Musings of a (Financially) Illiterate Father

by Anand Saxena

  Real Estate Investment Trust (REIT)

  REIT (pronounced as REET) is an idea whose time has come in India, albeit late. It is a very popular mode of investment in the developed economies as you have read about in my musing on ‘Model portfolios by financial masters.’ Global REIT industry is worth nearly $1.7 trillion today50. Simply stated, REIT will generate funding from investors (akin to mutual funds) which will get invested in commercial properties like offices, hotels and shopping complexes. This enables a common investor to invest in commercial properties which otherwise would have been out of his budget. Indian investors can invest in REIT with as less as ₹2 lakhs for which they will be allotted units which will be traded on the stock market.

  The REIT platform has been approved by the Securities and Exchange Board of India (SEBI) and is expected to be launched soon. It allows investors to partake the advantage of rise in prices in real estate without needing big money or getting stuck with unmanageable property. As a common investor one would like to keep a close eye on the developments in this field.

  Key Takeaways

  For transitory stay at a place, it is best to rent an appropriate house which should fit within the need bucket (50 percent bucket.)

  Once you take the decision to buy a house, do go through the checklist provided above.

  Always be alive to the possibility of paying off the loan earlier than the original period of the mortgage.

  MUSING 19: ALL THAT GLITTERS IS NOT GOLD

  “Practically all gold trading is for the purpose of hoarding or speculating so that the bullion can be sold later at a higher price. Almost none of the gold is actually used. The current inventory of gold is some fifty times its annual industrial requirement not to mention the large amounts of yet-to-be-mined metal stored below ground. In this kind of market, no one can tell where prices will go51.”

  Notwithstanding the above quote, in the Indian consciousness gold has always occupied centre stage. Whenever we think of a precious gift to a near and dear one, gold invariably takes the cake. Similar is the case of parents of a prospective bride (or groom for that matter) who start to accumulate gold from the time a child is born to take care of the requirements at the time of marriage. Any well-to-do household is bound to possess gold in form of jewellery, coins and so on. Gold gives a psychological feeling of security to us ostensibly due to its ever-increasing value and demand, easy liquidity and emotional well-being. Who has not observed the feeling of contentment on the face of a housewife as she lovingly takes out gold from her locker and caresses it longingly?

  Gold, however, does not make a good investment and there are good reasons for this averment. Any investment has to have potential to make money by virtue of its growth. So, an equity investment (stock, mutual funds, ETF or index funds) amounts to buying a part of a business which is going to grow and give us returns in form of corporate earnings and dividend yield. Similarly, a debt instrument (FD, debt mutual fund or bonds) promises a fixed return to the investor because the money being borrowed by the bank or financial institution is going to be deployed in the market for earning higher returns.

  When we compare gold by the investment fundamentals enumerated above, it does not meet these criteria. It is just a piece of metal (precious all right) which if left on its own, can’t appreciate in value. It is not contributing to the growth of the economy and hence not a sound business proposition. In fact, the only value gold is supposed to possess can be explained by ‘greater fool’s theory’ i.e. there is a fool who is willing to buy it from you thinking that he is getting a bargain meaning that he believes that there exists an even greater fool who will buy this gold from him at a higher price. So, fundamentally it amounts to a ‘demand and supply model’ where the gold price will go up if the demand for it goes up, with supply being constant. Don’t we see this phenomenon during festivals like Deepawali, Akshaya Tritiya and Dhanteras when the demand for gold reaches a peak and prices shoot up?

  Gold, however, has value during times of hyperinflation or when an economy just collapses. In such stressed times, paper currency loses its value significantly but gold will retain its value or even give more value. In other times too, like when stock markets take a tumble, gold has historically come out a winner. Like the stock market crash of 2008 “lifted domestic gold prices (24 karat) all the way from ₹1,060 per gram in December 2007, to Rs 3,000 per gram by December 2012. In these five years, Indian gold investors made a double-digit return every single year52.” With the market recovery, however, gold returns quickly reversed even dipping to minus 9 percent in 2014.

