Tuesday, December 30, 2008

Gold as an Investment

The concept of buying/holding Gold has been followed for ages. Gold has been one of the most sought after precious metals for generations and people have been crazy about owning gold always. In olden days the amount of gold possessed by a king signified his power. In the modern times the amount of gold in the reserves signifies the strength of a country's economy. It is an unsaid truth that Gold symbolizes wealth.

Gold as an Investment option is very attractive. When I was in my school my mom used to buy 10 grams of gold at the price I get her 1 gram now. That is how much the price of gold has gone up in the past 10 years. Also, gold is a limited resource. In India especially we do not have many gold mines that have been able to consistently produce as much gold as some nations around the world are producing. So considering these 2 factors Gold is a very attractive and a comparatively safe investment option.

What kind of returns you can expect from Gold?

The typical returns from Gold would range from somewhere around 10% or even more year on year. The amount of increase in the price may vary based on a variety of reasons but the consistent upswing in the gold prices is happening for years and would continue. Also it is a safe investment option where your gold is worth as much as the price of gold in the international market. It is not as risky as the stock market and hence the risk of holding gold is very minimal.

What affects Gold prices?

The price of gold is ultimately driven by the Supply & Demand theory. When the demand for gold exceeds the supply the price goes up. Yearly 2500 tonnes of gold is mined all around the world and the demand for gold is approximately 3500 tonnes. This means the demand for gold is a 1000 tonnes more than what is being mined all over the world. This translates into a steady increase in demand as well as the price of gold.

In general gold becomes a very favorable investment option during some situations like Economic Crisis, Depression, Recession etc. During these periods the returns on investment on other forms of investments like Stocks, Mutual funds, Real estate etc is negative. During such times the demand for gold goes up heavily. People take out their investment in other avenues out of fear of loss and invest into safer avenues like Gold or bank deposits. This causes the price of gold to go up drastically. The price of gold per 10 grams has gone up by nearly Rs. 1000/- in the last 6 months.

Methods of Investing in Gold:

The various methods in which one can invest in Gold are:

1. Bars

The most traditional way of investing in gold is by buying bullion gold bars. In some countries, like Argentina, Austria, Liechtenstein and Switzerland, these can easily be bought or sold "over the counter" of the major banks. Alternatively, there are bullion dealers which provide the same service. Bars are available in various sizes, for example in Europe these would typically be in 12.5kg or 1kg bars, although many other weights exist, such as the Tael, 10oz, 1oz bar, 10g, or 1 Tola.

Gold bars can be held either directly (i.e. held directly by you or in your own safe) or indirectly (held in a vault on your behalf). Banks in Switzerland offer this service of holding gold in Vaults on your behalf.

2. Coins

The most common way of investing in gold is by buying gold coins. These coins are available in jewelery shops all over the country. They come in weight ranges starting from 1 gram and are usually in the sizes of 1g, 2g, 4g, 8g. This is ornamental 22 Karat gold that is bought and sold at the price of gold in the international market.

Of late many banks in India are selling gold coins with certificates of purity and genuineness.

Note: The coins sold by banks are 24 Karat gold. They are sold at a premium when compared to the market price of gold because of the cost involved in packaging and certification of the gold. Most importantly banks would not buy back these gold coins. You would have to sell them at the nearest jewelery shop. You might lose a little money in this selling process.

3. Exchange Traded Funds

Exchange Traded Funds are the latest means of investing in Gold. Gold exchange-traded funds (or GETFs) are traded like shares on the major stock exchanges including London, New York and Sydney. The first gold ETF, Gold Bullion Securities (ticker symbol "GOLD"), was lunched in March 2003 on the Australian Stock Exchange, and originally represented exactly one-tenth of an ounce of gold. Due to costs, the amount of gold in each certificate is now slightly less. They are fully backed by gold which is both deposited and insured. The inventory of gold is managed by buying and selling gold on the open market.

Many investors who wish to hold gold on a long term basis find the Exchange Traded Fund method to be expensive as annual costs can range from 0.40% to 0.50%. For investors holding gold over the long term these costs add up. The major difficulty is that the costs are deducted as a reduction in physical bullion held. Thus the investor not only pays each year but loses the future performance of the bullion that has been deducted.

Gold ETFs represent an easy way to gain exposure to the gold price, without the inconvenience of storing physical bars. Typically a small commission is charged for trading in gold ETFs and a small annual storage fee is charged. The annual expenses of the fund such as storage, insurance, and management fees are charged by selling a small amount of gold represented by each certificate, so the amount of gold in each certificate will gradually decline over time. Economies of scale, liquidity, and ease of purchase and sale make ETFs an increasingly popular method of investing in gold.

