The Hindu Business Line : FMPs are no substitute for equities!

It is ironical that investors who were perfectly willing to pump money into new-fangled equity funds when the Sensex hovered at 21000 are now developing cold feet with the Sensex at 14000! Fresh money flowing into equity funds has slowed to a trickle in recent months. Money is instead flooding into products such as fixed maturity plans (FMPs) and capital guaranteed structures that promise to protect your capital, while actually limiting the upside from stocks.

Data from AMFI shows that a total of 51 new FMPs mopped up Rs 12,400 crore in July, while the single equity fund launched scrounged a measly Rs 15 crore. As many as 20 such mutual funds are open for fresh subscription even as this column is being written.

A debt substitute

FMPs are no doubt an attractive option today for the debt portion of an investor’s portfolio. With attractive indicative yields of 10.5-11 per cent and high tax efficiency, they are a superior alternative to fixed deposits or small savings schemes. FMPs also offer an attractive window of opportunity for those looking to take advantage of prevailing high interest ratesBut they are no substitute for equities in your long-term portfolio, no matter how bleak the near term scenario for stocks may look.

If you are looking to save towards a financial goal that is say 10 years away; a good portion of that money surely belongs in stocks or equity funds. By taking on a higher allocation to FMPs now, you’ll be assuming a “reinvestment” risk. When the FMP winds up, debt options may offer less attractive returns and stocks may not be as cheap as they are now.

Not risk-free

If FMPs offer a straightforward solution to today’s market uncertainties, structured products that offer capital guarantees seem to do just the opposite. The structures that are now available to fund investors do not promise any return.

Instead they offer a portfolio that is structured to protect your capital and delivers a limited “participation” in the equity markets. The net result is a fund that doesn’t let you lose capital, but which may significantly under-perform a plain equity fund, should the stock markets rally over the next 3 or 5 years.

The prospect of capital guarantee may look alluring to an investor who has just lost a packet to the market meltdown, but a few factors need consideration, before taking the plunge. First, nobody makes an investment, especially a three- or five-year one, just to protect his capital. The key objective is earning a return. But the return ‘kicker’ for the capital guaranteed product still comes from the stock market (via debentures linked to the Nifty or Sensex).

For this product to deliver a decent return, the stock markets do have to perform. In this aspect, investing in a capital guaranteed product does require you to take a positive view on the stock markets.

Therefore, perish the notion that you are avoiding risk by investing in capital guaranteed products. What you are effectively doing is removing risk to your initial capital. Your returns (and wealth!) are still at the mercy of market forces.

What of timing?

Two, note that these are closed end funds with fixed entry and exit points for investors, and your investment returns are pegged to point-to-point gains in the index.

In the stock market, the timing of entry and exit have a big bearing on what the investment eventually delivers; yet you have little control over this in a closed end fund. In fact, SIP-based investments in a plain vanilla open end equity fund may help manage timing much better than in a closed end fund.

Three, if you assume that the stellar returns offered by the broad markets over the past four years are a thing of the past and that returns will moderate from here on, your equity investments should, from now on ideally better broad market returns. Products that limit the upside of equities and take a passive call on the markets by investing in the index may then deliver modest returns.

All this suggests that structured products should again not be viewed as a substitute for equity in a portfolio, especially by investors who can handle risk.

Finally, the clamour for passively managed and closed end funds is regressive for the MF industry as a whole, over the long run. Passive funds allow little leeway for the fund manager or fund house to add value (and earn their fee) by outdoing the market or their peers.

The growing tribe of closed end funds, with lock-in periods and less stringent disclosure norms (you may not even know what debt securities an FMP is holding!), also means that transparency and liquidity- two of the key USPs that mutual funds offer over other investment options, take a beating. But that is another story!