Do you know the answer to the Arbitrage funds vs Debt funds debate?

3 minute read

In our earlier post here we had discussed the various factors which impact the returns of an arbitrage fund. Today, let us explore the taxation advantage of an arbitrage fund over debt fund.

Taxation for Arbitrage funds vs Debt Funds


Arbitrage funds are classified as equity funds and hence the returns do not get taxed after 1 year

The major taxation differential between arbitrage fund and a debt fund primarily kicks in for a 1 to 3 year investment horizon

Arbitrage funds enjoy taxation advantage over Ultra Short Term Debt Funds..


But Ultra Short Term funds generally have slightly better returns over arbitrage funds on a pre tax basis

Historically, on a 1 year basis, Ultra short term fund returns have been higher by around 0.5% to 1% over arbitrage funds on a pre tax basis


Note: Kotak Equity Arbitrage and Kotak Treasury Advantage have been used as a proxy for Arbitrage fund and Ultra Short Term Debt fund category. I have only used the data from Jan 2013 as the arbitrage fund category had undergone some changes in the way they are managed (which is beyond the scope of this article) and hence earlier data comparisons wouldn’t be too relevant.

So, putting all this together, for investment periods between 1 to 3 years

  1. Investors @10% taxation bracket
    The taxation advantage of around 0.5 to 1% for arbitrage funds over  Ultra Short Term fund gets compensated by the o.5 to 1% pre tax return disadvantage of arbitrage funds over Ultra Short Term funds.Hence investors in the 10% tax bracket can continue with Ultra Short Term funds for 1-3 year investments given their relatively lower volatility
  2. Investors @20% taxation bracket
    The taxation advantage of around 1.5 to 2% for arbitrage funds is higher than the 0.5% to 1% pre tax return advantage of Ultra Short Term funds.So typically there is still a 0.5% to 1.5% post tax return advantage in arbitrage funds over Ultra Short Term funds for investors in the 20% tax bracket.
  3. Investors @30% taxation bracket
    The taxation advantage of around 2% to 2.5% for arbitrage funds is higher than the 0.5% to 1% pre tax return advantage of Ultra Short Term funds.So typically there is still a 1% to 2% post tax return advantage in arbitrage funds over Ultra Short Term funds for investors in the 20% tax bracket.

    This being said, please note that arbitrage fund returns may go down below our expectations, in case of a 1) bear market 2)reduced borrowing and hedging cost for FII or 3)significant size increase for the category.


  1. Investors in the 20% and 30% taxation bracket who also understand the risk and volatility in the arbitrage fund category may choose an arbitrage fund over an Ultra Short Term fund from a 1-3 year investment perspective
  2. Investors in the 10% tax bracket can continue with Ultra Short Term funds for 1-3 year investments given their relatively lower volatility

P.S: If you like the content and would like to be updated on new posts, it would be awesome if you could consider subscribing to the blog with your mail id in the subscribe provision provided on the right most column. If you don’t like the contents or have suggestions for me to improve do feel free to let me know via the comments.

As always happy investing 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.


The Ultimate Guide to Liquid funds

This is the 3rd post in the debt mutual fund investing series. If you have the time, it would be great if you could go through the earlier posts in this series –

Part 1 – A primer for investing in debt mutual funds (Link 1)
Part 2 – 8 factor framework for analyzing any debt mutual fund (Link 2)

There are primarily 8 categories of debt funds:

  1. Liquid Funds
  2. Ultra Short Term funds
  3. Short Term funds
  4. Income Funds
  5. Dynamic Funds
  6. Accrual or Credit Funds
  7. FMP
  8. MIP

Phew..8 categories ..this seems to be complicated..

So instead of breaking our head over the complexities, lets try and break it down to the basics and nail down the few categories which will matter the most to us. In fact for my personal investments, I like to keep it extremely simple and stick to only the first three categories i.e Liquid, Ultra Short Term and Short Term Funds !! So hang on for a while and we will get this thing sorted.

If we strip down all the jargon, the underlying difference across the categories simply boils down to what type and extent of risk are the funds taking to improve returns via

  1. Interest rate risk (measured via modified duration)  
  2. Credit risk (measured via the % of portfolio with lower than AA securities))

With this in mind, let us explore various categories..

For all temporary parking of money which we need within 1 year, we can consider
       1. Liquid funds – upto 3 months
       2. Ultra Short Term funds – 3 to 12 months

Liquid Funds (Think of it as an alternate to Savings Bank Account)

Liquid Funds invest with minimal risk in short term debt instruments with a maximum maturity of 91 days. This is captured in the “Average Maturity” and in practice, for most funds it averages to less than 2 months. They have the lowest risk and are ideal for parking temporary money.

(Ignore if you find it a little technical: The instruments where liquid funds invest generally include CBLO, certificate of deposits (i.e short term lending to companies), commercial papers (short term lending to companies) and treasury bills (short term lending to government) and term deposits (bank FD) )

While investing in Liquid funds generally returns are not the top priority. I mean have you ever worried about your savings bank account paying you only 4%. The priority is safety, liquidity (i.e can be taken out anytime) and returns – in that order.