  What is the view of the experts on gold as an investment option? Dhirendra Kumar, CEO of Value Research says, “If you have access to a modern financial system with all its options of a large variety of asset classes, then you should not invest in gold. Gold makes sense only for those who have no access to or trust in the financial system53.”

  However, many financial masters do suggest having a small percentage (5-7 percent) of investment in gold. This investment though could be made in forms other than physical gold. Let’s explore further.

  Gold Funds: These funds may invest in physical gold or stocks of gold mining companies. It eliminates the possibility of theft which is possible in physical gold and their units can be redeemed at any time at the prevailing gold prices.

  Gold ETF: The topic of Exchange Traded Funds (ETF) will be covered in a later musing. Gold ETF are the ones which track the market price of gold. As an investor you gain when the prices fall (more units of gold ETF could be bought) and vice versa. You never own physical gold, not even at the time of redemption when you will get the equivalent money in cash as per the prevailing rates of gold. However, you need to pay the brokerage fee for trading and fund management charges.

  Gold Fund of Fund: A gold fund of fund (FOF) is simply a fund which invests in gold ETF and hence saves investor the need to open a demat account. These will work out costlier as you have to pay annual management charges for both, the underlying gold ETF and gold FOF.

  Sovereign Gold Bonds: This is a recently announced scheme by the Government of India wherein one can buy these gold bonds at the prevailing gold rates. The money gets locked in for 8 years but on maturity, you not only get the money at the new prevailing rates but also a 2.5 percent return. In addition, the amount is tax-free, unlike a gold mutual fund.

  Digital Gold: This is a new scheme which allows the investor to buy gold in denomination as low as ₹500 which remains stored in the vaults of the Asset Management Company (AMC) without any additional charges. The holding of gold is recorded in grams and can be converted into physical gold at any time. Investor can also exchange the units held with jewellery with the empanelled jewellers. The advantage is that one can accumulate gold of highest quality with small systematic investments through SIP. The disadvantage is that one has to either sell or have the gold delivered within five years of buying it.

  What then should a common investor do? Well, the allure of owning gold in form of jewellery or even coins and bars cannot be taken away from an average Indian housewife. Gold should then be considered a part of one’s want bucket (remember the musing on need, want and saving) and bought as any consumption item like a costly smartphone. Don’t try to fool yourself thinking you are buying an investment.

  If you are intent upon having a part of your investment portfolio in gold, then limit it to around 5 percent54 and go for the sovereign gold bonds that act as hedge against inflation and give you modest returns.

  EQUITY INVESTING

  MUSING 20: STOCK MARKET: A MINEFIELD BEST AVOIDED (DIRECTLY)

  This is one musing where I will let the financial masters do bulk of the talking. I, as a common investor, am not qualified enough to explain the subtle nuances to you.

  The rise and rise of Indian stock market especially in last 25 years is the story which dreams are made of. BSE Sensex has gifted a CAGR of 16.5 percent to its investors since its inception in 1986, which means that it is dou
bling investor’s money every 4.5 years or so. Truly phenomenal indeed, but then why am I trying to deter you from investing in stock market? What I am actually trying to dissuade you from is direct stock picking or dabbling in individual stocks which can best be described as the ‘loser’s game.’ Let me further qualify my argument.

  “The market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that works as well as those managed by the experts,” says Burton Malkiel in ‘A Random Walk Down Wall Street.’

  In this must-read book, Malkiel describes the movements of stock market to a ‘random walk’ meaning that its future direction cannot be predicted on the basis of past movements. He also brings to fore the theory of ‘efficient market’ meaning that any information of consequence to the stock market price has already been factored in the instant price of that stock. It means that we cannot utilise such information to our benefit to buy a stock howsoever fast we may move. He provides a lovely example.

