Money Plants

Tuesday, February 28, 2006

Budget 06: What does the future hold?

While the Finance Minister has not changed income tax rates for individuals, he has made a few important changes on the savings side. Here are the highlights of the budget impact on personal taxes. Details will trickle in the next few posts. If you have any queries, shoot.

-No change in tax rates
-One-by-six scheme for filing tax returns abolished. Now you would have to file tax returns only if you have income over the tax-exempt limit of Rs 1 lakh (Rs 1.35 lakh for women and Rs 1.85 lakh for senior citizens)
-Ceiling of Rs 10,000 per annum for investments in pension policies under section 80CCC removed. You can now invest up to Rs 1 lakh in pension policies. This will give a boost to your retirement planning.
-Investments in fixed deposits of scheduled banks for a term of more than 5 years is now eligible for a deduction of up to Rs 1 lakh under section 80C. So now, along with investments in Public Provident Fund, National Savings Certificates, Insurance, ELSS, you can also invest in bank fixed deposits.
-Cash transaction tax continues on cash withdrawals of over Rs 25,000 from current accounts
-Section 54EC for reinvestment of sale proceeds of capital asset amended. You can now invest the sale proceeds only in bonds of National Highways Authority of India and Rural Electrification Corporation, to enjoy tax-free capital gains, as against bonds of NABARD, NHB and SIDBI allowed earlier.
-Section 54ED, which allowed you to invest sale proceeds of capital assets in listed equities now abolished.
-You will be required to quote your Permanent Account Number (PAN) in more transactions now
-Service tax increased from 10% to 12%. More services brought under the scope of service tax.

Friday, February 24, 2006

Budget with MoneyPlants

Only 3 days to go before the finance ministers lays out your fortunes for the next financial year. Media is full of wishlists. Whether the FM will hear them all out is another matter. So what are the key realistic expectations from the budget?

1. More clarity on EET - this is the biggest expectation
2. Relaxation of the Fringe Benefit Tax
3. Expand tax deduction limit from Rs 1 lakh
4. Make interest on bank FDs tax free
5. Remove 2% education cess
6. Allow LTA for foreign trips also, now that holiday destinations are all overseas
7. Reintroduce Tax-free Bonds
8. Pass the pension bill

Budget day will solve the mystery. And MoneyPlants will try and make it simple for you.

Tuesday, February 21, 2006

The truth about home loans

The first truth: Your fixed rate loan may not be really fixed
Banks can word their loan agreements quite smartly. If you have taken a fixed rate home loan read the fine print carefully. Some agreements have wordings that say that while your loan is at a fixed interest rate, banks have the free will to increase the rate in case of any unforeseen circumstance. The banker will never tell you what 'unforseen' really means. These loans are also called money market loans.

So if you are taking a fixed rate home loan, make sure you know what it is. While a money market loan is not a bad product, make sure you are not tricked into believing that you got a completely fixed loan.

The second truth:
Your floating rate loan isnt really floating
Floating rate loan theoretically means that your interest rate is linked to an internal benchmark of the bank such as the Prime Lending Rate (PLR). Your floating rate of interest should ideally change if the PLR changes. Or at least, that's what the banker will tell you. This link between the home loan rate and the PLR is only the partial truth. What really happens is slightly different. There is a hidden clause of ‘spread’.

Spread is the difference between the PLR and the home loan interest rate and is unique to each home loan agreement. In case of home loans, the spread is negative, which means, the home loan interest rate is offered at less than the PLR. What banks do is change the spread and not the PLR.

For example, let's say PLR is 10% and spread is 1.5%. Thus, your interest rate is PLR minus spread which is 8.5%. Suppose interest rates in the economy fall. Now the bank announces interest rates to new customers at 7.5%. Now this does not mean that the loan you took at 8.5% will also reduce interest rate to 7.5%. Banks will only change the spread from 1.5% to 2.5% in case of new loans. Thus while new loans are at 7.5%, you will still pay 8.5% because the PLR hasnt changed.

The third truth: The benchmark itself is faulty

Each bank sets its own benchmark, or PLR, for the floating rate loan. PLR is not an external benchmark. It is something that the bank sets on its own. So really, it is in the control of the bank and not related to how exactly interest rates move in the economy.

While taking a home loan, make sure you read all the fine print. Contrary to popular belief, the language is not difficult to understand. It just need a bit of patience.

Tuesday, February 14, 2006

Sensex at 10000. What to do?

