The Application of Numeraire Portfolio in Pensions

This interview was first published by the Global Association of Risk Professionals on February 14, 2013

http://www.garp.org/risk-news-and-resources/2013/february/the-application-of-numeraire-portfolio-in-pensions.aspx?altTemplate=PrintStory

The complexities of pension fund management and maximizing retiree returns are compounded by "enormous risks," observes Eckhard Platen, professor of quantitative finance at the University of Technology, Sydney. "There is a need of a little bit of academic direction to do something about it. There is a way to do it. Even developed countries need to wake up and say, 'now something has to be done."Noting that classical finance theory has not filled all the gaps, Platen brings to the discussion a "Benchmark Approach" that, in a recent interview, he put in the context of a numeraire portfolio and how it could be applied to the practical issues and concerns surrounding pension schemes. At UTS Sydney since 1997 --as a joint appointment of its School of Finance and Economics and School of Mathematical Sciences -- Platen has been contributing to efforts to improve the pension system in Australia.

With a Ph.D. in Mathematics from the Technical University in Dresden and a Dr.Sc. from the Academy of Sciences in Berlin, where he headed the Sector of Stochastics at the Weierstrass Institute, Platen has written more than 150 research papers in quantitative finance and applied mathematics, and his books include "A Benchmark Approach to Quantitative Finance" (Springer, 2006).

This interview conducted by Nupur Pavan Bang, senior researcher, Centre for Investment at the Indian School of Business in Hyderabad, covers the evolution of Dr. Platen's views on diversification principles and risk neutrality, the numeraire portfolio and practical approaches to pension investing.

You do not believe in the classical principle of no-arbitrage. That is the most fundamental principle of asset pricing theories in financial literature.

In the early 1990s, when I started working with leading investment banks in Australia, I was confronted, in practice, with the classical paradigm called the no-arbitrage pricing theory. Over time, it became clear to me that this theory is too narrow; the assumptions made are too constraining, and we must have an alternative that is more appropriate, especially in the case of longer-term contracts. It just occurred to me that something is wrong. The classical notion of no-arbitrage restricts too much the modeling world. There is a less restrictive and economically very reasonable notion of arbitrage that one should use. In principle, we should be able to create financial contracts and hedge them in a way that is less expensive than what classical theory propounds. Over the years, I was able to demonstrate how this is indeed possible.

Are pension schemes, therefore, very long-term contracts where you think your theory can be applied?

Think of it this way: Governments, companies and individuals contribute to pension funds. The amount is very big for most of us. As soon as we start earning, we are told that this contribution is mandatory. The cumulative contribution over the years is very significant, because if you start earning at the age of 20, you will end up contributing for 40 to 45 years. Lots can be done with this money from the time when the contribution is made and the payoffs are really paid off.

What are the concerns with the traditional pension schemes? What went wrong?

It is an enormous challenge to gauge a developed market and an emerging market in the same light. To start with, the way pensions have developed, they have emerged as the core of the welfare system. Secondly, the defined benefit pension plans have failed in the countries of the West. Thirdly, large companies like General Motors and Ford are just pension-generating companies, nothing else. Fourth, governments organize pensions based on an average mortality.

The aging population is a concern in a lot of countries. Let's say people live longer -- say, 15 years longer on an average. The calculations completely go wrong. Also, some major industries of some countries or some economies, they may just decay or vanish. We have seen this many times. For example, if a pension scheme invests a big chunk of the money in, say, a mining group in Australia. It could happen that after 15 or 20 years, the mining action shifts to Africa. What do you do then? So it would be very good if a scheme is widely diversified, so that its performance does not depend on a single industry or nation.

There are many different types of contribution schemes nowadays. Doesn't that solve the problem?

No. Look at the equity-based contribution schemes that are now very popular in the developed nations. They often force people to liquidate everything at retirement date and buy an annuity. If the market is down in a particular year, and equities form 40% of the pension, then that is enormous risk. I would say this has to be removed soon.

What can be done?

One thing that should not be done is setting up a defined benefit scheme. Because you can never guarantee payoffs at the end of 5, 10 or 30 years. But what one can do is pool all the knowledge and best practices to create a mutual scheme or a pension scheme. The scheme should be diversified in terms of age of the participants, and it should have a large base of participants. Then keep adjusting the payoffs from time to time, depending on changes in life expectancy and economic conditions. So we aim to get the highest possible payout in the least expensive way. The challenge is how to set up such a scheme and make it fair so that, in principle, it is fully transparent to everyone.

How can such a scheme be set up?

There are different contribution plans that give different choices at retirement. This has to be put on the table. That is, if one contributes a certain amount in cash, then something will be done with that cash. It will be invested using certain strategies that target the highest possible payout. When you retire, you will get a payoff stream, like that of a life annuity, in cash. There is an agreement in principle that you get payments only until you die.;;

This pension has to be fully sustainable, fair and, of course, globally diversified. Since the level of payouts cannot be fully guaranteed, it should be a targeted life annuity. The entitlement depends on how much one paid in -- how many units of the life annuity one has purchased over time by contributions to the scheme. The assets and liabilities are matched regularly over time, using what I call real-world pricing. They are adjusted periodically, based on the latest mortality figures and model adjustments available.

In some countries -- for example, India -- the regulations do not allow for global diversification of the pension pool.

Yes, certain countries have certain regulations, and one can operate only under these regulations. I believe the policy in India is to very much keep pension funds inside the country. It may be too early now, but there will come a time when the authorities will realize the advantages of diversifying beyond the country.

Can you explain your approach in more detail?

I use the Benchmark Approach, a kind of more general framework that we have today in finance. It does not take anything away from existing classical theory. John Larry Kelly Jr., of Kelly criterion fame, published a paper, in 1956, founded on maximizing expected portfolio growth based on logarithmic utility and gambling contracts.

