Investors, beware of such practices!

Malpractice and mis-representation are an inseparable part of the investment world. And over the years, it has become more pronounced in the Indian context. Given the cutthroat competition in this space, financial institutions are under a lot of pressure to develop innovative ways to sell their products.

By itself there is nothing wrong in innovating, as long as it does not mislead investors. But when it does, then there is cause for concern.

Many a time, investors get carried away by the high returns offered by a particular offering. Out of sheer ignorance most investors do not bother to question the authenticity or the transparency of the examples/illustrations that have been used to project the high returns.

So if these examples/illustrations are inaccurate/misleading, investors never learn about them. Unfortunately, the brand name associated with the offering lulls the investor into believing that the example/illustration is probably true.

This is exactly what happened with two offerings launched recently. Since these investments were required by regulations to declare the expected returns upfront at the time of launch; the returns were projected in a way to make them appear more attractive than necessary.

While these are two popular offerings that caught our attention, there could be many others that have gone unnoticed.

1. NABARD Bonds

The promotional campaign of the last BNB (Bhavishya Nirman Bonds) issue was a clever marketing strategy to attract investors. First, NABARD chose to advertise the post-tax return of 12.82%, which was the simple annualised return.

Investors must note that this is not the conventional way to calculate returns; the conventional way is to state the compounded annualised growth rate (CAGR), which for BNB was not very impressive. Moreover, the CAGR of 9.26% projected by NABARD and presented to investors, was actually the pre-tax return i.e. that was before accounting for capital gains tax.

In our view, to provide a more representative picture of the expected returns, NABARD should have projected post-tax CAGR returns.

As per our calculation, the post-tax return turned out to be 8.51% CAGR (NABARD on the other hand was happy to state the pre-tax CAGR of 9.26%). The significant difference in the returns explains why NABARD chose to advertise the pre-tax return.

2. Fixed Maturity Plans (FMPs)

The financial year-end (February-March) is the time when many fund houses launch their FMPs. A lot of these FMPs have investment horizons of more than 365 days to enable investors to benefit from double indexation.

It is an established industry practice for FMPs to state the indicative return at the time of launch so that investors can quantify the return on maturity.

FMP returns are treated as capital gains (short-term or long-term depending on the investment tenure). For computing long-term capital gains (under double indexation), cost inflation index needs to be factored in.

Since most of the FMPs launched in February-March 2008 will mature in the financial year 2010; the cost inflation index of both the years 2010 and 2009 are not available as yet (they will only be declared in the future). This has led the asset management companies (AMCs) to make their own cost inflation index assumptions. And some AMCs, taking advantage of this 'flexibility', have exaggerated their cost inflation index projections to make the returns on their FMP more attractive.

The implication of this on the FMP's returns is that a high cost inflation index figure results in capital loss for investors thus attracting zero tax liability. Hence investors are likely to get a post-tax return equivalent to the indicative yield of the FMP.

However, the cost inflation index projections (a key variable in the calculation of the FMP returns) could go awry should the inflation numbers turn out differently from what is assumed by the fund houses. Fund houses on their part have conveniently ignored this scenario.

Let us understand this with the help of an example. Consider an FMP (launched in the year 2007-2008) offering a yield of 9.75% per annum and maturing in the year 2009-2010.

As per our calculation, on an investment of Rs 1 crore (Rs 10 million), an investor will get a post-tax return of 9.75% at maturity, if inflation is assumed at 6.20% (this inflation figure is considered by a few fund houses in their calculations). However, when lowered to 4.00%, the FMP's returns dropped to 9.34%. This explains why fund houses projected higher cost inflation index estimates.

In addition to the two offerings discussed above, there are other cases wherein companies project attractive returns to catch the investor's eye.

The difference between such cases and the two instances discussed above is that while the above-mentioned offerings project their returns unambiguously and formally, in the other cases the companies project their returns informally and will never commit them to paper.

ULIPs returns

Investors looking to buy a life insurance policy have most likely been pitched a ULIP at some stage. Insurance agents project ULIP returns based on the performance of stock markets over the last few years (which for most part has witnessed a secular rally).

Their take is that if stock markets continue to perform the way they have, the ULIP could give a very high return over the next several years like they have over the past few years.

However, the agents will refrain from documenting their projected returns on paper because according to regulations they cannot project a return higher than 10%.

So, while investors are told one thing in the sales pitch (very high return from a sustained market rally), on paper they are shown a projection of 10% with the assurance that it can be bested very easily.

Investors would do well to understand that a) it's impossible to project the returns from market-linked investments with the kind of confidence that insurance agents show; and b) while domestic stock markets are expected to grow significantly over the long-term, but to say that they will continue to grow at the rate they have grown over the recent past is very misleading.

What should investors do?

Stick to the fundamentals of investing. There is no denying the importance of returns while investing, but it should never be the sole parameter while judging an investment.

Other fundamental attributes like the investment proposition offered by the offering, its aptness in the portfolio, whether its risk profile is in line with that of the investor must also be considered while evaluating an investment.

As we have always maintained, a competent financial planner is best placed to aid the investor in making the right investment decision.