Benefits of Investing via Gold ETF's

1. You can buy quantities as small as 1 gram
2. You can buy them at the convenience of your home/office. All you need is a system with an internet connection and a valid DEMAT account
3. You need not bother about safeguarding your gold. The ETF provider takes care of it
4. You can sell it on any working day when the markets are open

UTI Gold Exchange Traded Fund

On 17 April 2007 UTI Mutual Fund listed Gold Exchange Traded Fund (NSE: GOLDSHARE) on the National Stock Exchange of India. The objective of UTI Gold Exchange Traded Fund is to endeavor to provide returns that, before expenses, closely track the performance and yield of Gold. Every unit of UTI Gold Exchange Traded Fund approximately represents one gram of pure gold. Units allotted under the scheme will be credited to investors’ demat accounts.

Furthermore, there are many more ETF's HDFC Gold ETF, ICICI Gold ETF, Benchmark GoldBees etc are gold based ETFs that invest in gold and can be bought and sold as shares.

Happy Investing...

Sunday, December 21, 2008

Insurance & Indian Income Tax

Life insurance is the least understood of all financial products. While the basic purpose of insurance is to protect the dependents of the insured from financial distress in the event of his/her death, it is usually bought as a tax saving tool or an investment option.

People often confuse investment and insurance and I had elaborated about the same in my article on Insurance. To read more Click Here

This article is about the conditions that need to be considered before taking an insurance policy for tax saving.

All of us know that insurance policies give us tax exemption under sec 80C of the Indian Tax laws but not all policies or rather not the entire amount of insurance premium is exempt from income tax.

Income tax comes into play at 2 points during the term of your insurance policy.

1. At the time of buying the policy (The tax benefits on the premium paid)
2. When you receive the policy proceeds at the end of the policy term

You may be wondering by now, I know that my entire premium is eligible for tax deduction as long as it is less than 1 lac. Well thats not the case. There is a catch here which not many of us know.

The deduction is allowed only if the premium is less than 20% of the insurance cover. For example if you take a policy for Rs. 1,00,000/- and your premium is Rs. 30,000/- per annum then only Rs. 20,000/- is eligible for tax purposes. The tax deduction also requires you to be bound to the policy for atleast 3 years to get the tax benefit. If you terminate your policy within 3 years, the tax deduction that you availed is withdrawn and that amount would be a taxable income and you would have to pay tax on it.

There are other tax rules that you should be aware of, especially if you take a single premium plan. If the insurance is terminated within 2 years in case of a single premium policy, the tax deduction allowed earlier is taxable as income.

Lastly, there is some good news for all of us. Any sum received by a policyholder (You) on maturity is totally tax free. (for normal insurance policies)

If you have a pension plan and are receiving your maturity amount, only 33% of the total corpus is tax free. The balance is taxable and you need to pay tax on the same that year.

Happy Insuring yourself...

Monday, December 1, 2008

Fixed Maturity Plans - FMP's

Of late people have been talking a lot about Fixed Maturity Plans and how they are better than bank FD's etc. This article is an attempt to introduce you to this investment option.

What are fixed maturity plans?

FMP's, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a little bit of difference. Fixed maturity plans are investment schemes floated by mutual funds and are close-ended with a maturity period ranging from three months to five years. These plans are predominantly debt-oriented, while some of them may have a small equity component.

The objective of such a scheme is to generate steady returns over a fixed-maturity period and immunizing the investor against market fluctuations.

The maturity amount of a fixed deposit in a bank is 'guaranteed', whereas it is only 'indicated' in the FMP of a mutual fund. The regulator for FMP's does not allow fund companies to guarantee returns, and hence they declare only 'indicated returns' in FMPs.

Typically, the fund house fixes a 'target amount' for a scheme, which it ties up informally with borrowers before the scheme opens. . Since the fund house knows the interest rate that it will earn on its investments, it can provide 'indicative returns' to investors.

How does a FMP work?

FMPs are debt schemes, where the corpus is invested in fixed-income securities. The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment.

These FMP NFOs are generally open for 2 to 3 days and are marketed to corporates and high net-worth individuals. Nevertheless, the minimum investment is usually Rs 5,000 and so a retail investor can comfortably invest too.

FMPs usually invest in certificate of deposits (CDs), commercial papers (CPs), money market instruments, corporate bonds and sometimes even in bank fixed deposits.

Depending on the tenure of the FMP, the fund manager invests in a combination of the above-mentioned instruments of similar maturity. Say if the FMP is for a year, then the fund manager invests in instruments that would be maturing in one year.

The prevalent yield minus the expense ratio, which varies from 0.25 to 1 per cent, will be the indicative return which can be expected from the FMP. The expense ratio is mentioned in the offer document. The yield can be indicated fairly accurately because these schemes are open only for a short while.

The fund received is for a pre-specified tenure and the exit load from this plan is high (usually 1 per cent to 3 per cent, depending on the time of redemption). So, the fund manager has the liberty to deploy most of the funds mobilized under the scheme as per his investment decision.

The actual return can vary slightly, if at all, from the indicated return. Against that, a bank fixed deposit exactly prints the amount which is due to you on maturity on the FD receipt. However, FMPs do earn better returns than fixed deposits of similar tenure.

Since FMP's and Bank deposits both invest in debt products the returns earned would be more or less similar. But the FMP's always earn a better return than a Bank deposit. Let us find out how...

