How does Short Term Capital Gain/Loss work?

I found this interesting snippet circulated through email by ICICIDirect, which describes in simple anecdotes how Short Term Capital Gain/Loss works in India. I am posting it straight away, without any modifications.

1. Mr. Sharma purchased some securities on May 7, 2008 at a total cost of Rs. 100,000. On July 3, 2008, he sold these securities for Rs. 130,000. Here the Short Term Capital Gain, STCG (gain arising from sale of securities which is less than 12 months old) was Rs. 30,000 (a) and STCG tax (15% as per current laws) for this gain calculated to Rs. 4,500.

2. But Mr. Sharma had also purchased securities worth Rs. 90,000 on June 12, 2008 and had sold them at Rs. 40,000 on February 10, 2009. Hence there is a Short Term Capital Loss (loss arising from sale of securities which is less than 12 months old) and equal to Rs. 50,000 (b).

3. Now as per the tax laws, Mr. Sharma’s Short Term Capital Gain (a) is offset by Short Term Capital Loss (b). Hence there is no Short Term Capital Gains tax payable by Mr. Sharma for the financial year 2008-09. Also, he carried forward Rs. 20,000 loss for offsetting any Short Term Capital Gains he makes in the next 8 years.

Thus a person needs to pay STCG tax only for the difference between Short Term Capital Gain and Short Term Capital Loss if the difference is positive; no tax if the difference is zero or negative. Moreover, if the difference is negative, he can even carry forward and offset the loss to gains in the next 8 years, until the loss is completely used off to offset those gains.

Thanks to ICICIDirect.com

Lessons from the sub-prime crisis

On Tuesday, the US senate passed the $819 billion economic stimulus bill, the second of the rescue package for the drowning US economy. Other governments have also come up with/are coming up with such measures to counter the financial crisis.

Even while issuing such packages, neither the US senate nor the other governments across the world can say with certainty that the financial crisis will be harnessed with these. Such is the size of the crisis and one might wonder how can we ensure that a crisis like this won’t happen again? What are the lessons learnt from the financial crisis?

In the case of sub-prime securities, risks were often under-estimated due in part to product complexity and over-reliance on quantitative analysis, including by rating agencies. Thus early detection and cure, which would have reduced the spill over effects of the crisis, didn’t happen in this case. Financial institutions were trying to cover up their losses till the last moment. The failed ones got uprooted in no time.

A major factor that contributed to the crisis is the use of standard risk assessment models used by risk management professionals by which they underestimated the systematic nature of risks. To put it in simple words, if everyone uses the same techniques, every one will be affected by the same issue. Independent assessment of risks using custom developed models would be one of the key lessons to be learnt from the crisis.

Derived from, Financial Risk Management: Lessons from the Current Crisis ... So Far

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Of Micro SIPs

For mutual funds having a Systematic Investment Plan (SIP) option, the SIP amount came down to as low as Rs. 500 per month but there were a lot of people out there for whom it was still unaffordable; people who are engaged in daily wage jobs, small businesses etc. and wanted to benefit from the higher returns of equity market.

From April 2007, few fund houses have allowed people to invest in SIPs with money as low as Rs. 50 per month. This could benefit about 330 million paid workers of India who didn’t have access to such investment schemes earlier.

But there are certain things that could affect the popularity of micro SIPs. PAN card being made mandatory for mutual fund investments by SEBI, distributors not pushing micro SIP due to lower commissions involved, longer SIP terms of around 60 months are few of them. But looking at the revenues that micro SIPs could rake in for Asset Management Companies due to its scale, let’s hope that this shall become a success, increasing the savings power of the average Indian and also making our equities market much bigger and stronger than they are now.

Why Mutual Funds Entry Load scrapping by SEBI is justified

Starting January 4 2008, mutual fund investors wouldn’t need to pay the existing entry load of 2.25% while investing in a fund directly through the fund house’s website or through its own customer desk. This is applicable to further investments in existing portfolios, schemes and to new schemes launched henceforth; basically, for any new investment made on existing or new mutual fund schemes.

Initially, when mutual funds were sold through brokers, the entry load was used to pay commission to the brokers. When fund houses started selling their funds online and directly through their channels, the role of a broker ceased to exist. Still, the fund houses were charging entry load, which was questionable.

