Why Union Budget 2017 Must Give the Nod to Target-Date Funds

In its February 2014 board meeting, market regulator SEBI alluded to “a long term product such as Mutual Fund Linked Retirement Plan (MFLRP)” as a part of its 'Long Term Policy for Mutual Funds in India'. Since then, some fund companies have launched their versions of retirement funds.

However, the regulator is yet to issue guidelines to pave the way for a defined MFLRP product. With Union Budget 2017 on the anvil, one hopes that the MFLRP segment is promulgated in the form of Target-Date Funds.

What are Target-Date Funds?

As the name suggests, target-date funds focus on a pre-set year of retirement. For instance, if you are 30 years of age, and intend to retire at the age of 60, then you will invest in a fund with a target date of 2047.

Target-Date funds are structured as fund-of-funds. They operate on the principle of asset allocation. In their initial years, target-date funds focus on wealth accumulation by largely investing in a combination of domestic and global equity funds. As the target-date approaches, the portfolio acquires a conservative bent with equity allocation being trimmed in favour of fixed income funds.

Simply put, a target-date fund can be a one-stop shop for accumulating a retirement kitty.

In the US, several billion dollars are invested in target-date funds. It certainly helps that target-date funds are often the default choice under defined contribution plans such as 401(K).

Retirement Planning and India

While awareness about retirement planning has grown over the last decade or so, it continues to be a bit of an alien concept for several Indians. Perhaps one can chalk it up to cultural factors. We have been a country of joint families wherein post-retirement, parents are provided for by their children. But thanks to a combination of factors such as growth of nuclear families, higher life expectancy, and cost of living, the need for retirement planning is real.

Successive governments have nudged citizens to independently provide for retirement as well: From opening up the National Pension System (NPS) for all citizens in 2009, enhancing its tax sops in Union Budget 2015, to launching the Atal Pension Yojana for those in the unorganised sector. The message is clear: Focus on retirement planning.

Tax Treatment and Benefits

The allure of tax benefits can be a strong motivator while making investment decisions. Let’s take the example of Equity Linked Savings Schemes (ELSS), a niche segment in the Indian mutual fund industry with assets of INR 501 bn (3% of industry assets) as on Dec 2016.

From Dec 2011 through Dec 2016, assets under ELSS have risen at an annualised rate of roughly 20%. That is no mean feat considering that the investments are subject to a three-year lock-in. To put things in perspective, over the same period, the broader category of other equity funds has grown by 25%.

So, what makes the niche ELSS category tick—tax benefits! Investments in ELSS are eligible for deductions under Section 80C of the Income Tax Act.

To enhance the appeal of target-date funds (and thereby facilitate retirement planning), it is pertinent that investments therein be made eligible for Section 80C deductions.

Another area which must be simultaneously addressed is the tax treatment of fund-of-funds. In India, fund-of-funds never took off. While the latter can be attributed to a variety of reasons, none is more significant than tax treatment.

Irrespective of their underlying investments (equity funds or fixed income funds), fund-of-funds are taxed akin to fixed income funds. Since the tax treatment for fixed income funds is more punitive (versus equity funds), fund-of-funds have been at a disadvantage.

Hence the need for regulatory intervention to ensure that target-date funds enjoy the same tax treatment as equity funds. And what better platform than the Union Budget to iron out these regulatory matters, and launch target-date funds on a strong footing.

How the Investor Wins

Presently while planning for retirement, investors can choose from NPS, small savings schemes (Public Provident Fund) and retirement plans of insurance companies. Target-date funds can effectively close the circle of retirement-focused avenues. 

The potential for ancillary benefits—inflow of long-term monies into mutual funds, greater influence of domestic institutional investors in markets, multiplier effect of higher consumption from retirees—is strong.

Hopefully, the Finance Minister will agree, and give the nod to target-date funds in Union Budget 2017.

Will This Be Robo Advisory Firms’ Achilles' Heel?

Robo advice has become a buzzword in the financial services domain, and robo advisory firms are mushrooming at a furious pace in India. A combination of factors—growing financial literacy among investors (especially in urban areas), internet penetration, and enhanced awareness about mutual funds, among others—has contributed to this phenomenon. It can be safely stated that robo advice is an idea whose time has come.

As the name suggests, robo advice eliminates human intervention. Instead of an adviser, the investor is guided by algorithms run on a website. Typically, the investor feeds in information about his age, risk-taking ability, income and expenses, current assets and liabilities, financial goals, expected inflation et al. The robo adviser uses the data to produce a suggested asset-allocation and a list of mutual funds that can aid the investor achieve his financial goals while adhering to his risk appetite. Furthermore, robo advisory firms also enable investors to make online mutual fund investments thereby acting as distributors too.

