chapters.txt

introducing-technical-analysis
2.1– overview
in the previous chapter, we briefly understood technical analysis and the main difference between technical and fundamental analysis. in this chapter, we will dig a bit deeper and explore the assumptions technical analysis is based upon.
2.2 – application on asset types
one of the greatest advantages of technical analysis is that you can apply ta on any asset class as long as the asset type has historical time series data. time series data in technical analysis is the price information, namely – open high, low, close, volume, etc.
here is an analogy that may help. think about learning how to drive a car. once you learn how to drive a car, you can drive any car, whether a mahindra xuv or a maruti swift. likewise, you only need to learn technical analysis once. once you do so, you can apply ta on any asset class – equities, commodities, foreign exchange, fixed income, etc.
the fact that ta can be applied to multiple assets is probably one of the biggest advantages of ta compared to the other stock market research techniques. for example, one has to study the profit and loss, balance sheet, and cash flow statements when it comes to the fundamental analysis of equity. however, the fundamental analysis of commodities is completely different.
when dealing with an agricultural commodity like coffee or pepper, the fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory etc. however, the fundamentals of metal commodities are different, so it is for energy commodities. so every time you choose a commodity, the fundamentals change.
on the other hand, the concept of technical analysis will remain the same irrespective of the asset you are studying. for example, an indicator such as ‘moving average convergence divergence (macd) or ‘relative strength index (rsi) is used the same way on equity, commodity, or currency.
2.3 – assumption in technical analysis
unlike fundamental analysts, technical analysts don’t worry about the company’s valuation. the only thing that matters is the stock’s historical trading data (price and volume) and the insights the past data provides about the future movement in stock price.
technical analysis is based on a few key assumptions. you need to know these assumptions to ensure you use technical analysis effectively.
1) markets discount everything – this assumption tells us that all known and unknown information in the public domain is reflected in the latest stock price. for example, an insider could buy the company’s stock in large quantities in anticipation of a good quarterly earnings announcement. while the insider does this secretively, the price reacts, revealing to the technical analyst that something is about to happen in the stock price.
2) the ‘how’ is more important than the ‘why’ – this is an extension of the first assumption. going with the same example discussed above – the technical analyst would not be interested in questioning why the insider bought the stock as long as the technical analyst knows how the price reacted to the insider’s action.
3) price moves in trend – all major moves in the market are an outcome of a trend. the concept of trend is the foundation of technical analysis. for example, the recent upward movement in the nifty 50 index to 18500 from 14750 did not happen overnight. this move happened in a phased manner in over 11 months. another way to look at it is that once the trend is established, the price moves in the direction of the trend.
4) history tends to repeat itself – in the technical analysis context, the price trend tends to repeat itself. this happens because the market participants consistently react to price movements in remarkably similar ways every time the price moves in a certain direction. for example, in an uptrend, market participants get greedy and want to buy irrespective of the high price. likewise, market participants want to sell in a downtrend irrespective of the low and unattractive prices. this human reaction has been the same towards stock prices over time, ensuring that history repeats itself.
2.4 – the trade summary
the indian stock market is open from 9:15 am to 03:30 pm. during the 6 hours 15-minute market session, millions of trades occur. think about an individual stock – every minute, a trade gets executed on the exchange. as market participants do we need to keep track of all the different price points at which a trade is executed?
to illustrate this further, let us consider this imaginary stock in which many trades exist. look at the picture below. each point refers to a trade being executed at a particular time. if one manages to plot a graph that includes every second from 9:15 am to 3:30 pm, the graph will be cluttered with many points. i’ve tried to represent this in the chart below –
the market opened at 9:15 am and closed at 3:30 pm, during which there were many trades. it will be practically impossible to track all these different price points. one needs a summary of the trading action and not the details on all the different price points.
we can summarise the price action by tracking the open, high, low, and close.
open price – when the markets open for trading, the first price a trade executes is called the opening price.
the high price – this represents the highest price at which a trade occurred for the given day.
the low price – this represents the lowest price at which a trade occurred for the given day.
the close price – this is the most important price because it is the final price at which the market closes for the day. the close indicates the intraday strength and a reference price for the next day. if the close is higher than the open, it is considered a positive day; otherwise negative. of course, we will deal with this in greater detail as we progress through the module.
the closing price also shows the market sentiment and serves as a reference point for the next day’s trading. for these reasons, closing is more important than the opening, high or low prices.
the main data points from the technical analysis perspective are open, high, low, and close prices. each of these prices has to be plotted on the chart and analyzed.

- its scope does not bind to technical analysis. the ta concepts can be applied across asset classes as long as it has time-series data.
- ta is based on a few core assumptions.
- markets discount everything
- the how is more important than the why
- price moves in trends
- history tends to repeat itself.
- a good way to summarize the daily trading action is by marking the open, high, low, and close prices, usually abbreviated as ohlc
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clearing-and-settlement-process
10.1 – market structure
the topic of clearing and settlement is super important to understand as it gives you a sense of the movement of money and funds between your account and, let’s just say, the stock market. for instance, when you buy a stock, say 100 shares of marico, you need to clearly understand how long it takes for the broker to remit these 100 marico shares to your demat account. we can extend this to stock selling as well.
the lack of understanding of the clearing and settlement process could leave a void and leave you with many unanswered questions related to the market structure. hence, for this reason, we will explore what happens behind the scenes from when you buy a stock to when it hits your demat account.
we will keep this discussion practical with a clear emphasis on what you need to know about clearing and settlement.
10.2 – what happens when you buy a stock?
day 1 – the trade (t day), monday
assume on a monday, you buy 100 shares of reliance industries at rs.1,000/- per share. the total buy value is rs.1,00,000/- (100 * 1000). the day you make the transaction is the trade date; brokers refer to this as the ‘t day.’ the assumption is that you intend to hold reliance industries in your demat account for a few days or maybe years, and it is not an intraday trade.
when you place an order to buy, the broker quickly validates if you have the necessary funds. in this example, the order will go through only if you have rs.1,00,000/- in your trading account; it will be rejected otherwise. assuming the trade is executed through zerodha, the applicable charges are –
|sl no||chargeable item||applicable charges||amount|
|01||brokerage||zero for equity delivery. for intraday, charges are 0.03% or rs.20/- whichever is lower, per executed order||zero|
|02||security transaction charges(stt)||0.1% of the turnover||100/-|
|03||exchange transaction charges||0.00345% of the turnover||3.45/-|
|04||gst||18% of brokerage + transaction charges + sebi charges||0.62/-|
|07||sebi charges||rs.10 per crore of transaction||0.12/-|
|total||104.19/-|
additionally, rs.15/- towards stamp duty is applicable. stamp duty is charged at 0.015% on the buy side. hence the total applicable charges are rs.119.19. note that these rates are subject to change; you can visit zerodha’s brokerage calculator to figure out the exact applicable rate when you wish to carry out a transaction.
so an amount of rs.1,00,000 plus 119.19 totaling rs.1,00,119.19/- is required to carry out this particular transaction. remember, the money is blocked in your account when you place a trade, but the stock is yet to hit your demat account.
also, on the t day, the broker generates a ‘contract note’ and emails you the copy to your registered email id. a contract note is like a bill detailing all your daily transactions. you can save the contract note for future reference. a contract note gives you a break up of all daily transactions and the trade reference number. it also shows the breakup of charges charged by the broker.
day 2 – trade day + 1 (t+1 day, tuesday)
brokers refer to the day after the transaction day as t+1 day. on t+1 day, you can sell the stock you purchased the previous day. if you do so, you are making a quick trade called “buy today, sell tomorrow” (btst) or “acquire today, sell tomorrow” (atst). remember, the stock is not in your demat account yet. hence, a risk is involved, and you can be in trouble for selling a stock you don’t own. this doesn’t mean every time you make a btst trade, you end up in trouble, but it does once in a way, especially when you trade stocks that are not liquid enough. i’d encourage you to read this article to understand the risks of a btst trade.
if you are a fresher in the market, i suggest you do not get into btst trades unless you understand the risk involved. continuing the example, from your perspective, nothing happens on t+1 day.
to summarize – on t day, you placed an order to buy 1l worth of reliance shares. the broker validated that you have the necessary funds. upon validation, the funds were blocked by the broker. on t day, the broker runs a post-trade process, where an obligation amount equal to what’s payable (for purchase) and receivable (for sale) is posted to their respective ledgers. the shares you bought will show up in your trading terminal with a ‘t+1’ tag, indicating that the shares are available for you to sell if you wish. but doing so results in a t+1 or btst transaction with its associated risk.
day 3 – trade day + 2 (t+2 day, wednesday)
on day 3, also called t+2, the settlement is due to the exchange. assuming the purchaser and seller are trading via two different brokers, the funds are debited from the buyer’s broker’s pool account by the clearing corporation and credited to the selling broker’s pool account. also, on t+2 day, the shares will reflect in the purchaser’s demat account, indicating that you own 100 shares of reliance.
so for all practical purposes, if you buy a share on day t day, you can expect to receive the shares will be fully settled in your demat account only by the end of t+2 day.
10.3 – what happens when you sell a stock?
the day you sell the stocks is again referred to as the ‘t day’. the stock gets blocked when you sell the stock from your demat account, and by the end of the day, the stocks are ‘earmarked’ for settlement. please refer the next section to know more on earmarking.
before the t+2 day, the earmarked shares are delivered to the depositary. on settlement day, the blocked shares are debited from your demat account and moved to the clearing corporation for payin. against the debit of such shares, you’d have received a credit for the sale after deducting all charges. you may be interested to note that you will receive 80% of the funds on t+1 and the remaining 20% on t+2. in other words, the seller will be settled fully on a t+2 basis, just like how the buyer is settled.
what transpires between t day and t+2 is a complex settlement process involving the stockbroker, clearing corporation, depositary, and the stock exchange. each entity uploads and receives multiple files to ensure the transaction goes smoothly. as far as you are concerned, you need to remember that equity transactions are settled on t+2 basis, meaning, if you are a buyer, you will get the shares on t+2, and if you are a seller, the funds are credited on t+2 basis.
10.4 – earmarking and t+1 settlement
earlier, for the settlement of a sell trade, the broker would be required to debit shares from a selling client, hold the securities in the broker’s pool account and transfer the securities to the clearing corporation (cc) on t+2. upon transfer, the client would receive a credit of funds against the sale, and the transaction would have been said to be settled. it was usual practice for brokers to debit shares on t day or t+1 day and transfer it to cc on t+2 (since the settlement is on t+2).
from the time the shares were debited until they were settled, the client shares lie in the broker’s pool account, possibly allowing a broker to misuse these securities. sebi identified this as a potential risk and introduced “earmarking” for settlement. in this new earmarking system, shares are no longer debited from the client’s account; they are only earmarked for settlement. think of earmarking as a temporary hold on the securities towards an upcoming settlement for the sale transaction initiated by the client.
on settlement day, the shares are debited from the investor’s account and credited to the clearing corporation. this new process eliminates the need for brokers to hold client shares in their pool account, thereby eliminating the risk that comes along. the new earmarking process has been made mandatory from november 2022.
by the way, our regulators are continuously working towards safeguarding retail investors from any possible pitfalls and, in the process, improving the efficiency of the market structure. one such effort is to move to a t+1 settlement for all equity settlements by march 2023.
exciting times ahead 🙂

- the day you make a transaction, the trade date is referred to as the ‘t day.’