For an amount of Rs. 100000 (one Lakh) invested in a mutual fund, the entry load took Rs. 2250 away from the investment amount. Considering a one time investment of Rs 100000 made on a mutual fund having a yearly return of 30% for an investment period of 15 years, Rs. 2250 alone could get a potential return of Rs. 115168 (more than one Lakh), which the investor stand to lose.

The set motive of mutual funds was to allow small investors with small chunks of money to invest and get the benefit of scale from the stock market. But if you look at the entry load, it’s waived for investments greater than Rs. 5 Crore in most cases, thoroughly favoring large investors, which is contrary to its purpose. The irony is investors who are able to invest more than 5 Crore would normally be companies, who take the benefit of mutual funds, that are primarily meant for small investors. Also, normally companies won’t invest for longer time periods as compared to small investors. Thus, the entry load of a mutual fund was a deterrent factor for small investments.

The process behind this move from SEBI started in August 2007. And now, when it comes to effect on the start of the year, it has become nothing less than a great new year gift to the small investors.

Endowment Policies – when it comes to maximizing returns

“Back in July 2002, I took an endowment policy. I was in my first job and for the first time in my life I was submitting investment proof to claim the munificent tax rebate. I had heard from someone that taking an endowment policy would be a better option as the higher premiums I pay would take me near the magical, tax rebate figure of One Lakh and to top it, I would get good returns on policy maturity! I didn’t think twice; called up an insurance agent. All he told me was about endowment policies. Finally, for an annual premium of around Rs. 21,000, I took an endowment policy with a policy term of 25 years. The rest I managed with National Savings Certificate.”

“It’s been three years and having diligently paid all the premiums, now I am a loyal customer of the insurance company. But some of my colleagues who had invested in stock markets that time, directly or through Mutual Funds, have already tripled or quadrupled their savings. Some had made even more. That’s when I started thinking about my endowment policy and the kind of returns it gave me with respect to the investment I made in the form of premiums. Is my endowment policy actually giving me good returns?”

I’m sure most of us who own an endowment policy would have thought like this at least once. This post succinctly examines the same. In the due course, we will find out how endowment policies don’t give much returns or insurance cover vis-à-vis some of the other investment opportunities.

Let’s have a closer look at Endowment Policies. Endowment Policies by definition agree to pay a lump sum on maturity while giving a small insurance cover during the policy term. Thus it’s a combination of both insurance and investment. The policy holder pays premium (this is the investment) reasonably higher than a term-insurance policy and gets yearly bonuses from the insurance company that get accrued and added to the lump sum. On the event of death or on maturity he gets the sum assured plus the accrued bonus (both constitutes the return on investment), which according the insurance company or the agent, is a formidable amount.

Thus, on policy maturity, the policy holder gets money in two ways.

Every year,
a) Reversionary Bonus: Distributed from company profits, based on plan, term and sum assured.
b) Terminal Bonus: Distributed from company profits for customer loyalty, based on plan, term and sum assured.

On maturity
a) Sum assured

So that the Total Amount on maturity = Sum Assured + Accrued Annual Bonuses.

Now let’s study an endowment policy in detail to calculate the returns from it. The policy under study has the following parameters.

  Annual Premium = Rs. 21,000
  Policy Term = 25 years
  Premium Paying Term = 25 years
  Sum Assured = 5 Lakh

Bonus declared by the insurance company for this particular policy during the years 2003-04, 2004-05 and 2005-06 were Rs. 53, Rs. 47 and Rs. 44 respectively, for every thousand rupees sum assured, i.e., an average of Rs. 48. Though I understand that the bonus amount would vary from year to year and may increase in the coming years, I take this average value for the calculations. Also, please to note the decreasing trend in bonus amount.

Thus for a sum assured of Rs. 5 Lakh, the bonus would come out to be Rs. 24,000 per year which is Rs. 6 Lakh for 25 years.

The terminal bonus is usually not made public by the insurance company. Hence we have no other way but to assume it to be on the range of Rs. 4 Lakh.

That makes the total amount the above policy holder would get after 25 years to be Rs. 15 Lakh. And the total premium he would have paid during the policy term would be Rs. 5 Lakh [21,000 X 25]. Thus the policy gives him an annualized return of 12%. [((15 / 5) X 100) / 25]

In this way you can calculate the returns you get from your endowment policy.

Now we got an idea about the returns from an endowment policy. Going ahead, let’s think about the next question. Is there any other way for us to get more returns and more insurance cover from the same investment amount? Is there a way to maximize our investments without compromising on the insurance cover?