The markets are euphoric. 10000 and still counting. You need to read this post if:
1) You have already invested in the markets (since I am not a stocks person, I am assuming you have invested through mutual funds)
2) If you are planning to invest
3) You are not planning to invest

Ya, so basically I have not left out anyone here :-)

Let's take it case by case, starting with those who have already invested in the markets. Take this quiz:
Why have I invested in the markets?
a) To make quick money
b) To accumulate funds for a house I plan to buy this year
c) To build wealth for retirement

What will I do with the money if I sell now?
a) Blow it up on some indulgences
b) Use it to fund my house
c) I am not selling

If you answered both questions in (a), then don't even bother reading ahead. You are using the markets to make a quick buck and that is not what the Money Gardener believes in. Money Gardener has always talked about long term wealth building and that will happen only if you allow your funds to grow over a long time.

Equities should not be gambling dens. Equities, when used wisely, will give the best returns over a longer term of 7-10 years. Markets are at all time highs now, and a short-term correction is inevitable. But over a long term, the markets will just continue to grow.

If you answered both in (b), then this maybe a good time to book some profits. After all, it is important that you don't lose the money you have accumulated for your home. Markets are at all time highs and nobody is able to tell if it will go up further, if so, how much and if so, when.

If you answered both in (c), you are a winner. Just hang on there and the results will show.

What if you haven't invested and are wondering whether you should start doing it now? Time to introspect. Why are you investing?
a) Because everyone else seems to be making money around me
b) Because I need to build wealth

How long will you hold on to your investment?
a) For as long as it takes to make some great profits
b) For at least 7 years

At the risk of sounding repetitive, let me tell you how you fare. If you answered both questions in (a), don't bother investing now.

If you answered both questions in (b), go on and invest. It does not matter at what levels you enter the markets because you are planning to hold on for a long term. Over 7-10 years the sensex could go up to 15000, then fall to 7000 and then rise again to 12000. So patience will pay off.

A tip: Invest through a systematic investment plan.

Now if you were too scared to put your money in equities, I suggest you overcome that fear. Markets are risky in the short run but great for the long run.

So start putting in a little money every month and watch your investments grow over the years. Don't get jittery if there is a small fall. Falls happen. But falls are followed by rises.

Friday, February 10, 2006

Why MF IPOs are a farce...

1.Offer open at par
Your agent probably told you that you must buy into a MF IPO or as it is now called New Fund Offer (NFO) because the NAV is at Rs 10. He will tell you that the NAV of Rs 10 is far cheaper than the NAV of an existing fund.He is taking you for a ride.

All the money of the fund, whether collected at the time of IPO or otherwise, is invested in equity shares at market price existing at the time of investment. So, if you have invested Rs 10 in a unit of an IPO and after one month, if the shares in which investments have been made grew at 10%, your scheme will have an NAV of Rs 11. Had the same money been invested in another well performing scheme with a similar asset allocation, the NAV again would have grown by 10% notwithstanding what it was earlier.

It’s a common notion that a scheme with an NAV of say Rs 80 is more expensive than a scheme with an NAV of say Rs 10 or Rs 12. This is untrue. Other things remaining equal, if both schemes grow at the rate 10%, the scheme with an NAV of Rs 80 will rise to Rs. 88 whereas a scheme with an NAV of Rs 10 will rise to Rs 11. Therefore, investors should look at the percentage growth in the amount of capital invested and not the number of units they have got or what NAV they have invested at.

2.There’s zero entry load
Another marketing gimmick is to announce a zero entry load on the IPO. If you buy units of an existing scheme, you will have to bear an entry load of between 2-2.5%. However, no such load is levied on your IPO issue.

But that does not mean that IPO issues are free from such charges. Although they are not called entry loads, there are initial issue expenses that the fund house incurs for all the costs of advertisement and distribution during the IPO. This expense is ultimately passed on to the investor. Initial issue expenses can go up to 6%. These expenses can be deferred over a period of five years. So while this 6% will not hit you in one go, it will have an impact on your NAV.

3. New product
Your agent will tell you to buy a fund because it has features different from an existing fund. Mutual Fund IPOs, especially for diversified equity schemes is nothing but old wine in a new bottle.

MF IPOs are just ways for fund houses to garner funds. They offer heavy commissions to agents and distributors to sell IPOs.

So don't fall for these traps. Tell your agent you know better ;-)

Choose a fund which has a track record of good performance. When I say track record I mean a fund that has been around for long enough to have survived bulls runs and bear runs. It would be ideal if you can look at returns of funds for the last 7-10 years.