The difference maker is in the tax treatment of a mutual fund FMP. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:

* Dividend in the hands of the investor is tax-free. But the mutual fund has to deduct a dividend distribution tax of 14.025 per cent in the case of individuals and Hindu Undivided Families (HUFs), and 22.44 per cent in the case of corporates.
* Long-term capital gains (investment of more than a year) enjoy indexation benefit.
* Short-term capital gains are added to the income of the investor and taxed as per his/her slab, whereas the interest on a bank deposit (except where special 80C approved) is added to the income of the investor and taxed as per his/her slab.

The results of all these are quite dramatic.

Let us take an example of a 90 Day FD with a returns of 8% compared to an FMP (Both Growth & Dividend) at the same 8% per annum for an investor who is in the highest tax bracket in India.

Bank FD FMP - Dividend option FMP - Growth option
Yield 8% 8% 8%
Tax 33.66% NIL 33.66%
DDT NIL 14.025% NIL
Net Yield 5.3% 6.8% 5.3%

Actually, the dividend distribution tax is deducted on the gross yield. So the return from the dividend option can be 10-20 bps higher.

But for the sake of simplicity, it is calculated here on net yield. If the tenure of the FMP is more than a year, the growth option gives a higher yield because of the indexation benefit.

What is indexation benefit?

Our minister has been generous enough to recognise that inflation erodes the real value of any investment. So every year, he comes out with an inflation index based on the prevailing rate of inflation. The cost of investment is indexed by multiplying the index of the year of maturity and divided by the inflation index prevailing on the year of investment. If you have arrived at an indexed cost, then the long-term capital gain is taxed at 22.44 per cent and if you do not opt for the indexed cost, then the tax is 11.22 per cent.

A 30 month Bank FD would give us a post tax return of 5.5% whereas a 30 month FMP with indexation benefit would give us approximately 7.7%.

Note: If your investment horizon is short (3 - 6 months) then opt for Dividend option of FMP. If your investment horizon is long (> 1 year) then opt for Growth option to enjoy the indexation benefit.

Factors influencing decision to invest in a FMP

The following are the key factors which an investor must look at before investing in FMPs.

1. Cash flow forecasting: FMPs are suitable for investors who require locking in funds for a particular period of time. E.g. If an individual has a certain cash outflow in three years time, investing in a debt FMP with three year maturity can be considered as the investor is only concerned with receiving the principal plus return on the investment at the end of three years.

2. Immunization of investments: FMPs are a good investment vehicle for investors who are targeting a return on their investments over a fixed period of time and are indifferent to market volatility within that period.

3. Interest rates currently prevailing in the market: The investor should look at interest rates on government bonds, corporate bonds, commercial papers, certificate of deposits, securitised assets, bank deposits, company deposits and other short to medium term fixed income products before taking an investment decision in a FMP. This exercise will give an idea to the investor on the return one can expect on FMPs.

You may be wondering why not so many people are investing in FMP's. All good things have their risks too. FMP's do not come with '0' RISK like the Bank deposits do.

Risks involved in Investing in FMPs

The close ended nature of FMPs does not really protect them against risks including market, credit and liquidity risks. FMPs have the potential for capital depreciation. Investors should take a closer look at the risks in FMPs before making an investment decision. The risks in FMPs are elaborated below.

1. Market risk: Market risk in an FMP is high where there is an equity component in the plan. The fixed maturity nature of the FMP, forces the fund manager to take shorter term calls on equities. This can lead to trading losses as the fund manager does not have the luxury of time to hold on to the investments.

2. Interest rate risk: FMPs are designed to immunize investor against interest rate risk. However, as a plan is launched and money is collected, interest rates can fall before the money is invested and the funds will have to be invested at a lower rate. In such a case the Fund manager may not be able to meet the indicated returns that was declared during the NFO. The non availability of a forward rate market in India is a chief contributor to interest rate risk in a FMP.

3. Gapping risk: If the fund manager is unable to find assets exactly maturing with the plan, this leads to a risk of asset liability mismatch. This risk can negate the immunization of the investment. That is, funds can lie idle with the fund house thereby earning no returns which in turn erodes the final return.

4. Credit risk: Since the FMP's invest in company deposits, the returns on such investment is not guaranteed. Lets assume our FMP invests 10% of its corpus in ABC Ltd and the company declares bankruptcy before the due date, then the amount due from them is wiped off. The fund house would have to manage without this corpus which would eat out on the net returns of the FMP.

5. Terms for large investors: Investors will have to watch out for terms on large investors i.e., if large investors are given zero or low exit loads. This can lead to early exit by large investors from the plan. This will affect the returns on the plan substantially.

Carrying out the above suggested due diligence on a FMP can protect investors from heart aches on wrong decision on FMP investments. FMPs are illiquid and investments can be only liquidated in specific periods. During periods where redemption is allowed, markets may have moved adversely leading to capital loss on liquidation. The load barriers are also quite heavy to prevent pre-mature withdrawals.

So think twice before investing in FMP's. They are not suitable for everyone.

Happy Investing...
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