Frame the Choice : It will skew the buyer’s Decision

By Parag Parikh in Behavioral Finance, insurance, Investing 1 Comment

Of all the markets, the financial markets are known to possess the least amount of integrity where the only ruling ethos is how to make money from the other person. A few months back you had intermediaries selling mutual funds and they would swear by them. Then came the regulator and made drastic changes in the commission structure of mutual funds so as to benefit the investor. The intermediaries got hit and so did the sale of mutual funds. However equity markets were still attractive so the insurance companies saw this as a great opportunity to sell investment products as insurance products. Moreover insurance companies were free to give handsome commissions to intermediaries and agents at the cost of investor. These companies understood the framing affects and the perception driven market to come out with a product and an advertisement campaign brilliantly named “Guarantee of the highest NAV”. The product was framed in such a way that the investor would fall for a guarantee of the highest NAV and invest.( the catch was that it was not the highest NAV of the market but of the investor’s own portfolio). The market having risen drastically from a sensex of 8000 to 16000 had made the investors fearful. However they were still greedy to make maximum returns. There was a great opportunity to exploit this greed. Moreover the intermediaries of mutual funds would be provided a new product with fat commissions to earn. It was a perfect setting to sell inferior products to the investor.

 
 
You probably have seen the advertisements. Insurance companies offering a guarantee on the highest NAV of their ULIP scheme. ULIP funds invest in market listed securities which can be both equity and debt related. Since these schemes are long term in nature, investors invariably choose 100% equity allocations. However during the crash of 2008 investors have seen significant erosion in their investments and had become loss averse to such schemes. Thus there was an urgent need to rename such schemes.
 
Now “Assured Highest NAV” schemes have been projected as the ultimate solution to market risk. You are guaranteed the highest NAV during a certain period, or fund value whichever is higher at the end of term. What is sold to investors is the idea that the fund will be invested completely in equities and the highest returns from such an equity portfolio will be made available to them. This is not the truth.

This is how the structure works:

1. The initial investments may be 100% equity or a combination of debt and equity depending on the strategy followed by the fund manager.

2. The fund manager follows a portfolio insurance strategy that can be done by allocating funds between debt and equity – Here the fund manager sells equity as the market falls, so as to protect the downside. Unfortunately the ‘guarantee’ on highest Nav does not allow for the reverse to happen i.e. to buy equities as the market recovers. This results in sub-par returns from the Equity portfolio.

3. Money removed from the Equity portfolio is invested in debt. The proportion of debt increases steadily and soon the debt part of the portfolio will become large enough to ensure the highest NAV.

 
Let’s assume that over the next 10 years a 100% equity portfolio will deliver a 15% CAGR.  However a ‘highest NAV assured scheme’ will deliver anything between 6 to 10% CAGR during the same period.(As it is not 100% equity) If one were to deduct costs of 3 to 4% spread over the duration of the scheme the returns will still go down. Moreover one also pays for insurance (mortality charges). If one were to account for all these costs one would conclude these are  really inferior products. In fact they are inferior to even regular ULIP products because the guarantee on highest NAV is available only if you survive the term. If you die during the term, your nominees will get the prevailing value of the fund. They are inferior to even a regular debt product because of the high cost structure. Yes they serve the interest of the issuing companies and the intermediaries. 

A guaranteed NAV does not guarantee ‘equity linked’ returns. There is no way of knowing what the highest NAV would be and that NAV would probably have nothing to do with the stock market’s highest level during the same time. The so called guarantee is a marketing gimmick and is implicitly a result of the way the investment is structured i.e. with high proportion of debt. As an investor you are paying for such a guarantee, by accepting less than optimal returns.

Please evaluate your insurance needs and asset allocations before investing in any product. Understand your behavioral biases and do not allow others to exploit it. If you are greedy there is always someone to exploit that greed.