So as expected, these funds do not take credit risk as they are predominantly invested in AAA equivalent bonds and also do not take interest rate risk (they have very low modified duration) to improve returns. This basically implies that liquid fund NAV returns will generally be very stable as the underlying returns are predominantly driven by interest income (from the underlying debt securities) which accrue everyday.

Approximate Return Expectation from a liquid fund = Net YTM = YTM-Expense ratio

Also remember that while investing in liquid funds, if interest rates increase our returns also increase and if interest rates decline then our returns will also decline. 

Liquid funds for people like us can be used in several ways. For eg

  1. Temporary parking: For eg, every month when I get my salary, I immediately park my intended savings in a liquid fund. Then as and when I find time, I transfer it to equity funds or any other option which I like at that juncture.
  2. For systematic transfer plans into equity funds: Sometimes you may have a large amount of money which you don’t want to put in equities at one shot. So you may put it in a liquid fund and do a systematic transfer plan into equity funds or manually move it as and when you want.

So how do we select our liquid fund??

The first advantage when it comes to selecting a liquid fund is that the chances of a big mistake is not there. Since most of them prioritize liquidity, do not take credit risk (except for a select few funds which may take minimal credit risk to show better performance) and have very low modified duration, the returns across different liquid funds is generally in a narrow range and most of the return differential can be explained in terms of expense ratio and portfolio composition.

In terms of the portfolio composition, the returns are higher in the order of Commercial paper (CP) > Certificate of deposit (CD)  > Treasury bill (T Bills). T Bills and Certificate of deposits are more liquid compared to Commercial Papers. A liquid fund with higher exposure in commercial papers is considered to be more volatile as these securities are generally not as liquid as CDs or T-Bill.  So the fund may be producing higher returns but will also have a slightly higher risk. Hence if you are extremely conservative choose a fund which has a lower % of Commercial Papers).

Simple steps to choose our required liquid fund

  1. Stick to large AMCs
  2. Check credit quality
  3. Go for a fund size above 1000 cr
  4. Lower the expense ratio the better

When it comes to Debt funds, I generally prefer to stick to major AMCs such as ICICI, HDFC, Reliance, Kotak, IDFC, Axis etc. Is there something wrong with other AMCs. Of course not but given the narrow range of return outcomes I am more comfortable investing via the larger names. Some funds under the large AMCs are ICICI Prudential Liquid Plan, Reliance Liquid Fund – Treasury Plan, IDFC Cash Fund, HDFC Liquid Fund, Kotak Liquid fund, Axis Liquid fund. You can consider any of the above. I generally use IDFC Cash Fund. If you want more options you can check here – Link

Liquid Fund Data

Most importantly, let’s not get too lost in the tendency to over analyse (which yours faithfully gets caught into often), as anyway the return differential is not going to be too high and the primary reason for using liquid funds is for safety, liquidity, convenience and of course some reasonable returns.

In fact when I was researching for this article , I found that there is a new app called Finozen which has just started with the premise of letting you switch back and forth between a savings bank account and liquid fund. I never thought someone could build a business model around liquid funds. But nevertheless simplicity always has its charm. They have a nice 30 second video on liquid funds. Do check if you have the time – Link (by the way I have no clue on who they are..nor am I recommending them..Found the idea to be interesting and hence the mention 🙂

At the current juncture the Net YTM (i.e YTM- Expense ratio) for most of the liquid funds work to be around 7%. So the daily returns going forward assuming interest rates remain the same will be roughly 7%/365 = 0.019%. This implies that if I invest Rs 1 lakh, I can expect approximately Rs 19 to get added everyday.

Now while liquid funds are for all practical purposes extremely safe and provide better returns than an SB account, we also need to be aware of some possible risks.

  1. Sharp increase in interest rates:
    On 16-Jul-2013, India was going through a currency crisis due to the announcement of Fed Taper. As a result there was a sharp increase in interest rates of up to 2% leading to negative returns in liquid funds for a day. Kindly go through the articles to understand what really happened –  Link 1 Link2

    Now what if we had a similar scenario like that repeat and interest rates went up by 2%. Taking the example of IDFC Cash Fund, it currently has a Net YTM = YTM-Expense ratio of 6.95%. Therefore daily returns from interest accrued is 6.95%/365 = 0.019% or Rs 19 added per day for every 1 lakh invested. It has modified duration of 0.08 years – which means that the negative NAV impact in our fund for a 2% increase in interest rate would be a  -2%*0.08 =-0.16%. Now if you adjust for the interest income everyday (i.e 0.019%) then the negative impact will be -0.14%. Or in other words, Rs 1 lakh investment would be roughly down by Rs 140 to Rs 99,860. This is equivalent to 0.16%/0.019% = 9 days of usual returns in the fund. Now remember that our Net YTM has now increased from 6.95% to 8.95%. Therefore daily returns from interest accrued post the interest rate increase is 8.95%/365 = 0.025% or Rs 25 added per day for every 1 lakh invested. So to compensate for the loss of -0.14%, we will need to wait for 0.14%/0.025% (or Rs 140/Rs25) i.e approximately 6 days.

    While these are rare events, whenever they occur there will be a lot of panic which will be disproportionately exaggerated by the business news channels. So if in case something like that happens, the most important thing is not to panic as we clearly know how liquid funds derive their returns and to remember that its only a matter of waiting for 7-10 days before we tide over our temporary decline. 