In July 1990, theJournal of Financial Economics,a mainstream finance journal, published "Numeraire Portfolio," a paper by John Long Jr. This is a portfolio which, when taken as a "numeraire" or a benchmark, and some given portfolio is denominated in units of this benchmark, then the current benchmarked value of the portfolio is greater than or equal to its expected future benchmarked values. Using this insight, we can potentially get a fair benchmarked portfolio process, forming a so-called martingale, where the current benchmarked value is equal to the expected future benchmarked values. I am suggesting to search always for this least expensive portfolio to hedge future payoffs. When doing this, use the real-world pricing formula, assuming that there exists a numeraire portfolio -- the benchmark -- and the expectations are taken under the real-world probability measure that models future change.

Doesn't most of the financial literature use a risk-neutral probability measure?

Yes. Almost 90% of the literature. But I don't believe that the risk-neutral probability measure exists. In fact, I know that this measure does not exist when fitting long-term models. Parts of the industry see the problem too, and that is why the largest reinsurance company in the world is interested in what I found.

I can tell you that I am a non-equity premium puzzle person, because the modeling world that the Benchmark Approach provides is so rich that a high equity premium is not a puzzle at all. It's like you want to force a classical risk-neutral model [to calculate a risk premium] onto something where, in principle, you should accept and use the observed risk premium, which is higher than the classical theory allows. It is just another indication that the classical theory is too narrow.

How does your theory compare with the classical theory?

While we don't take anything away from the classical theory, we go into a richer modeling world by making a very simple assumption: that there exists a numeraire portfolio. The numeraire portfolio, when used as a benchmark, makes all benchmarked non-negative portfolios supermartingales -- their current benchmarked value is greater than or equal to the expected future benchmarked values. The greater-than-or-equal sign indicates the crucial supermartingale property. Since this property holds for all non-negative benchmarked portfolios, one can say that the numeraire portfolio is the best portfolio in this sense. It performs so well that when used as a benchmark, it forces all non-negative portfolios in expectation down, besides those that are martingales. With the supermartingale property, and no extra assumptions, I can prove that this portfolio in the long run outperforms any portfolio. It's a dream portfolio.

It is also the portfolio that maximizes the expected logarithmic utility. It is growth-optimal. It's a portfolio that in the shortest time reaches a certain level. It is the portfolio that cannot be systematically outperformed in any time period by any other portfolio. All these properties are model-independent and, thus, very robust. In fact, even the Indian market, if you take a close look at it as an investment universe, has its own numeraire portfolio somewhere, extremely well-performing. The question is just to find and construct it.

How do you account for the down side?

If I look with the Benchmark Approach beyond the classical theory, then there are some classical arbitrage opportunities in this richer modeling world. However, these are strategies and portfolios where I have to allow, for certain periods, some probability to become negative. But I argue that it is not necessary to exclude those strategies. We should look only at non-negative portfolios, because, with a notion of reasonable economic sense, when the worth of market participants becomes negative, then we have to remove them from the market because they are bankrupt. We take limited liability into account, but there is no need to look at the negative portfolios and exclude arbitrage for these.

This supermartingale property is also in this respect very elegant and powerful. It provides the simple mathematical conclusion that any non-negative supermartingale that reaches zero will never get out of zero. In this sense, one cannot create out of zero capital some positive wealth with a non-negative portfolio. This type of arbitrage, called strong arbitrage, is then automatically excluded in the wider modeling world of the benchmark approach.

How do you construct the numeraire portfolio?

The numeraire portfolio is very diversified -- the best diversified portfolio you can build. In principle, it is capturing the non-diversifiable risk of the market that follows from a theorem that I have. Of course, this clings very much to the classical theory. Harry Markowitz once told me that I should call my theorem the Diversification Theorem, which brings all the finance theorems and principles together.;;

Using this diversification theorem, I create, in its simplest application, an equally weighted index (EWI), equi-weighted over companies, industries and countries. This index has a higher growth rate and higher Sharpe ratio (as well as lower volatility) when compared to the index weighted by market capitalization. It is a better proxy for the numeraire portfolio than the market-cap-weighted index. It can be used directly in portfolio management, as a best performing portfolio, as a benchmark.

The larger the number of companies, the closer we get, in principle, to the numeraire portfolio. The fundamental Law of Large Numbers is at work here. The market needs to be well securitized, which is a very simple and easy condition. In a well-securitized market, with an increasing number of securities, the sequence of equally weighted indices is a sequence of approximate numeraire portfolios. This is something that is covered by the Naïve Diversification Theorem.

How does the numeraire portfolio work as an investment strategy?

The strategy of an EWI is to buy low and sell high, and if a market is always trending up, you get people only wanting to buy and not to sell. But this fund will sell in such a scenario. On the other hand, if the market crashes, this fund will buy. So it has a very stabilizing effect on the market. The systemic risk in the market, with this kind of portfolio on a macroeconomic scale, is reduced.

Then there are people who might say, "All this is good, but what about transaction costs?" At 40 or 80 or even 200 basis points, the performance, of course, goes down but this portfolio still performs better than the market-capitalization-weighted portfolio. The Sharpe ratio is still better for the proxy of the numeraire portfolio. It is a very robust, stable kind of situation.

How can the pension fund industry use the numeraire portfolio?

The pension fund must invest in a proxy of the numeraire portfolio. Not just that, but the numeraire portfolio also gives us a pricing rule. In the supermartingale world, we call it the fair price process. Let's take a savings account; and also a proxy of the numeraire portfolio, a benchmark; and let's benchmark the savings account. Over the long term we get an on-average downward-sloping fluctuating curve for the benchmarked savings account, because the numeraire portfolio is going up more in the long run than the savings account. So this is a self-financing portfolio. Financial planning tells you that when you are young you should invest in the equity market (the benchmark), and then in later years fixed income (the savings account).

Using the numeraire portfolio and the savings account, about which I just spoke, we can construct a self-financing hedging strategy, where according to some model, you invest almost everything into the numeraire portfolio when you are young and then slide over, in a precisely defined manner, to the savings account over time.

Does this portfolio take care of inflation? In a country like India, where inflation is on the higher side, people are worried about the time value of their money.

