Tall promises, high NAVs

It's yet another clever marketing ploy by insurance companies. The promise of the highest NAV in seven years and, in some cases, 10 years, is certainly attractive, but it comes with several strings attached. For one, the 'highest NAV guaranteed' plans launched by a clutch of insurance companies over the past year are not your regular unit-linked insurance plans (Ulips), where an investor can choose from four or more funds and tweak his allocation to debt and equity whenever he wants.

According to these new plans, there is just one fund and the allocation is decided by the fund manager, not the policyholder. Usually, the fund is managed actively and can invest between 0% and 100% in equity and debt. In this case, it will invest a large chunk of the corpus in equities at the beginning of the term. Thereafter, it will follow a dynamic asset allocation based on the performance of the equity and bond markets, while bringing down its exposure to volatile assets (read, equities) as the term progresses.

Seven years is a fairly long period, long enough to do away with the risk in equity investing. In the past 30 years, the average return from the Sensex in any 7-year period (calendar years) has been 17.2 per cent. Also, the risk of loss diminishes as the holding term increases. If you are prepared to hold the Sensex stocks for seven years, the probability of loss will be 13.5 per cent. So a patient investor is bound to reap rich rewards.

The moot question is, how will these funds pay the highest NAV if the markets crash, as they did in 2008? Simple. The fund will shift its corpus to debt to ensure that the guarantee of highest NAV is met by the time the plan matures. The slow and sure growth from debt investment will eventually make up for the drop in the NAV following the fall in equities. However, this might not be the best strategy when stock prices are down. "This goes against the fundamental principle of investing—buying low and selling high," says Dhirendra Kumar, CEO of Value Research. But then the plan merely promises you the 'highest NAV', not necessarily the highest returns.

These plans work on the same principle as that for the capital protection mutual funds, which had become a rage a few years ago. Those funds used to allocate 80 per cent of their corpus to debt and 20 per cent to equities. Even if the value of the equity portion fell by 50 per cent, the high proportion of debt investments ensured that the fund managed to claw its way back to the green when the three-year lock-in period ended.

The promise of highest NAV should be taken with a pinch of salt. A plain vanilla Ulip, where you can choose the allocation between equity and debt, might be a better idea. If you don't have the temperament or the time to monitor the markets and rejig your portfolio periodically, outsource this to a mutual fund by investing in one.

It's not only the insurance companies that are trying such gimmicks. Mutual funds too are trying to grab the attention of investors by declaring dividends and highlighting their payout records. Few investors realise that unlike the dividend received on a company's equity shares, the dividend from a mutual fund scheme reduces its NAV and is only a profit-booking mechanism.

Taking note of the big dividends being paid by fund houses, Sebi has asked them to pay these only from the realised gains and not by dipping into the unit premium reserve maintained by them. Typically, when the units of an open-ended scheme are sold, and the sale price is higher than the face value of the unit, part of the sale proceeds that represents unrealised gains is credited to a separate account (also known as the unit premium reserve). For instance, if you buy a fund at an NAV of Rs 30, and assuming the fund's face value was Rs 10, the balance Rs 20 is the unit premium reserve. This will not be utilised while determining distributable surplus. So, it's time investors got used to smaller dividends in the future.