  2. Crisis scenarios leading to significant redemption from the funds and the fund not able to sell underlying securities due to low liquidity (read as no buyers):
    When this scenario happened last time during 2008, since redemptions were high from liquid funds and buyers were not there, few funds were forced to liquidate their underlying debt securities at lower prices thereby taking an NAV impact. The larger AMC’s were able to tide over this as they arranged for temporary loans/support from their sponsors after which RBI came to the rescue. So this is the reason why I generally stick to large AMC’s with strong debt fund management teams.

Parting Thoughts:

  1. Think of Liquid funds as an alternative to our Savings Bank account
  2. Typically used for parking of money for time periods upto 3 months
  3. No credit risk and extremely low modified duration
  4. Returns are predominantly from interest income – hence daily NAV movement is extremely stable
  5. Returns across different liquid funds is generally in a narrow range
  6. Hence, opt for well established funds with strong pedigree

So with that we come to the end of our liquid fund analysis and I hope you found it useful. Next week we shall discuss the remaining categories.

Happy investing 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

The real truth about Fixed Deposits

In our last post (link), we had created our own financial plan which gave us a glimpse of the future expenses needed for our goals. Now the next step is to figure out an investment plan that will help us accumulate enough money for our goals.

Planning for short term goals where time frame is less than 5 years

For all short term goals (less than 5 years), the priority will be to ensure the safety of capital, keep it less volatile and earn reasonable returns which are slightly above inflation (in India the historical average is around 7-8%)

Given this order of priority and the unavailability of a longer time period for investing, we would primarily be using Fixed Income Mutual Funds or Fixed Deposits for planning our short term goals.

I personally prefer Fixed Income mutual funds (also called as Debt mutual funds) over Fixed Deposits.

I have explained my rationale in detail in these posts

  1. Fixed Deposits – What you see is not what you get
  2. Debt Mutual Funds – What returns to expect

For those who don’t have the time, here is the quick takeaway

  1. For periods above 3 years, choose Debt Mutual Funds. They have an inherent advantage over Fixed Deposits because of the difference in taxation.
  2. In most cases, the tax on fixed deposit interest rates has to be declared and paid on an accrual basis i.e every year and not on the fixed deposit maturing date. This impacts the compounding effect in a fixed deposit as intermittent taxes reduce the amount in play. In this case, Debt funds have an advantage as they get taxed only at the time they are sold and hence the entire amount is available for compounding throughout the tenure.
  3. But there is also an option to pay fixed deposit taxes during maturity if it’s a cumulative FD (i.e interest is reinvested with principal amount and compounded as per the time period mentioned). In this case both fixed deposit and debt mutual funds have the same advantage of having the entire capital in play and can enjoy the full benefits of compounding. Read this for better understanding  Link
  4. Debt mutual funds can be sold any day you want (exit load period depending on the category generally varies from 0 days to 1 year) unlike an FD where the bank may have some penalty charges if you close the FD before the maturity date
  5. For periods below 3 years, there is no major difference between an F.D and debt mutual fund as the capital gains are similar and in both the cases are taxed as per our income tax slab. While you are free to choose either an FD or Debt mutual fund for investment time horizon less than 3 years, I would still prefer debt mutual funds given the flexibility to exit without penalty. (Some funds may have exit load period i.e a period before which if you exit you have to pay a % charge (goes up to 3%) which is called exit load. But liquid and ultra short term category generally have nil exit load period and charges)

Just in case you are still not convinced, try this Fixed Deposit vs Debt Mutual fund calculator to see how much money you can save.

Fixed Deposit vs Debt Mutual fund calculator*
Download link: FD vs Debt MF Calculator

*Remember this calculator is relevant only for periods above 3 years.

Sample this, for a Rs 10 lakh investment for 3 years at 8% interest rate, you end up saving a whopping Rs 70,384 if invested in debt mutual fund instead of an FD!!! 

FD vs Debt Fund Excel

Ok, debt mutual funds do make some sense. But hold on. Debt mutual funds seem to be damn complicated. There are several categories (like short term, income, ultra short term liquid etc), different risks (interest rates risk, credit risk etc), some weird terminologies like duration, YTM, credit rating etc and add to it 1000 plus funds. How in the world do I make sense of all this and select the right fund ??

I don’t blame you. Despite me being in the industry, even I took a long time to understand debt mutual funds. No wonder most of us end up investing in our “simple yet extremely inefficient” fixed deposits.

Not to worry. In our next post we will demystify the world of debt mutual funds, figure out how to pick the right fund and also look at how to use debt funds for our investments.

Don’t even think about Real Estate without reading this !

What a fancy title. Well, that’s just about it. Fancy !! Please don’t take it too seriously. You have every right to think about real estate without reading this article. I am just dabbling around with some “how to make a sexy headline” articles and henceforth the dumb attempt. Please excuse me 🙂

Anyway, let me start this post with an honest confession. I am not an expert in real estate. Rather, I am your average 30 year old, just married, neighborhood guy who is currently going through the usual pressures of “Why haven’t you bought your own house yet?” from his lovable mom, grandpa, granny, aunties, uncles and every other human hierarchy in that order.

