent) Riders Riders are add-ons to the life insurance policies described above. These add-ons can be purchased with the base policy on payment of a small additional premium. The commonly offered riders in the Indian context are: Accidental Death Beneﬁt (ADB) Rider Critical Illness (CI) Rider Waiver of Premium (WoP) Rider Term Rider Tax Breaks At the time of writing, the tax breaks from a policyholder’s perspective are as follows: The premium payable under a life insurance policy can be deducted from taxable income under Section 80 C of the Income Tax Act, 1961. The amount of premium which can be deducted from the taxable income is restricted to 10 percent of the initial assured sum. Note that insurance premium is only one of the eligible investments qualifying for deduction under Section 80C. The maximum deduction under this section is restricted to Rs. 100,000. The premium paid by an individual under a pension plan offered by a life insurance company or any other IRDA - approved insurer can be deducted from the taxable income of that individual under Section 80C of the Income Tax Act. The deduction under this section is restricted to Rs. 100,000. 2.16 Investment Analysis and Portfolio Management If the insurance policy qualiﬁes for deduction under both Section 80C and Section 80CCC, the deduction can be claimed under only one of these sections. Any sum received under a life insurance policy, including the sum allocated by way of bonus on such policy is exempt from tax under Section 10 (10D) of the Income Tax Act. Considerations in Choosing a Policy Bear in mind the following considerations in choosing a policy. Review your own insurance needs and circumstances. Choose the kind of policy that has beneﬁts that most closely ﬁt your needs. A life insurance agent or a ﬁnancial advisor can help you in this task. Be sure that you can handle premium payments. Can you afford the initial premium? If the premium increases later and you still need insurance, can you still afford it? Don’t buy life insurance unless you intend to stick with your plan. It may be very costly if you quit during the early years of the policy’s term. Check the claim settlement record before buying a cover. Make sure that the insurance company has a high settlement ratio (say over 90 percent) for the kind of policy you are looking for. You can get information about the claim settlement record from the annual report of the Insurance Development and Regulatory Authority (IRDA). If you are thinking of surrendering your insurance policy or replacing it with a new one, you should carefully assess the surrender value and the rights and beneﬁts of the new policy vis-à-vis the existing policy. 2.8 RETIREMENT PRODUCTS Retirement products may be divided into two broad categories viz., mandatory retirement schemes and voluntary retirement schemes. Mandatory Retirement Schemes The Employees Provident Fund and Miscellaneous Provisions (EPF & MP) Act of 1952 requires employers covered under the act to offer the following schemes to the workers: Employees’ Provident Fund (EPF) Scheme, 1952 Employees’ Pension Scheme (EPS), 1995 New Pension Scheme Employees’ Provident Fund Scheme A major vehicle of savings for salaried employees, the Employees’ Provident Fund Scheme has the following features: Each employee has a separate provident fund account into which both the employer and employee are required to contribute 12 percent of the employee's basic wages, dearness allowance, and retaining allowance every month. Investment Alternatives 2.17 The employee can choose to contribute additional amounts, subject to certain restrictions. While the contribution made by the employer is fully tax exempt (from the point of view of the employee), the contributions made by the employee can be deducted before computing the taxable income under Section 80 C. The interest rate on the provident fund balance is declared annually. Interest is totally exempt from taxes. The interest however, is accumulated in the provident fund account and not paid annually to the employee. The balance in the provident fund account is fully exempt from wealth tax. Further, it is not subject to attachment under any order or decree of a court. Within certain limit, the employee is eligible to take a loan against the provident fund balance pertaining to his contributions only. Employees’ Pension Scheme (EPS) Guaranteed by the government, this scheme is administered by the Employees Provident Fund Organisation (EPFO). Under this scheme 8.33 percent from the employer’s contribution of 12 percent to the Employee Provident Fund is diverted to the Employee Pension Scheme. The central government also contributes one and one-sixth percent of wages. Under this scheme, pension is provided to the member (or family) upon retirement. New Pension Scheme Effective January 1, 2004, the central government introduced the New Pension Scheme (NPS) to cover all central government employees who joined service on or after January 1, 2004. The salient features of the NPS are as follows: It will work on deﬁned contribution basis. In a deﬁned contribution scheme, the payout on the completion of the scheme or retirement depends on the returns generated from the contributions made by subscribers. It will have two tiers – Tier I and Tier II. Tier I is