So, let’s look at another investment option; say Mutual Funds. Over the years, mutual funds have been giving very good returns, in the range of 40% per year. But if we assume an average return of even 15%, an investment of Rs. 21,000 per year for 25 years would give the above person a return of Rs. 51 Lakh, had he invested the same amount in Mutual Funds every year! Quite amazed?

Unlike endowment policies, mutual funds don’t give any insurance cover. So how do we take care of the insurance part? Well, one way to do that would be to cut down the investment amount a bit and take a term insurance using that. Just to give you a hint, for an annual premium of around 6,000 rupees you will get a term insurance of about Rs. 25 Lakh for the same time period of 25 years! Hence splitting the endowment policy into term insurance + mutual fund combination would be an intelligent way to get more returns and insurance cover. When you play around with such a combination, probably you would end up with a better investment, having more returns and more insurance cover for the same investment amount.

Now one may ask, with endowment policies he will get a return for sure but if he invests in mutual funds, isn’t there a risk of losing money? Well yes, since the mutual funds invest in shares there is a risk of losing money. But mutual fund companies maintain a portfolio of shares to reduce this risk, due to which the downfall may be less. Also, for the less risky, there are balanced funds which invest only half the amount in shares. By the way, the bonus amount of an endowment policy is based on the insurance company’s profit. What if the company made a loss?

Thus there are better ways to invest than taking an endowment policy. Though I haven’t told you how to plan your investment or what to take, I hope that this post would have helped you to think a bit before going for an endowment policy.

Back Slash: An insurance agent gets commission for every premium you pay. For an endowment policy, you will pay premium for longer time periods; 25 years may be, possibly the reason why he may persuade you to go for an endowment policy and may not tell you about the more essential, term-insurance policies.

US Sub-prime Crisis

The US sub-prime mortgage lending crisis or simply sub-prime crisis has been the catchphrase in various media over the last few weeks. In this entire hullabaloo, one may want to know what this episode is all about and how it will affect the Indian economy or rather the world economy as a whole. Let’s have a look.

Sub-prime borrower
In US almost everything, right from getting a credit card to receiving various banking services, is dependent on the credit history of a person. A good credit history can be directly attributed to making payments on time, less revolving credit on credit cards, fewer payment defaults and check bounces etc. and is denoted by the FICO score or credit score of a person set by few credit rating agencies. It is easy for a person with a good credit history to get loans and other services while it’s exceedingly difficult for a person with a not so good credit history or low FICO score to avail banks’ services, let alone loans. Such poor credit history borrowers are called sub-prime borrowers. Since there is a risk of default on loans to sub-prime borrowers, US banks usually charge a higher rate of interest to them for the risk they are taking. From the bank’s side, a higher interest means a higher return, well with a risk. As a result, some banks had seen lending money to sub-prime borrowers as an opportunity.

Sub-prime boom
For a crisis to happen, first there has to be a boom. There were a few things that led to the sub-prime boom. I better quote Christian Stracke of Financial Times who had explained the situation quite nicely. “It all originated with a global imbalance between the supply of credit and the demand for credit. Global Central Bank let monetary policy move to a nearly unprecedented accommodative stance, pumping money into the system. At the same time, corporate, the traditional mainstays in terms of borrowing funds to invest moved to a defensive stance, having grown much more conservative in the wake of the Enron and WorldCom fiascos. Finally, the major developed countries began to gain a measure of fiscal discipline, with budget deficits shrinking, which further reduced the demand for credit on a global basis. That imbalance between investors flush with cash and the traditional borrowers not really needing or wanting that cash meant that investors had to look for new markets to invest in. As the Asset Backed Securities (ABS) market had been taking off and coming into the mainstream, a natural target was the sub-prime borrower - borrowers who in the past had wanted to borrow but who had been locked out of credit markets. Eager lenders met eager borrowers, with the mortgage originators, ABS underwriters, and credit ratings agencies playing the role of matchmaker, and the sub-prime boom was born.” Now, let's see what the banks or mortgage originators did to target the sub-prime borrowers’ market.

