Sunil, an MNC senior manager has just got promoted as Chief Marketing Officer. He is 47, and his wife Anita, 45 is a homemaker. They have two school going children, a son 14 and a daughter 12. His salary is now Rs. 1.5 crore per annum. He has an accumulated a Provident Fund balance of Rs. 32 lacs with his employer and has 40 regular equity mutual fund investments of current value Rs. 0.95 crores( accumulated profit of Rs. 15 lacs and generating annual dividends of Rs. 3.5 lacs ). The family also has an FD in spouse’s name for Rs. 10 lacs and in each of two kids’ names of Rs. 5 lacs each. Sunil felt they could save about Rs. 40 lacs per annum, hence was wondering if he should start investing Rs. 3 lacs per month – half in Gold and half to be a contrarian investor in new age internet biz model stocks ( which have fallen a lot already).
Analysis and Recommendations
The Identified Quick Wins in their case are:
1) They have regular funds and should switch into direct funds if they do nothing else. They will save about 1% per annum or about 95,000 per annum with no incremental risk.
2) They are not using the National Pension Scheme and would benefit from doing so.
3) They should move their fixed deposits into Government Savings Schemes.
Observations
Diversification is a cornerstone of good financial and investment planning. Sunil and Anita have a very large number of mutual funds, all actively managed by well-regarded investment management firms and their professional investment managers. Is this not a textbook case of a well-diversified investment portfolio? The portfolio of funds has been constructed on the advice of two financial advisors and they feel that they have the additional benefit of getting diversification of advice and views as well. They are convinced of the benefit of moving to the direct class of the funds but wanted to know if they should just move to the direct classes of the same funds.
Paradoxically, a portfolio of a well-diversified portfolio of actively managed funds is almost sure to underperform a well-diversified portfolio of a few of index funds that have a similar asset allocation to the portfolio of mutual funds. Why is this the case? We are going to
break up the explanation into two parts:
1) Why the portfolio is not any more diversified than a single index fund and
2) Why it is almost sure to underperform.
Why the portfolio is not any more diversified than a single index fund:
Each of the many mutual funds invests in the same stocks. If one looks through each of the funds, one can construct a list of the stocks that one has a list of all the stocks that one has exposure to and the weights of each of the stocks. If one looks at the resulting underlying portfolio, it will look very close to a well-diversified benchmark index fund that owns a very large number of stocks directly. Therefore, for all the complexity, you get no more diversity than a single index fund. Remember each of the managers is judged against how they do relative to the benchmark index. They make bets by overweighting the stocks they like and underweighting the stocks they do not. Each of them is often not too far from the index and when you average across many of them you get the market index.
Why it is almost sure to underperform:
Active managers cost more than the benchmark indices on account of higher fees and transaction costs. Most active managers fail to beat the benchmark indices. When you put a lot of them together you are sure to get the average market performance on a before-fee basis and underperformance against the benchmark on an after-cost basis. Additionally, with 40 funds it is hard to know what the asset allocation is and to track it over time. The funds included equity, fixed income, and balanced funds. Looking through the holdings of the funds, we determined that 40 lakhs was fixed income and 55 lakhs was equity risk.
Asset Allocation
Our recommendation for a 47-year-old is a range of 43% to 86% equity, depending on risk tolerance. The recommendation for those with average risk tolerance is 63% equity. Their mutual funds are currently allocated to 58% equity and 42% fixed income. Including their Public Pension Fund and Fixed deposit holdings, the aggregate asset allocation is 63% equity and 37% fixed income. For a 47 year old, the equity allocation is on the low end. They should consider increasing their equity exposure. Given Sunil’s earning capacity, they have a high component of human capital relative to their investments and financial capital. They should be able to tolerate the risk from a 63% equity allocation. It is also important to insure Sunil’s earnings stream by buying term life insurance.
Investment Recommendations
NPS
Move the mutual funds into the NPS; 25% into Tier 1 and 75% into Tier 2. The maximum allocation of equity Option E in Tier 1 is 75% with the balance 25% going into the Govt Fixed Income Option G. 100% of the investment in Tier 2 can be put in Tier 2 Option E. We have
picked State Bank of India as the investment advisor as it is the largest investment manager on the NPS platform. The other large investment manager options are also reasonable if they have a strong preference but they did not. The earnings within the NPS are not going to generate any tax liability during the investment period. Any reallocations within funds in Tier 1 also will not trigger any taxes. On withdrawal, 60% can be taken as a lump sum and will not generate any taxes. 40% has to be taken as an annuity. It is good to have an annuity for a portion of your assets since it will last for your life and will hedge the risk that you live a very long life and run out of retirement income. After retirement, your income level is going to be much lower and the effective tax rate will also be quite low. The fees at the NPS are about 0.10% and are much lower than the 1.53% they are currently paying on the mutual funds that they have. They are also much lower than the 0.91% you can reduce the fees to by switching to direct funds.
International Equity
Sunil and Anita are going to accumulate a substantial equity portfolio over time. Adding international diversification to their equity portfolio is worthwhile and worth going through the added complexity. The international equity portfolio is much more diversified than an Indian equity portfolio. Which will do better in the future? We don’t have a strong opinion. Indian growth prospects are better than the rest of the world. Valuations of Indian companies are higher. Our baseline expectation is equal returns from the two.
The allocation between the Indian and international portfolios is a subjective decision. We recommend 50% to the equity portfolio in India through the NPS and 50% in international equity through the Vanguard ETF VT.
All The monthly savings can also be invested in equity till the equity allocation gets to the recommended 63%. After that, they can re-evaluate their equity allocation and decide if they want to increase it further or reallocate the savings to fixed income and equity to keep the
equity allocation at the desired level. To manage the tax cost, the fixed income investments should be made in Tier 1 and the equity allocations in Tier 2 and internationally in the VT ETF.
Fixed Deposits
They can do better than bank Fixed deposits. Their daughter’s fixed deposit can be transferred to the Samruddhi Sukanya Yojana that is currently paying 8% per annum. The maximum investment per year is 1.5 lakhs. Anita can also move her Fixed deposits to the NPS. She can put the minimum amount in Tier 1 and the balance in Tier 2 all in the Govt Fixed Income Option G managed by SBI.
Other Considerations
Gold is commodity speculation and an inflation hedge. Real estate over time is a better option than gold. If they are really keen on gold, they should consider the RBI gold bonds instead. There is a strong economic basis for the positive real returns on traditional equity, fixed income, and real estate investments that come from the productive activity they support. When you hold gold, there is no underlying activity that contributes to your earning positive real returns over long periods of time. It has a reasonable amount of risk and low expected returns. in our opinion, as they are building their core investment portfolio, gold is not a good investment choice.
As regards internet stocks, if they have a strong view about value there, they can carve it out of their equity bucket and manage themselves. If they do not have a competitive edge in understanding this space as is the case for most people, it is better to put it as part of the equity allocation into NPS 2 Equity and Vanguard Global, both of which are very diversified and low-cost.
