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Beware! High returns are not always good

Arnav Pandya | August 18, 2008 10:01 IST

Higher returns on their investments are always a great lure for everyone. Beating the benchmark index is always a great inspiration for the investor. However, such instruments always have a high risk element, which is something most investors forget in their attempt to garner great returns.

While higher returns are good in most situations, there are times when such outperformance has to be critically viewed. Here are some examples where it might make sense to take a re-look at the overall position, when returns from some instruments are way beyond the prevailing returns in the market.

Index funds: When it comes to an index fund, the portfolio of the scheme comprises of stocks that are present in the index and that too, in the exact proportion. The idea is that the scheme should match the returns of the underlying index. Thus, the investor shows a preference for passive investment at the cost of active management, which is done by equity diversified funds.

In such a situation, the scheme has to perform in line with the returns of the index, whether negative or positive. The difference, if any, is called tracking error. And a high tracking error is not a good sign. Internationally, the average tracking error is 0.5 per cent. In India, 1 per cent is the average.

For investors, even if their scheme gives higher returns than the benchmark, it might not be a thing to rejoice because the fund's mandate is to track the index, and not try to beat it. This implies that while sometimes, it might beat the underlying index, the trend might reverse as well.

For instance, if one looks at ICICI [Get Quote] Prudential's two index schemes - ICICI Prudential Index and ICICI Prudential SPIcE, the former has returned 2.28 per cent more than Nifty and the latter has returned 2.01 per cent lower than Sensex.

Debt instruments: There are times when some companies offer returns from bonds and debentures that are at least 3-4 per cent higher than that being offered by highly rated papers. This might be construed as an opportunity by many to earn a higher rate of return. But at the same time, this also gives out a signal that the investment carries higher risk.

Sometimes, there is no security for such instruments, which means that there is no additional protection that the investor will be able to enjoy.

The tricky situation is that for a short time, such bonds and debentures may actually give high rate of returns. Investors, in such cases, also may start feeling that the good times are here to stay. But, more often than not, when the tide turns and companies run into trouble, there could be repayment issues. In India, several companies have failed to pay up in the past.

Commodity exchange traded fund: Exchange traded funds are now available in the country. A good example is a gold exchange traded fund where the scheme tracks the price of gold.

While gold ETFs have been doing well and returns have been impressive given the upturn in the fortunes of gold in the last one year, one has to be cautious of the ETFs they do not move in line, that is, the composition of the fund is different or the grade of commodity that has been chosen does not match the one being tracked.

Investors need to understand that the high performance need not be long-term in nature and it definitely involves higher risk. It is ideal that one gauges the financial position carefully before getting into such instruments.

Also, it is very important that one does not go the whole hog, that is, invest more than a large part of the portfolio in such instruments. Ideally, such investments should be done with surplus money and in small proportion.

The writer is a certified financial planner


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