mandatory for all government servants joining government service on or after 1.1.2004. In Tier I, a government servant will have to make a contribution of 10 percent of his Basic Pay, and DA which will be deducted from his salary every month. The government will make an equal matching contribution. Tier I contribution will be kept in a non-withdrawable Pension Tier I account. Tier II will be optional and at the discretion of the government servant. Tier II contributions will be kept in a separate account that will be withdrawable at the option of the government servant. The Pension Fund Regulatory and Development Authority (PFRDA) will regulate and develop the pension market. A government servant can exit at or after the age of 60 years from Tier I of the Scheme. At exit, it would be mandatory for him to invest 40 percent of pension wealth to purchase an annuity (from an IRDA regulated life insurance company) which will provide for pension for the life time of the employee and his dependent parents. In case a government servant leaves the scheme before attaining the age of 60, the mandatory annuitisation would be 80 percent of the pension wealth. 2.18 Investment Analysis and Portfolio Management At present the NPS corpus is managed by three fund managers sponsored by SBI, UTI, and LIC respectively. The management fees charged by the fund managers is less that 0.01 percent which is miniscule compared to what mutual funds and insurance companies charge. The scheme offers various mixes of equity and debt and also has a default option that allocates contributions between debt and equity based on the age of the contributor. Presently the equity investments are restricted to Nifty 50 stocks. Since the NPS is a good vehicle for building a corpus for retirement, the government has opened it to all individuals with effect from April 1, 2009. This is indeed highly welcome. Now any one can participate in the NPS which offers the advantage of low cost and ﬂexibility in asset mix (debt-equity mix). Voluntary Retirement Schemes There are various schemes and annuity products that investors may subscribe to voluntarily primarily to provide retirement beneﬁts. The important ones are Public Provident Fund, New Pension Scheme, and pension plans of insurance companies and mutual funds. Since the Public Provident Fund Scheme and New Pension Scheme have been discussed earlier, we will discuss here the pension plans of insurance companies and mutual funds. The pension plans of insurance companies and mutual funds typically provide for annuity payments. There are broadly two types of plans, immediate annuity plans and deferred annuity plans. Immediate Annuity Plan An immediate annuity plan can be purchased by paying a lump sum amount. It provides for annuity payments at a stated amount immediately after purchase of the plan. A variety of options are available for the type and mode of payment. For example, under the Jeevan Akshay VI Pension Plan, the following options are available. Annuity payable for life at a uniform rate. Annuity payable for 5,10,15 or 20 years certain and thereafter as long as the annuitant lives. Annuity for life with return of purchase price on death of the annuitant. Annuity payable for life, increasing at a simple rate of 3 percent per annum. Annuity for life with a provision of 50 percent of the annuity payable to spouse during his / her lifetime on death of the annuitant. Annuity for life with a provision of 100 percent of the annuity payable to spouse during his / her lifetime on death of the annuitant. Further, the annuity may be paid either at monthly, quarterly, half yearly, or yearly intervals. Deferred Annuity The usual structure of this policy is that the policyholder pays regular premiums for a period up to the speciﬁed “vesting date.” These premiums buy amounts Investment Alternatives 2.19 of regular income, payable to the policyholder from the vesting date. A single premium at the start of the policy is a possible alternative to regular premiums. A deferred annuity enables the policyholder to build up a pension that becomes payable on his or her retirement from gainful employment. At the vesting date of the annuity, the alternative of a lump sum may be offered in lieu of part or all of the pension, thereby meeting any need for a cash sum at that point, for example to pay off a housing loan. As in the case of immediate annuity plan a variety of options are available for the type and mode of payment. 2.9 REAL ESTATE For the bulk of the investors, the most important asset in their portfolio is a residential house. In addition to a residential house, the more afﬂuent investors are likely to be interested in the following types of real estate. Semi-urban land A second house Commercial property Agricultural land Time share in a holiday resort Historically, real estate in India has been ﬁnancially the most rewarding asset class. The pros and cons of investing in real estate are as follows: Pros Cons Rental yield (or saving) Large ticket size Attractive capital appreciation Legal disputes Psychic pleasure Illiquid markets Low risk High spread and commissions Tax beneﬁts Maintenance effort 2.10 PRECIOUS OBJECTS Precious objects in general are valuable objects that are physically not voluminous. The major types of precious