Tuesday, February 07, 2006

MF returns - Growth, dividends or dividend reinvestment

There are a number of ways in which a MF distributes gains to unitholders. Dividend, Growth and Dividend Reinvestment. At the time of investing, you would have to choose any one of these 3 options. So what's the difference between the 3 and how do you choose?

In a dividend option, when the net asset value (NAV) of the fund goes up, they pay out the gain as dividend. So for instance, suppose at the time of investment your NAV was Rs 20 and after a year it goes up to Rs 25, the MF will distributed the gain of Rs 5 as dividend.Once the dividend is paid, the NAV falls to the extent to which dividend is paid (not exactly to that extent but more or less). Let us assume here that it slips back to Rs 20. Suppose you sell your unit, you will get sale price of Rs 20 only.

In a growth option, the NAV of the fund goes on increasing. The gains are not distributed as dividends but keep on accumulating. When you sell the units, you will get a higher sale value. So if after a yaer, your NAV has gone up from Rs 20 to Rs 25, if you sell your units, you will get a sale price of Rs 25.

Dividend Reinvestment:
In dividend reinvestment, the dividend is invested back into the scheme. When a company declares a dividend, the value of the dividend is converted into an equivalent number of units at NAV, after the dividend declaration date.

So suppose you buy 10 units of a scheme at NAV Rs 20. After a year, the NAV goes up to Rs 25. The MF declares a dividend of Rs 5 per unit. As a result, you are entitled to a total dividend of Rs 50. After the dividend is declared, the NAV slips back to Rs 20. You will now be allotted 2.5 units at NAV of Rs 20. So unlike in the growth option where you sell your units at a higher NAV, in a dividend reinvestment option, you are selling greater number of units at the same NAV.

How to choose?
Taxation decides how you choose an option. That table above shows how the taxation works. On the basis of taxation impact and your needs, here's the result on how to choose:
Choose dividend if...
You are planning to hold the units for less than 1 year ORIf you are holding for longer than a year and want a regular income

Choose growth if...
You are planning to hold the units for more than 1 year and want to allow your fund to grow in value

Choose dividend reinvestment if...
You are holding the units for more than 1 year and want to reduce the impact of capital gains tax on sale because once the dividend is declared the NAV falls and your capital gain is reduced.

But remember that the period of one year will be considered from the day on which reinvestment is done and not when the original units are purchased.

So ideally, a dividend reinvestment option may not make too much sense.

Coming up:
Why MF IPOs are a farce

Monday, February 06, 2006

MF fees: There are no free lunches

In the last post, we looked at how a mutual fund works, what an NAV means and how one can make a profit or loss.

While our illustration had just 5 investors, in the real world, there are thousands of them who entrust their money with mutual fund houses. MFs mop up money from investors and go about investing the same in equity shares. Of course, I am referring only to equity mutual funds here. If they make profits, they share the profits with investors. In case of losses too, investors have to bear them.

And like I said in the headline, there are no free lunches. A mutual fund manager is using his expertise to make money for you. So he surely needs to be compensated. There are 2 main types of compensations. One is the 'load' and second is the 'asset management charge or AMC'.

A load is a charge that the fund house levies on your investment amount as administration charges. There are 2 types of loads - entry loads and exit loads.

An entry load is a charge that is levied at the time of making the investment. Presently, this load is around 2% of invested amount. So for instance, suppose you invest Rs 10,000 in an equity mutual fund, the fund house will deduct 2%, that is Rs 200 as charges and invest the remaining Rs 9,800 in shares. The fee of Rs 200 is used to cover costs of documentation and processing your investment, commission to your agent, sending you regular updates of NAVs and portfolio allocations and so on. So your actual investment is Rs 9,800. Entry loads apply for all mutual fund schemes.

Exit load is the charge that is levied at the time of exiting from the fund. These loads are levied in case of schemes that have a minimum lock-in period. For example, the ELSS tax saving scheme. Here the minimum lock-in is 3 years. If you withdraw before completion of 3 years, you will have to pay an exit load on the amount you withdraw. The exit load varies between 2-6%.

Asset Management Charge:
This charge is levied as a percentage of the fund value. This is the charge for asset management, that is for compensating the fund manager for his portfolio management skills. This charge is around 2% per annum of the fund value and is adjusted in the daily NAV. Expenses are important and have a bearing on your return. Although a 2% fee may appear small, it is nevertheless significant.

You may have read about expense ratios of various MF schemes. An expense ratio is nothing but the impact of both the above charges on your returns.