  “A favourable piece of information like discovery of a rich mineral deposit will be first known to the insiders who quickly act and buy stocks causing its price to rise. The insiders will then inform their friends and family who act similarly. Then the professionals find out and buy the stocks in bulk for their portfolios increasing the price further. A common investor, by the time he/she gets the news, buys the stock at a much-inflated price, which may be well above the fair price of that stock55.”

  The ironical thing is that the common investor will never know that thousands or lakhs of stocks have already been bought by others at much lower prices earlier and if they decide to sell these stocks, the prices may crash, causing serious financial loss to the common investor. After all, stock price is a function of demand and supply. The prices rise when there is excess demand and vice versa. This brings me to the first point to support my argument. If a stockbroker really knew that the price of a particular stock is going to rise why would he tell it to anyone?

  “He would quit his job, borrow to the hilt, purchase as much of the stock as he could and then go to the beach56.”

  The same holds true for the magazines/newsletters/internet sites who keep on giving you ‘hot tips’ about particular stocks and their price movement over next week to six months. Don’t pay any heed to these; they all are out to fleece you of your hard-earned money.

  Sample some more facts: Millions of traders (approximately 10 million) trade about 10 billion stocks in a day in over 44 stock exchanges in the world. High-Frequency Trading (HFT) takes place meaning that 50-70 percent of the trades are generated by high-speed machines. What is the implication for a common investor?

  “It takes only half a second to click your mouse to complete your E-trade order. In that short time, the big boys with the supercomputers will have bought and sold thousands of the shares of the same stock hundreds of times over, making micro profits with each transaction. One HFT firm spent quarter of a billion dollars to straighten the fibre-optic cables between Chicago and New York to shave 1.4 milliseconds off its transmission time57.”

  “By most estimates around 80 percent of all investing in public stock markets is carried out by institutional investors. They are the ones who set the prices and dominate trading. It’s a stretch to think that you can outperform these professional investors on the strength of doing a few minutes or few hours of personal research on a few individual stocks58.”

  Now consider what chances do you stand as a common investor to compete against such a highly rigged system? It is best to avoid individual stock picking and take the equity exposure via the mutual fund route, a topic we will tackle immediately hereafter.

  MUSING 21: ARE EQUITY MUTUAL FUNDS THE PANACEA?

  Of late, mutual funds, especially the equity mutual funds are gaining huge popularity amongst Indian retail investors. As per the latest data, in the month of Apr 2018 itself, more than ₹25,000 crores flowed in equity mutual funds, taking the combined assets under management (AUM) of the mutual fund industry to Rs 23.25 lakh crores (23.25 trillion.) The figure is really huge and makes one wonder as to why equity mutual funds have become such a big hit with investors?

  Let’s look at some numbers – the average annualised returns of equity mutual funds in the last five years are as follows59. Large Cap: 14.6 percent, Multi-Cap: 17.9 percent, Mid-Cap: 23.7 percent, Small Cap: 29.6 percent (we will soon unravel this jargon of types of returns and capitalisation of funds-please stay with me.) No wonder that investors are flocking to these funds. But is it a fact that investors are actually getting these returns? Why not, you might ask and you will not be wrong in asking, but tread with caution here. The returns that are advertised are those that a particular category or type of mutual fund made but not what the investor received. Confused? So was I till I read about it in the wonderful book ‘Money—Master the Game’ by Tony Robbins who states that, “the real cost of owning a mutual fund is about 3.17 percent to the investor60.” So in the US, a proud owner of an average large-cap mutual fund which has made returns of 14.6 percent, will end up getting only about 11 percent returns. What’s the situation in India? Let’s look at the breakdown of the costs which erode the returns to investors in India.