People like their pension payouts to be inflation-indexed. That is because the pension contract is very long-term and much can happen over that period. In my experience, interest rates are generally a percentage or two higher than inflation in most economies. It is very difficult over long time periods to get the interest modeled correctly. So why not take it out completely? What we do is assume that one unit of payment is equal to one unit of the saving account. All the payments that you contribute and get later on in your post-retirement stream are in the form of savings account units. In particular, the targeted payouts are units of the savings account. So when you purchase your life annuity, you get rid of the risk or uncertainties from the modeling problems coming from the short rate. My payout unit is the unit of the saving account; my basic instruments are the benchmark and the savings account.

Current actuarial methodologies focus primarily on modeling the interest rate evolution to value pension funds and life annuities. Several developed countries have moved to a zero-interest-rate regime. This creates problems for the growth of wealth when using classical actuarial methods. Using the benchmark approach and the proposed targeted pension, one can avoid several of the currently burning problems. In the design of new pension schemes, one can benefit in several ways.

Trend is your best friend

This article was first published in the Hindu Businessline, Investment World, February 10, 2013; Co-Author: Archana Mishra, NMIMS Hyderabad.

 

If prices follow a random walk, past prices cannot be used to predict the future prices. And prices do follow a random walk- this was and still is believed by most academicians and many professionals in the field of finance. This belief gives rise to the belief about the ineffectiveness of Technical Analysis as a tool for aiding trading decisions.

But the question is, do the prices really follow a random walk? The Efficient Market Hypothesis (EMH) has propagated that Technical Analysis is useless if the markets are even "weak form efficient". Lo and Hasanhodzic in their book, 'The Heretics of Finance' (Bloomberg Press, 2009) point out that, research shows, patterns do repeat themselves and identifying these patterns can result in forming profitable trading strategies.

Let us clarify at the outset, that we find the notion of EMH itself is questionable. Having said that, research in developed nations point towards at least weak-form efficiency of the markets. Which might be the reason why many fund houses reduced the number of chartists on their teams in the last two decades. For example, in 2005, Citigroup's Smith Barney unit let go of its entire team of technicians. "The clients no longer wanted technical analysis", reported Wall Street Journal.

In India, technical analysis is still very popular and investors are still fascinated by what the complicated looking lines have to say. Even the "Big Bull" of Dalal Street, Mr. Rakesh Jhunjhunwala said in an interview with the Economic Times, "I use a lot of technical analysis for trading at times".

While more and more analysts and investors are preferring to use fundamental analysis, technical analysis has its own share of loyal chartists in India. Research on the Indian bourses give mixed results, with some of them indicating that price movements in India may not be even weak form efficient, making Technical analysis relevant in the Indian context.

Typically, long term investors like to use fundamental analysis, while traders use technical analysis along with fundamental analysis. However, loyal chartists believe that the charts reflect long term trends too as fundamentals are reflected in price movements.

It is advisable for any trader to look for the following indications before taking any position:

a)      Look for the Trend: first check whether the stock has an upward trend or downward trend. If the trend is upward then take a long position. If the trend is downward, then take a short position.

b)      Look for the indicators: After analyzing the trend, look for indicators accordingly. If the stock has an upward trend, then look for buying indicators such as hammer, morning star, morning star doji, bullish engulfing etc. If the stock has a downward trend, then look for sell signals such as hanging man, bearish engulfing, evening star, shooting star, shooting star doji etc.

c)       Look for Confirmation Candle: If the candlestick chart is used, then after the indicator look for confirmation candle to occur. For the buy indicator, the confirmation candle should close higher than the high of the indicator. While for the sell indicators, the confirmation candle should close lower than the low of the indicator candle.

d)      Look for Volume: The confirmation should always be followed by large volume either at the indicator candle or the confirmation candle.

e)      Verify by using various trading tools: MA, MACD, DMI, Fastk, RSI, Pivot are few of them.

After getting positive indication of the trend from the aforementioned steps, take the position (buy or sell) with stop loss below the low of confirmation candle for buy positions and above the high of confirmation for sell positions.

There are various patterns which may be formed by the prices. A few popular one's are the head and shoulder, triangle, rectangle, flag. Patterns are difficult to find. But once you find them, it's worth the effort.

There is no tailor made ideal way to invest. It really depends on the individual’s comfort level in using the technical analysis tools, or analyzing the fundamentals to take positions. However, one should ensure that at least 3-4 indicators are in sync with each other before taking a decision.

The role of stock markets

This article was originally published in Postnoon on January 4th, 2013: Co-Author- Purvee Hetamsaria

http://postnoon.com/2013/01/04/role-of-stock-markets/100171

The Udupi restaurant owner at the corner of the street where Prof. Nicky lived, came and sat across the table in front of her, while she was enjoying the delicious meal. With an eye on the cash counter, which he had handed over to his aide for the time being, he asked her if he could chat with her for a while.

Prof. Nicky (with a wink): Sure Raju, if you make my meal free!

Raju: It's you shop only madam.

Nicky: I was just joking. Tell me what do you want to talk about?

Raju: My son is doing MBA. He has been telling me to invest my spare money in the stock markets instead of keeping it in Fixed Deposit. I have so many doubts. If I ask him, he gets angry. He says that I think too much. He wants me to go and give my money to a broker, who will take care of everything. Tell me madam, how can I put my hard earned money in something I don't understand?

Nicky: You are right Raju. You should never put your money into something you don't understand. While you can take the professional help of a broker or an advisor, you should still know what you are doing. You can ask me all your doubts.

Raju: What is the need of stock markets? Can't we buy and sell shares from/to the company directly?
Nicky: When a company offers its shares to the Public for the first time, through the exchange, and you buy them, then you are buying directly from the company. This is known as an Initial Public Offering (IPO) and the market is categorized as the Primary Market.

Raju: Oh...so those who bought shares of Bharti Infratel recently, bought it from the company directly?

Nicky: Exactly. Similarly, you can also buy directly from the company during Follow On Public Offering (FPO). A company which is already listed on the exchange but needs more money, can raise more money by selling more shares through a FPO. You can sell your shares directly to the company, if the company comes with a buy back scheme or gets delisted from the exchange.