Since a real estate investment is generally one of the largest investments for most of us, a wrong decision can have a significant impact on our lives. Hence, it is extremely important to try and understand some underlying fundamentals of real estate investing. The article is my attempt at understanding real estate investing.

First things, first. Why do you want to buy real estate. Are you buying a home where you can live or are you investing for future returns and have no plans of staying at the place you are buying. Now if you are buying a home to stay, this article ends just here for all practical purposes. You cant put a price to the joy of owning an own house, the joy of watching your kid scribble across the walls..blah blah..and so on goes the argument. An own house is like an IPhone. While both definitely have some practical purpose, you never try justifying their price vis-a-vis the features !! An “own house” is not an investment , its a feeling 🙂

Now if you are not a part of the “it’s a feeling” gang, the rest of the article is for us.

Common belief : Real estate always provides you great returns. Prices never fall.

As always, we turn to evidence. Lets see how real estate prices across different cities have moved in the last 8 years.

Real Estate Price Trends.jpg

NHB RESIDEX tracks the movement in prices of residential properties on a quarterly basis. This is being done since 2007

I have taken 2007 to be the starting date as NHB Residex data is only available from then and has been updated only till Mar-15 (courtesy, the lazy folks at NHB)

As seen above, Chennai has been the top performing Real state market with a whopping 17% annual returns. But if you look at other major cities, 7 out of 26 cities have had returns between 9 to 12% which while not very attractive has at least stayed ahead of Inflation (7-8%). But the shocker is that, 18 out of the 26 cities have had returns equal to or below 8% not even covering for inflation !!

Just to ensure, that the evidence is concrete, let’s confirm the pricing trend from another source  – Magic Bricks National Property Index which again confirms the subdued returns from real estate in the last few years.


So going back to our first statement – “Real estate always provides you great returns”.
The evidence doesn’t support this as most of the cities have had dismal price appreciation in the last 8 years (the above lines at this juncture apply only to chennai folks like me 🙂

Now addressing the second part – Do real estate prices fall?

Rewind to year 1997..

Read this India Today Article Real estate business in india faces unprecedented crisis as prices plummets

Real estate price crashes are pretty common across the world – Japan in 1990, US in 2007 etc. As seen in the above article even Indian real estate saw a sharp price decline during the 1996-2002 period.

“No asset class or investment has the birthright of a high return. An asset is only attractive if it’s priced right.”
― Howard Marks

So lets get our basics right,

Real Estate does not provide high returns at all points in time and can go through periods of decline or long periods of stagnant prices (time correction) !!

Real Estate prices just like any other asset goes through cycles (historically around 14 years with 7 years of high returns + 7 years of low returns according to JP Morgan Research) – there are periods of high returns inevitably followed by low returns.

Source: JP Morgan

The timing of exact turn in the cycle is extremely difficult. However an approximate evaluation of whether we are near the peak or the bottom of the cycle should be possible. Given the fact that real estate investing involves a large capital and significant loan component (at least for most of us), we need to be extremely careful and it is important to ensure that we are buying at the right price (read as valuation).

So, how do we go about evaluating if the prices are right ??

I will be using the Chennai market as an example. Given that Real estate markets are highly localized, you may apply the same framework for your respective location.

The first task is to make sure we are not caught near the peak of the cycle. But, how??

Test 1: Invert !!

The great 19th century mathematician Carl Jacobi was fond of saying that when you encounter a tough problem, “Invert, always invert.” So let us invert our problem and start with asking a simple question “What returns do we expect from our real estate investment?”

Going by the last 8 years, a lot of us would expect Chennai real estate to repeat the same 17% annualised returns. Let us invert this and see if this is possible.

A decent 2 BHK, 1200 sq ft apartment within the city would easily cost anywhere between 1 to 2 cr based on the locality. Hypothetically  assuming you get an 20 year EMI for the entire amount (generally loans are provided only for a portion – around 80% of the house cost), at the current rate of 9.6% (Source: Bank Bazaar Link) it works out to approximately 94,000 to 1,88,000 every month. Assuming you require a salary that is at least twice your EMI amount and thus you must be earning at least 1.8 lakhs to 3.7 lakhs per month to buy a decent house within the city !!

Now assuming we want our property to appreciate by 17% for the next 20 years, this implies the price should multiply by 23 times or in other words a house worth 1-2 cr should become 23-46 cr. And for someone to buy it after 20 years, the EMI at the current 9.6% would work out to be 21-43 lakhs per month. Thus the buyer’s salary must be around 43-86 lakhs per month after 20 years !!!

A similar calculation at:

  • 15% return expectation, works to a monthly salary requirement of Rs 30 to 61 lakhs
  • 12% return expectation, works to a monthly salary requirement of Rs 18 to 36 lakhs
  • 10% return expectation, works to a monthly salary requirement of Rs 12 to 25 lakhs
  • 8% return expectation, works to a  monthly salary requirement of Rs 8 to 17 lakhs

My head is already spinning.. Now don’t ask me what is the right price. But one thing clearly stares at our face. Real Estate prices in the long run must be a reflection of aggregate salary growth. The future salaries required to justify current chennai real estate prices look a little too unrealistic in my opinion. The past glory days of 15% plus returns in Chennai real estate look highly unlikely unless there is a new industry like IT which can manage to employ a lot of us and pay exorbitant salaries !!

