Investment Triangle - Knowledge

Knowledge, Discipline & Time are the 3 vertices of an investment triangle. In this issue, we are going to examine the first area - Knowledge.

Knowledge is foremost

As investors, we need to be aware of the various financial products available in the market. Without first hand knowledge of various products, it is easy to fall prey to quick sales tricks and part our money to unsuitable products. Let us take the case of Anand, a manager in a private sector firm. In 2017, when he received his bonus, his relationship manager called him and recommended him to invest in Arbitrage funds (AF).

The primary reason cited to him being good returns and no long term tax since arbitrage fund is treated at par with equity funds. It was further explained to him that a portion of the arbitrage funds would be invested in derivatives to cover any fall in stocks held by the fund. Anand was convinced and invested his entire bonus in one such arbitrage fund. However, Anand is very disappointed that his 6.7% returns from the fund has been lower than liquid funds (7.2%).

Seek knowledge..

When treading in unknown waters, it is better to familiarize with the new product by reading or seeking expert opinion. Had Anand sought help from experts or advisors on arbitrage funds, he would have come to understand that Arbitrage Funds (AF) is a type of mutual fund that uses the price differential in the cash and derivatives market to generate returns. The returns are dependent on the volatility of the asset. AFs buys stocks in the equity market and simultaneously sells it in the derivatives market. The price differential between equity market & derivatives market is used to generate returns for the fund.

Many funds in this category were launched in 2014 when the bull market in sensex had just began, which is a ripe platform for AFs to perform. It was also in the same year that the holding period for FMPs (Fixed Maturity Plans) to qualify as long term was revised from 12 to 36 months. This led investors to search for tax free avenues with a maximum of 12 month holding period, resulting in a shift from debt to equity oriented Arbitrage funds.

Is a product suited to retail investors?

AFs seems to be designed for businesses to park their idle cash and enjoy tax-free returns in a short time (1 year). It is also suitable to stock traders familiar with derivatives. Inflows into AFs have particularly spiked post-demonetization. And its story sold well with a retail investor who is obsessed with tax savings.

Gaining knowledge on Afs reveals that there are three main issues with AFs.

1. From a risk profile perspective, under the premise of tax savings, this fund shifts an investor from low risk to high risk (debt to equity).
2. From a product perspective, if an investor is ready to take on equities, better alternatives are available in large-cap & multi-cap equity funds.
3. From arbitrage perspective, when more money chases fewer arbitrage opportunities, returns will be zero.

Also, the risk of the tax benefit of AFs being taken away became real in 2018 budget. Overall, AFs are not a good fit for retail investors who have custom-built their portfolio to align with their financial goals. A well-planned portfolio worth Rs.30 Lacs or even higher would be very tax efficient with proper asset allocation, eliminating the need for a retail investor to chase unsuitable tax saving funds such as Arbitrage funds.

How knowledge helps an investor?

Knowledge helps dispel myth & fear and helps in understanding a product. Without this understanding, if you chase returns, you will end up with a portfolio full of irrelevant products which may not grow adequately to fund your financial goals. Once you acquire knowledge, you may or may not become comfortable with a product – but you would be in a much better position to make an informed decision, which is key to an investor.

In the next article, we are going to look at the second & third vertices of the investment triangle – Discipline & Time!