Raju: But after buying a stock, what if I need the money back? I cannot wait till the company decides to buy back or delist. Can I sell my shares back to the company?

Nicky: No, you cannot do that. You must know that a company is not liable to return the capital that it has raised by way of stock. But, you can sell it to someone else. And that's why we need the stock exchanges, to facilitate the buying and selling of stocks, to provide liquidity. The market where shares are traded, after getting listed, is known as the secondary market. You can sell your stocks easily in this market. All you need is a demat account.

Raju: A demat account?

Nicky: Yes. But I need to leave now. More on it the next time I come here to eat...

RBI keeps us guessing

This article was originally published in Postnoon on December 28, 2012. Co-author: Purvee Hetamsaria

http://postnoon.com/2012/12/28/rbi-keeps-us-guessing/98181

Prof. Nicky was strolling in the park when she heard a familiar voice calling out her name. She turned around to face a gasping Mr. Mukherjee. The face had a question mark.

Prof: Hello Mr. Mukherjee. What's troubling you?

Mukherjee (trying to regain his breath): You got me! I was wondering if the Reserve Bank of India (RBI) will lower the interest rates in their upcoming policy review. The general view is that there is a strong possibility of a 75 basis points cut next year. With 50 bps being cut during the last quarter of the current fiscal year.

Prof. Nicky: Well. I cannot predict what RBI is going to do. But yes, it might be welcome by many sections of the industries and the common man.

Mukherjee: That is what I am not able to understand. How does it help the common man? Why should he worry about the matters of monetary policy? I am personally indifferent to it.

Nicky: So you feel! But it's not true. Remember the time when you took a loan to buy that car of yours and you were complaining to me about the high interest rates?

Mukherjee: Yes. But what does that have to do with RBI and rate cuts?

Nicky: How do banks determine at what rate to lend? How are auto loan, home loan, personal loan, etc, their interest rates determined? It depends on the interest rates set by the RBI. The rate at which banks can borrow funds from the RBI is known as the Repo rate. When the repo rate goes down, banks get funds at a lower rate, which they can pass on to their customers in the form of cheaper loans.

Mukherjee: Hmmm...but since I have already taken the loan, it's not going to help me.

Nicky: Its not going to help you if your loan has a fixed interest rate. If the loan has a floating interest rate, that is, it changes with the changes in the Prime Lending Rate (PLR), then your Equated Monthly Instalments (EMIs) will come down.

Mukherjee: PLR?

Nicky: It's the rate at which banks lend to their most credit worthy customers. So for most of us, after taking our credit worthiness into account, the banks decide on an x percent to be added to the PLR, to determine the interest rate. For those who have floating rate loans, the banks generally quote the interest rate as PLR plus x percent. So when PLR comes down, EMI also comes down.

Mukherjee: Got it. But what about my deposits? Will the banks continue to pay me the same interest rates on them?

Nicky: For your existing Fixed Deposits, the answer is yes. For new fixed deposits, the banks may reduce the rates.

Mukherjee: Understood. Thank you.

KYC Norms eased

This article was originally published in Postnoon on December 21, 2012. Co-author: Purvee Hetamsaria

http://postnoon.com/2012/12/21/kyc-norms-eased/96450

“The KYC (Know Your Customer) Guidelines were formulated to protect the financial system against threat of money laundering/terror financing and frauds”, said Prof. Nicky, when she was asked about their purpose by one of the new first year student.

Prof. Nicky: But why do you ask?

Student: I have been trying to open a savings bank account in a bank which has a branch just outside my home. The executive wanted a host of documents which I provided to him. But he is asking for separate identification and address proofs. I gave him my passport which also has my address. But he says that he needs an electricity bill or a bank statement as an address proof. Now where do I get that from? There is no separate electricity bill for me. It's on my father's name. Also, I want a bank account because I don't have one.

Prof. Nicky: Oh! In that case you need not worry any more. Just a couple of days back, the Reserve Bank of India, the regulator for all banks in India, revised the guidelines for KYC. To ease the burden in complying with the KYC requirements for opening new accounts, RBI has now notified that if the address on the document submitted for identity proof is same as that declared in the account opening form, the document may be accepted as a valid proof of both identity and address.

Student: Ah...that solves at least part of my problems.

Prof. Nicky: You must keep in mind though, that this happens only if you give the same address in the form as mentioned in the proof that you have provided.

Student: Ok. That is what I have done. Though I have another problem.

Prof. Nicky: And that is?

Student: The executive has also asked me for an introduction from an existing customer. My parents have accounts in a different bank. I do not know of anyone who has an account with this bank. What am I to do?

Prof. Nicky: You are in luck lady! Seems like RBI has been taking note of your prayers! RBI has notified that the introduction is not necessary any more under the KYC guidelines. So the bank should not insist on introduction for opening an account. So call back the executive and ask him to update himself with the newest changes and then open your account.

Student: I must thank RBI for these changes. This problem was being faced by a few of my other friends too. I must go and inform them too about these developments. Thank you, as usual!

Deeper PF cut will help in long term

This article was originally published in Postnoon on December 14, 2012. Co-author: Purvee Hetamsaria

http://postnoon.com/2012/12/14/deeper-pf-cut-will-help-in-long-term/94547

There was urgency in Abhi's voice when he called to ask me if he could see me. I immediately agreed. He was in my office before I could get myself a cup of coffee from the Cafe. What is it Abhi?, I asked. "You look disturbed".

Abhi: Yes. I am disturbed. And who wouldn't be? My salary just went down because of the Government's action.

Nicky: Really? What did the Government do now?

Abhi: The Employees Provident Fund Organisation (EPFO) of India has come out with a notification which says that now we will have to contribute towards the provident fund on the basis of allowances as well. This will reduce my take home salary.

Nicky: Ah that! You should be happy. Don't think short term. Think long term. You are forced to save more.

Abhi: What do you mean?