- the broker must issue you a contract note for all transactions by the end of t day.
- when you buy a share, the same will be reflected in your demat account by the end of t+2 day.
- all equity/stock settlements in india happen on a t+2 basis.
- when you sell shares, the shares are blocked immediately, and the sale proceeds are credited again on t +2 day
- earmarking of shares was introduced to ensure the securities dont move out of client’s demat account to the broker’s pool account
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personal-finance-review-part-1
31.1 – overview
it’s a new year, and that means it’s time to review your personal finances. most tips about reviewing personal finances tend to be about investing, which always annoys me. i don’t know why, but people forget that there’s “personal” before “finance” and that the “personal” matters more than “finance.”
any plan without considering your unique life circumstances will always be incomplete. in this post, i’ll highlight the important aspects that you should take care of when managing your personal finances. it’s not possible to cover everything because something will be unique to your situation.
this post is for people who are still working and have started their personal finance journeys, as well as those who haven’t. the financial review process for retired people will be different, and i’ll try writing about it in the future.
31.2 – don’t be scared
everything about money is uncertain, and we are hardwired to hate uncertainty. a study showed humans find not knowing what will happen more stressful than knowing something bad will happen for certain. you would’ve also heard that losing something hurts twice as much as gaining something—this is called loss aversion. but there’s more to it. we also prefer the known over the unknown—this is called ambiguity aversion.
but why do we hate uncertainty?
another study showed that losing money activates the same brain regions that also process pain. in a sense, losing money feels like getting punched in the face.
when reviewing your personal finances, you will have to make tough decisions whose outcome you won’t know for decades. it’s easy to get tricked by our brains into avoiding this uncertainty by doing nothing or taking the easy way out. i’m not saying nonsense like, “don’t be afraid.” know that you will always be afraid when making financial decisions and be aware that we can be our own worst enemies.
for new investors
one reason people don’t think about their personal finances is because they are scared. questions like “what if i make a mistake?”, “will i lose money if i do this?” or “this sounds too complex” stop people from getting started. making mistakes is part of the process; how else will you learn? but there’s no bigger mistake than having the time and ability to take care of your personal finances but not doing so.
the first step will always be the hardest. but as you start taking care of your finances, you will learn, and things will become easier. it’s the same with anything that seems difficult in life.
when making important financial decisions, it’s ok to be scared—we aren’t robots. but avoiding decisions due to fear is the difference between a happy retirement and a miserable one. you might be thinking, all this motivational stuff sounds nice, but how do you deal with the fear of uncertainty? the rest of the post is dedicated to answering that question.
31.3 – a time for reflection
the phrase “the map is not the territory” was coined by the polish scholar alfred korzybski. it means that our assumptions about reality are not the actual reality. this also applies to personal finance. we often have a map of our personal finances, but the territory tends to be different. that’s because life happens, and you can’t plan life—you just have to deal with it.
it’s a tragedy that personal finance has become all about what [insert product name] to buy. financial products are a means to an end and not the end itself. an important aspect of your personal finance review process is to take a moment to reflect on your life circumstances.
what does this mean?
a year is a long time, and a lot can happen. think about all that has happened in the past year because major life events can affect your finances. having this big picture view of your life makes it easier to act.
for perspective, think about the last three years. we’ve lived through a pandemic that upended our lives, a historic spike in inflation that has increased the cost of living, and a terrible economic environment that has led to sharp pay cuts and job losses. then there might be changes in your life, such as marriage, having a kid, family emergencies, job losses, business failures, etc. all these events affect your personal finances.
then there’s also the fact that money is a deeply uncomfortable subject, and we rarely discuss it with our parents and partners. often, financial shocks come as a surprise because of the lack of communication. personal finance isn’t just about you; it’s also about your dependents and partner.
take the case of the elderly, like your parents, etc. they are the most vulnerable to financial fraud and mis-selling. most parents don’t discuss their finances with their kids. so if they are defrauded or if they buy some terrible product, the kids don’t discover it for years, and it’s often too late to do anything. there have been countless cases where senior citizens have lost their retirement kitties to such fraud.
having a holistic view of you and your dependents is important.
for new investors
this applies to new investors as well. even before you get to the “where to invest” and “what product to buy,” know where you are. money conversations might feel like opening pandora’s box—open it!
31.4 – know where your finances are
the next step is to take a financial inventory and figure out your net worth.
why?
knowing how your finances stack up is like getting a full body health checkup, it’s the bare minimum you can do every year. your net worth is your assets minus liabilities. but before that, you need to analyze your cashflows. i know that sounds dreadful but figuring out the health of your finances without knowing your inflows and outflows is impossible. you don’t have to track every single spend, either. you can look at your aggregate inflows and outflows every month.
i know gathering the details is painful, but most banking apps provide basic spending analysis. if you are using other personal finance apps, then this can be easier. you can also use a spreadsheet to do this. use this morningstar template guide to start.
as an aside, now that most banks are part of the account aggregator framework, we will see more robust personal finance tools in the future.
tracking your cashflows can help you figure out where your expenses are increasing. this will help you cut down on unnecessary spending and save more. but the biggest advantage is that it can help you avoid lifestyle creep or lifestyle inflation. it’s the tendency for your expenses to increase as your income grows. nothing damages your retirement readiness like a stagnant saving rate and increasing expenses.
once you’ve analyzed your cashflows, you can build your personal balance sheet or net worth statement. your net worth gives you a starting point for understanding how your finances stack up. tracking how it evolves can help you understand the strengths and weaknesses of your personal finances. it makes it easier to change things and improve your finances.
start by making a list of all your assets and liabilities.
assets
- cash balances in all your bank accounts.
- investments across fixed deposits, stocks, mutual funds, bonds, insurance, pensions, annuities, chit funds, govt savings schemes, etc.
- a realistic value if you own a house, jewelry, art, etc. estimating the values of illiquid assets like houses can be hard, but you can use a reasonable guesstimate based on similar properties, online sales data, or other prices. it’s better to be conservative when estimating.
- other assets
liabilities
- housing loan balances
- loan balances for all other loans like car loans, personal loans, buy now pay later (bnpl), loans against securities, loans against insurance, jewelry, etc.
- other loans and liabilities
use a spreadsheet to calculate your net worth–your assets minus liabilities. you can use this morningstar template as a guide.
without knowing your net worth, managing your finances is like shooting in the dark.
consolidate whatever you can
reviewing your finances will also help you figure out if your finances are scattered across different platforms. you should consolidate your finances because it makes managing them easier. for example, investing in mutual funds on a different platform doesn’t make sense if you already have a zerodha account or any other broking account that offers direct mutual funds. you get all the details of you and your family from your back-office in a few clicks.
- if you are married, involve your partner when reviewing your finances.
- if your parents are taking care of their own finances, you should encourage them to review their finances. if you are taking care of their finances, review them and ensure your parents are financially set.
- you might also have multiple accounts with multiple brokers, banks, and platforms. close them all unless needed.
- if you have any toxic products like endowment policies, traditional insurance policies, ulips, etc., it’s best to get rid of them. they are costly and opaque. they just make the insurance companies richer and you poorer.
reviewing all your finances can be a clarifying exercise because it forces you to think about all aspects of your life.
31.5 – review your goals
now that you have a broad idea of your finances, the next step is to review your financial goals.
finance is the only industry where people argue about everything, and goal setting is one of them. some think that you’re doomed without setting goals because setting goals helps you be realistic and focus on tangible outcomes. but others argue that we don’t know our goals, and even if we do, they keep changing. they think setting specific goals can distort risk perceptions, cause investors to take outsized risks, induce tunnel vision, become narrowly focused, miss the bigger picture, and lead to bad behavior once a goal is met.
the truth, as always, lies somewhere in between. we’re kind of hardwired to think in terms of goals. think about the end of the month when you get your salary, you mentally start allocating that money to various buckets like rent, savings, shopping, etc. this is called mental accounting, and it was made famous by nobel laureate richard thaler. goals-based investing harnesses that natural tendency.
being outcome-oriented is risky, and we don’t always know our goals. even if we do, they change. if you’re saving to buy a house after 5 years, you will likely change your mind about what house, where, etc., in year 5.
morningstar had conducted a study in which they asked people to list their top 3 goals, after which they showed everyone a list of common financial goals. after seeing the master list of goals, 73% of the people changed at least one of the top 3 goals.
some people advocate for possibilities planning that starts with figuring out what’s possible to achieve and then planning for those goals. i prefer this approach because it’s more flexible. most financial plans fail because they aren’t flexible. they ignore that life is unpredictable and that we have to be adaptable. reminds me of that old saying, “man plans, and god laughs.”
there’s no right or wrong way to manage your personal finances. some people save as much as possible without specific goals, some just have generic goals, and some have specific goals. you have to figure out what works for you and stick with it. focus on building good systems rather than trying to be specific. all you can do is control the processes, you can’t control the outcomes.
how to review your goals?
a few things to remember if you have goals:
- goals should be well-defined. for example, i want to retire in 2065 with 10 crores and withdraw 4% every year.
- estimate the cost of the goal.
- calculate the amount you need to save and adjust it for inflation. the sebi website has useful calculators to help you plan.
- figure out the right asset allocation for each goal with reasonable return assumptions. here’s an example:
a few things to keep in mind
always have reasonable return assumptions. take a look at the return assumption in the footer of the image above. assuming 12% for a 50% equity and 50% debt portfolio and 14% for a 75% equity and 25% debt portfolio is a recipe for disaster. just because nifty has given returns of 12% historically doesn’t mean you assume the same rate in your planning.
moreover, you won’t invest 100% in equity, and for long-term goals like retirement, you have to reduce your equity exposure as you get closer to your retirement. the blended returns of equity, debt, and gold won’t be 15% but lesser. having a reasonable assumption for your longest goals, like retirement, is important. if you get higher returns, then that’s a bonus.
for shorter-term goals, under 5 years, use a savings bank, fd, or liquid fund returns.
know the difference between risk tolerance and risk capacity.
- risk tolerance is your ability to withstand market volatility.
