Let’s begin with why 12%, why did they always consider that figure.
No businessman likes to keep his cash idle. Today, we have a lot of investment options, both for short and long period, like overnight debt funds, short and long-term mutual funds, FDs, etc. to invest in and earn that extra buck. Back in the day it wasn’t so.
One of the most common methods for keeping that surplus cash engaged then, used to be to lend it out. Every businessman for centuries has engaged in such unsecured loans, also called Hundi.
Now, for decades the average interest rate at which people lend their money has been 1% Per Month or 12% Per Annum. This is where the 12% opportunity cost comes into picture.
They meant to say that, if by sitting at home I could earn 12% on my money without any efforts, which is just by lending it to others. Why would anyone in the right mind do a business earning less than 12% or even 12%.
But there were way too many drawbacks to this:
- They didn’t take into account the bad debt (the people who failed to pay the money back), which would technically reduce your 12% interest return by a huge margin, because you’re not only losing your interest which you’re not earning but also the principal amount.
Note that these were unsecured loans (not backed by any asset, except for the borrowers promise to repay), so when your borrower defaults you could end up with nothing. It’s because the proceeds from assets sold would first be used to pay off all the secured creditors and then will your turn come (if any cash is left).
- They didn’t take into account the commission the brokers took. There were in most cases brokers involved, who would take a 1% commission on the amount lent through him or basically one month’s interest worth of commission.
- They didn’t take into account the taxes charged on the interest earned. A lot lent out back in the day were cash loans, which were totally unaccounted for income tax purposes. But a lot were also, accounted interest incomes on which tax would have to paid.
- They didn’t take into account the lack of liquidity. This doesn’t directly affect the numbers which we are considering but is a big barrier. When a hundi is signed for say 12 months, you’re locked for the time frame and can’t just demand your money back after 2 months. This is a big consideration to keep in mind but doesn’t have a direct effect on the 12%.
These are the reasons why we should’ve never considered a 12% interest return as our benchmark return. The concept by itself has a lot of limitations and the 12%, even more of it.
But we have to have a benchmark to compare our returns to, but it just can’t be the obsolete 12% Hundi return. On the other hand, we can also not take the average 6% FD return or the 7-8% PPF return. These are all riskless returns and can’t be directly compared to an entrepreneur’s risk appetite.
An entrepreneur starts a business because he sees potential and has the risk apetite to exploit such potential. Thus, if not for his business he would rather invest in other entrepreneurs and businesses. Now, which is a better set of businesses to invest in than the Nifty. The Nifty 50 is a weighted average index consisting of the top 50 companies across 17 sectors in India which are traded in the stock exchange.
Thus, an ideal benchmark to assess any businesses’ return would be to compare it to Nifty’s return. over the same course of the business’s operational duration. For example – If a business has been operational from 2007 to 2017, we would compare the businesses 10-year return to that of Nifty’s 10 Year CAGR return from 2007 to 2017, to see if the business .
But Nifty being an index, we can’t directly invest in it. Thus, we would use NIFTY ETFs for our research.
Nifty ETFs (exchange traded funds) invest in stocks that are a part of the Nifty 50 Index. Its main objective is to try and replicate the performance of the Nifty index by buying the same stocks in the same proportion as they are in the index. Thus, we are technically buying the Nifty, which is exactly what we desired.
Now, Nifty ETFs are investment vehicles offered by a lot of Asset Management Companies (AMC). On doing my research, I found that Nifty ETF offered by NIPPON Mutual Fund (formerly known as Reliance Nippon) NSE:NIFTYBEES, was the perfect match for study.
A few facts and figures on the ETF:
- NIPPON INDIA ETF NIFTY BeES (Benchmark Exchange Traded Scheme) was the first exchange traded fund (ETF) in India, listed on 08/01/02
- It is an open ended index scheme, listed on the Exchange the form of an ETF tracking the Nifty 50 Index. (An Open-ended scheme is an investment scheme where the shares can be issued and redeemed at any time vs a closed ended fund where new investors cannot enter, nor can the existing investors exit till the term of the scheme ends)
- Investment Focus – The Scheme employs a passive investment approach designed to track the performance of Nifty 50 Index. The Scheme seeks to achieve this goal by investing in securities as in the Index constituting Nifty 50 Index in same proportion
- Nifty 50 forms the representation of Indian Equity market with 50 stocks across broad sectors. It is one of the most traded index in the world and the top traded derivative index in India.
- It is the most liquid Nifty ETF in India with an average volume of 50 Lakhs shares being traded every year.
Thus, in the forthcoming space I have calculated the Nifty’s ETF return for our reference.
Steps to Calculation:
Step 1 – What I first did was gather the closing prices of every financial year from our ETF’s listing in 08/01/02 until the most recent available. I’ve used every year, as we will be computing the rolling returns. 31st March prices were used, but for those years when 31stMarch landed on a non-trading day, we took the prior trading day. These data were gathered from NSE website.
Step 2 – Using the above data we now calculate rolling period returns for 1 year, 3 years, 5 years, 7 years, 10 years and 15 years.
