scorecardresearchAvoid debt to whatever extent possible, says Nehal Mota of Finnovate

Avoid debt to whatever extent possible, says Nehal Mota of Finnovate

Updated: 11 May 2023, 09:11 AM IST

In an interview with MintGenie, Mota said investors are in a sweet spot as long-term equities are attractive, long-duration debt is looking good and even gold offers a smart bet.

Nehal Mota, Co-founder, Finnovate

Nehal Mota, Co-founder, Finnovate

The REIT & INVIT index offers a good diversification of risk, says Nehal Mota, Co-founder, Finnovate.

In an interview with MintGenie, Mota shared how real estate investment trusts (REITs) are like a mutual pool of commercial real estate assets that are rent-generating.

Edited Excerpts:

NSE launched India’s first REIT and INVIT Index. Do you think this would gradually take the focus on other investment options beyond just equities, debt, and gold?

Alternate asset classes are constantly evolving. In mutual funds, there has been a gradual shift from active investments to passive investments. Thanks to gold ETFs and sovereign gold bonds, the allocation to gold as an investment has also been increasing. However, real estate being relatively heterogenous in nature did not find a place in investment portfolios. REITs and INVITs did offer that, but the recent launch of the REIT/INVIT index offers a passive option.

To quickly recap, real estate investment trusts (REITs) are like a mutual pool of commercial real estate assets that are rent-generating. Similarly, infrastructure investment trusts (INVITs) are pools of infrastructure assets like roads, power lines, grids, etc. With REITs and INVITs available in the last few years, there was an alternative option to diversify, but the index gives a barometer.

The REITs and INVITs distribute most of their regular earnings to the unitholders as dividends. The REIT/INVIT index takes 2019 as the base year and if you consider CAGR returns since then, it is at 10.8 per cent. That is lower than the Nifty, but that is not the point. The REIT and INVIT index has a low correlation of just 0.38 with the Nifty. For a portfolio of equities, it offers a good diversification of risk. That is the value that the REIT & INVIT index will add to individual portfolios.

In an interesting development, the NSE has launched two multi-asset indices. Both these indices are a mix of equity, debt, and derivatives with a 10 per cent allocation to the REIT/INVIT index. That gives a distinct portfolio advantage to investors as they get an investable index that automatically has a 10 per cent allocation to the REIT/INVIT index. Remember, REITs and INVITs offer a new asset class that offers diversification. Now investors have the choice to invest actively or passively in these hard assets. If that creates a problem of choice for investors, it is a good problem to have.

Q. Debt funds have lost their indexation benefit. Should one still invest in them? Why and to what extent?

In the latest Finance Bill, there was a subtle shift in the way debt funds will be taxed. Currently, mutual funds with an exposure of 65 per cent or more to equity are classified as equity funds and taxed at a concessional tax rate. However, even for debt funds, taxes were lower. Short-term capital gains (less than three years) were taxed at the peak rate, but long-term capital gains (more than three years) were taxed at 20 per cent with indexation benefits.

Under the Finance Bill 2023-24, debt funds would be further classified into two categories. The debt funds with equity holdings between 35 per cent and 65 per cent would continue to enjoy benefits as before. However, debt funds with less than 35 per cent equity will see capital gains treated as other income and taxed at the peak rate. Traditional debt funds will lose on concessional tax benefits on capital gains and double indexation.

This announcement led to a surge of debt fund new fund offers (NFOs) in March 2023 to capitalize on the last hurrah for debt funds. It now raises a pertinent question. Should investors consider debt funds as the primary debt allocation? Should they prefer debt funds with a higher equity component (35-65%)? These are important questions for asset allocation.

Firstly, investors can now look at debt from a wider perspective. In the past, tax benefits on capital gains were a key reason for many investors to prefer debt funds over bank fixed deposits. Now, investors would be indifferent between bank fixed deposits (FDs) and pure debt funds as both will be taxed similarly. Thus, the choice would now become more agnostic; more so with FD rates going up sharply.