Test 2: Rental Yields vs Home Loan Rates

One of the simple ways to evaluate if the property you are buying is reasonable or expensive is to compare the rental yields with home loan interest rates. Rental yield refers to the annual rent received from a property as a % of the total price of the property. Property price market is an illiquid market where generally the sellers in case of correction do not sell and mostly postpone their selling decision. Further even the real estate builders tend to not reduce prices even if demand is weak and try to wait out the period by getting support from banks who lend to them. Add to it the component of black money involved, the prices in real estate in India do not exactly respond to the economics of demand and supply as seen in other asset classes. However the rental market in comparison, is a lot more dynamic as tenants can easily shift between houses and hence responds to the demand scenario in a much better manner. Generally, in a fairly priced real estate market, the rental yield tends to be somewhere close to the cost of borrowing. Thus comparing the gap between the rental yield and home loan rates provides a good way to evaluate if real estate is cheap or expensive




Now the above data is from a Jul-2015 report. Applying current home loan rates of 9.6% and rental yields of around 2.5 % (I am taking my current rented place yield. Generally the range is between 2-4%) the gap works out to be ~7% which is pretty expensive compared to other global markets where the range is around 2-3%. So either rental yields should go up or home loan rates should come down or a combination of both should happen for real estate prices to become attractive.

In India, we also enjoy tax benefits* on home loans and hence adjusting for them, a simple rule of thumb can be:
Buy: when home loan interest rate – rental yield < 4 to 5%
Sell: when home loan interest rate – rental yield > 7%

Thus applying this metric, again the verdict is – Real Estate in Chennai is expensive

*To understand in detail the tax benefits in a home loan read the following article

Test 3: If last 7-8 year returns are damn good then be cautious 

Again, Chennai Real Estate has had phenomenal returns in the last 7-8 years . Caution !!

Test 4: If everyone says real estate will always go up and come up with their own stories of how they multiplied their money in the last few years – Your danger signalling siren should be at its loudest !!

In Chennai markets, the siren is still loud enough…

Phew a long post. But, nevertheless let me sum it up

  • Real Estate Investing Returns = Rental Yield + Price Appreciation
  • Real Estate Prices aren’t destined to go up always and can fall or go through long periods of time correction
  • Real Estate just like any other asset class goes through cycles – periods of high returns followed by low returns
  • When buying a property:
    • Evaluate future affordability by applying “inversion”
    • Evaluate “Rental Yield vs Home Loan Rates” – Buy when its less than 4-5% and sell when it is above 7%
    • If past 7-8Y returns are very high, then be cautious
    • Add to it, if everyone is gung ho on real estate, then be extra cautious
  • Verdict on Chennai Real Estate – looks damn expensive – need to be extremely cautious 


Being from the financial industry, there is a natural bias built within me against real estate.While I have tried to be as rational as possible, I may have missed out on some perspectives given my biases. If you think I have missed out something or don’t agree with my thoughts, please feel free to share your thoughts in the comment section. I am consciously on the lookout for contradicting evidence and would love to be wrong !! Thanks for dropping by and happy investing 🙂

Why the odds are against you when it comes to good financial advice

All of us are regularly making decisions of varying degree of importance, for most part of our lives. This may include serious ones like how to improve sales in your company, buying a new house, evaluating a new job etc to day to day ones like which route to take, which restaurant for dinner etc. While simple decisions don’t require much of an effort as the stakes are pretty low, however in situations where the stakes are high, the decisions that we take, need to be taken after some reasonable analysis.

Though the situations and problems will be different, if we can develop a set of thinking tools which we can apply selectively to various problems, it would help us to improve our decisions dramatically. In essence, you don’t want to start a bike repair shop with only one spanner, you essentially want to have various tools which you can use based on the nature of problem in the bike.

So with the same premise, we are going to slowly build our own mental tool kit which will help us both in our day to day lives and investing. Our first tool that we will be adding to our mental tool kit is called “Incentives”

Most of economics can be summarized in four words: “People respond to incentives.”  The rest is commentary. – Steven E Landsburg

The basic idea is to ask the simple question “What’s in it for the fellow on the other side of the table”

Let’s apply this simple question to the financial industry and investing.

Most of us or someone in our family would definitely have an investment linked insurance product sold to us. But when it comes to mutual funds, most of us have hardly heard about them, leave alone buying them. Intuitively, our first line of reasoning goes – a better product gets more popular and hence insurance products must be better than mutual funds. But if you have held on to any investment linked insurance product (except for pure term insurance which in my honest opinion is the only decent product in the insurance industry) for more than 5 years and you do the calculation for returns, you realize the sad truth 😦

But what explains their popularity ??

You guessed it right. Incentives !!

When you are sold a mutual fund, the distributor commission is generally around 1% for equity mutual funds and around 0.5% for debt funds. So if you invest Rs 1 lakh in an equity mutual fund, your advisor will make just Rs 1,000 for the entire year.