- risk capacity is how much risk you can take at a goal level.
for example, let’s say you are 30 years old and want to retire at 60. since the goal is 30 years away, you can take more risk with a higher equity allocation. even a 70% equity and 30% debt portfolio will be ok.
but let’s assume you want to buy a house in 7 years, you are an aggressive investor, and you don’t care about market volatility. it still doesn’t make sense to take more risks because this is a short-term goal. even though you have a higher risk tolerance, the risk capacity for the goal is low. you are taking on sequence risk if you put 60% in equity for a 7-year goal. in other words, what happens if the market falls 50% in year 6?
aligning your goals with your values
an issue with setting goals is that we don’t think about the things that matter to us. with or without realizing it, we all follow an internal compass. we work hard toward the things that matter and are meaningful to us. it might not always be obvious, but we tend to have a fuzzy idea.
when thinking about your goals, lean into this. think about the things that matter to you and your most deeply held values, and you’ll notice that your goals revolve around your values. i know these are very vague topics, but personal finance is not a math problem, it’s a people problem. by no means is this a simple process. you must ask yourself the hard questions. this is the role of a financial advisor, but you can do this on your own as well.
i love george kinder’s three questions for financial planning.
question 1: design your life
i want you to imagine that you are financially secure, that you have enough money to take care of your needs, now and in the future. the question is, how would you live your life? what would you do with the money? would you change anything? let yourself go. don’t hold back your dreams. describe a life that is complete, that is richly yours.
question 2: you have less time
this time, you visit your doctor who tells you that you have five to ten years left to live. the good part is that you won’t ever feel sick. the bad news is that you will have no notice of the moment of your death. what will you do in the time you have remaining to live? will you change your life, and how will you do it?
question 3: today’s the day
this time, your doctor shocks you with the news that you have only one day left to live. notice what feelings arise as you confront your very real mortality. ask yourself: what dreams will be left unfulfilled? what do i wish i had finished or had been? what do i wish i had done? [did i miss anything]?
george is the father of financial life planning, and he devised these questions to force people to think about the things that matter to them. if you notice, each question pushes you to think deeper. these questions can also evoke strong emotions like guilt, shame, regret, and profound sadness. but working through those emotions can help you work, save and invest toward the goals that matter most and bring meaning
31.6 – debt
managing debt is a key aspect of personal finance. it doesn’t matter if you are an investing genius and you are outperforming warren buffett, bad debt management can ruin you.
before you review, gather all the relevant details of your liabilities. most forms of debt have a terrible reputation, but not all debt is bad. the costliest debt is bad, period! unless you have overextended yourself, loans like housing loans and reverse mortgages can be useful.
once you have all the details of your loans, it’s not hard to figure out the issue.
here’s a broad range of interest rates for major loan categories.
|loan types||interest rates|
|credit cards||up to 42%|
|lending apps||up to 36%|
|personal loans||up to 36%|
|loan against property||8%-25%|
|housing loans||up to 15%|
|loan against securities||up to 15%|
|auto loans||8%-20%|
|education loans||8%-16%|
credit card loans are the worst because the interest rates can go as high as 42%. in the hands of people who know how to manage a credit card, it can be an useful tool. if not, it’s a deadly trap.
loans from lending apps are the next worst. housing loans tend to be the largest and paying them off might not be possible. depending on the interest rate, paying them as per the loan schedule might be ok. but if you can afford to pay extra every month, it can reduce the amount of interest you pay. that’s because, early on, most of your emis go toward interest rather than paying the principal.
not paying off costly loans like credit cards and personal loans is a bad idea. even before you save or invest, your priority should be to clear these costly loans. here are some simple strategies you can follow.
snowball method
make a list of all your loans and arrange them by the outstanding amount, from small to large. make the minimum payments on all the loans except the smallest loan. use the amount remaining to pay the smallest loan. paying off the smaller loans, move on to the others and clear them all.
avalanche method
make a list of all your loans and arrange them by the interest rate—from the highest to the lowest. make the minimum payments on all the loans except the loan with the highest interest rate. use the amount remaining to pay it. once that is paid off, move on to the next.
if you are lucky enough to have a high salary but also high debt, not clearing your loans early is stupid. paying off a loan is like earning a guaranteed return, and the mental peace of not having debt is priceless.
credit score
it’s also important to check your credit scores annually. your credit score determines your creditworthiness. india has four credit bureaus: experian, equifax, transunion cibil, and crif highmark. these companies monitor your loans and assign a score from 300-900—the higher your score, the better your creditworthiness. 750+ is what you should aim for.
all the credit bureaus provide a free report, which you can download from their websites. you might also see wrong details in your report, which affects your credit score. in such cases, you can raise a dispute on the credit bureau’s website and have it fixed. your credit score depends on the credit type, mix, and duration, among other factors. at a basic level, not taking too many loans and paying all your dues on time is a good start. here are a few more tips.
31.7 – insurance
at this stage, you might be thinking, why am i not talking about investments? it’s a tragedy that personal finance has become all about investing and products. it’s important to play defence before you play offense.
why?
it should be obvious but let me spell it out anyway. let’s assume that you don’t have emergency savings or insurance but a high savings rate, a good investment portfolio, and excellent returns. if you were to have a health emergency, your investments would become your insurance and emergency fund. most indians are just one serious health incident away from ruin—it sounds depressing, but that’s the sad truth. even people with decent incomes in india don’t have any insurance. when hit with emergencies, they end up depleting their savings or taking high interest loans.
the 2 key types of insurance you need are
- if you have dependents, term insurance (life insurance).
- health insurance.
term insurance
if you have dependents, then having life insurance is critical. a term insurance policy pays out in the case of your death. the ideal cover depends on factors like your income, expenses, family situation, etc. but at a basic level, the insurance cover should replace the lost income in the case of your death. so, if you have a cover of rs 1 crore invested in an fd at 7%, the monthly interest would be rs 57,994. would that be enough for your dependents to lead a comfortable life? you also have to assume inflation because expenses increase every year. the rule of thumb is the higher the cover, the better it is.
health insurance
i cannot stress the importance of health insurance because health costs have and will continue to rise. paying for them out of your pocket is impractical. starting with a base policy of rs 10–20 lakhs and then adding a top-up policy as necessary will go a long way. shrehith, from ditto, had written a wonderful post on choosing health insurance cover. he’s also written an entire module on health insurance in detail, which i recommend reading.
review
- check if you have appropriate term insurance cover. use this guide as a reference.
- check if you have adequate health cover and the right policy. here are a few things you need to watch out for when picking a health insurance policy.
- avoid any insurance products that mix insurance and investments. they are toxic products that offer the worst of both worlds.
having said that, insurance is a personal product that depends on your unique life circumstances. it’s always wise to speak to an insurance advisor. if you need help with an existing product or need to buy a new policy, you can speak to an advisor from ditto.
for newbies
if you are just starting your personal finance journey, ensure you have adequate insurance cover before you do anything. it’s important to protect both yourself and your dependents.
31.8 – emergency fund
the next important item on your personal finance checklist should be to create an emergency fund. apart from health emergencies, life will throw you 100 other curveballs, from job losses to house repairs. you can’t sell your investments in these situations, and taking debt is a bad idea. an emergency fund is meant to help you deal with such situations.
how much should you have as an emergency fund?
it depends. the common advice is to keep between 3 and 12 months of your living expense as emergency funds. but, if you have a high degree of job predictability or are young, you can afford to have a smaller reserve. but having a bigger reserve is a good idea if you are a contract worker, have a high-income job, or have an uncertain job.
where to park your emergency fund?
an emergency fund should always be liquid and be accessible anytime. you cannot use stocks to park your emergency fund because they are volatile. stick to instruments that you can access easily, like liquid mutual funds. you will have second thoughts about parking such a large amount in a place where the returns are low. the goal of an emergency fund isn’t to generate returns but to cover your emergencies.
liquidity of the emergency fund matters more than the returns.
a few pointers
- the right amount of money to put in a liquid fund depends on the nature of your income and expenses. the higher the predictability and security, the smaller the emergency reserve you can have.
- there’s no need to go overboard and have 5 years of your salary in an emergency fund. aim to achieve a reasonable balance.
- if you are young, you need not have a 6 months emergency fund on day 1. you can start a sip and build it up. you can also add money whenever you get bonuses or large cash inflows.
- don’t chase returns with your emergency fund. you will regret it.
###
the-usd-inr-pair
4.1 – the contract
we make an extremely critical assumption at this stage – we will assume you are familiar with how future and options contracts work.
technical analysis plays an important role in setting up short term currency trades, so we’ll assume you know technical analysis as well.
if you are not familiar with these topics, then i’d strongly suggest you read through these modules before proceeding further. the currency and commodities market is largely a futures market; hence a working knowledge of these derivative instruments is the key.
now, assuming you understand these concepts fairly well, let us begin by slicing and dicing the usd inr futures contract. the contract specification of the usd inr futures gives us insights on trade logistics.
here are the salient features of the usd inr pair –
|particular||details||remark|
|lot size||$1,000||inequity derivatives, the lot is number of shares, but here it’s a dollar amount|
|underlying||the rate of indian rupee against 1 usd|
|tick size||0.25 paise or in rupee terms inr 0.0025|
|trading hours||monday to friday between 9:00 am to 5:00 pm|
|expiry cycle||upto 11 weekly expires and 12 monthly expiries||note, equity derivatives have an expiry upto 3 months.|
|last trading day||
|
all weekly expiry contracts will expire on the friday of the expiring week
|all contracts other than weekly, will expire two working days prior to the last business day of the expiry month at 12:30 pm|
|final settlement day||last working day of the month|
|quantity freeze limit||10,001 or greater|
|margin||span + exposure||usually, span is about 2%, and exposure is around 0.5%. hence roughly about 2.5% is the overall margin requirement.|
|settlement price||rbi reference rate on the day of final settlement||the closing price of spot|
to give you a sense of how this works, let’s take an example –
this is the 15-minute chart of the usd inr pair, as you can see the encircled candle has formed a bearish marubuzo. one can initiate a short trade based on this, keeping the high of the marubuzo as the stoploss.
note that i’m not trying to justify a trade here, my objective is to showcase how the usd inr contract works.
the trade details are as below –
date: 1st july 2016
position – short
entry – 67.6900
sl – 67.7500
number of lots to short – 10
1 lot of usd inr = $ 1000
the contract value of 1 lot of usd inr = lot size * price
=1000 * 67.7000
=67,700
the margin required for this can be fetched from zerodha’s margin calculator; here is the snapshot of the same.
as you can see, the margin required to initiate a fresh position in usd inr is about rs.1,524/-. therefore on a contract size of 67700, this works out to –
1525/67700
= 2.251%
out of this, i’m guessing about 1.5% would be sapn margin requirement (read as the minimum margin required as per exchange) and the rest as exposure margin.
further, the idea is to short 10 lots, hence total margin required is –
10 * 1525
= 15,250/-
a point to note here – when trading equity futures, one has to earmark anywhere between 15% and 65% of the contract value as margins, this obviously varies from stock to stock. in contrast to equities, the margin charged in currencies is way lower. this should give you a sense of how leveraged currency trading really is.
on the other hand, currency sticks to a tight trading range compared to equities—hence higher leverage.