But note that we’ve calculated Compound annual growth rate, or CAGR, which is the average annual growth rate of an investment over a specified period of time longer than one year. Thus, when you say my investment has earned me a CAGR of 16% over 8 years, it means that your investment value has grown 16% every year over the period of 8 years.
Also note that I’ve also used Rolling Returns here, which are annualized average returns for a period, ending with the listed year. Rolling returns are useful for examining the behavior of returns for holding periods, similar to those actually experienced by investors.
So, to explain this better, let’s use an example from the returns calculated above –
The 3-year rolling return for 31-Mar-08, which is 33.72% is actually the return earned when invested in 31-Mar-05 and held until 31-Mar-08. Also, note that these are CAGR figures, so it means that we’ve earned 33.72% every year from 31-Mar-05 until 31-Mar-08.
Similarly, the 3-year rolling return for 31-Mar-09, which is -4.23% is actually the return earned when invested in 31-Mar-06 and held until 31-Mar-09. It is a negative 4.23%, which means that we’ve lost 4.23% of the investment every year from 31-Mar-06 until 31-Mar-09.
In the same manner, a 10-year rolling return for 31-Mar-11 would mean that 100 rupees invested in 28-Mar-02 has grown 19.47 rupees in value every year until 31-Mar-11.
But the reason we’ve used so my time periods like 1 year, 3 years, 5 years, 7 years, 10 year, 15 years is because we never know which time period could come of use to us. It could be that we are comparing a 5-year business started in 2006 or a 10-year business started in 2004.
Step 3 – Next, we’ve taken average of every period return, for our general comparison. This is the ultimate figure we need which has averaged out all highs and lows over an 18-year period.
But you may ask if we are addressing all the issues that the Hundi return calculations faced. Yes, we have and this is how:
Step 4 – Capital Gains Tax – Recently, we saw the re-introduction of long-term capital gains (LTCG) tax on equities. Any equity holding held for longer than a year and sold for a gain attracts a LTCG Tax of 10%.
However, the gains realized from equities sold are exempt up until 1 Lakh, but anything over and above Rs 1 lakh in a financial year is taxable at 10%. Thus, for simplicity we assume that all gains earned will be higher than a Lakh.
Thus, we shall adjust the Nifty returns for LTCG by deducting 10% of the returns. Remember how in the 12% Hundi Return they never accounted for the tax on interest gains.
Step 5 – Entry & Exit Load – Entry load can be said to be the amount or fee charged to an investor while entering a mutual fund scheme while Exit load is charged while leaving. The ETF taken into account doesn’t have any charges, both loads are zero.
Whereas in a hundi system, the brokers charged 1%
Step 6 – Expense ratio – The TER refers to a percentage of a scheme’s corpus that a fund house charges towards administrative, fund management, and other expenses. A recurring expense, this is charged to the overall assets of the scheme. A fund’s net asset value is arrived at after deducting this expense on a daily basis. A lower expenses ratio translates into better returns from a fund. Since the money saved is invested in the fund, it helps to create more money over a long period. Our subject scheme has an industry low TER of 0.05%. However, we don’t need to separately account for this as the NAVs are already adjusted for the same and reported by the scheme.
Step 7 – Taxes and charges – We are assuming that the purchase and sale was done through discount brokerage platforms like Zerodha or Upstox, which doesn’t charge any commissions. Hence, we won’t take into account any brokerage charges. I also did an experimental trade on Zerodha to confirm the same. It was hence confirmed that there were no additional charges and no further taxes. However, a few investors using other trading platforms might be charged, so we’ve taken an estimated 0.01% charge each on buying and selling to account for the same. So, 0.02%
There were also other substantial advantages to our choice:
- Ease of transaction and liquidity – Can be easily bought / sold like any other stock on the exchange during market hours at prices prevailing in the market. Thus, investor transacts at real-time prices unlike in Hundis where the investor has to wait until the end of agreement to get his money back.
- Diversification and Low minimum investment – Instant diversification through exposure to 50 stocks by purchasing as low as 1 unit versus the limited number of borrowers you can lend to. High number of companies and low amount of investment vs Low number of borrowers and high amount of investment with each.
- Additional Liquidity provided from AMC – In case of big investments to be made like 50L INR plus, you can directly with the AMC for a minimum of 50,000 units, in case such these number of units are not available to buy directly from the market.
This Net Returns percentage of Nifty ETF BeES calculated after Subtracting Capital Gain Taxes and Additional Taxes is what we need. This final percentage returns varying from 11% to 13% can confidently be considered our benchmark before making any business/investment decision.
So, if your business is earning you a return of anything lower, you should know your efforts are going for a waste because you could earn a higher return just by investing in the Nifty ETF.
If you’re an equity investor and your portfolio company is earning a ROIC (Return on Invested Capital) lower than that, you should think hard if it’s the right company to be investing in, because your portfolio company could do nothing and still get a higher ROIC investing in the Nifty ETF.
Thus, we should make investments only if it crosses our calculated threshold.
I am also adding a link to my calculations for your reference – Here.