But when you sell an investment linked insurance product, the first year commissions (including rewards) can be as high as 49% (see the below chart). So if your premium is Rs 1,00,000 then upto Rs 49,000 may go into the pockets of your agent or the bank. Then,the charges are capped at 7.5% of the premium till the 5th year and thereafter it is 5% of the premium. If you had a heart attack looking at this, hang on, these charges were even more exorbitant a few years back and the current rates are post the regulatory intervention putting a cap on the charges. You can imagine the “gala” times that your friendly insurance agent had those days.

You can see below the maximum commission charges for various plans and tenures. (Link)


This has led to significant mis-selling in investment based insurance products. Since the incentives are front loaded the focus is on churning your insurance products given the high 1 st year commissions. This behavior is evident as seen from the low persistence of holding an insurance product beyond 5 years. Refer to this article for a detailed explanation  (Link)

Excerpts from the article,

“According to figures of financial year 2015, as reported by the insurance regulator in its handbook of statistics, the industry, on an average, reported a persistency of 59% in the 13th month, i.e., after a year of sale. In other words, out of 100, just 59 policies got renewed. In fact, the average persistency for the 61st month is about 22%, which means by the end of the fifth year, only 22 policies got renewed.

India compares badly with the rest of the world. The 13th month persistency in member countries of Organisation for Economic Co-operation and Development is above 90% and about 65% for the 61st month.”


This is a clear case of how incentives of our friendly insurance agent which are not aligned to our interests generally leads to a bad investing experience.

Quick take away:
At the current juncture, given the opaque cost structure, just-about-average investment managers who manage our money and not-in-our-favour commission structure avoid any insurance product which promises returns. Don’t confuse an insurance product with investments. If you need insurance, opt for pure term insurance which promise no investment returns but provide the insured value in case of your death within the term.

So, now let us assume you are just about 2-3 years into your career and you decide to save around 10,000 per month. Mutual funds are perhaps one of the best investment vehicle available for you (given their low costs, simple structure, high transparency, investor friendly regulator and the presence of seasoned fund managers). But you hardly have any knowledge on the markets and wish to work with an advisor. As you are relatively inexperienced, you also have a lot of queries and often get shit scared when markets go down. This means an advisor will also have to spend a lot of time hand holding you, meeting you, explaining to you about markets and stopping you from making hasty decisions. You would also like to meet your advisor regularly every month and discuss your various financial plans and queries. On top of it you are averse to paying your advisor. After all who pays for financial advice in India. We get it free of cost from our beloved news channels and friends 😦

So the advisor has to work on the wafer thin commissions that the mutual fund pays him which is approx 1% for distributing their funds. If your SIP is 100% equity, then the advisor gets around 1% of 1,20,000  (i.e 10,000 * 12) and it works out to Rs 1,200 !! Yup you read it right ..Lets assume the advisor remains patient and works with you for 5 years and your SIP of 10,000 each month has compounded at 15% and has increased to a value of Rs 9 lakhs. And how much does your advisor get paid for all this effort, honesty and persistence.. Rs 9000 !! Add to it the risk that the % of commission might further reduce after 5 years.

I hope you get the picture. Now you know why those lousy insurance products get sold to you (why in the world would anyone let go of an opportunity to make 30% plus 1st year hell with long term client relationship). Did mutual funds not have a problem of incentives. Of course they did. The recent selling of closed ended funds (which had one time commissions which went as high as 7%) is a classic case. But the difference is you have an extremely investor friendly regulator by the name SEBI who regularly keeps a check on any possible investor unfriendly activities. While in insurance, the regulator IRDA continues to have its eyes closed on the high commission driven insurance sales.

For a good advisor, it generally makes sense to cater to larger clients where the efforts and time spent, while is the same as spent on a small client, provides him with a far better remuneration (a 1 cr client, with a 50% in equity and 50% in debt would provide an income of around Rs 75,000 per year)

So they key implication, is that if you are a small investor its extremely difficult to get decent and honest advice. 

Now given this practical reality, the safest choice for all of us is to educate ourselves on the bare minimal basics of investing. Sounds boring. But think about this, in a career spanning 38 years from the age of 22 to 60, you end up working approx 79,000 hours in exchange for all the money you make. Don’t you think should spend just about 2 hours a month, which works out to just 1% of your overall work hours, on making your money work equally hard as you.

“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.”  – Abraham Lincoln

This blog is a small attempt from my part to ensure that all of us get good financial advice, and hopefully have a reasonably good investing experience. (intelligent folks should interpret these lines as shameless marketing 🙂 )

Now for those of us for whom investing sounds like greek and latin, and that’s the last thing on which you want to spend your well earned free time, don’t worry, all is not lost. To your rescue comes the new breed of online based advisors called robo advisors (Eg Scripbox, Arthayantra, Advicesure, Fundsindia etc) which are slowly gaining popularity. These guys provide advice through apps/websites with bare minimal human intervention and address the main issue of cost to service us, as most of the investment advice is standardized and can be easily scaled (think of uber, airbnb etc). While this is still at an initial stage and most of them are very basic, my sense is that in another 2-3 years we will have some really solid and evolved online advisory models for people like us. Till then let’s keep learning !!


