The Hindu Business Line : Read ULIPs well before investing

A mutual fund offers better advantages in terms of costs, variety in investment style, and exit options. ULIPs, on the other hand, give you the flexibility to shift between various funds within the house, and without a load. Consider ULIPs only with a 10-year horizon and ensure that your insurance needs are adequately taken care of.

Unit-Linked Insurance Plans have received overwhelming response from investors, thanks to the bullish market and the convenience of addressing insurance and investment needs at one go. After the recent guidelines issued by the Insurance Regulatory and Development Authority, ULIPs will appeal only to the long-term investor who is also looking for insurance cover. However, steep expense ratios remain a cause for concern.

From a performance perspective, only a couple of ULIP equity funds, such as HDFC and SBI Life, have outperformed the benchmark indices. Quite a few of the others have under-performed.

However, the major ULIP equity-oriented funds have outperformed the top equity mutual funds over a one-year period. Debt ULIPs are a no-no as the high expense ratios erode the returns generated.

Business Line has maintained that an investor's needs are best served if he takes care of his insurance and investment needs separately, and this view remains unchanged.

After the recent guidelines there is a clear distinction between ULIPs and mutual funds. A mutual fund offers more advantages in terms of costs, variety in investment style, and the flexibility to exit the fund and shift to another in case of consistent underperformance.

ULIPs, on the other hand, give you the flexibility to shift among the various funds within the house, without a load.

Do consider ULIPs only if you are looking at a minimum 10-year investment horizon and ensure that your insurance needs are adequately taken care of.

Performance record

Most equity-oriented ULIPs have under-performed the Sensex and the Nifty. Only the equity funds of HDFC Life and SBI Life have outperformed the benchmark indices, the latter by a considerable margin.

Most of the aggressive ULIP equity funds invest wholly in equities. But, on average, these funds allocate 80-90 per cent in equities. We calculated returns for a one-year period for easy comparison among ULIPs as very few funds have been in existence for a longer period.

Interestingly, SBI Life outperformed the top performing mutual fund too by a good margin over a one-year period. HDFC Life's performance was almost on a par with the top equity mutual fund.

On the flip side, SBI Life's expense structure is high. From an expense as well as performance perspective, HDFC Life scores over the others.

Most ULIPs have contained losses to 5-6 per cent in the last four months, the only comparable bear phase in the market. Nifty is at a 3.9 per cent loss for the same period. HDFC, which has a mid-cap exposure, suffered a 9 per cent loss.

Large-cap focus

Most ULIPs have a large-cap focus and stick to the top stocks within sectors. HDFC, however, has a slight mid-cap tilt. Shanthi Gears and Blue Star are some of its offbeat mid-cap picks. SBI Life is stocked up heavily on IT and capital goods. These two sectors comprise over 30 per cent of its portfolio. Being overweight on technology also explains its substantial outperformance.

Both HDFC Life and SBI Life have a concentrated portfolio compared to others that were more diversified in terms of sectors as well as stocks.

We compared the portfolios of diversified equity mutual funds with ULIPs from the same group to see if investment styles are mimicked. Diversified equity funds had more exposure to mid-cap stocks compared to ULIP equity portfolios. This suggests that life insurance companies follow a more cautious approach to investing by sticking to top stocks.

ULIP debt funds

If you have chosen to invest in a ULIP, stay clear of debt funds. The only funds that may be considered are aggressive or equity-oriented funds as only such funds may turn in expense-beating returns over the long run. However, a pure equity-oriented portfolio with constraints on exit options is risky. Therefore, ULIPs should not form a substantial part of your portfolio.

The charges for a debt fund are much higher than those for a mutual fund. The expense ratio for a debt fund is 0.5-1 per cent. Whereas in a ULIP, most funds have a fund management charge of 1 per cent, apart from administrative and premium allocation charges.

On average, these charges can add up to 3-4 per cent of the premium. With debt funds fetching just 5-6 per cent, the real returns (inflation-adjusted) may actually be negative. Performance wise, ULIP debt funds may not be practically able to churn out superior performance to mutual funds to justify the steep expense ratio. From a taxation perspective, ULIP debt funds may appear to be a superior option to mutual funds.

However, if you opt for the dividend option, mutual funds are on a par, even from a taxation perspective, as dividends are tax-free in the hands of the investor. Maturity proceeds of ULIP debt funds are exempt from tax. You will have to pay a 10 per cent tax on debt funds if you hold for more than a year, and at the applicable tax slab if held for less than a year.

Charges, a concern

Hefty charges still remain a big deterrent to ULIPs. Even after HDFC Life reduced its expenses substantially, others failed to follow. HDFC Life has the lowest expense ratio in the industry, at 4 per cent. Considered here are only the regular yearly charges, such as premium allocation charge, fund management charge and administration charges; the initial premium allocation charges have been ignored to aid easy comparison. All expense ratios mentioned above assume an annual premium of Rs 10,000, with the ratios declining as the premium rises. This is still higher than the maximum expenses allowed for a mutual fund, at 2.25 per cent. This challenges the argument that charges even out from a long-term perspective.

Even from a 10-year horizon, ULIPs will continue to be an expensive alternative to mutual funds for your investment portfolio.

Lock-in, a deterrent

The recent IRDA guidelines stress the long-term nature of the product and have increased the life cover component for a ULIP. This does give ULIPs an identity of their own. However, from an investor's perspective, the lock-in restricts his freedom to choose between various fund management styles. The high initial premium allocation expenses start evening out only if you stay invested for over 10 years. Thus you are forced to stay with the fund even if it under-performs and even with superior alternatives in the market.

An open-ended mutual fund offers an investor the flexibility to move out if there is a better alternative. Given the low entry and exit loads, shifting from one fund to another is not as expensive. The total expenses, including entry and exit load, for a mutual fund do not exceed 5 per cent, whereas they are over 6 per cent for most ULIPs.

Taxation

From a taxation perspective, ELSS plans of mutual funds are an alternative as they also have a minimum three-year lock-in and enjoy benefits under Section 80-C. With the choices for eligible investment options for tax breaks expanding to include even long-term fixed deposits, considering ULIPs for tax savings does not appear prudent. The maturity proceeds of equity mutual funds also enjoy tax exemption in the hands of an investor if held for more than a year.

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