4.2 – the contract logistics
notice how the currency futures are quoted – they go upto the 4th decimal digit. there is a reason for this – when it comes to currency futures, a number as small as this – 0.0025 is considered big.
when rbi states the reference rate, they quote upto the 4th decimal. even a minor difference at the 4th decimal can alter the foreign reserves by a large degree. in fact, it is a norm world over to quote the currency to 4th decimal – in case of usd inr, this is 0.0025. this is called the tick size or in currency parlance, a ‘pip’. a pip/tick is the minimum number of points by which a currency can move.
so when the usd inr moved from 67.9000 to 67.9025, it is said that the currency has moved up by a pip.
how much money would you make per pip in the usd inr pair? well, this should be easy to figure out –
lot size * pip (tick size)
= 1000 * 0.0025
= 2.5
this means to say, for every pip or every tick movement you make rs.2.5/-.
going back to the short trade, here is how the marubuzo panned out –
after initiating the short, the currency pair declined 67.6000. if i choose to close this position, he is how much i would make –
entry = 67.6900
cmp = 67.6000
total number of points = 67.6900 – 67.6000 = 0.0900
position – short
this could be a bit tricky, do pay attention. a pip as you know is the minimum number of points the currency can move. to know how many pips a currency had moved when it moved by 0.09 paise, we divide the total number of points moved by the pip size.
number of pips = 0.0900/0.0025
= 36
as you can see the trade managed to capture 36 pips, let us now calculate how much money one would make –
lot size * number of lots * number of pips * tick size
we know, number of pips * tick size is as good as the total number of points caught with this trade. therefore we can restate the above formula –
lot size * number of lots * total number of points
= 1000 * 10 * 0.0900
= 900
remember this is an intraday trade. what if you were to carry this forward to expiry? well, we can carry this forward as long as we maintain the adequate margin requirements. the july contract will stay in series 2 days before the last working day of the month.
here is the calendar –
so 29th july happens to be the last working day of the month. hence 27th july will be the expiry of this series. in fact, you can hold the contract only till 12:30 pm on 27th july.
of course, you can always look at the contract to see the exact date of the expiry.
another question at this stage – at what price will the settlement happen?
the settlement will happen at the rbi reference rate set for 27th july, and it is important to note that the p&l will be settled in inr.
so for example, if i hold this position till 12:30 pm on 27th july and let it expiry, assume the price is 67.4000, then i’d stand to make –
= 1000 * 0.29 * 10
=2900/-
and this money will be credited to my trading account on 28th july 2016. needless to say, as long as you hold the contract, your position will be marked to market (m2m). this is similar to the way it works for equity futures.
hopefully, this example should give you a sense of how the logistics for the currency futures work.
let us quickly run through the usdinr options contract.
4.3 – usd inr options contract
let us have a look at how the usdinr option contract is structured. you may be interested to know that the option contract is made available only for the usd inr pair. hopefully, in the future, we could see option contracts on other currency pairs as well. while most of the parameters are similar to the futures contract, there are few features specific to option contracts.
option expiry style – european
premium – quoted in inr
contract cycle – while the future contracts are available for 12 months forward, the options contracts are available just 3 months forward. this is similar to equity derivatives. so, since we are in july, contracts are available for july, august, and september.
strikes available – 12 in the money, 12 out of the money, and 1 near the money option. so this is roughly 25 strikes available for you to pick and choose from. of course, more options are added based on how the market behaves. strikes are available at every 0.25 paisa intervals.
settlement – settled in inr based on the settlement price (rbi reference rate on expiry date).
let’s have a look at the usd inr option contract and figure out the logistics. have a look at the following image –
from the option quote, we know the following –
option type – call option
strike – 67.0000
spot price (see rbi reference rate) – 67.1848
expiry date – 27th july 2016
position – long
premium – 0.7400 (quoted in inr)
we know the lot size is $1000, although the lot size has not been mentioned in the quote above. usually, this information is made available in the quote for equity derivatives. so if you are seeing this for the first time, be aware that the lot size is $1000.
now, if you were to buy this option, what would be the premium outlay? well, this is fairly easy to calculate –
premium to be paid = lot size * premium
= 1000 * 0.7400
= 740
the option contract works similar to the equity derivative contracts. here is another snapshot i captured –
as you can see, the premium has shot up, and i can choose to close my trade right away. if i did, here is how much i would make –
= 1000 * 0.7750
=775
this translated to a profit of 775 – 740 = 35 per lot.
what if you were to sell/write this option instead? well, you know that option selling requires you to deposit margins. you can use zerodha’s f&o margin calculator to get an estimate on the margin required.
have a look at the snapshot below; i’ve used the calculator to identify the margin required to write (short) this option –
as you can see, the margin required is rs.2,390/-.
i hope this chapter has given you a basic sense of how the usd inr contracts are designed. in the next chapter, we will try and discuss some quantitative aspects of the usd inr pair and perhaps look at the contract specification of other currency pairs.

- the contract specification specs out the logistics of the usd inr derivative.
- the lot size is fixed to $1,000, but this can be changed by the exchange anytime.
- expiry of the usd inr contract is 2 days before the last working day of the month. the contract can be held/traded till 12:30 pm.
- margins applicable = span + exposure, usually the margins add upto 2.25 – 2.5%.
- currency pairs are quoted upto the 4th decimal place.
- a pip is the minimum price moment allowed in a currency.
- currency options are european in nature.
- the premium quoted in currency options is in inr.
- strikes are available at every 25 paisa price difference.
- margins are blocked when you intend to write currency options.
###
supplementary-note-ipo-ofs-fpo
ipo, ofs, and fpo – how are they different?
ipo
initial public offering is when a company is introduced into the publicly traded stock markets for the first time. in the ipo, the company’s promoters choose to offer a certain percentage of shares to the public. the reason for going public and the process of an ipo is explained in detail in chapters 4 and 5.
the primary reason for going public is to raise capital to fund expansion projects or cash out early investors. after the ipo is listed on the exchange and is traded in the secondary market, promoters of the company might still want additional capital. there are three options available: rights issue, offer for sale and follow-on public offer.
rights issue
the promoters can choose to raise additional capital from its existing shareholders by offering them new shares at a discounted price (generally lower than market price). the company offers new shares in the proportion of shares already held by the shareholders. for example, a 1:4 rights issue would mean that every 4 shares held 1 additional share is offered. although this option looks good, it limits the company to raise the capital from a small number of investors who are already holding shares of the company and might not want to invest more. a rights issue leads to the creation of new shares that are offered to the shareholders, which dilutes the value of the previously held shares.
an example of a rights issue is south indian bank which announced a 1:3(one share for every 3 held) issue for rs 14 which is 30% lower than the market price the stock was trading (rs 20 as on record date 17 feb 2017). the bank offered 45.07 lakh shares to the existing shareholders.
the rights issue is covered in detail in chapter 11, covering key corporate actions.
ofs
the promoters can choose to offer the secondary issue of shares to the whole market, unlike a rights issue restricted to existing shareholders. the exchange provides a separate window through the stockbrokers for the offer for sale. the exchange allows a company to route funds through ofs only if the promoters want to sell out their holdings and/or maintain minimum public shareholding requirements (govt. psu have a public shareholding requirement of 25%).
there is a floor price set by the company, at or above which both retail and non-retail investors can make bids. the shares are allotted, if bids are at a cut-off price or above will be settled by the exchange into the investor demat account in t+1 days.
an example of an offer for sale is ntpc limited, which offered a maximum of 46.35 million shares at a floor price of rs 168 and was fully subscribed in the 2 day period. the ofs was held on 29th august 2017 for non-retail investors and 30th august 2017.
fpo
an fpo also has the same intent of raising additional capital after it has been listed but follows a different mechanism for applying and allotting shares. shares can be diluted, and fresh shares can be created and offered in an fpo. just like an ipo, an fpo requires that merchant bankers be appointed to create a draft red herring prospectus which has to be approved by sebi after which bidding is allowed in a 3-5 day period. investors can place their bids through asba and shares are allotted based on the cut-off price decided after the book-building process. since the introduction of ofs in 2012, fpos are seldom used due to the lengthy approval process.
the company decides on a price band, and the fpo is publicly advertised. prospective investors can bid for the issue using the asba portal through internet banking or apply offline through a bank branch. after the bidding process is complete, the cut-off price is declared based on the demand and the additional shares allotted are listed on the exchange for trading in the secondary markets.
an example of an fpo is of engineers india ltd which underwent an issue in february 2014 with rs 145-rs 150. the issue was oversubscribed by 3 times. the shares on the day of the starting date of the issue were trading at rs 151.1. the lower price band was at a 4.2% discount from the market price.
difference between ofs and fpo
- an ofs is used to offload promoters’ shares while an fpo is used to fund new projects.
- dilution of shares is allowed in an fpo leading to change in shareholding structure while ofs does not affect the number of authorized shares.
- only the companies with a market capitalisation of rs 1000 crores and above can use the ofs route to raise funds while all the listed companies can use the fpo option.
- ever since sebi has introduced ofs, fpo issues have come down, and companies prefer to choose the ofs route to raise funds
###
personal-finance-review-part-2
32.1 – investments
this is the sexiest part of the personal finance journey and one that most people focus on. the amount of time people waste fussing over xyz stock or mutual fund always surprises me. in the grand scheme of things, as long as you get a few basics right, investing doesn’t matter.
before you review your investments, it’s important to keep a few things in mind:
- your portfolio is meant to reach your goals, not to achieve the highest returns. your investments are subservient to your goals.
- your benchmark in life is not to beat the nifty 50, but to reach your goals. have the right benchmark.
- savings rate is more important than the rate of return on your investments.
- asset allocation, risk management, and behavior determine your returns—not picking the “best fund” or “best strategy.”
- a sub-par portfolio that you can stick with is much better than the perfect portfolio you can’t.
- the portfolio you need is not the same as the portfolio you want.
- risk management will make or break your portfolio. you have to reduce the risk as you grow older.
- when planning for retirement, people often consider average life expectancy which can be misleading. it’s better to be overprepared and save more than less. karthik has explained this in detail in the below video:
32.2 – diversification and asset allocation
diversification
one of the oldest clichés in the markets is that diversification is the only free lunch. but just because it’s a cliché doesn’t mean it’s not true. diversification is the process of investing in and within different asset classes. a good portfolio will always be diversified across asset classes.
why?
as a reminder, humans haven’t yet figured out a way to predict which asset will do well. until we do, the best way to build wealth slowly is to allocate between different asset classes.
action item
make sure your portfolio is diversified across the following asset classes.
equity: domestic equities, and international equities.
debt: between various durations and risk levels.
- taking too much risk in your debt portfolio makes no sense. stick to funds with high exposure to aaa-rated bonds and government bonds.
- i’m also not a fan of taking duration risks. most investors are better off with short to intermediate-duration funds.
