Monday, March 22, 2010

Highest NAV Guarantee: What's the Catch?

Found the following article in DNA interesting.:
Highest NAV guaranteed!  We have been bombarded with these advertisements recently. Almost all the top insurance companies such as LIC, ICICI Pru Life, Bajaj Allianz, SBI, Tata AIG, Reliance and Birla Sunlife are offering such products.

It probably sounds like magic and to a limited extent, it actually is. To provide this kind of a guarantee, use a dynamic trading strategy known as constant proportion portfolio insurance. The model is fairly intricate and is probably understood by a limited number of statistically-oriented people who earn a living by pricing options, interest rates and risks (I cannot claim to be among them).

However, the broad contours of this strategy can be understood. Let me explain what I have understood. (Caution: Please seek professional advice before making an investment. This is a general purpose article and not meant to replace professional advise.)

The strategy would start with a base allocation of the funds between risky assets (read equity and related products) and relatively safer assets (debt market and derivative products) depending on their assumption of returns expected from a risk-less instrument as well as the amount of market price drop/ interest rate changes that they seek cover from and a host of other similar assumptions.

Depending on how the actual market prices/ interest rates perform, the portfolio is rebalanced periodically to maintain a guaranteed capital.

So, the players may havedifferent initial portfolios depending on their initial assumptions and the extent of risk of change in prices/ rates that they are willing to underwrite. I, for one, would not hazard a guess on what gross returns these funds would generate.
So should one invest in such products? Here are some things to consider:

l Like any other Ulips, the amount invested in the fund is lower than the premium paid by you due to various charges like policy allocation charges, policy admin charges, etc. These are generally stiffer in the case of such Ulips as compared to regular Ulips from the same insurance companies for similar amount of premium paid. There are also guarantee charges that the insurance companies charge over and above the other charges.

l Highest NAV guarantee does not mean return is guaranteed. It is only a capital guarantee at a point of time. Let me explain with a simple example. Say you have invested Rs 1 lakh per year for three years in such a fund:

You now have 28,079 units at an average price of Rs 10.68 on which it is guaranteed that at the end of the policy term (say 10 years) you will get Rs 3,21,505 (i.e. 28,079 units X 11.45). All this ensures is that as long as you hold these to maturity and continue paying any other premiums/ charges, you will get at least Rs 3,21,505 at maturity. Your return, of course, will vary depending on when this amount is due, even higher NAVs reached during the further guarantee period (which is normally higher than the premium paying term which is assumed to be 3 years in this example) and when such highest NAV was reached.
This is just an example to show how this is a capital-guarantee product rather than a return-guarantee product.

l The strategy is designed to guarantee capital and not guarantee returns and hence, protection is inherent in the model itself. This precludes the chances of this return being comparable to a long-term investment in equity.

l There are a host of surrounding terms and conditions, which may make this product less attractive.
For example, in one product, the guarantee is available for the investment made in the first 3 years but premiums need to be paid for 10 years with the last 7 years premium effectively being a regular ulip. In another such product, the guaranteed NAV is not available in case of a drastic fall in NAV (defined in the product and unlikely to be ever reached, but nonetheless, it detracts from the overall product positioning and its very unlikely the customers would be aware of such a provision).

To get back to the original question, should you invest in such a product?
Firstly, large investors can probably save on costs by having a portfolio manager run this scheme for them (without the guarantee of course) and the charges will be much lower.

Smaller investors need to have realistic expectations about returns (more likely to be nearer to a fixed income investment rather than an equity investment) and are committed to pay all due premiums till maturity and hold on till maturity. For smaller investors, it may be advisable to stick to ELSS mutual funds or tax-based small savings plans such as PPF or NSC.

Posted via email from Ranjan's posterous

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