objects are: A. Precious Metals Gold Silver B. Precious Stones Diamonds Others 2.20 Investment Analysis and Portfolio Management C. Art Objects and Collectibles Paintings Sculpture Antiques Others The pros and cons of investing in Precious assets are as follows: Pros Cons Inﬂation hedge Illiquid markets Efﬁcient diversiﬁcation High spread and commissions Psychic pleasure Maintenance effort Safe haven 2.11 FINANCIAL DERIVATIVES A derivative is an instrument whose value depends on the value of some underlying asset. Hence, it may be viewed as a side bet on that asset. From the point of view of investors and portfolio managers, futures and options are the two most important ﬁnancial derivatives. They are used for hedging and speculation. Futures A futures contract is an agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is speciﬁed today. The party which agrees to purchase the asset is said to have a long position and the party which agrees to sell the asset is said to have a short position. The party holding the long position beneﬁts if the price increases, whereas the party holding the short position loses if the price increases and vice versa. To illustrate this point, consider a futures contract between two parties, viz., A and B. A agrees to buy 1000 shares of Acme Chemicals at Rs.100 from B to be delivered 90 days hence. A has a long position and B has a short position. On the 90th day, if the price of Acme Chemicals happens to be Rs.105, A gains Rs. 5,000 [1000 (105 – 100)] whereas B loses Rs.5000. On the other hand, if the price of Acme Chemicals on the 90th day happens to be Rs.95, A loses Rs.5000 [1000 (95 – 100)], whereas B gains Rs.5000. Options An option gives its holder the right to buy or sell an underlying asset (our focus here will be on equity shares) on or before a given date at a predetermined price. Note that options represent a special kind of ﬁnancial contract under which the option holder enjoys the right (for which he pays a price), but has no obligation, to do something. There are two basic types of options: call options and put options. A call option gives the option holder the right to buy a ﬁxed number of shares of a certain stock, at a given exercise price on or before the expiration date. To enjoy this option, the option buyer (holder) pays a premium to the option writer (seller) which is non-refundable. The writer (seller) of the call option is obliged to sell the shares at the speciﬁed price, if the buyer chooses to exercise the option. Investment Alternatives 2.21 A put option gives the option holder the right to sell a ﬁxed number of shares of a certain stock at a given exercise price on or before the expiration date. To enjoy this right, the option buyer (holder) pays a non-refundable premium to the option seller (writer). The writer of the put option is obliged to buy the shares at the speciﬁed price, if the option holder chooses to exercise the option. SUMMARY A bewildering range of investment alternatives is available. They fall into two broad categories viz., ﬁnancial assets and real assets. The important ﬁnancial assets are deposits, government savings schemes, money market instruments, bonds or debentures, equity shares, mutual fund schemes, insurance products, retirement products, and ﬁnancial derivatives. The important real assets are real estate and precious objects. A good portion of the ﬁnancial assets of individual investors is held in the form of deposits like bank deposits, post ofﬁce deposits, and company deposits. The important government savings schemes available to individual investors are Public Provident Fund Scheme, Senior Citizens’ Saving Scheme, and National Savings Certiﬁcate. Debt instruments, which have a maturity of less than one year at the time of issue, are called money market instruments. The major money market instruments are Treasury bills, certiﬁcates of deposit, commercial paper, repos, and CBLO. Bonds or debentures represent long-term, debt instruments such as central government securities, state development loans, PSU bonds, and private sector debentures. Equity shares represent ownership capital. Equity shareholders collectively own the company. They bear the risk and enjoy the rewards of ownership. A mutual fund represents a vehicle for collective investment. When you participate in a mutual fund scheme, you become a part – owner of the investments held under that scheme. The common types of insurance products are Endowment Assurance, Money Back Plan, Whole Life Assurance, Unit Linked Plan, and Term Assurance. Retirement products may be divided into two broad categories viz., mandatory retirement schemes (such as Employees’ Provident Fund Scheme and New Pension Scheme) and voluntary retirement schemes (such as pension plans of insurance companies and mutual funds which provide for annuity payments). For the bulk of the investors, the most important asset in their portfolio is a residential house. In addition to a residential house, the more afﬂuent investors are likely to invest in other types of real estate. Precious objects in general are valuable objects that are physically not voluminous. The major types of precious objects are precious metals, precious stones, and art objects and collectibles.

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