Mutual Funds, ULIPs, NPS, PMS: How is return performance reported?

Let’s say this is what you see for mutual fund performance.

If the 5-year performance of a mutual fund indicates that you earned 20.93% p.a. and you invested exactly 5 years back in the scheme, you will earn exactly the same return. Let’s say the NAV was Rs 100 on the date of your investment and you purchased 100 units. After five years, NAV would grow to Rs 258.6.

Rs 10,000 invested (100 units X 100) exactly 5 years back would grow to Rs 25,826 (return of 20.93% p.a.).

All the costs (Fund management, distribution etc) are already built into the NAV. In the case of mutual funds, all these costs can be combinedly represented by its expense ratio. Since reported performance is calculated based on growth in NAV, you will earn the reported returns on your investment.

If you and your friend invested in the same scheme on the same day, you will earn exactly the same return.

Many times, you see returns in ValueResearch or MorningStar and wonder why you have earned lower returns in the same mutual fund. Such difference in returns is due to the timing of your investments (and not due to any charges). These websites primarily show point-to-point returns. 5-year return implies the return on your investment if you had made the investment exactly 5 years back. However, you didn’t do that. You may have invested on a different date or you may be investing by way of SIPs. Therefore, your return experience from the product may be different from what you see on these websites. CAGR vs IRR vs XIRR?

In the case of ULIPs, your net returns will be lower than the fund performance. Why? Because your ULIP fund units are redeemed to recover the charges.

Let’s say you have invested in a single premium plan and you received 100 units of Fund X. Let’s assume Fund X delivers the same returns as mentioned mutual funds example above. Just to be clear, Fund X is a ULIP fund and not a mutual fund.

NAV on the date of your investment is Rs 100. Your wealth is Rs 10,000 (100X 100). In 5 years, the NAV of the unit grows to Rs 258.6 at CAGR of 20.93% (NAV in the mutual fund example also grew to the same number).

However, over the years, some of your units will be redeemed to recover various charges such as mortality charges, administration charges etc. Let’s say over the next 5 years, 10 of your units get redeemed. You are left with only 90 units.

You net wealth after 5 years is 90 units X 258.6NAV/unit = Rs 23,276.

Your effective compounded return is only 18.04% p.a. (and not 20.93% p.a.)

To be fair to insurance companies, this is the only way they can report ULIP fund returns. In a ULIP, every investor will experience different returns. This will happen even if you purchase the exact same plan on the same date, pay the same premium, choose the exact same funds.

This is because your age plays an important role. Even though all the other charges can be the same for all the investors, the mortality charges are linked to the investor’s age. Greater your age, higher the impact of mortality charges since a greater number of units need to be redeemed to recover the charges. Everything else being same, a 25-year-old (entry age) will earn higher returns than a 35-year-old. A 35-year old will earn higher returns than a 45-year old and so on.

It wouldn’t be fair to expect the insurance company to report returns for each entry age. Therefore, it reports performance after accounting for fund management charges or other fund expense items, if any.

To put it crisply, mutual fund NAV is net of all the charges. This is not the case with ULIPs.  To recover other charges, your ULIP fund units have to be redeemed. Your NAV remains the same but the portfolio value goes down due to redemption of units.

The intent of this post is not to get into whether ULIPs are better than mutual funds or vice-versa. For my views on ULIP vs Mutual Fund debate, refer to this post.

National Pension Scheme is also quite like ULIPs.  Not all the costs are built into the NAV.

However, since NPS is a pure investment product, there is no concept of mortality charges. Moreover, the charges (not included in the NAV) are nominal, it does not affect your performance much. Therefore, the returns you earn will be quite similar to the reported performance (provided your NPS portfolio is not very small).

This is one of the reasons I advise older investors to stay away from ULIPs. Mortality charges can eat up a good chunk of their returns.

In the case of PMS, the reported performance typically does not even adjust for fund management fee or the performance fees. These expenses are over and above. You need to get to good hang of PMS expenses and fees to assess the impact.

There is an additional issue. In a PMS, you hold securities directly in your demat account. Any churning in the portfolio gives rise to capital gains tax liability. You may not take out money from the PMS and still have taxes to pay due to this churning.

In the case of mutual funds, a fund manager can keep churning the portfolio. It does not generate any tax liability for you or for the fund. Your tax liability arises only when you redeem your units.

By the way, I am not implying that mutual funds are better than PMS. All I am saying you need to dig deeper into costs of PMS to compare reported performance against mutual fund performance.

We know that mutual funds, ULIPs, NPS and PMS are not the same products. ULIPs provide life insurance too. NPS is a retirement product and provides for mandatory annuity purchase. We have different financial needs and different risk appetite. Therefore, the choice between these products should not be made on return performance alone. For instance, you can’t compare the performance of 10 stock deep value PMS offering (potentially very high risk) with a diversified multi-cap mutual fund. However, while comparing returns, we must still make an apples-to-apples comparison.