Finance and Economics Education for the Life Insurance Sales and Marketing Persons

Knowledge is Power

Learn Concepts that Are Today’s Market Language

This is the fourth article of the Explained Series of Articles from me. In this series I will be explaining a few concepts in financial theory and how they are linked to selling life insurance. It is important to know these financial concepts to understand the financial markets and also to know how to canvas for life insurance products.

In an earlier post (read The Layman is a Prudent Financial Planner) I mentioned that mutual funds are not instruments in which you invest for long term needs, such as children’s education and marriage and for retirement planning. I would like to explain why. The proposition that it is more risky to hold the mutual fund investment for longer terms is corroborated by scientific analysis, which is what I wish to draw your attention to in this article.

Mutual funds are risky investments. The longer the period of holding a mutual fund, the more the risk in later years. Prudent financial analysts and investors typically hold a risky investment for short periods of time and keep moving in and out of risky investments every few years, if not months. The investors do that because the risk of holding a risky investment increases with time. There are many methods of measuring risk in a scientific manner. Measures such as Alpha, Beta, Standard deviation, Sharpe Ratio, etc. are some of those measures. (Go to the end of this article for an explanation of these terms). Any website that aggregates data for all mutual funds in India will give you the data on these risk measures. We have taken the data from the Website https://www.morningstar.in/

The long term investment risk in mutual funds – what the science says

Morningstar, is a leading global investment and research organisation. You can visit their website for https://www.morningstar.in/ for India-related data on mutual funds. Morningstar has its own classification of mutual funds. A few samples of randomly selected data from Morninigstar, show how the risk in mutual funds increases for a 5 year period of holding as compared to a 1 year holding period.

1. For a Category of mutual funds they classified as Conservative, the beta for 1 year is 0.8389, has increased  to 1.0789 for the 5-year projection period. The higher the beta, the more volatile the fund is and therefore more risky. For the same fund category, Morningstar has calculated the Alpha measure as -1.3583 for a one year projection and -2.3706 for the 5-year projection. A negative alpha indicates that the fund category will perform less than the benchmark index for the category. In this particular case the alpha has worsened, (dropping from -1.3583 to -2.3706) indicating that in the longer time frame of the future the risk has increased considerably.
2. For another category of mutual funds, ELSS Category, Morningstar gives the Sharpe ratio for 1-year as -0.4548, indicating much lower risk, as compared to the 5-year projection of 0.8357, indicating higher risk of holding the fund over a 5-year holding of funds in this category.
3. For the category retirement mutual funds the Sharpe ratio is -0.3564 for a 1 year projection and rises to 1.0436 for a 5 year projection, a considerable increase in risk. Those seeking to park their retirement funds must most definitely not place their money in mutual funds. As you can see the Sharpe Ratio has increased almost 3 times. It is like saying the risk has tripled in a 5-year projection.

The examples given above have not been picked and chosen for putting forth the view point that holding a mutual fund for the long term implies greater risk to the investor. The examples given above have been randomly picked to make the point. Readers are advised to visit the website https://www.morningstar.in/ or any other mutual fund aggregator website to see for themselves that it is true for all mutual funds.

In Layman language

Removing the technical words of finance such as Sharpe ratio, etc, we can say  in common language that risks in an investment increase with time. We cannot therefore contend that a mutual fund earning 12 % this year will continue to earn 12 % every year for the next 10 years. In fact it never happens. Returns on a mutual fund are volatile.

Mutual fund earnings in a 30-year period

In an exhaustive research (See https://blog.wallstreetsurvivor.com/) performance of 2,076 actively managed mutual funds between 1976 and 2006  (the period of study was 30 years, which is as long term as long term can be) was studied. After accounting for fees of the mutual fund, they found that 75% of them returned zero “alpha”, or negative “alpha”.  A zero alpha or negative alpha means that the fund is earning equal to the benchmark index (zero alpha) or less than the benchmark index (negative alpha). Only 0.6%, showed any consistent returns in excess of the benchmark index.  So 75% of the mutual funds over a period of 30 years, were earning a low return. Only 0.6 % of the mutual funds had earned more than the benchmark index, which we may consider as high returns. Thirty years is a long enough period. Mutual funds in the long run carry more risks and the chances of making more losses is consequently high. The chances of making high gains are not high.

Mutual fund earnings in a 5-year period

In another study, Standard & Poor (a highly reputed global rating agency) studied the top 25% of the mutual funds in USA. Only 2 out of 2,862 funds managed to consistently outperform their peers over a 5 year period. “What’s the chance the fund you picked was one of those two?” asks Team Wall Street Survivor in its Blog https://blog.wallstreetsurvivor.com/. Funds that earn well in one year usually do not do well for the subsequent years.

This is the risk of investing in mutual funds. Those selling mutual funds will not share these details with their customers. If they mention the risks of investing in mutual funds, no one will invest in mutual funds. But it is the duty of the life insurance agents to educate their customers on the risks of investment.

Sell Risks Not Returns

Further Reading: Explanation the Risk Measures Mentioned Above

For those of you who wish to learn about the risk measures mentioned above, a brief explanation is given below for your reading. For further reading please read www.investopedia.com

Alpha (Greek symbol α )

When you want to measure the performance of a mutual fund with a benchmark index, α is used. For example you want to compare a mutual fund that has primarily invested in banking sector, the performance of the mutual fund is assessed against the index of the banking sector performance. If the performance of the mutual fund is better than that of the banking sector index, the alpha (α), will be positive that is > 0. A negative alpha indicates that the mutual fund has earned less than the banking sector benchmark.

Beta (Greek symbol β pronounced as beeta)

The beta of a mutual fund is an indicator of the volatility of the fund. That is to say by how much the fund’s NAV moves up and down and how often as compared to the market. The market’s beta is taken as 1. If the fund’s beta is more than 1 it indicates that the fund is more volatile than the market. If the beta is less than 1, it indicates that the fund is less volatile than the market.

Standard Deviation (Greek symbol δ)

Standard deviation is a statistical method of calculating a fund’s volatility. Suppose you are expecting that the fund will give 15 % return p.a. in future. From past data we plot the exact returns earned by the fund to understand how much the fund performance has deviated from the projected 15 %. Hypothetically suppose the range of past performance return on the fund varied between 3 % to 19%, this data is used to calculate the standard deviation. The more the spread (both below and above the expected 15 %) from the expected 15 %, the higher the volatility and consequently higher the risk. Standard deviation is a measure of the spread around 15 %. So conceptually, the higher the standard deviation, the higher the risk.

Sharpe Ratio

William Sharpe, an Economics Noble Prize winner, developed a ratio to compare the returns of different investments in a scientifically correct manner. Some investments are more risky than others. In such cases we cannot compare the returns of an investment of a higher risk investment with that of a lower risk in a direct manner. For example we cannot say that on a Share A you will earn 15 % and on a bank deposit you will get 7 %, therefore you will make more money by investing in shares. Shares carry a risk far more than bank deposits. We can compare the returns of both only when we adjust the higher risk of the shares and the lower risk bank deposits to a risk free rate. Sharpe gave a method of doing so. It is called the Sharpe Ratio. The higher the Sharpe Ratio the better the risk-adjusted performance of the fund. For example a fund with Sharpe Ratio of .1345 indicates that the risk adjusted return of the fund is lower than say, a fund that has a Sharpe ratio of .6485.