Investment Management Strategies – Part 1

Some time back, Nick (id Nickp2) had left a question in the comments section of a previous article Index fund Investments . What he suggested was as follows:
If I have say a sum of 10 lakhs which I know I would not need immediately.
If I put it in a fixed deposit account in the name of my parents so that the tax effect is minimum.
Now if I ask for a monthly interest option and then invest the interest amount as a SIP in any of the index funds will it be a good strategy of getting good returns while minimizing the risk?

This seems to be a good strategy, though there are some shortfalls associated with this investment strategy.

Let’s analyze this strategy:
He is willing to invest 1 million Rs. (10 Lakhs). He is willing to take the MONTHLY INTEREST option scheme, where the interest calculated for a month is given immediately on the month end. He then takes the interest and invests it in equity market, in any ETF, and keeps his 10 Lakhs as it is.

Basically, this kind of strategy falls under the category of what is called “Principal Protection Scheme”. What nick is trying to achieve is to protect his principal income (10 Lakh) and play around or take risk with the interest that he is going to earn.

Let’s take some realistic figures to understand this: Suppose the interest rate offered by the bank for a period of 30 days is 5% (latest rates available from banks). For people who do not know, the banks offer different interest rates for different tenure of FDs. For an example, here is the interest rate chart from one of the banks:

PERIOD	INTEREST RATES ON DOMESTIC DEPOSITS %
DEPOSITS	Interest Rate on Deposits Below Rs 15 lakhs
7 days to 14 days	0
15 days to 45 days	5
46 days to 60 days	5.5
61 days to less than 3 months	5.5
3 months to less than 4 months	6
4 months to less than 6 months	6.15
6 months to less than 9 months	7.25
9 months to less than 1 year	8
1 year to less than 2 years	9.5
2 year to less than 3 years	9
3 Years to less than 5 years	8
5 Years upto 10 years	8

Suppose Nick invests 10 Lakhs. At the end of the month, he will receive an approximate interest of 10 Lakh * 5% * (1 year/12 months) = 4100 Rs. approximately. He will then invest this 4100 Rs. to buy Exchange Traded Funds or ETF, and this will go on each month continuously.

Say we analyze the portfolio after 1 year: At the end of the year, what Nick will have is his 10 Lakh Rs, intact in the bank, while he would have invested a total accumulated value of 4100 * 12 = 49,200 Rs. in the ETF, like a Systematic investment Plan (SIP). If the ETF investment grows by 10%, he would make approximately 4920 on his ETF investment, so at the end of the year, he will have 49200 + 4920 = 54120. On the principal of 10 Lakhs, his return is approximately 5.4%. This effective return is way less than the 8% return which he could have received if he had invested the entire 10 Lakh amount for a 1 year fixed deposit, because bank if offering 8% return on 1 year long fix deposit (see table above). Results could have been better if ETF returns are higher than 10%, say 20% or 25%. But then, nothing is guaranteed in the Equity world. If returns can be good and positive, they can as well be negative, in which case the investor would suffer a loss. This is the primary reason why almost all the financial personnel take the return which is above the “Risk Free Rate of Return”. This term - Risk free Rate – is nothing but the interest you get when you deposit the money in the bank for a period of time. Its called risk free because money put in the bank is considered to earn an interest rate without any risk.

Hence, for a yearly return of 5.4% achieved by Nick following this strategy, his effective return (above risk free rate for 1 year) is 5.4% - 8% = -2.6%. In this case, his effective return is negative – which is no way good. Taking the Effective Rate of Return (after subtracting Banks’ risk free rate) gives a value. If this value is positive, then it is wise to go ahead with the investment. If this value if negative (as illustrated above), then its better to put your money in the bank for that period.

However, if Nick decides to carry on this strategy of investment for a very long time, say 10 or 20 years. It is possible that interest rate offered by the banks may come down and equity returns may increase substantially. This may result in a very good profit from the ETF investment – like the NiftyBees ETF has returned a simple average of 70% each year over the past 5 years. (Please read previous post: ETF- Example)The tradeoff that comes is that since the bank interest rates are lower, you will learn less interest – which will mean investing less in equities – which will mean lower value of money in terms of ETF returns. Though there can be periods where both the interest rates offered by banks are higher, and the equity returns are also higher (like what is going on currently). However, there can be no certainty on how long will this situation continue. Ultimately, the market situation changes, both for banks as well as equity markets, and no one can be sure about what’s going to happen and how exactly the returns will come. The best possible way is to protect your principle and then play around with the extra money. First of all, let’s learn to calculate if we can earn better returns just by putting the money in the bank as compared to what we earn from the strategies that we come up with. There is nothing wrong in coming up with a scheme or a model or a system and try to follow it. The part that we ignore is how to evaluate it and how to back test it, whether it works effectively or not.

Across the globe, researches working for investment companies keep on coming up with models and strategies. Before putting it into practice, they back test it and make sure that they understand what they are doing. The first step we individuals should take is to learn this testing and evaluating part.

Another problem with this strategy is that you need big amount of money to put in FD. So that you can earn a substantial interest money. Then you should invest it in such a way that taxes are zero – like investing in the name of retired parents.

However, this strategy is not at all bad. It is one of the very good schemes for principle protection and can be followed religiously. Once I read in the films section of a newspaper (may be a gossip), that “Actor Akshay Kumar has put in 5 Crores Rs. in his bank. The interest earned is sufficient for him and his family to meet the monthly expense.” I would say he has done a wise thing for someone who may not want to get into the hassles of understanding the complexities of the financial world and is looking for a sure shot protection of his money and wants to take care of his living expenses.

This strategy results can be improved substantially once we start looking at the options and futures as an instrument for investment. For that, I’ll have to write the introductory part of options and futures – which will come following this article.


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You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.