Thursday, March 25, 2010

Can ULIPs really guarantee returns

Of late the latest hype is about ULIPs guaranteeing the highest NAV in the first few years during maturity. Many people including me are wondering is this really possible? Can an equity market related instrument really guarantee the returns it generates? If that is the case, why do fund management companies have a fine print that says "Equity market investments carry a certain risk. Current performance may or may not be sustained in the future"

The main reason for fund houses to come up with such schemes is to attract more investors. The market for ULIPs and Mutual funds has become extremely competitive. A fund house that provides a marginally lesser returns than the market can find no takers in the subsequent years. People (we investors) have become very demanding and expect the fund manager to give us solid returns year after year. So schemes like this add the extra masala to the usual routine investment option that would attract the investor who is averse to risk and does not want to make a risky investment. Let me explain how.

Let us take the case of a middle class gentleman who is of our father's age (In his fifty's) A person of our fathers age prefers to stay away from the stock market because the chances of the money disappearing are pretty high. Investments in the stock market is considered a gamble and hence they prefer to stick to debt instruments like PPF, Fixed Deposits etc. They know that the NAV of a ULIP grows every year based on the market performance and if you guarantee them that the NAV in the first 'X' years at maturity they would believe that the returns would definitely be more than debt instruments and come forward to invest in them. Increased investments means increased revenue for the fund house, hence such schemes have surfaced.

Let us now get into the real topic of discussion: Can ULIPs or MFs guarantee returns. Actually speaking "YES"

Before getting into the details of how, the simple answer to the question based on common sense is "YES". Do you really think reputed fund houses like ICICI or LIC would come up with schemes that guarantee the highest NAV reached by the fund in the first 'X' years at maturity when they feel that they cannot keep up their word? Definitely not. Now let us see how they would do it...

According to history of performance given by our stock market the market goes up every year. Even if there is recession in any particular year, in the next few years the market would recover and definitely beat its previous values. So now if you check these funds - the maturity date will be definitely 2 years or more after the date till which this maximum NAV is guaranteed. So even if the stock market crashes after the fund reaches its maximum NAV, the fund manager would have 2 or more years to ensure that the NAV of the fund crosses the highest NAV the fund reached in the stipulated period so that the fund house doesnt suffer any losses.

Imagine 10 people invest 10 lakhs each in a fund that does this guaranteeing thing. So a total of 1 crore is invested in the stock market at Rs. 10/- NAV. Assuming the highest NAV at the end of say 5 years is Rs. 75/- per unit and then the stock market crashes and the value comes down to Rs. 20/- per unit and you redeem your investment - the fund house has to pay you 75 lakhs instead of 20 lakhs. The value of your investment is only 20 lakhs but the fund house has to pay you 75 lakhs a loss of 55 lakhs per person. No company would incur such losses knowingly. That is why there is this gap of a few years between the highest NAV guarantee period and the maturity period. It is the fund managers responsibility to ensure that the NAV comes back to atleast Rs. 75/- so that the fund house doesnt suffer huge losses.

Below is what I would do if I were the fund manager of such a guaranteed returns fund:

In the first few years I would be like any other fund manager aggressively investing in stocks to increase the NAV of my fund every year to beat the market returns. But once the NAV value guaranteed return year is reached my investment MANTRA would be different

1. Have a good allocation towards debt instruments to ensure that the NAV of the fund doesnt get affected heavily even if the market crashes
2. Concentrate only on large or very large cap stocks. These are the stocks to rebound first even if the market happens to crash
3. Avoid small cap, medium cap and penny stocks. These are the stocks that are worst hit in case of a market crash
4. Avoid premature withdrawals. Premature withdrawals affect the fund managers ability to predict/manage the funds future performance

My aim would be to take all possible steps to ensure that the NAV of my fund does not fall too much...

Finally - Would I recommend such schemes? YES. These are good schemes that would attract even the risk averse investor. As always equity investments would give better returns than deposits in banks and hence these are good options for long term investors...

Happy Investing!!!
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