There is another catch about expenses that you need to be wary of. When new schemes are launched (called as MF New Fund Offers-NFOs), fund houses advertise saying there is no entry load during the initial offer period. If you think thats a great bargain, then you ought to be warned. There is a devious accounting practice involved here. According to that, MFs are allowed to spread over the initial expenses in a NFO over a period of 5 years. So while there maybe no entry load, there will be an 'initial expense' that will be deducted from your NAV over the next 5 years. And this initial expense can be as high as 6% because companies tend to spend huge amounts on advertising and distributing new offers.

Coming up:
Returns on MFs-Growth, dividends or dividend reinvestments

Sunday, February 05, 2006

Dummies guide to Mutual Funds

A mutual fund is just what it is named - a fund that is operated by mutual contributions. Here is a story for you.

Sachin has a sum of Rs 1,000 to invest in equity shares. He picks up the latest copy of ET and looks up the share prices of good companies. Here is what his research reveals:

Tata Steel Rs 400
Infosys Rs 2000
ITC Rs 100
Ranbaxy Rs 300
HDFC Rs 1000
(all prices per share)

With his outlay of Rs 1,000, he can buy a couple of shares of Tata Steel and a few of ITC or some shares of Ranbaxy. He cannot invest in Infosys or HDFC at all. In fact, he cannot invest in more than one or two companies.
He read in an investment journal that the key to good investing is healthy diversification. Buying into just one or two companies goes against that theory. He is in a fix.

At a practice match, Sachin meets Rahul, Yuvraj, Anil and Irfan. Each of them is in a similar situation. Rahul has Rs 1,000 to invest, Anil Rs 800 and Yuvi and Irfan have Rs 500 each. Together, they have a total of Rs 3,800.

They decide to form a mutual fund. They pool in their money and buy one share each of the above 5 companies. They form 380 units of Rs 10 each totalling to Rs 3,800. This Rs 10 is the starting NAV or Net Asset Value. Each person gets the number of units proportionate to their investment. So, here is how their units pan out:

Sachin 100 units (Rs 1000 divided by Rs 10)
Rahul 100 units (Rs 1000 divided by Rs 10)
Anil 80 units (Rs 800 divided by Rs 10)
Yuvraj 50 units (Rs 500 divided by Rs 10)
Irfan 50 units (Rs 500 divided by Rs 10)

After one month, they check out ET again to see what the value of their investments are. Here is what they see:

Tata Steel Rs 450
Infosys Rs 2050
ITC Rs 150
Ranbaxy Rs 280
HDFC Rs 990

Total fund value is Rs 3,920. Total number of units is 380. So NAV is Rs 10.32 (Rs 3,920 divided by 380). So each unit has made a gain of Rs. 0.32 paise. This gain mulitiplied by the number of units held by each person is the gain of each person. So here is the situation of investmtent values of all 5 after one month:

Sachin Rs 1,032 (Rs 10.32 multiplied by 100 units)
Rahul Rs 1,032 (Rs 10.32 multiplied by 100 units)
Anil Rs 825.6 (Rs 10.32 multiplied by 80 units)
Yuvraj Rs 516 (Rs 10.32 multiplied by 50 units)
Irfan Rs 516 (Rs 10.32 multiplied by 50 units)

So, if any of them decides to sell the units, he will make a profit of Rs 0.32 on each unit that he holds. If someone sells and exits the fund, the NAV of the fund will remain unchanged because the number of units will also fall proportionately. Now what I have explained is an optimistic scenario. If the fund value falls below the initial investment of Rs 3,800, the NAVs will be less than Rs 10 and hence each person will bear a loss.

This is the basic of how a Mutual fund works. Now instead of just 5 investors, imagine hundreds and thousands of them.

So what is the moral of the story? How do MFs help?
1) A MF will help you to diversify. Sachin could not invest in all companies alone but could do it mutually with 5 others and share the resultant gains.
2) Diversification in turn, reduces risks. For instance, though the share prices of Ranbaxy and HDFC fell, the value of overall portfolio went up thanks to the rise in price of the other companies.
3) Sachin is a cricket player. So are the others. They have no sense of the market. They need an expert to manage their fund, to decide which stocks to invest in, which stocks within the portfolio to sell or buy and so on. A MF gives you expertise. Of course for a charge.

Coming up:
A look at how do MFs make their money. Its simple - they charge you.

Disclaimer: All these share prices have been randomly assumed. They do not indicate actual performances or quality of stocks.