However, debt funds still hold some benefits. Amidst falling rates, debt funds capture capital gains better than bank FDs. Debt funds also offer a wider choice ranging from G-Secs to corporate debt to credit risk. However, investors have to be wary about the use of Systematic Withdrawal Plans (SWPs) in the absence of tax benefits. Investors must allocate accordingly.

Q. What is the first thing you advise your customers looking to create an adequate corpus for future needs?

The general belief is that creating a corpus for future goals is about making investments grow at a rate that is better than inflation. However, that is the endpoint and not the starting point. The starting point for financial fitness is not just wealth creation but about putting the six pillars of personal finance, i.e., goal planning, budgeting and tax, loan management, insurance, investments, and finally estate/inheritance management in action. The first thing investors must do in such cases is to address the three-stage priority stack.

The first priority stack is to get adequate insurance. Insurance is not just about managing uncertainty but also improving your risk appetite. Even if your debt is reduced, there is a risk to your life, the risk to your health, and the risk to your assets. The priority must be to get adequate health coverage for the family members and also term life cover for the earning members of the family.

The second priority stack must be to create an emergency fund equivalent to six to 12 months of income in liquid assets. Exigencies can strike at any time, and you cannot let that derail your long-term financial goals.

The third priority stack to address is the reduction of debt. Obviously, you need to borrow for your home or for your car and that is understandable. However, here we are referring to high-cost debt. Splurging on conspicuous consumption with credit cards and personal loans looks cool, but it is not too wise. These loans cost anywhere between 21 per cent and 40 per cent and if you are servicing that kind of loan, there is no way you will create wealth. The first stack is to cut down on high-cost debt.

Once these priority stacks are addressed, the base is set for you to plan an adequate corpus for your long-term life goals. Miss these three priority stacks at your own risk.

Q. There is an increasing trend of people seeking to retire at the age of 45. What is your advice to people seeking the Financially Independent Retire Early (FIRE) way of life?

The legendary Peter Lynch, the extraordinarily successful manager of the Fidelity Magellan Fund, opted to retire at the age of 38 because he wanted to watch his daughters grow into teenagers. Not everyone is that fortunate. The question is, even if you are not Peter Lynch, is it possible to retire early at the age of 45, without any financial worries for the rest of your life.

It is tough, but it is possible. However, there are four things that are essential for such a decision. The first is to start investing early. If you start at the age of 20, then you are still giving yourself 25 years of savings. Even a conservative SIP investment can give you a powerful corpus at the age of 45 to be able to retire. Secondly, you must consistently avoid living beyond your means. That really means, avoiding debt to the extent possible, and certainly not for your consumption needs.

The third prerequisite is discipline. It is okay to project goals and investments on an Excel sheet. Implementing such a boring game plan month after month calls for intense discipline. It is the discipline that gives the best benefits of time in investing. Lastly, it is essential to be liquid well before your targeted retirement date. After all, nobody relishes a negative surprise, especially when it comes to money.

Even with these four prerequisites met, there are some key trends to remember. Keep in mind that active fund managers in India are finding it increasingly difficult to beat the index consistently, which means investors must be prepared for lower returns on equities. Moreover, inflation has surprised most people in the last few years, which can impact real returns. Lastly, keeping a tab on taxes is crucial. Small changes can make a big difference in your post-tax returns. By following these guidelines and prioritizing financial fitness, you can achieve the FIRE way of life with ease.

Q. When it comes to asset allocation, how much would you advise new investors to allocate to equities, debt, and gold?

Empirical studies have underlined that portfolio returns are driven less by stock selection and more by asset allocation. That means; how you allocate your funds broadly between equity, debt, gold, and other assets can make a huge difference to your risk-adjusted returns in the long run. Here we talk of a young person (possibly in their mid-twenties) and starting out in their career. How should they go about the asset allocation task?

Let us talk about equities first. Obviously, if you are looking at long-term growth, then equity is the first port of call. In the long run, the biggest risk is not taking adequate risk. A diversified portfolio of equities held for at least seven years has almost zero probability of negative returns. Ideally, allocate 55% to 60% of your corpus to equities and split it between active equity funds and passive funds for better management of market risk. This allocation can be tweaked as you go along.