  • Keep an eye on incentives – Always ask what’s in it for the guy on the other side
  • Investment-linked-Insurance products are injurious to your financial health
  • Tough to find good financial advice for small investors – the incentives for advisors are tilted towards the larger investors
  • Invest in improving your investing knowledge – no two ways about it !!
  • Robo-Advisors, while currently at a nascent stage, may be the solution to decent financial advice for small investors in the coming years


Equity Investing – Just 2 things to remember

In our previous two posts, we had covered in detail, the two key factors to evaluate when investing in equities. In case you haven’t read them, do take some time out to read them here – Link 1  Link 2

Now for those who don’t have the time and would like a “no-nonsense” summary of those posts, hang on, this post is just for you folks !!

Quick Summary

  1. Equity market returns are driven by
    • Earnings growth
    • Increase or decrease in Valuations
    • Dividends (In India, this component is not too significant and adds to around 1 to 1.5% additional returns for the Sensex annually)
  2. Earnings growth and Valuations are cyclical
  3. Earnings growth is the key determinant of long term equity returns
  4. So always evaluate which part of the cycle are we in terms of earnings growth
  5. Valuations = weighted average market opinion on the value of companies
  6. Valuations are a key contributor to the short term volatility seen in equity markets
  7. Evaluate if valuations are expensive, cheap or neutral (degree of difference with the long term average – ~15-16 times 1Y forward PE for Sensex)
  8. Do this evaluation once in 3 months
  9. Based on your evaluation, decide on whether you have to adjust your overall allocation to equities within your portfolio

Musing no 1: Stock prices are slaves of earnings growth in the long run !

Now to understand the role of earnings growth and stock prices better, lets take the help of investor Ralph Wanger who has come up with an interesting analogy between the stock market and a man walking a dog.

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”

The dog in our case is the stock price and the owners walking speed and direction is the earnings growth !!

Earnings vs Valuations

Musing no 2: Starting Valuations matter !

While earnings growth is the dominant driver of equity returns over a long investment horizon (let’s say >5 years), the starting valuations also play an important role as an increase in valuations can provide additional returns over and above earnings growth and vice versa. Generally valuations tend to revert to their long term averages . Think of valuations as tied to a pole called “long term average” with a rubber band. The farther away the current valuations of the market moves away from long term averages the higher is the force from the rubber band to bring them closer to the long term averages.The mean reversion effects of valuation have a significant impact on the overall returns in the near term and gets gradually evened out in the long term.

Starting Valuations = Low
Mean reversion in valuations will provide additional returns over and above earnings growth

Starting Valuations = High
Above normal earnings growth & Long investment time frame needed to nullify the impact of mean reversion in valuations

In order to appreciate the impact of starting valuations, I have calculated the annualized return impact over different time horizons due to valuations returning  to their average ( 16 times 1Y Fwd PE) assuming no contribution from earnings growth (i.e assuming it to be 0%)

Valuation Kicker

As seen above, higher starting valuations have a significant impact over returns in the short term if they were to mean revert (which is most often the case). For eg if you had invested at 24 times PE and it mean reverts to 16 times in 5 years it would have provided ~negative 8% annualised impact on the overall returns (read as earnings growth). Long investment time frames & above normal growth are required to subdue the impact of overvaluation.

Lower starting valuations, provide the potential for significant upside in case of mean reversion. For eg if you had invested at 12 times PE and it mean reverts to 16 times in 5 years it would have provided ~positive 6% annualised impact on the overall returns (read as earnings growth).

Thus summing it up..

  1. Stock prices are slaves of earnings growth in the long run !
  2. Starting Valuations matter !


For those who are still with me, check out how the actual 10 Year sensex returns have been impacted by earnings growth and valuations

Earnings growth + Valuation IMpact

Source: MOSL

A layman’s guide to equity valuations

In the last post (Link), we had discussed on how equity returns are driven by earnings growth and valuations. We had further detailed on how to evaluate earnings growth. In this post we will move to the second part of the equation – Valuations.

Let’s start with a basic question – How do you put a value to a company?

Sounds kinda geeky . Lets try and simplify.

Imagine this. One fine morning you wake up and you suddenly  see a “number” blinking in red across your dad’s forehead. It reads Rs 2,10,00,000 (Rs 2.1 cr) and keeps blinking and strangely, also changes each and every minute. A little confused, you turn around and to your surprise see Rs 50,00,000 (Rs 50 lakhs) blinking across your brother’s forehead . Throughout the day, each and every person whom you happen to see has a number on their forehead and the same phenomena continues. And just when you are contemplating if you have a serious mental disorder, your phone rings. The display reads “Almighty”. What the heck. A thundering voice orders”I am extremely pleased with your devotion to me. And as a token of love, you and several of my other devotees have been given the special power to receive the entire life time salaries/earnings (as and when they get) of anyone you choose to buy. The price that you will have to pay for buying someone, will have to be bid and its latest bid price will be flashing across their head. I have deposited Rs 10 cr in your account which you can use only for this purpose”…

Take a minute and think of how you will go about choosing the people for the Rs 10 cr?

In order to decide whom to buy, we need to evaluate two things

  1. What can be the possible future earnings i.e salaries in the future and how much are they worth in today’s terms (adjusting for the returns you need)?
  2. Is the current price which is flashing across their forehead, below your calculated price or above your calculated price?