Nicky: See, earlier, you and your employer, both contributed 12% each, on your Basic plus Dearness Allowance (DA) only, towards the EPF. Now, suppose your Basic plus DA is ₹4,000. The contribution will amount to ₹480 from you and ₹480 from your employer. There is no contribution on the allowances that you receive. If your allowances total up to ₹2,000, your take home salary will be ₹4,000 minus ₹480 plus ₹2,000. That is ₹5,520. And your total contribution to EPFO is ₹960.

Abhi: Yes, this is exactly what happens in my case right now.

Nicky: But with the new circular, contribution will need to be made on Basic plus DA plus Allowances. This means, your contribution will be on ₹6,000. Hence, the total contribution to the EPFO by your employer (₹720) and you (₹720) will be ₹1440. This way, you take home only ₹5,280 but you save ₹480 more and your total income goes up by ₹240, the extra contribution made by the employer! So you should be happy.

Abhi: Hmmm...you are right, but I am still not happy about the lower take home salary. You know that I recently got married and have bought a flat too, which comes with a fat EMI.

Nicky (laughing): True Abhi. But saving for your old age is important too. And many employees structure their salary to increase allowances and decrease PF contributions. This means that they are not saving enough. Also, because of higher contributions to the PF account, you will be able to claim a higher amount as section 80c deductions in income tax.

Abhi: But the limit for section 80c is ₹1 lakh right?

Nicky: Yes. So it will be beneficial to you only if you are not able to meet the ₹1 lakh through your life insurance and existing PF contributions.

Abhi: So overall, you are saying, the government may not have done such a bad thing! Well, I am not happy, but I do understand the government's point of view now. I'll have to think of rationing certain expenditures though!

For investors or govt?

This article was originally published in Postnoon on December 7, 2012

http://postnoon.com/2012/12/07/for-investors-or-govt/92810

"So Life Insurance Corporation (LIC) of India is launching a new Unit Linked Insurance Plan (ULIP)?" asked Srikanth.

"Yes. So the newspapers and news channels have reported", I replied.

Srikanth: I remember, ULIPs were really popular a couple of years back. Everyone was talking about it, investing in it. Then suddenly, they disappeared from the investments arena. Why? What happened?

Me: Well, as the regulations stood way back in 2010, the costs to the investors were huge in the case of ULIPs. The distributors and agents got large selling commissions, as high as 40% of the first year premium, and hence many of them pushed the product, mis-informed and mis-sold it to the investors.

Srikanth: Wow...isn't that wrong?

Me: It is. Hence the investors protested, once they realized that they had a product which was a sure way to lose money. Following the protests and a legal battle with the capital markets' regulator, SEBI, the Insurance Regulatory and Development Authority (IRDA), brought in new regulations regarding the costs and losses in the event an investor fails to pay subsequent premium installments. After this, ULIPs did not remain as lucrative for the agents as they were earlier. Hence they stopped pushing it to the investors. And the sheen faded.

Srikanth: Legal battle with SEBI?

Me: Yeah, SEBI claimed that ULIPs were Mutual Funds being sold as Insurance and hence they should have jurisdiction over ULIPs. Anyways, the result was a set of new regulations, which brought down the charges for the investors and increased the minimum lock-in period of ULIPS from three years to five years.

Earlier, most of the insurers charged higher during the initial years of the plan. But now, the charges have to be distributed evenly over all the years of the lock-in period. IRDA also mandated a minimum mortality cover and a minimum guaranteed return. The charges are capped between 2.25% to 4%.

Srikanth: That's good for the investors. But not for the insurers and the distributors.

Me: That's the reason the share of ULIPs has only gone downhill since 2010. LIC is now coming out with a ULIP product after almost two years. And even that may not be with the investors' in mind. As Vivek Kaul points out in his article on www.firstpost.com, it could just be a ploy to help the government raise money through divestment. Since the investor's may not be willing to pick up stocks in PSUs, LIC will bail out the government by picking up stake in those companies.

Srikanth: But why launch a ULIP product for it?

Me: That's because the premiums collected through traditional plans cannot be invested in the Equity markets completely. There is a cap of 15% on equity exposure for the traditional plans, according to the Insurance Act. However, in the case of ULIPs, the entire premium can be invested in equities.

Srikanth: Ah, so basically LIC may be hoodwinking the investors, in order to help the government.

Me: Hmmm...I did not think in that direction earlier. But after reading Vive Kaul's article, I feel that may be the real story! Ultimately, the investors must do their homework before making any investment decision!

Debit Cards, Credit Convenience

This article was originally published in Postnoon on November 30, 2012

http://postnoon.com/2012/11/30/debit-cards-credit-convenience/91262

Laxmiamma was a happy soul. Instead of keeping her savings under the mattress, she had opened up a bank account and had started a recurring deposit on my insistence. The obligation of putting aside the money for the deposit every month, made her save more. Also, she had no choice when tempted to buy unnecessary food or household articles as there was no money lying around at home to do so. Now she had accumulated enough money to buy back her jewellery from the jeweller, which she had sold way back in 2002, when her husband died and she needed some money to tide over the bad times.

She invited me home to celebrate the liberation of her jewellery, over a cup of Irani chai and biscuits. While chit chatting with her about the weather, she told me that she needs to go to the bank to withdraw some cash the next day. I was surprised. In this day and age, who goes to the bank to withdraw cash, unless the amount is very large?

On being asked, she said, "then how else does one withdraw cash?"

Nicky: Haven't you seen ATMs around?

Laxmiamma: I have heard about them, but I thought that those are not for people like us. I thought those are for the rich.

Nicky: Nonsense. It's for everyone who has an account with the bank.

Laxmiamma: How? And what is an ATM? I have seen the large box like things around, but don't know how that shells out cash!

Nicky: An ATM or an Automated Teller Machine is a machine which counts and gives out the amount of cash that you want, after ensuring that your bank account has the desired amount. Did you get a small card when you opened an account?

Laxmiamma: Yes I did. But I just kept it away safely.