Role of Banks and Hedge Funds
So there was an opportunity among sub-prime borrowers and there has to be someone who could take the money from investors and give it to the borrowers. Who could do this better than the banks? Banks gave money to sub-prime borrowers and then they bundle the loans to a package and sold securities whose value was linked to the performance of the package of mortgage loans. Investors bought these securities and thus indirectly provided the money required for sub-prime lending. These derivative instruments are called Collateralized Debt Obligations (CDOs), which is one form of Asset Backed Securities. Thus, banks did away with the role of playing a financial intermediary. The total volume of CDOs in the US market is around $900 billion and only 17% of the CDOs were created out of sub-prime mortgages. Hedge Funds hold majority of these sub-prime related securities due to the inherent nature of their business making them extremely vulnerable to sub-prime related issues. So everything was set and now let’s find out what triggered the crisis.

Sub-prime crisis
Quite obviously the sub-prime crisis occurred when the sub-prime borrowers defaulted in their mortgage loans, which affected the returns of CDOs. The main reason was the inability of sub-prime borrowers to pay back the money. Another catalyst was the rising segment of credits like Home Equity Loans through which the borrowers could take a second credit on the same mortgage. These added to their inability to payback the money. As a result, some defaulted. Some started force selling their houses due to which property prices came down, which made it more difficult for other sub-prime borrowers to refinance their mortgages into loans with lower rates. The result, more and more defaults!

Now at the securities side, the highly leveraged hedge funds, found themselves in distress due to the rising defaults by sub-prime borrowers. Investors who had put their money in these funds wanted their money back which forced these funds to liquidate their assets. And thus started a vicious spiral of forced selling of sub-prime securities! This reduced the price of these securities in the market and thus the crisis grew new bounds. Since hedge funds are highly leveraged, a small decrease in their asset values is enough to make them bankrupt. As a result several funds filed for bankruptcy. Thus the sub-prime crisis showed its red face!

Effect on global and Indian economies
Few companies in the US filed for bankruptcy which led to the loss of thousands of jobs. People who invested through hedge funds lost their money. UK and Japanese economies were affected a lot as there were a lot of money from investors belonging to these geographies that had been put into sub-prime securities through the hedge funds.

In other economies, hedge funds faced selling pressure to meet margin calls which led to the fall of various non-US stock indices, Sensex, Nifty being few of them!

Though not severe, Indian economy got affected by this in the following ways. A reduction in the investments in Indian securities/major selling of Indian stocks by foreign investors (foreign funds having CDOs created out of sub-prime loans and had selling pressure) and a subsequent melt down of Indian stock markets, IT companies losing few of their clients belonging to US mortgage industry & Hedge Funds due to cost cutting or bankruptcy are some of these.

Analysts say that the US sub-prime crisis is not over yet. Let’s see what more this disaster has in its store in the days to come. In the hindsight, one might think, had the banks been not greedy enough to put their money in riskier sub-prime borrowers and made securities out of it!

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NFOs and expansion of AMCs

Once again Mutual Fund Houses have entered into the New Fund Offer (NFO) bandwagon. With Asset Management Companies (AMC) such as Fidelity, SBI, HDFC, HSBC etc releasing their NFOs for various sectors, Reliance has also entered into the foray with their Reliance Equity Advantage Fund.

But what interests me is that Reliance MF is about to double their branch network from 300, due to an expected 25% increase in their Assets Under Management to Rs. 75,000 crore. Quite in line with the tradition of Reliance, ‘when doing something, do it big’.

Well, these are private matters pertaining to Fund houses. But, did you happen to think about the huge amount of money that would go into the hands of various mutual funds in the next few years? No wonder why the stock market is expected to touch more heights and create more records!

MF Entry Load

A sum equal to 2.25% of the investment amount is taken by Mutual Fund Houses of India as an entry fee for the investment made by investors. Majority, or even whole, of this amount is given as commission to brokers who act between investors and fund houses. The brokers market the fund, provide financial advisory services to investors and do the required paper work.

Possibility of making investments online eliminated the need of a broker. Still, the entry load is levied by fund houses, which seem kind of illogical. SEBI (Securities and Exchange board of India), the regulatory authority of securities market came out with a welcome move in this regard.

Business Standard says, “The SEBI on Wednesday brought out a concept paper proposing to do away with the entry load charged by mutual funds through direct route. If the current proposal is accepted, mutual fund investors will not need to pay entry load for applications filed online or through AMC collection centers. The proposal is open for public comments till September 12, 2007.”

This is indeed a great proposal from SEBI as investors are paying for nothing, when they make an investment online. But yes, this would be a major blow to the broker houses as they stand to lose a lot of money when people prefer online investments for saving the entry fee. Public comments can be send to SEBI on this proposal. More details here.