- categories like long-duration funds, dynamic asset allocation funds, and credit risk funds should be avoided unless you are an expert in debt
precious metals: gold can act as a diversifier if you understand the risks. gold can go a long time not doing anything, it can fall as much as equity, and doesn’t always have a negative correlation with equities.
off late, a lot of silver etfs and funds have been launched, but it makes no sense to me. silver is all risk and no returns.
diworsification
i remember reading somewhere that the average retail investor holds between 20-30 mutual funds in a portfolio. in case you’re wondering, that’s not diversification; that’s diworsification.
let me explain.
according to sebi guidelines, large-cap mutual funds can invest in the 100 largest companies by market cap. if you were to hold 3 large-cap funds, you would not just be holding similar funds with similar portfolio exposure, but you would also be replicating an index fund by paying more. the average expense ratio of a direct plan of an index fund is about 0.25%, but the average expense ratio of direct large-cap funds is about ~1.3%.
if you have multiple funds in the same categories, that’s a red flag. you need to review and trim your portfolio.
review your portfolio
are you well diversified? as i explained above, make sure you are well diversified across various asset classes and sub-asset classes.
is your asset allocation in line with your goals and risk capacity?
asset allocation is how you divide your portfolio between various asset classes. the younger you are, the more risk you can take by having a higher equity allocation. as you get closer to retirement, it’s better to reduce your equity allocation and increase your debt allocation.
how are your funds performing?
check the performance of your active funds against their chosen benchmarks and not against category averages. don’t judge their performance just based on 1-2 year performance, no fund can outperform all the time.
how?
that’s the million-dollar question. when you pick an active fund, you’re betting on the fund manager. some prefer to pick funds and managers only based on quantitative measures like;
- consistency of returns across market cycles based on metrics like rolling returns.
- looks at various ratios like sharpe ratio, sortino ratio, information ratio, and capture ratios.
- decomposing the fund returns based on factor models to assess exposures toward factors like value, quality, momentum, and volatility. holdings-based analysis by decomposing returns to styles, asset classes, and other exposures.
- fees. does the manager still deliver alpha (risk-adjusted outperformance) after fees?
some use qualitative measures with quantitative measures like the personality and temperament of the manager, processes, risk management, alignment of interests, reputation, and track record of the amc. there’s an entire cfa book on the topic if you’re interested.
you can use all fancy tools, techniques, artificial intelligence, and machine learning, but most active fund managers fail to beat their benchmarks. the underperformance of active funds is quite sharp in the large-cap category, with 70-80% of all funds underperforming s&p bse 100.
in mid-caps and small-caps, the argument you’ll hear is that they are “inefficient” and that active fund managers can “add value,” but the evidence says otherwise. the number of underperforming active mid-cap funds is increasing when compared against the s&p bse midcap 150 or the nifty midcap 150 indices. at best, picking a good active fund is a coin toss.
(source: s&p global)
based on the evidence, these are the building blocks of your core portfolio:
large-cap: nifty 50
this index consists of the 50 biggest companies in india, and it’s 62% of the free float market capitalization. buying a nifty 50 index fund is as good as owning 62% of all listed companies.
large-cap: nifty next 50
nse categorizes this index as a large-cap, but it behaves like a mid-cap index. the index consists of the 50 biggest companies after nifty 50 companies. it accounts for 10% of the free float market capitalization of the stocks listed on the nse.
mid-cap: nifty midcap 150
this index consists of the 150 biggest companies after nifty 100 and accounts for 12.9% of the free float market capitalization of the stocks listed on nse.
small-cap funds are risky, and they are not for most investors.
debt
except for target maturity etfs, funds, and some g-sec etfs, we don’t have passive debt funds. but if target maturity funds suit your goals, you can check them out.
point to consider
though nifty next 50 is categorized as a large-cap index, it behaves more like a mid-cap index. for most of its history, the performance of the nifty next 50 and nifty midcap 150 look similar, barring the last 5 years. so, it’s unclear whether adding a mid-cap 150 fund to a portfolio offers additional diversification.
but if you still believe in your active fund manager:
- you have to give the fund at least 5 years before judging. some prefer shorter time periods, but that’s noise.
- on shorter timeframes, if an active fund underperforms its chosen benchmark by more than 5-10%, that’s a red flag.
- if there’s a corporate governance issue, change in the strategy of the fund, the fund manager, or the acquisition of an amc, whether to stick with the fund or not is another judgment call you have to make.
reviewing stocks
you should review your portfolio if you are investing in direct equities.
- check if the thesis behind your stocks still holds.
- if there are any financial or corporate governance issues.
- ensure your portfolio is well diversified. a lot of retail investors tend to hold 50+ stocks in their portfolio. it’s not just hard to monitor it, but hard to maintain it. there’s no right number of stocks, but beyond a point, there are no diversification benefits, and the portfolio becomes hard to monitor.
check out these chapters to dive into more detail:
32.3 – rebalancing
asset allocation is the process of allocating a percentage of your portfolio to an asset class. let’s say you decide that 60% equity, 30% debt, and 10% gold is the right asset allocation for you. after a year, if equities go up, the equity allocation in your portfolio would’ve gone to 70%, and debt and gold would’ve become 25% and 5%. if you let the portfolio, be as is and don’t readjust them, the risk in your portfolio increases and so does the volatility.
the higher your portfolio volatility, the more variation in the odds of reaching your goals, especially if you are closer to your goals. to reduce the volatility of your portfolio, you need to rebalance your portfolio periodically to reduce the risk.
how do you do that?
you sell the assets that have gone above your desired allocation and buy those that have fallen below. in the above example, you would sell 10% of your equity allocation and 5% of your debt allocation to bring it back to 70% and increase your gold allocation to 10%. this is called rebalancing.
i know what you’re thinking—the dreaded t word. yes, by rebalancing, you will incur taxes, but saving taxes is not the objective of investing, reaching your goals is.
a few things to remember:
- the tax impact of rebalancing won’t always be huge. it’ll be a small part of your overall portfolio. remember, ltcg in equity only applies after rs 1 lakh of gains, and indexation is available for debt funds.
- rebalancing is not about the returns, but about reducing risk. taxes are a small price to pay for it. the image above shows how much various portfolios would’ve fallen during the 2020 covid-19 crash.
- you don’t always have to rebalance every time your allocation changes. for example, you can stick to an annual rebalancing frequency and have a tolerance band of 5% for each asset class. you do nothing if your equity allocation increases from 60% to 63%. but if it goes to 65%, you rebalance.
- you don’t always have to sell a part of your portfolio. you can use fresh investments to adjust the weights by investing in an asset class that has fallen below your target allocation.
- rebalancing will reduce the risk of your portfolio—that’s a given. as for returns, rebalancing can reduce returns or increase them, depending on luck, how you rebalance and when you rebalance.
- you can exploit rebalancing opportunities with sub-asset classes. let’s say equities have fallen, but mid-caps and small-caps have fallen more, and valuations are low. you can allocate more to mid and small-caps when rebalancing to increase your equity allocation. this is likely to increase your expected returns.
here’s a handy guide to the taxation on equities and debt.
32.4 – savings rate matters more than the return on investments
remember that old maruti suzuki advertisement about kitna deti hai? that sums up most investors. they waste a lot of time worrying about the returns on their investments without realizing that the savings rate matters more than the return on their investment. what’s more, you can control your savings rate, but not the return on your investment. the market will give what it wants to give.
a simple example.
|a||b|
|monthly sip||10,000||10,000|
|rate of return||9%||13%|
|annual sip increase||10%||0%|
|duration||30 years||30 years|
|final investment value||₹ 5,53,21,220||₹ 4,42,06,469|
in the long run, your rate of savings will matter more than the rate of return on your investments.
what’s a good savings rate?
the simple answer is whatever you can save without being miserable in life and foregoing coffee, soap, and toothpaste. but if you are starting your personal finance journey, aim to save 15-20% and increase your savings every year. the “increase every year” part is the most important aspect.
what if i can’t save much?
this is where the next point comes into the picture.
your biggest asset
if you were to build your personal balance sheet, it would look like this.
|asset||amount||liabilities||amount|
|house||3,000,000||home loan||180,000|
|car||1,200,000||car loan||100,000|
|cash||200,000||credit card||30,000|
|investments||500,000|
but let me ask you this, what’s your biggest asset?
it’s not your house, land, or your investment portfolio, it’s your human capital. in other words, human capital is the present value of your future earnings potential. we think that we are working to build financial assets to retire comfortably. but we’re converting our human capital into financial capital.
(source: cfa institute)
people don’t understand this concept well, and most financial planners don’t even include this as part of the financial planning process. all the conversations revolve around stocks, mutual funds, and asset allocation. they don’t understand that the source of financial wealth is human capital, not the other way around.
in summary, the most valuable asset that requires the utmost amount of care and consideration is not your investment portfolio, but your human capital.
the younger you are, the higher your human capital. if you’re reading this, you’d be well aware of the magic of compounding on your investments. but imagine the power of compounding your skills. the rate of return from improving your skills and knowledge will be far greater than the rate of return on your investments.
the rate of return on your human capital determines your savings rate. it is far more important than the rate of return on your investments.
so, what does that mean?
- the younger you are, the more valuable your human capital is. its value diminishes as you grow older.
- any investment you make on improving your education, skills, and knowledge when you are younger will pay off in terms of better opportunities.
- you can also think of human capital as a financial asset. if you have a stable and predictable job, then your human capital is like a bond. but if you have a volatile and unpredictable job, then it’s equity-like.
human capital should be a consideration in your asset allocation. the nature of your job and your skills can influence your risk preferences.
32.5 – behave!
one of the best things to have happened in finance in the last 40-odd years is the rise of behavioral finance. this is one of my favorite images ever, not because i’ve memorized all the biases and live a perfect life but i like it because it shows humans aren’t the cold, calculating, and rational beings that they are made out to be. we’re capable of some dumb things too.
but somewhere along the way, behavioral science lost its way. the focus shifted from finding solutions to help people to creating a laundry list of biases, labels, and cute experiments. the term “bias” also became a dirty word. people started throwing them around to paint people as dumb and stupid. but that’s the mainstream, nonsensical interpretation of behavioral science.
our biases are not a bug, they’re a feature. research has shown that these biases have an evolutionary explanation—they helped our ancestors survive. while these “quirks” helped us survive, they are unsuited for the task of investing. our ancestors lived in a harsh world where there was no guarantee of tomorrow, so saving for tomorrow made no sense. but the world is a different place today.
coming back to the point, the core idea of behavioral science remains true—that we don’t always act in our best interests and make “utility-maximizing decisions.”
we make mistakes like:
- not saving enough even though we can.
- inability to balance enjoying today vs. saving for tomorrow.
- leaving money on the table by keeping money in bank accounts, staying invested in costly funds, having a sub-par asset allocation, excessive conservatism, etc.
- sticking to default options even if they are terrible.
- being driven by greed and chasing quick money and other investment fads.
by now, it must be obvious that investing is a giant distraction once you have taken care of key basics. once you have covered the key bases, the success or failure of your portfolio doesn’t depend on stock or fund selection but rather on your behavior. you can build the perfect portfolio, but it’s pointless if you can’t hold it through the good times and bad times. being disciplined with your investment is one thing, but behavior matters more.
how do you behave?
the best way to behave is to get out of your way, so automate your finances.
- invest systematically through sips. create a mandate for your sips to automatically debit money from your bank account.