Nicky: That is a Debit Card. The card carries a unique number, which is linked to your savings account. You can use this card to withdraw and deposit cash, transfer money to other accounts, pay your bills, look at your account balance and statement for the last few transactions, all through the ATM. You can even use this card at shops to pay. The money will be directly debited to your account, provided you have enough money in the account. So, you do not need to carry cash with you when you go shopping. But of course, you can't use it when you shop at smaller establishments like kirana shops or vegetable carts.

Laxmiamma: Ah see, its of no use to me then! I don't go to the malls like you.

Nicky: You miss the point. Apart from shopping, there are so many other uses of debit cards and ATM. You conveniently ignored that!

Laxmiamma (sheepishly): Uh...hmmm...I heard. I'll use this card to withdraw cash from now on. But what about safety? Can anyone with my card withdraw money from my account?

Nicky: No. There will be a 4 digit password given to you from the bank. You need to key in that password for authenticating the transaction. Also, you can change this password if you want. Don't share the password with anyone.

Laxmiamma: Ah...I forgot to tell you about this new recipe for karela burji...you might want to try it out!

Tax implications of buying versus renting

This article was originally published in Postnoon on November 23, 2012

http://postnoon.com/2012/11/23/tax-implications-of-buying-versus-renting/89643

Nicky: Oh hello Abhi! When did you come?

Abhi complained: I have been waiting for you since the past half an hour.

Nicky: You should have called before coming. I would have told you that I would be in a meeting. Anyways, tell me how is your new house? I am sorry, I could not come for the house warming ceremony.

Abhi: The house is good, comfortable. Actually I am here to discuss the tax implications of buying the house.

Nicky: What about it?

Abhi: Till last year, I was claiming Housing Rent Allowance (HRA) deduction under section 10(13A) of the income tax act. Am I still eligible to claim those?

Nicky: How can you? Since you are living in your own house, you are not paying any rent. So you cannot claim HRA as a deduction. It is treated as an income for you. But you can claim deductions for your Equated Monthly Installments (EMIs) on your home loan.
Abhi: How?

Nicky: The EMI is divided into the principal component and the interest component. The bank must have sent a statement to you with this break up. Or they will send it to you, if they haven't done it yet. The principal component of up to Rs1 Lakh can be claimed under section 80c and the interest component of up to Rs1.5 Lakhs can be claimed under section 24b of the income tax act.

Abhi: But isn't section 80c the same section where we claim our life insurance premium and provident fund (EPF) contributions?

Nicky: Yes, you are right. Hence the benefit of claiming the principal under section 80c is limited. In the initial years of the EMI payment, the principal component is very small. In the later years, when the principal component is larger, assuming that your salary goes up with time, the entire 80c limit may be reached with EPF contributions and insurance premiums alone.

The interest deductions do help in saving significant amounts of tax though. If you fall under the 30% tax bracket and pay more than Rs1.5 lakhs as interest, you end up saving Rs45,000 in taxes.

Abhi: So even if I am not able to claim the HRA, a home loan still helps me reduce my tax burden.

Nicky: Absolutely. Infact you did a very good job of buying a house in Hyderabad. A recent research done by www.arthayantra.com has shown that Hyderabad is one of the most affordable places to buy a house for a professional.

Abhi: Oh really? I am glad I made the right decision.

Will Social Media give birth to the next Warren Buffett?

This article was first Published in Hindu BusinessLine on 25th November, 2012. Co-author: Khemchand H. Sakaldeepi

http://www.thehindubusinessline.com/features/investment-world/market-watch/will-social-media-give-birth-to-the-next-warren-buffet/article4130565.ece

While taking a hard look at the evolution of human civilisation one cannot help but notice how the financial markets indicate our evolution more than anything else.

To quote Prof. Niall Ferguson of Harvard University, in his book “The Ascent of Money”, “financial history is the essential back-story behind all history”.

It is a well know fact that every bull - bear run is largely correlated with something major happening in the world.

The invention of electricity, use of small motors that power home and kitchen appliances, the advent of television and computers, etc. have all impacted how financial markets behave. These events have changed how the world is connected and does business, for good. Today the biggest driver in the way we connect and do business is social media.

Any student or practitioner of finance would have come across the term “Efficient Market Hypothesis (EMH)”. It essentially says that the stock market is “informationally efficient”, that is, the current prices reflect all the available information. Flow of information is one of the most important ingredients in making the markets efficient.

While EMH is one of the most profound theories in the history of finance, of late, it is also the most disproved.

The recent global financial crisis has further raised questions about the rationality of the EMH. Warren Buffet argues that the preponderance of value investors among the world’s best money managers rebuts the claim of EMH proponents.

Similarly, former Federal Reserve Chairman, Paul Volcker said that it’s “clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations [and] market efficiencies”.

In fact there are many investors who scout for opportunities (read: inefficiencies) with the changing business environment and capitalise on information advantage.

Traders at Wall Street are known to use Flash Trading - which allows certain market participants to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee.

Lately, some of the major financial institutions are latching onto the fact there might be something to the information that is available in social networks such as Facebook, Twitter, Blogging sites, etc.

For instance, a research done by Bollen et. al. (2011), published in the Journal of Computational Science, looked at around ten million Tweets posted between March and December of 2008 to see if the micro blogs could be used to predict the market.

The authors sorted the Tweets into different indices – calm, alert, sure, vital, kind and happy – and compared them to the market. The researchers found that the calmness index can predict with 87 per cent accuracy whether the Dow Jones Industrial Average goes up or down for a time horizon between two and six days.

Certain proprietary terminals have, over the past few years, kept various traders informed with live new feeds. They, however, have not come close to creating a way to instantaneously monitor the pulse of the world and observe the stream of human consciousness. The news regarding the death of Osama Bin Laden first entered the public sphere through a tweet and a tool called DataMinr was able to spot this with just 19 tweets on the subject.

The company then issued a signal to their clients, alerting them to this important piece of information. It would have been over 20 minutes before that story appeared on traditional news sites.

Access to a data stream that can beat traditional media sources by over 20 minutes requires no explanation as to its value for traders and investors. Speed matters.

It will just be an understatement to say that there will be an increasing relation between social media and finance. Traders and fund managers are relying on social signs and sentiment analysis to base their decisions on.