We now come to debt. Obviously, debt cannot generate the same return as equities in the long run, but they provide stability and regular income. Hence, debt provides adequate buffers to the overall asset allocation. Most people are already exposed to debt through PFs, so the overall allocation can be maintained at around 25-30 per cent. The returns in the long run would be lower, but more stable and predictable.

Finally, a 10 per cent allocation to gold is a great hedge in uncertain times. Gold does very well when there is geopolitical uncertainty or currency volatility. It can outperform other asset classes during such periods. Once these 3 are met, then any residual opportunities can be used for exposure to REITs and INVITs. This can either be a direct allocation or an indirect allocation through specific allocation indices. That is the starting point, and this mix has to be reviewed on an annual basis to maintain your financial fitness.

Q. IT stocks have reached their preferred valuation levels. Should investors now look at greater allocation to funds or investments allocating money heavily to the technology sector?

The Information Technology (IT) stocks in India are currently trading at a P/E ratio of 23.2X rolling quarter earnings. If you look at the last five years, the lowest valuation for the IT index was 14.5X and the peak valuation was 39.6X. It may not, therefore, be correct to say that IT stocks have reached their peak valuations because currently, it is even below the five-year average valuations. But, let us address the larger issue of the sell-off in IT stocks and whether the time is ripe to add more.

The cat was let among the pigeons when Infosys faced a series of downgrades from global broking houses with a sharply reduced target price. There were two key challenges. Firstly, the series of rate hikes in the US was threatening to steal the thunder from the global growth engine. That would mean; weak growth (possibly recession) but certainly lower tech spending. The second concern for IT companies has been that tough times normally lead to calls for IT projects to operate on thinner margins and that is evident from the cautious OPM guidance of Infosys.

Then, of course, there is the added issue of the banking crisis in the US with SVB Financial and Signature Bank going down and First Republican Bank on the edge. The banking, financial services, and insurance (BFSI) sector has been the mainstay of the Indian IT industry and has accounted for a chunk of its revenue flows. The apprehension is that the crisis may force these mid-sized banks to focus more on conserving capital and reducing tech spending.

Would it be a good idea to add more IT stocks in this situation? The headwinds are strong and FPIs have been selling aggressively in Indian IT. Q4FY23 results would hold the key and give an indication of whether the story is intact. Till then, it would be a good idea to be cautious on IT. It is anticipated that the IT sector could become more divergent with smaller niche plays doing better. It is better to wait out this quarter and then evaluate the cues.

Q. The RBI has put a pause on repo rate hikes and is expected to stand by its decision. Should investors tweak their investment portfolios accordingly?

In the April 2023 monetary policy, the RBI held the repo rates at 6.5 per cent, contrary to the general belief that the RBI would hike rates by 25 bps. RBI has maintained that this is just a pause and not a shift in the hawkishness of the central bank. However, other cues are also compelling. Rising interest rates are putting pressure on corporate bottom lines and that was evident in the third quarter, which saw margins shrinking and interest coverage narrowing. Even the FICCI and CII had urged the RBI governor to go slow on rate hikes.

While it may be too early to call the end of rate hikes, one thing is obvious India is close to the peak. That means; the investment axiom at these levels must be attuned to a macro situation wherein the rates and the bond yields could either be flat at current levels or gradually trend lower. Firstly, that is good news for equities and risk assets as it reduces the pressure on corporate profits and also lowers the cost of capital. Cash flows will now get discounted at lower rates.

What about debt? With rates at or close to the peak, it is a good time to lock in higher yields for the long term. Long-duration funds are a good bet at these levels. Also, in the event of falling rates, these long-duration funds would stand to benefit the most. With the changed tax benefits on debt funds, locking into long-term FDs can be a double benefit of high yields and tax exemptions.

What about gold? Lower rates are always conducive to gold prices, especially if falling rates are accompanied by global uncertainty. Lower rates reduce the opportunity cost of holding gold. In a nutshell, investors may be in a sweet spot wherein long-term equities are attractive, long-duration debt is looking good and even gold offers a smart bet.

We explain decentralised finance (De-Fi) here.
First Published: 11 May 2023, 09:11 AM IST