To my mind, several of the robo advisory firms do a decent enough job when it comes to risk-profiling and arithmetic calculations. Likewise, it is evident that some have paid due attention to areas such as user interface. It is the last mile—recommending mutual funds—where most err.

It is commonplace to see funds being recommended based solely on performance. Typically, the three-year period is considered, and top-performing funds make it to the robo adviser's list. Recommendations are also offered in the form of a portfolio of mutual funds. Yet again, the three-year showing is the primary factor for picking funds from various categories. Given the strong showing posted by small/mid-caps in the recent past, it comes as no surprise that at present several recommended portfolios have a strong small/mid-cap bias.

A rule of thumb approach is perceptible in the recommendations. For instance, investors with a moderate risk appetite are offered large-cap funds. However, no thought is applied to the nature of the fund. For instance, a large-cap fund wherein the manager aggressively churns the portfolio, and draws on factors such as news flow, market sentiment and momentum while investing might not be suited for a moderate risk-taker. Yet such funds make the cut thanks to their performance and large-cap classification.

Not only is making recommendations based solely on performance a fundamentally flawed approach, it also reveals a poor understanding of the basics of investing. When the present top-performers are replaced by others (as it can and does happen in the case of market-linked investments) will investors be expected to churn their portfolios? Robo advisory firms can’t take refuge under the premise that their advice is bound to be ‘formulaic’. There is a difference between formulaic advice and flawed advice.

Don’t get me wrong. I’m not questioning the utility of robo advice. For first-time investors and those with uncomplicated investment needs, robo advice can be the way to go. But robo advisory firms must realise that there is more to investment advice than just running calculations. Indeed, flawed advice can significantly hurt investors' interests.

Robo advisory firms have a huge opportunity at hand. If tapped well, robo advice can prove to be a game-changer for both the mutual fund and distribution industries. However ignoring the ‘advice’ aspect of the business will prove to be a costly miss.

Stupid Portfolio Manager vs. Ignorant Portfolio Manager

Aggression seems to be the flavour of the season. Several politicians routinely breathe fire; at present, students at a New Delhi campus are in a belligerent mood. No discussion on Indian cricket is complete without the mention of aggression; likewise, a bespectacled newscaster known for his confrontational demeanour tops the TRP charts. And just when one thought it couldn’t get any more interesting, aggression has reached the mutual fund industry.

Recently, the promoter of an asset management company published a piece insinuating that competing portfolio managers are stupid. His contention is that since the NDA government assumed charge at the centre, bogus/hyped earnings estimates have been doing the rounds. Hence, equity portfolio managers who believed in and acted on the same are stupid. Furthermore, portfolio managers who didn’t fall for the hype, but failed to communicate their misgivings (on lucrativeness of equities) to investors are dishonest.

Apart from a touch of arrogance, the piece also reveals a poor grasp of how investing works. Investing is a personalised activity i.e. each investor pursues an investment philosophy and strategy that works for him. This principle holds good for portfolio managers as well.

For instance, while some managers pay more attention to top-down factors, others rely on bottom-up analysis. Some invest with a growth-bias, while others have a value-bias. There are managers plying research-oriented strategies and others who deploy a sentiment and momentum-driven approach. Even the investment horizon can vary significantly. Admittedly some strategies are more efficient than others, but that doesn’t take away from the fact that investing isn’t a one-size-fits-all activity, as the article erroneously suggests.

Equity investing isn’t a pure science. When a manager evaluates a business, factors such as his investment philosophy, interpretation and biases (among others) come into play. To suggest that every manager should have (or did) read the macroeconomic environment in a uniform manner is oversimplification. More importantly, is it apt to evaluate managers based on one event? Prudence demands that an equity manager be evaluated over the long-haul spanning a market cycle.

An element of bragging rights is perceptible too. Over the last year or so, equity markets have experienced a fair bit of volatility. The flagship equity fund (from the author’s AMC) takes cash calls based on valuations, and has expectedly fared well in a peer-relative sense. The portfolio manager and strategy deserve credit for the showing. However, that doesn’t diminish the credibility of competing managers who don’t take cash calls; expectedly, such funds have fared poorly in the recent past.

   

On the dishonesty bit, yet again the author displays his ignorance by mixing up the roles of an adviser and a portfolio manager. The latter is responsible for running the fund to the best of his abilities and in the investor’s interest at all times. However, offering the investor asset allocation-related advice, or managing the investor’s portfolio is not the manager’s role. That’s what advisers are engaged for.

In the competitive asset management industry, the need to celebrate and spread the word about one’s success is understandable. However, branding the competition as stupid and dishonest on untenable grounds reeks of ignorance.