  Total Expense Ratio (TER): Whenever one looks at the performance chart of mutual funds, expense ratios are invariably mentioned. In fact, this is the only cost that is disclosed to the investor, if one is perceptive enough to look for it. It is the cost one pays to the mutual fund company for managing one’s money: in effect, for taking investment decisions on your behalf as to where should your money be deployed to maximise returns. TER consists of the management fee, distributors’ commission, registrar’s fee and marketing expenses and is expressed as a percentage of the AUM. This fee varies from one to another fund, but in India, the mandated upper limit as laid down by Securities and Exchange Board of India (SEBI) for equity mutual funds is 2.5 percent and debt mutual funds is 2.25%. So, if a fund advertised a return of 14.6 percent, it may actually be only 12 percent for the investor. This is just the beginning, read on.

  Turnover Costs: In India, till Financial Year 2017-18, if one held a stock or equity mutual fund for more than a year, one didn’t have to pay any capital gains tax on that investment (the law has since changed to 10 percent Long-Term Capital Gains (LTCG) Tax on these even if held for more than one year provided the total income is above ₹1 lakh.) However, even when you held the mutual fund for more than a year, the fund manager might be buying and selling the stocks (which form the portfolio of that particular mutual fund) in less than a year thus incurring LTCG Tax. Fortunately, mutual funds are given a ‘pass through’ status for taxation meaning that this Capital gains tax will be applicable at the investor’s end only. So, the liability to pay STCG or LTCG tax will arise based on the holding period of the individual investor. The good news though, stops here. Every transaction that the mutual fund AMC makes incurs costs, which are finally borne by the investor. As a corollary, the more frequent this buying and selling (called ‘turnover ratio’) is, the more the tax liability for the investor. These costs can range between 1-1.2 percent61.

  Cash Drag: A fund manager is required to keep some liquidity in the form of cash to take advantage of emerging opportunities in the market as also to cater for redemption by the investors. Hence, this component does not get invested in the market and lays idle thus reducing effective returns. For a large-cap mutual fund, over a 10-year time horizon, this cost can be close to 0.83 percent62.

  Redemption Fee: If you wish to redeem your money invested in equity mutual fund within one year of purchase, you have to pay a redemption fee to the Fund House.

  In addition to these major expenses, there are whole lot of other costs like exchange fee, purchase fee, account fee et al,63 which also reduce the effective returns that an investor gets. Effectively, for a mutual fund which charges 2.5 percent as expense ratio, the total charges for the investor could be as high as 4 percent (appears too h
igh? Just total all the costs given above. There are more to follow.) The corresponding figure for mutual funds in the U.S. is 3.17 percent, as given by Tony Robbins in his book because the expense ratios for mutual funds in India are much higher than those in the U.S. (0.9 percent only.)

  This is a very major concern for an investor as the impact on the long-term compounded returns can be devastating. To take an example, even if the publicised returns in an equity mutual fund are 12 percent over a period of 20 years, an investor who invests an amount of ₹1 lakh, will get only ₹4.66 lakhs as against ₹9.64 lakhs that would have been available if these bleeding costs (4 percent) could have been avoided.

  The other issue of concern is that the fund performance that is shown to a common investor does not account for ‘survivorship bias,’ explained beautifully by Burton G Malkiel in ‘A Random Walk Down Wall Street.’

  “A number of mutual fund management complexes employ the practice of starting ‘incubator’ funds. A complex may start ten small new equity funds with different in-house managers and wait to see which ones are successful. Suppose after a few years only three funds produce total returns better than the broad market averages. The complex begins to market those successful funds aggressively, dropping the other seven and burying their records. The full records from inception of the successful funds will be the only ones to appear in the usual publications of mutual fund returns. When you read press stories of how well mutual funds do, it is likely you are seeing only the records of surviving funds64.”

  I have taken the liberty to reproduce an entire paragraph from this wonderful book as this concept cannot be explained more succinctly by anyone, definitely not by a novice like me. And how much is the likely cost of this survivorship bias to an investor? “It’s estimated that including these defunct funds decreases the actual average active fund performance by about 1.5 percent per year65.”