- create a sip to build up your emergency fund.
- automate the payments for your health and life insurance policies.
- set up automatic repayments for your credit cards and other loans.
- automate your rent and bill payments.
the other aspect is to minimize the odds of you doing silly things.
- the best antidote to stupidity is learning the basics of finance. once you have a working understanding, you’ll realize that building wealth is slow, and there are no get-rich-quick schemes.
- don’t check your portfolio often. the more frequently you check, the higher the odds of you doing something that you’ll regret. in fact, uninstalling all your finance apps and installing them at the end of the year to review your investments isn’t a bad idea.
- understand that the odds of you picking the best stock or best fund is zero. look at the evidence. once you have, invest in low-cost broad market index funds and move on with your life.
- be mindful of external influences on your money behavior. this often happens subconsciously but can cause a lot of grief. don’t benchmark your net worth to some random people on the internet or in your circle. be ok with having less. be ok getting rich slowly.
32.6 – money and mental health
in this section, i want to talk about something that is near and dear to my heart, and i had written about it earlier as well. if there’s just one thing i want you to take away from this post, it’s this.
for better or worse, money looms large in our lives. it’s easy to say “money doesn’t matter” or “money isn’t everything in life” when you have a lot of money. but you don’t have that luxury when you are living paycheck to paycheck and have bills to pay. but given how central money is in day-to-day decisions, it can be a source of significant stress and anxiety.
the american psychological association conducts a survey to gauge the perceptions of people toward stress and also identify the sources of stress. since the survey started, money has consistently ranked as one of the top sources of stress. we don’t have robust data about financial anxiety in india, but i have no doubt it’ll be the same.
financial stress and anxiety can occur due to a host of reasons, both external and internal. in the last three years, we’ve had a pandemic, a war, and tremendous economic uncertainty. these events have led to financial shocks of a lifetime and have caused immense stress and anxiety, but they are not in our control.
but financial stress can also be caused by having a bad relationship with money. we don’t realize it, but there are a lot of overt and covert influences on how you think about money. your earliest experiences with money and the money beliefs of your parents have a large impact on your own money beliefs. these beliefs manifest in a multitude of ways. for example, people who face hardships early in life or grow up during economic downturns tend to become more conservative. these beliefs impact everything from how they eat, save, and spend to their chosen jobs.
i cannot overstate the importance of understanding how money affects the rest of your life. money is a source of significant financial stress and anxiety. financial stress and anxiety can impact your mental health, which affects your physical health. knowing this relationship is important if you want to learn how to deal with financial stress and anxiety.
(source: money and mental health)
financial stress and anxiety are complex issues, and there’s no one-size-fits-all solution. for example, in an uncertain economic environment like 2020-2023, when there had been a recession, recovery, and another economic downturn coupled with job losses and business closures, there’s very little in our hands. the only choice is to adapt to the environment.
but there are things in your control that can cause significant financial stress:
- spending too much on unnecessary things.
- not saving enough, even if you can.
- not having adequate emergency savings and insurance.
- not upskilling yourself to deal with an ever-changing workplace.
- being secretive about money with your partners and family.
- benchmarking your net worth to others.
- defining your success and failures with money.
these are things you can control and change. all you can do in life is control what you can and make peace with the things you cannot. have you heard of the serenity prayer?
god, grant me the serenity to accept the things i cannot change, the courage to change the things i can, and the wisdom to know the difference.
32.7 – create a what if? folder
did you know that according to an economic times estimate, there’s over rs 80,000 crores of unclaimed money in investments, banks, and insurance policies?
this is because of two reasons:
- no nomination
- not telling the nominees even if there’s a nomination
someone who works in financial services told me one such story recently. his friend had passed away due to covid-19, and he had over a crore in investments, which his parents didn’t know. but since he knew, he helped them claim. otherwise, his parents wouldn’t have known about it.
when we work hard to ensure our loved ones have a comfortable life, not ensuring that they are taken care of in the event of our passing is stupid.
things to keep in mind:
- have nominees for all your investments and insurance policies. all you have to do is fill out a form online or courier it.
- tell your nominees that you’ve nominated them. otherwise, what’s the point?
now, this is the most important thing, create a physical or digital folder with the following details:
- details and documents related to all your investments. what, where etc.
- details of all your bank accounts.
- details about all your insurance policies.
- details of all the liabilities like home loans, loan against investments, etc.
- documents of your properties and other assets.
- copies of your identity proofs, educational documents, etc., used to open accounts and purchase products.
- a document detailing the claims process for all the assets and investments.
create a folder on a platform like google and share it with your nominees. but before you share, make sure your nominees have a strong password on their emails, and two-factor authentication enabled.
32.8 – beware of financial fraud
from hacking to identity theft, financial fraud is rampant everywhere.
- use strong passwords for all your investment accounts and bank accounts. make sure you enable two-factor authentication.
- enable two-factor authentication on all your emails.
- enable biometric and two-factor authentication on your mobile devices in case you lose them, or they are stolen.
- never share account-specific information, documents, or other personally identifiable details on phone calls and whatsapp.
- make sure to verify the authenticity of websites because phishing scams where lookalike websites are created to steal passwords are rampant.
- never share personal information or passwords with anyone.
- never deal with platforms and services with bad reputations. it’s subjective and tricky, but the worst offenders often stick out like a sore thumb.
32.9 – your information diet
be mindful of the financial information you consume. we live in an age of excess, where there’s more garbage than sensible content. then there’s the issue of social media influencers who are not just saying ridiculous things, but dangerous things. we saw a demonstration of how things can go badly when a crypto platform promoted by these influencers went bankrupt. those people making funny faces and teaching you how to invest in a 60-second instagram reel—the odds are they don’t know what they are talking about.
- 99% of day-to-day financial news is garbage.
- making portfolio decisions based on what you read in the news or what your auto driver told you is a guaranteed way to lose money.
- the key principles of personal finance are timeless. for example, “a person should always divide his money into three: one-third in land, one-third in commerce, and one-third at hand.” this basic idea of diversification is from the talmud. you won’t discover some new get-rich secret from some loudmouth on youtube.
- read some good books on personal finance and investing. i recommend the following to start with
- the behavioral investor by daniel crosby
- psychology of money by morgan housel
- common sense on mutual funds by jack bogle
- triumph of the optimists by elroy dimson, paul marsh, and mike staunton
- the delusions of crowds by william bernstein
###
taxation-for-investors
4.1 – quick recap
in continuation of the previous chapter: classifying your market activity
you can consider yourself an investor when –
- buying and selling stocks after taking delivery to your demat account
if the frequency of transactions (buy/sells) is high, it is best to consider them as trades and not investments. if considered as trades, any income is non-speculative business income, whereas if these are investments, then it falls under capital gains.
keeping this in perspective, you may have few questions –
- what is long term?
- what is considered high frequency of transactions (buy/sells)?
we discussed this in the previous chapter, but just to refresh your memory – there is no set rule from the it department to quantify ‘frequency’ or determine ‘long term’.
as long as your intent is right, and you are consistent across financial years in the way you identify long term or high frequency, there is nothing to worry about.
do note, if you are indulging in equity delivery based trades as frequently as a few times every week, it would be best to consider all of them as ‘trades’ and classifying income from them as business income instead of capital gains.
reiterating again that if investing/trading on the markets is the only source of income, and even if you are trading with moderate frequency, it is best to classify income from all your equity trades as a business income instead of capital gains.
on the other hand, if you are salaried or have some other business as your primary source of business, it becomes easier to show your equity trades as capital gains even if the frequency of trades is slightly higher.
updated 2nd march 2016
finally, the income tax department has brought in clarity by allowing an individual to decide on his own to either show his stock investments as capital gains or as a business income (trading) irrespective of the period of holding the listed shares and securities. whatever is the stance once taken, the taxpayer will have to continue with the same in the subsequent years. check this circular.
so essentially,
- stocks that you hold for more than 1 year can be considered as investments as you would have most likely received some dividends and also held for a longish time
- shorter-term equity delivery buy/sells can be considered as investments as long as the frequency of such buy/sell is low.
- if you wish, you can also show your equity delivery trades as a business income, but whatever stance you take, you should continue with it in the future years as well.
the focus of this chapter is on investing; hence we will keep the discussion limited to just points 1 and 2. we will talk about taxation when trading/business income in the next chapter.
4.2 – long term capital gain (ltcg)
firstly you need to know that, when you buy & sell (long trades) or sell & buy (short trades) stocks within a single trading day then such transactions are called intraday equity/stock trades. alternatively, if you are buying stocks/equity and wait till it gets delivered to your demat account before selling it, then it is called ‘equity delivery based’ transactions.
any gain or profit earned through equity delivery based trades or mutual funds can be categorized under capital gains, which can be subdivided into:
- long term capital gain (ltcg): equity delivery based investments where the holding period is more than 1 year
- short term capital gain (stcg): equity delivery based investments where the holding period is lesser than 1 year
taxes on long term capital gains for equity and mutual funds are discussed below –
for stocks/equity – 0% for first rs 1lk and @10% exceeding rs 1lk
the above taxation rate is only if the transactions (buy/sells) are executed on recognized stock exchanges where stt (security transaction tax) is paid. as discussed above, ltcg is a holding period of more than 1 year.
if the transactions (buy/sells) are executed through off-market transfer where shares are transferred from one person to another via delivery instruction booklet and not via a recognized exchange by paying stt, then ltcg is 20% in case of both listed and non-listed stocks (listed are those which trade on recognized exchanges). do note that when you carry an off-market transaction security transaction tax (stt) is not paid, but you end up paying higher capital gains tax.
note that a gift from a relative through dis slip is not considered as a transaction and hence not capital gain. it is important that gift not be treated as transfer, and relative could be (i) spouse of the individual (ii) brother or sister of the individual (iii) brother or sister of the spouse of the individual(iv) brother or sister of either of the parents of the individual (v) any lineal ascendant or descendant of the individual(vi) any lineal ascendant or descendant of the spouse of the individual (vii) spouse of the person referred to in clauses (ii) to (vi)
for equity mutual funds (mf) – 0% for first rs 1lk and @10% exceeding rs 1lk
similar to equity delivery based trades, any gain in investment in equity-oriented mutual funds for more than 1 year is considered as ltcg and exempt from taxes up to rs 1lk per year. a mutual fund is considered as equity-oriented if at least 65% of the investible funds are deployed into equity or shares of domestic companies.
for non-equity oriented/debt mf – flat 20% on the gain with indexation benefit
union budget 2014 brought in a major change to non-equity mutual funds. as opposed to 1 year in equity-based funds, you have to stay invested for 3 years in non-equity/debt funds for the investment to be considered as long term capital gain. if you sell the funds within 3 years to realize profits, then that gain is considered as stcg.
note: the government in the finance bill 2023 made certain amendments that apply to debt funds that invest not more than 35% in equity shares in indian companies. as per the new rules, these mutual funds and etfs will not be eligible for indexation benefits and will be taxed at applicable slab rates, for investments made on or after april 1, 2023.