You see the challenge right. How in the world can you accurately estimate the future earnings of someone. Leave others. To be honest, I would find it extremely difficult to predict my own salary 5 years down the line, leave alone for my entire life. On top of this, imagine that millions of people are trying to do this exercise on valuation, each and every day and are bidding for different people based on the valuation that they arrive. No wonder the prices are going to keep fluctuating.

So we know for sure that we cannot come up with a “precise and accurate” value for the people around us because of the simple fact that we are dealing with the future and the future is uncertain. But by analyzing their educational and professional qualifications, skills, current job, salary, industry prospects, talent etc and making some reasonable assumptions we can try to come up with an “approximately right kind of range” for estimating the value. Since we know that the future is uncertain and our assumptions can go wrong, we decide to

  1. Buy around 10-20 people so that even if we go wrong in valuing a few we can still take advantage of the remaining ones that we got right (this in investing parlance is called diversification)
  2. Buy them at a price which is at a sufficient discount to our estimated range (this in investing is called “margin of safety” or rather a humble acceptance of the fact that “We can go wrong”)

Some will come up with the valuation based on

  1. The evaluation of earnings for the future based on fundamentals like – industry growth, current position, salary, skill set etc (in investing this is called fundamental analysis )
  2. Movement of prices at which people are available and decide based on the demand and supply ..etc (in investing this is called technical analysis )

The interesting thing here is that, each and every one may have a different way or method to evaluate the future. Some are sanguine, some pessimistic, some pretty balanced and so on. Hence the final price at which a person is quoting (read as the valuation) is a weighted average opinion on the value at which various people are willing to buy and sell (weighted average in crude terms takes into account that the guy with 100 cr will have a greater impact on the price than the one with 1 lakh).

Now replace the “people” in our imaginary story with “companies” (i.e stocks). Yep..

Welcome to the world of stock markets !!

This is exactly what happens in stock markets, where partial ownership in several companies are available to be bought or sold, each and every day, by millions of people. Further, each and every one has their own way of evaluating the value of the company based on their outlook for the company’s future. Whether we like it or not, the weighted average opinion of market participants are extremely unpredictable and keep changing. There are times when everyone is convinced of an amazing future and valuations are extremely high factoring in high growth in company’s earnings and there are times when everyone believes the world is coming to an end and valuations are extremely low painting a “doom & gloom” outlook for the future. The valuations thus keep altering between periods of optimism, pessimism and balance !!

Now let’s go back to our basic framework which we spoke about in our earlier post,

Sensex = Earnings per share * PE ratio (i.e Price earnings ratio)

Each and every day, or rather to be more precise each and every minute, the Sensex value changes. By this time you would easily be able to guess the culprit who is responsible for that. More often than not, the fundamentals of a company do not change every day, but rather the weighted average opinion of market participants on the future of the company (read as valuations) changes .

The weighted average opinion unfortunately gets driven by news flows, quarterly results, macro economic data, global and Indian events, elections, rainfall ..blah blah. Often, the weighted average opinion, gets carried away and builds a lot more pessimism or optimism than necessary.

Our task is not to become an astrologer and predict each and every event which will affect the weighted average opinion (which is what unfortunately most people think you need to do in investing) but rather to identify periods where the weighted average opinion is building in excess pessimism or optimism. Then all that we need to do, is to take a simple call on human nature – humans will always oscillate between the emotions of greed and fear.

Valuations are the proxy for evaluating the position of the weighted average market opinion moving between optimism (greed) and pessimism (fear). So in reality, the intent is to reduce equity allocation when valuations are very high and vice versa.

Lets see some actual data on valuations in Indian Equities

Sensex Valuations - 1Y Fwd PE

Source: MOSL Research Report
1Y Fwd PE is the sesex value divided by the estimated next 1Y earnings i.e at how many times the next 1 year earnings is the market currently evaluating Sensex. I have not used other metrics of valuation in this post as I will cover them in detail in my future posts.

You can see that the valuations have oscillated in a wide range between 10.7 to 24.6.

In Jan-2008, at the peak of last bull market, the Sensex was trading at 24 times its expected next year earnings and in Oct-2008, close to the bottom of the bear market, the Sensex was trading at 10.7 times its expected next year earnings. How fast the market opinion changes !!

Our idea as already stated, is not to predict the next recession or catch the exact bottom, but to monitor valuations and be conservative when valuations are expensive (i.e reduce equity exposure) and be aggressive when valuations are cheap (i.e increase equity exposure). I will delve into the exact mechanics of how to increase and decrease allocations in future posts. But generally, if you are looking for a simple rule of thumb, while investing in Indian equities we need to be extremely cautious when Sensex 1Y Fwd PE is more than 18 (earnings growth will have to be extremely strong to support such valuations) and be extremely aggressive when Sensex 1Y Fwd PE is less than 13.

Currently, the Sensex is trading slightly lower than its long term average at 15.7 times its 1 year earnings. The valuations indicate a weighted average market opinion which is neither too optimistic nor pessimistic and earnings growth will have to be the primary driver of returns going forward (if valuations rise and become optimistic, then we have a chance of making added returns over the earnings growth and vice versa).

Thus summing it up,

In the long run, equity markets will be a slave of earnings. Period.

But in the short run, valuations cause significant ups and downs in the markets.
Thus an eye on valuations in addition to earnings growth, will help us take advantage of these frequent bouts of extreme pessimism and optimism.