There is no doubt that technologies are improving and challenging the finance and banking industry. In the language of Analytics, the more data you have the better your decisions are and better is your competitive advantage. And social media can do just that.

So the point to note here is that in this era of Social Networks, it has become essential for any budding investor to be able to analyse the social data if she/he wants to “get the pulse of the market”.

Plan your retirement

This article was originally published in Postnoon on November 16, 2012

http://postnoon.com/2012/11/16/plan-your-retirement/88192

Why should we plan for our retirement?, asked an indignant Mr. Mukherjee. "Professor, you don't understand our Indian culture and values. My son will take care of me when my wife and I grow old. We are giving him the best possible education, so that when he starts earning, I can retire in peace. He is a good son. And, I too save some money every month. My wife runs the household very efficiently".

Prof. Nicky: I agree Mr. Mukherjee. I am not denying that your son is a good son and your wife is very efficient. All I am saying is that, why do you want to depend on your son in your old age? What if he gets a job in another city or another country? Are you willing to move with him? Do you want to leave all your friends and family behind, so that your son can take care of you?

Mukherjee: Not at all. I will not leave Hyderabad. I have lived here all my life. But my son will not take a job anywhere else. He will take up a job in Hyderabad only.

Prof. Nicky: How can you be so sure? He may get transferred, he may get a better opportunity somewhere else. Would you want him to sacrifice all the opportunities for you?

Mukherjee: No I would not like that. But even if he lives somewhere else, he can still send money for us.

Prof. Nicky: Yes he can. But what if he finds it difficult? He will have his own family to fend for. Everything is so expensive now a days. Maintaining two different households may be difficult for him. Since you are already saving some money every month, all that I am asking you to do is invest it in a way which will help you lead a better life during your retirement.

Mukherjee: But even the money that I am putting aside every month, in a recurring deposit, will be available to me when I retire. What is the difference between saving and retirement planning?

Prof. Nicky: Finally you have asked a relevant question. Saving is good. It gives you returns close to the prevailing interest rates, whether you put your money in fixed deposits or recurring deposit. You save what you have left after all your monthly expenses.

On the other hand, retirement planning determines how much you must invest every month, so that you don't have to change your lifestyle much after your retire. The planning includes planning your investments in different asset classes like mutual funds, insurance, equities, real estate etc., so that you achieve your financial goals.

Mukherjee: But who will do it for me? Will you do it?

Prof. Nicky: No, I will not do it. There are certified financial planners, who will do the planning for you for a fee. You only need to ensure that you find a good financial planner who is qualified and experienced.

Mukherjee: There seems to be merit in what you are saying. Let me think about it!

Nicky: Whatever...

Gold on my mind

This article was originally published in Postnoon on November 9, 2012

http://postnoon.com/2012/11/09/gold-on-my-mind/86843

Diwali is round the corner and the retailers are trying everything from discounts to promotions to free gifts, to lure the customers into buying. Gold has a special place in the hearts of the Indian customers. Buying gold on 'Dhanteras' is considered auspicious and is a part of our culture. But, apart from heart, the mind also has a role to play in buying gold. Historically, gold is seen as a hedge against inflation and less risky than the other asset classes.

In recent times, gold is also being seen as The Performer! In the past 10 years, gold has given a return of approximately 18% per annum, and close to 25% per annum over the last five year period, on a compounded basis. That is much higher than the returns on the other popular classes of investments, be it equities, debt or mutual funds. So buying gold not just gratifies the heart, but also the mind.

To tap on this opportunity, Gold Exchange Traded Funds (ETFs) was introduced on the Indian stock exchanges in 2007. Since then, it has become a very popular product with the current Assets Under Management (AUM) in Gold ETFs being more than Rs10,000 crores.

Buying gold for investment purposes, in its physical forms, comes with associated costs like making charges (jewellery), storage and insurance costs (jewellery, coins, bars) or risks of theft. These are reduced to zero in the case of gold ETFs, while giving returns that are very close to the returns of the physical asset, as each unit of the ETF is equivalent to 1 gram of 99.5% pure Gold. There are transaction costs but they are very small.

The attractiveness of the fund is also due to the fact that they are tax efficient. They are not subject to sales tax, value added tax, securities transactions tax or the wealth tax, which the physical gold is subject to. The ETFs can also be exchanged for 99.5% pure Gold when needed, in multiples of 1 kg. The prices at which the transactions take place are transparent and real time, just like stocks on the stock exchange.

Both NSE and BSE have announced that they will hold special trading sessions for gold ETFs alone on Sunday, Dhanteras, November 11th, from 11.00am to 3.30pm. BSE has also announced to waive off any transaction costs as well on that day. So this Diwali, make a new beginning, by investing in Gold ETFs. Even if it is only for 1gm of Gold. It's just a better way of investing in gold.

Here's wishing all the readers a very happy and prosperous Diwali!

Disclaimer: The author is not associated with any fund house or the exchanges offering Gold ETFs. The author has not yet invested in Gold through ETFs but plans to do it this Diwali.

Sebi to the Rescue

This article was originally published in Postnoon on November 2, 2012


http://postnoon.com/2012/11/02/sebi-to-the-rescue/85039

Srikanth was clearly in a bad mood, when I met him outside my office. He was pacing up and down the corridor with a scowl and fists clenched. On seeing me, he smiled faintly. I led him into my office and asked, "what happened? Did you lose a lot of money in the stock market?", for Srikanth was an active investor!

Srikanth: Yes I did. But I would not feel so bad if I had made a wrong call and invested in the wrong stock. I am feeling bad and I am upset because I lost money due to my broker's mistake.

Nicky: Really? How? What happened?

Srikanth: I had placed a sell order for my holdings in a company, through my broker. But the shares were not sold on the same day. In fact they were sold two days later. In those two days, the stock price went down by about 6% and I ended up losing close to Rs20,000/-.

Nicky: Did you ask the broker for a clarification?

Srikanth (annoyed at the question): Of course I did. They said that there were some technical issues.

