If some news reports are to be believed, then the government has decided that equity mutual funds are not going to be permissible investments under the Rajiv Gandhi Equity Savings Scheme. The government seems to have decided that the scheme will only permit direct equity investments in the top 100 companies of the NSE and the BSE. There will be a lock-in of three years. However, according to an analysis done by Value Research, such a structure for this scheme could expose novice investors to a lot of risk. A quick backgrounder: RGESS is a scheme that was announced in this yearís budget. Under this, first-time equity investors can invest up to Rs 50,000 once to get a tax rebate. Not many details were announced in the budget since the scheme was still being designed. Subsequently, there was a widespread view that equity mutual funds would be the best vehicle for novice investors. It was reported that this was also SEBIís recommendation to the finance ministry.
But the government has stuck to the original plan. Even though the exact details are still not formally announced, itís expected that the scheme will be limited to direct investments on the stock markets and exclude investments made through equity mutual funds. Clearly, the goal is not just to let investors enjoy the returns of equities (which are easier realised through funds) but to actually have them open demat accounts and broker account and buy stocks in their own name.
As to the argument that it was risky for novices to dabble in stocks directly, the governmentís response seems to be that if investors are limited to the 100 largest companies and forced into a three-year lock-in then they are bound to make money. On the face of it, this makes sense. Surely, if you limit yourself to the largest companies and use a buy and hold strategy then surely you should make money over three years. But does the data support this assumption? I decided to check it out. I pulled up the rolling three returns of each company in the BSE 100 for a period of five years. That means that if you had invested in a company for a period of three years ending at any point in the last five years, then what would your returns have been. The calculation was done for each month over the five year period. This would be a total of 6100 data points had all companies existed through all periods but since some were newer companies, there were actually 5408 data points. Of these, fully 1108 were negative. Far from being a shield against losses because of their size and the long period, fully 20 per cent of possible investments would be loss-making.
Moreover, there are periods where this number rises to one-third of the total. Interestingly, if one sees the average return of these companies, one gets nice, healthy total returns of 193 per cent, representing a doubling of money in just three years. The fact that the average is so good when a good number of the individual returns are poor indicates the value of diversification and is a solid argument for mutual funds.
There are two more issues with the structure of the scheme. One is the lack of liquidity. It would be terrible to trap novice investors into one or two or handful of stocks that turn out to be wrong choices. The markets have many large stocks like Reliance Comm and Unitech which lost around 90 per cent of their value over given three year periods. Long- term lock-in would be the enemy of investors in these once solid-looking companies. Thereís another issue which is to do with the business model and the culture of broking in India. A broker would earn a commission of no more than Rs 350 or so from the Rs 50,000 that an RGESS investor would invest. For brokers, the scheme would be nothing more than a lure with which to hook novices into the routine cycle of short-term leveraged punting which forms the bulk of Indian investing activity. For many investors, that would eventually become the real problem