4.3 – indexation
when calculating capital gains in case of non-equity oriented mutual funds, property, gold, and others where you are taxed on ltcg, you get the indexation benefit to determine your net capital gain.
i guess we would all agree that inflation eats into most of what is earned as profits by investing in capital assets such as the ones mentioned above.
for someone wondering what that inflation is, here is a simple example to help you understand the same –
all else equal, if a box of sweets priced at rs.100 last year, chances are the same could cost rs.110 this year. the price differential is attributable to inflation, which in this example is 10%. inflation is the % by which the purchasing value of your money diminishes.
assuming the average inflation rate in india of around 6.5%, if you had invested into a debt fund, wouldn’t a big portion of your long term capital gain at the end of 3 years get eaten away by inflation?
for example assume you had invested rs.100, 000/- into a debt fund, and you got back rs 130,000/- at the end of 3 years. you have a long term capital gain of rs.30,000/-. but in the same period assume the purchasing value of money is dropped by 18k because of inflation. should you still pay long term capital gain on the entire 30k? clearly this does not make sense right?
indexation is a simple method to determine the true value of the sale of an asset after considering the effect of inflation. this can be done with the help of the cost inflation index (cii) which can be found on the income tax website.
let me explain this with an example of a purchase/sale of a debt mutual fund.
purchase value: rs.100,000/-
year of purchase: 2005
sale value: rs 300,000
year of sale: 2015
long term capital gain: rs 200,000/-
without indexation, i would have to pay tax of 20% on the capital gains of rs 200,000/-, which works out to rs 40,000/-.
but we can reduce the ltcg by considering indexation.
to calculate indexed purchase value, we need to use the cost inflation index (cii). find below the cost inflation index from the income tax website until 2019/20. refer to this for cii data before 2001/02.
|financial year||cii|
|2001-02||100|
|2002-03||105|
|2003-04||109|
|2004-05||113|
|2005-06||117|
|2006-07||122|
|2007-08||129|
|2008-09||137|
|2009-10||148|
|2010-11||167|
|2011-12||184|
|2012-13||200|
|2013-14||220|
|2014-15||240|
|2015-16||254|
|2016-17||264|
|2017-18||272|
|2018-19||280|
|2019-20||289|
going back to the above example,
cii in the year of purchase (2005): 117
cii in the year of sale (2015): 240
indexed purchase value = purchase value * (cii for the year of sale/ cii for the year of purchase)
so –
indexed purchase value = rs 100000 * (240/117)
= rs 205128.21
long term capital gain = sale value – indexed purchase value
therefore, in our example
ltcg = rs 300,000 – rs 205128.21
= rs 94871.79/-
so the tax now would be 20% of rs 94,871.79 = rs 18,974.36, much lesser than rs 40,000/- you would have had to pay without the indexation benefit.
like i had said earlier, the indexed purchase value can be calculated using the above method for all long term capital gains which are taxable like debt funds, real estate, gold, among others. you could use the it department’s cost inflation index utility to check on the indexed purchase value of your capital assets instead of having to calculate manually.
the interesting thing to note in regards to 20% after indexation for non-equity oriented or debt funds: most of these funds return between 8 to 10% and typically inflation in india has been around that for the last many years. so with the indexation benefit, you typically won’t have to pay any tax on ltcg of non-equity oriented funds.
4.4 – short term capital gain (stcg)
tax on short term capital gains for equity and mutual funds are discussed below –
for stocks/equity: 15% of the gain
it is 15% of the gain if the transactions (buy/sells) are executed on recognized stock exchanges where stt (security transaction tax) is paid. stcg is applicable for holding period over 1 day and not more than 12 months.
if the transactions (buy/sells) are executed via off-market transfer (where shares are transferred from one person to another via delivery instruction booklet and not on the exchange) where stt is not paid, stcg will be taxable as per your applicable tax slab rate. for example, if you are earning over rs.10,00,000/- per year in salary, you will fall in the 30% slab, and hence stcg will also be taxed at 30%. also, stcg is applicable only when the income exceeds the minimum tax slab of rs 2.5lks/year. so if there is no other income for the year and assuming there was rs 1lk stcg, it would not entail the flat 15% tax.
for equity mutual funds (mf): 15% of the gain
similar to stcg for equity delivery based trades, any gain in investment in equity-oriented mutual funds held for lesser than 1 year is considered as stcg and taxed at 15% of the gain. do note a fund is considered equity based if 65% of the funds are invested in domestic companies.
for non-equity oriented/debt mf: as per your individual tax slab
union budget 2014 brought in a major change to non-equity mutual funds. you have to now stay invested for 3 years for the investment to be considered as long term capital gain. all gains made on investments in such funds held for less than 3 years are now considered as stcg. stcg, in this case, has to be added to your other business income and tax paid according to your income tax slab.
for example, if you are earning around rs 800,000/- per year in your normal business/salary and you had stcg of rs 100,000/- from debt funds, you will fall in the 20% slab as your total income is rs 9,00,000/-. so effectively in this example, you will pay 20% of stcg as taxes.
4.5 – days of holding
for an investor, the taxation difference between ltcg and stcg is quite huge. if you sold stocks 360 days from when you had bought, you would have to pay 15% of all gains as taxes on stcg. the same stock if held for 5 days more (1 year or 365 days), the entire gain would be exempt from taxation as it would be ltcg now.
it becomes imperative that you as an investor keep a tab on the number of days since you purchased your stock holdings. if you have purchased the same stock multiple times during the holding period, then the period will be determined using fifo (first in first out) method.
let me explain –
assume on 10th april 2014, you bought 100 shares of reliance at rs.800 per share, and on june 1st, 2014 another 100 shares were bought at rs.820 per share.
a year later, on may 1st, 2015, you sold 150 shares at 920.
following fifo guidelines, 100 shares bought on 10th april 2014 and 50 shares from the 100 bought on june 1st, 2014 should be considered as being sold.
hence, for shares bought on 10th april 2014 gains = rs 120 (920-800) x 100 = rs 12,000/- (ltcg and hence 0 tax).
for shares bought on june 1st, gain = rs 100 (920-820) x 50 = rs 5,000/- (stcg and hence 15% tax).
small little sales pitch here 🙂 – if you are trading at zerodha the holdings page in our back office platform called console will keep a tab for you on a number of days since your holdings were purchased, and even a breakdown if bought in multiple trades.
here is a snapshot of the same –
the highlights show –
- day counter
- a green arrow signifying holdings more than 365 days, selling which won’t attract any taxes.
- if you have bought the same holdings in multiple trades, the split up showing the same.
besides zerodha q, equity tax p&l is probably the only report offered by an indian brokerage which gives you a complete breakdown of speculative income, stcg, and ltcg.
4.6 – quick note on stt, advance tax, and more
stt (securities transaction tax) is a tax payable to the government of india on trades executed on recognized stock exchanges. the tax is not applicable to off-market transactions which are when shares are transferred from one demat to another through delivery instruction slips instead of routing the trades via exchange. but off-market transactions attract higher capital gains tax as explained previously. the current rate of stt for equity delivery based trades is 0.1% of the trade value.
when calculating taxes on capital gains, stt can’t be added to the cost of acquisition or sale of shares/stocks/equity. whereas brokerage and all other charges (which include exchange charges, sebi charges, stamp duty, service tax) that you pay when buying/selling shares on the exchange can be added to the cost of share, hence indirectly taking benefit of these expenses that you incur.
advance tax when you have realized capital gains (stcg)
every taxpayer with business income or with realized (profit booked) short term capital gains is required to pay advance tax on 15th june, 15th sept, 15th december, and 15th march. advance tax is paid keeping in mind an approximate income and taxes that you would have to pay on your business and capital gain income by the end of the year. you as an individual are required to pay 15% of the expected annual tax that you are likely to pay for that financial year by 15th june, 45% by 15th sept, 75% by 15th dec, and 100% by 15th march. not paying would entail a penalty of annualized interest of around 12% for the period by which it was delayed.
when you are investing in the stock markets, it is very tough to extrapolate the capital gain (stcg) or profit that will be earned by selling shares for an entire year just based on stcg earned for a small period of time. so if you have sold shares and are sitting on profits (stcg), it is best to pay advance tax only on that profit which is booked until now. even if you eventually end up making a profit for the entire year which is lesser than for what you had paid advance tax, you can claim for a tax refund. tax refunds are processed in quick time by the it department now.
you can make your advance tax payments online by clicking on challan no./itns 280 on https://incometaxindiaefiling.gov.in/.
which itr form to use
you can declare capital gains either on itr 2 or itr3
itr3 (itr 4 until 2017): when you have business income and capital gains
itr 2: when you have a salary and capital gains or just capital gains
4.7 – short and long term capital losses
we pay 15% tax on short term capital gains and 0% on long term capital gains, what if these were not gains but net losses for the year.
short term capital losses if filed within time can be carried forward for 8 consecutive years and set off against any gains made in those years. for example, if the net short term capital loss for this year is rs.100,000/-, this can be carried forward to next year, and if net short term capital gain next year is rs.50,000/- then 15% of this gain need not be paid as taxes because this gain can be set off against the loss which was carried forward. we will still be left with rs rs.50,000 (rs.100,000 – rs.50,000) loss which is carried forward for another 7 years.
long term capital losses can now (post introduction of ltcg tax@10%) also be set off against long term gains.
long term capital loss can be setoff only against long term capital gain. short term capital loss can be setoff against both long term gains and short term gains.
key takeaways:
- ltcg : equity, equity mf – 0% for first rs 1lk, 10% on exceeding rs 1lk, debt mf: 20% after indexation benefit
- stcg: equity: 15%, equity mf: 15%, debt mf: as per individual tax slab
- you can use the cost inflation index to determine and get the benefit from the indexed purchase value
- index purchase price = indexed purchase value = purchase value * (cii for the year of sale/ cii for the year of purchase)
- if you have bought and sold the same shares multiple times then use fifo methodology to calculate the holding period and capital gains
- stt is payable to the govt and cannot be claimed as expense when investing
interesting reads:
livemint: if you pay stt stcg is 15% otherwise as per tax slab
income tax india website – cost inflation index utility
taxguru – taxation of income & capital gains for mutual funds
hdfc- debt mutual funds scenario post finance bill (no2), 2014
disclaimer – do consult a chartered accountant (ca) before filing your returns. the content above is in the context of taxation for retail individual investors/traders only.