Nicky: Do you have a record or any documentation relating to when you placed the order?

Srikanth: You are not really helping me by asking these obvious questions. But, to answer you, of course I do. The records will be available in the 'order history' of my account.

Nicky: I am asking you these questions because I have a solution for you. Why don't you complain to the Securities Exchange Board of India (SEBI)? SEBI has a cell dedicated for Investor Assistance and Education (OIAE), which also handles investor grievances. But before you go to them, you must file a complaint with the stock exchange against the broker. If the exchange's response is not satisfactory to you, then you can go to SEBI.

Srikanth: Why should I unnecessarily get into litigation? My money is not going to come back.

Nicky: Well, it might! The stock exchange might pay you from their investor protection fund, or they might instruct the broker to pay you the amount of loss incurred by you. In case the exchange is not able to settle the case and you lodge a complaint with SEBI, then SEBI might get the exchange or the broker to pay to you.

Srikanth (finally getting what I was talking about): But how do I lodge my complain?

Nicky: Now you are asking obvious questions...Complain by writing to them through post, mail, hand deliver your written complaint or talk to them on their toll free number. All these details are available on the SEBI website.

Srikanth: Thank you professor. Yet again, your inputs were very helpful.

Will FDI in retail be good for consumers?

This article was first published in Moneylife Magazine and www.moneylife.com on October 25th, 2012

http://www.moneylife.in/article/will-fdi-in-retail-be-good-for-consumers/29272.html

Wal-mart or Tesco may fail in India but consumers must get a choice

At 6am on a Tuesday, the wholesale market for vegetables—Bowenpally Monda (Hyderabad)—is already humming with activity. When talking to a commission agent about their cornering a share of the farmers’ profits, the agent asks, “While statistics are available and the media quotes the number of farmers who have committed suicide or number of farmers who have become impoverished or their condition has worsened, does any government institution or any institution have statistics on how many intermediaries have gone bankrupt? How many people have entered the trading business and lost money and, hence, quit? How much bad debt is there in intermediation? If this statistic is compiled, one would realise that intermediation is not an easy job.” In this, and possibly other markets, the intermediaries or commission agents perform a very important function—that of taking financial risk.

Others from his trade join in to ask: “Why should a farmer worry about what the others are getting? If a farmer gets Rs2 and he has invested only Re1, it’s good business. He makes 100%-200% return on his investment. Any project should be measured on the basis of return on capital. Intermediaries do not make money on each transaction. They make money once in a while. That’s part of the game. Sometimes, they make a killing; on other days, they barely break even or make losses. Volumes bring them money. Their average margins are wafer-thin.

Across the country, debate is raging over foreign direct investment (FDI) in retail and the entry of larger players like Wal-Mart and Tesco. The traders do not seem to be concerned about this. One of the agents asks me, “How is a Reliance or an ITC less smart than Wal-Mart?”

Reliance has the deepest pockets in the country and did hire the best talent in the world for its retail operations. But Reliance Retail has been a fiasco. While one can argue that Reliance has always operated in the industrial arena and does not have a mindset for retail, what about ITC? ITC is a thoroughly farm-consumer market company with deep pockets and deep understanding of the entire value chain. They have worked with farmers at the grassroots level for over 100 years in India. Yet, their fresh retailing business has not been successful.

What is the problem? And can Wal-Mart and others handle it? The CEO of a company, who does not want to be named, which is into large-scale commercial farming, says, “Either the market is more efficient than is believed or the market has not evolved to a point where models of large retail chains can be absorbed in the system.”

It is often said that in India 30%-40% of the fresh produce gets wasted. I once heard Damodar Mall, director of strategy-food at the Future group, which pioneered organised retail business in India, say that in a country like India where people make serious living out of rag-picking, nothing is thrown away. Nothing is wasted. “Yes, the value of the produce can be better preserved. But the cost of retaining that value through refrigeration or pre-cooling, etc, versus the value saved is not financially viable.”

The natural chain is far more efficient. Apples are a classic example where cold chain can be applied. They are produced only in one part of the country and consumed across the country. Concentrated production and distributed consumption. Companies like Adani and Concor, have invested heavily in the cold chain. Yet, cold chain has not become entirely successful.

The marketing and distribution channels have designed themselves in such a way that it is very close to ‘Just-in-Time’. In the US, food habits are more or less uniform throughout the country. In India, every 300km, eating habits are completely different, determined by production in the local catchment which, in turn, depends on the soil, agro-climatic conditions, etc. So the production and consumption is more localised. While there are products like paddy and wheat which are produced in one part of the country and consumed across the country, fruits and vegetables, especially vegetables, are localised. Except for onions and potatoes, few products move further than 300-400km in the country.

When asked about the impact of FDI on the mom-and-pop kirana stores, the CEO, who prefers to be called a farmer, says “Mom-and-pop stores will flourish. They will not go anywhere. In fact, in places where the retail chains set up shop, the mom-and-pop stores will become even more efficient. The Indian trader is very smart. There are several instances where when organised retailers like Reliance run a promotion on tomatoes, for, say, Rs5 per kg, the corner shop vendor comes and buys 10kg and stocks it in his shop. These promotions result in losses for organised retailers and gains for the small shops.”

The guidelines for FDI in retail impose limitations too. Outlets can be opened only in cities with a population of one million and above; 50% of the investment should be for backward linkages. These are tough conditions to meet.

Also, the regulatory and procedural hurdles are not going to be easy for foreign investors to manoeuvre around. Even a simple food-processing unit needs anywhere between 15-20 licences/permissions from agencies/authorities such as electricity, pollution control, labour, fire safety, panchayat, taluka, weights and measures, etc. They are needed and should be there. But the way they are monitored and the way the system operates, it is very difficult to start and operate a project.

The retail pie is obviously very big and everyone can benefit from it. But it’s only fair to give the consumers a choice. If a Wal-Mart or a Tesco is more efficient and offers cheaper products, then why should the customer suffer? Whether they will be able to do so is a big question; but it is worth giving them a chance for the sake of the consumer.