###
supplementary-note-the-20-market-depth
the 20 market depth (level 3 data) window
i’ve driven a car for many years and i’ve even changed my car a few times now. each time i changed my car, the engine remained more or less the same, but the features within the vehicle and its aesthetics continuously changed. air conditioner, power steering, and power windows were all luxury features in the car at one point, but today, i guess no one buys a car without these essential features. the game-changer for me though was parking assist. the little camera at the back of the car gave me complete visibility of the parking space available. i was no longer required to pop and twist my head out and struggle to park the car, nor did i have to bug my co-passenger to get down and help me navigate my way into a parking spot. the parking assist feature did everything and helped me execute a perfect parallel park. the parking assist feature was my edge for hassle-free car parking.
i feel the same edge while trading the markets with the level 3 data 🙂
level 3 or the 20 market depth feature is unique and has multiple uses. you’ll probably appreciate the level 3 market window if you have traded at an institutional desk. a regular retail trader would not understand this feature anytime soon, simply because this feature was unavailable all these years until we introduced it for the very first time to the indian retail traders.
the purpose of this chapter is to help you understand how useful this feature is and get you started on building trading strategies around this feature.
if you are entirely new to this, i’d suggest you read this blog to understand what the level 3 data is all about.
assuming you know what it is, this chapter will help you understand the multiple uses of this feature.
contract availability
for the option traders, the 20-depth order book gives great visibility into the availability of contracts to trade and help identify better price points to execute these trade. without this visibility, it becomes really hard to trade illiquid contracts. while i’m specifically talking about options here, you can extend this to futures contracts as well, especially the illiquid ones.
let us put this in context, have a look at the regular market depth (i.e. the top 5 bid-ask) of the 13000 ce expiring in jan 2020.
we can see narrow bids on the left and a notch better offer on the right. you’d probably hesitate to trade this contract if you are someone looking at trading a few lots of nifty.
but check what’s hiding under the hood here by opening the level 3 data –
as you can see, there are many contracts available, but they are not visible in the regular market depth. in fact, the bid and offer quantities are heavily concentrated below the 8th row respectively.
given the availability of the contracts in this strike, the perspective to trade or not completely changes and will now depend upon your trading strategy.
execution control
level 3 data gives you full visibility of the approximate execution price for your trade. this is particularly useful when you decide to scalp the market. when you scalp the market —
- you trade large quantities, i.e. buy and sell large amounts in quick succession to profit from small tick moves in the stock
- since these are quick trades, you place market orders only
let us say you want to buy and sell 5000 shares of hindustan zinc; the regular market depth window gives you the following information —
as you can see, there is no visibility on how these 5000 shares will get filled. now, take a look at the 20 depth window —
the 20 depth window paints an entirely different picture. it not only tells me that i’ll get the 5000 shares, but it also gives me information about the approximate buy price. if i were to place a market order for 5000 shares, i’d be buying this order book from 210.5 to 211.25. i also see at 211; there are 2425 shares available, so i can expect the average price is at or around 211.
now, my decision to scalp the stock should depend on the pop i’d expect over and above 211. maybe 211.5 or so. of course, you’ll get the exact breakeven (post charges) if you were to use a brokerage calculator.
position sizing
level 3 market window plays a critical role in ‘guesstimating’ the number of shares to trade, given the liquidity of the stock. for the sake of this discussion, we will assume that the availability of capital is not an issue.
now, have a look at the regular market depth —
you expect siemens to move from 1675 to about 1690 over the next hour. so, given the fact that you are not constrained by capital, how many shares will you buy for this intraday trade?
the regular market depth window suggests that you can buy close to 175 shares. however, the 20 depth opens up a different perspective altogether —
in fact, the liquidity in this stock lies below the best five bid and ask, and the impact cost is reasonable. the regular market depth window fails to capture this information. assuming you intend to buy about 1500 shares, the buy price will lie somewhere within 1675.5 to 1678, which is spread of 0.149%.
in this case, assuming you are sure about the target price (1690), you can go all in and buy through whatever is available at that moment.
order placement
you can extend the position sizing concept and use the 20 depth market watch to place a stop loss or a limit order. assume you have an intraday buy position in vst tillers at 1313.8.
the question is, where you would place the stop loss for this trade? can the 20 market depth help us with this?
of course. have a look at the 20 depth window for vst tillers. as you can see, there is a concentration of bids in 1290. the good part is that the number of order count is also the highest (35) in 1290.
this implies that several traders have placed an order at 1290, indicating some sort of price action at that level. this perhaps builds a case for placing the stop-loss.
a prudent trader would probably place a stoploss not at 1290, but maybe at a price just below it.
so i was a buyer in this stock, then purely based on 20 depth i’d probably place my sl at 1290 or below, maybe at 1287 and by the same logic, set my target at 1340 or at 1338.8.
validate the support and resistance level
i find this extremely interesting. in the example above, we identified 1290 as the stoploss price, simply because there was a concentration of bids. in other words, we expect 1290 as a support price.
if this is indeed true, then it should show up on the charts as well, right? have a look at the chart below –
clearly, there is some price action around 1296. remember, support and resistance is not one price point, but rather a range. therefore 1290 – 1300 marks as an intraday support for this stock.
this is a perfect example of seeing the price action concept play out in the market.
another way to look at this is first to identify the s&r level and then check the 20 depth to figure if there is a concentration of bids/offers in that zone.
hopefully, by now you’ve started to appreciate the immeasurable value 20 depth order book brings to you while trading.
remember, irrespective of which technique you use to develop a point of view (technical or quantitative analysis), things boil down to price, and the action trades take at that price.
the 20 depth market window is essentially your ticket to validate the truth of this price action. make sure you use your card wisely!
do post your comments and tell us how differently you will use the 20 depth window for identifying trading opportunities.
good luck!
###
key-events-and-their-impact-on-markets
12.1 – events
trading or investing based on just company-specific information may not be sufficient. outside events, both economic and/or non-economic, impact stocks and the market’s performance in general. it is also important to understand the events that influence the markets.
in this chapter, we will try to understand some common events and how the stock market reacts to these events.
12.2 – monetary policy
the monetary policy is a tool through which the reserve bank of india (rbi) controls the money supply by controlling the interest rates. rbi is india’s central bank. likewise, every country’s central bank is responsible for setting interest rates. for example, the european central bank in europe and federal reserves in the us. central banks tweak the interest rates to control the money supply in the mainstream economy.
while setting the interest rates, the rbi has to strike a balance between growth and inflation. in a nutshell – if the interest rates are high, the borrowing rates are high (particularly for corporations). if corporate can’t borrow easily, they cannot grow. if corporations don’t grow, the economy slows down.
on the other hand, borrowing becomes easier when the interest rates are low. this translates to more money in the hands of corporations and consumers. with more money, there is increased spending which means the sellers tend to increase the prices of goods and services, leading to inflation.
i’d encourage you to watch this youtube video where i’ve tried to explain what causes inflation and the means through which rbi controls inflation.
to strike a balance, the rbi has to consider all economic factors and carefully set the key rates. any imbalance in these rates can lead to economic chaos. the key rbi rates that you need to track are as follows:
repo rate – banks can borrow from the rbi. the rate at which rbi lends money to other banks is called the repo rate. if the repo rate is high, the cost of borrowing is high, leading to slow economic growth. you can check the latest repo rate (and other rates, too) on rbi’s website. markets don’t like the rbi increasing the repo rates because it slows down economic growth.
reverse repo rate – reverse repo rate is the rate at which rbi borrows money from banks. or in other words, reverse repo is the deposit rate rbi offers to other banks when the banks park funds with rbi. when banks deposit money to rbi, they are certain that rbi will not default, so the rate rbi offers is relatively low. however, the banking system’s money supply reduces when banks deposit money with rbi (at a lower rate) instead of the corporate entity. an increase in the reverse repo rate is not great for the economy as it tightens the money supply. sometimes via the central bank’s policy, the central bank mandates higher deposits by banks; again, this is a way to curtail excess money supply in the mainstream economy.
cash reserve ratio (crr) – every bank must maintain funds with rbi. the amount that they maintain is dependent on the crr. if crr increases, more money is sucked out of the mainstream economy, which is not good for the economy.
the monetary policy committee members meet regularly to review the economic situation and decide upon these key rates; hence keeping track of the monetary policy event is a must for any active trader. the first to react to rate decisions would be interest-rate sensitive stocks across various sectors such as – banks, automobiles, housing finance, real estate, metals, etc.
12.3 – inflation
inflation is a sustained increase in the general prices of goods and services. increasing inflation erodes the purchasing power of money. all things being equal, if the cost of 1 kg of onion has increased from rs.15 to rs.20, this price increase is attributed to inflation. inflation is inevitable, but a high inflation rate is not desirable as it could lead to economic uneasiness. a high level of inflation tends to send a bad signal to markets. both the government and rbi work towards reducing inflation to a manageable level. inflation is generally measured using an index. if the inflation index increases by certain percentage points, it indicates rising inflation. likewise, an index falling indicates inflation cooling off.
there are two inflation indices – the wholesale price index (wpi) and consumer price index (cpi).
wholesale price index (wpi) – the wpi indicates the movement in prices at the wholesale level. it captures the price change when goods are bought and sold wholesale. wpi is an easy and convenient method to calculate inflation. the inflation measured here is at an institutional level and does not necessarily capture the consumer’s inflation.
consumer price index (cpi)– the cpi, on the other hand, captures the effect of the change in prices at a retail level. as a consumer, cpi inflation is what matters. the calculation of cpi is quite detailed as it involves classifying consumption into various categories and subcategories across urban and rural regions. each of these categories is made into an index, the final cpi index is a composition of several internal indices. the cpi captures the effect of inflation on daily household consumables like fruits, vegetables, cereals, and even fuels like petrol and diesel.
the computation of cpi is quite rigorous and detailed. it is one of the most critical metrics for studying the economy. a national statistical agency, the ministry of statistics and programme implementation (mospi), publishes the cpi numbers around the 2nd week of every month. the rbi’s challenge is to strike a balance between inflation and interest rates. usually, a low-interest rate tends to increase inflation, and a high-interest rate tends to arrest inflation.
12.4 – index of industrial production (iip)
the index of industrial production (iip) is a short-term indicator of the country’s industrial sector’s progress. the data is released every month (along with inflation data) by the ministry of statistics and programme implementation (mospi). as the name suggests, the iip measures the indian industrial sectors’ production, keeping a fixed reference point. as of today, india uses the reference point of 2004-05. the reference point is also called the base year.
roughly about 15 different industries submit their production data to the ministry, which collates the data and releases it as an index number. if the iip increases, it indicates a vibrant industrial environment (as the production is going up) and hence a positive sign for the economy and markets. a decreasing iip indicates a sluggish production environment, hence a negative sign for the economy and markets.
to sum up, an upswing in industrial production is good for the economy, and a downswing rings an alarm. as india is getting more industrialized, the relative importance of the index of industrial production is increasing.
a lower iip number puts pressure on the rbi to lower the interest rates and aid industrial credit with cheaper credit.
12.5 – purchasing managers index (pmi)
the purchasing managers’ index (pmi) is an economic indicator that tries to capture business activity across the country’s manufacturing and service sectors. this is a survey-based indicator where the respondents – usually the purchasing managers- indicate their business perception change concerning the previous month. a separate survey is conducted for the service and manufacturing sectors. the data from the survey are consolidated on a single index. typical areas covered in the survey include new orders, output, business expectations, and employment.
the pmi number usually oscillates around 50. a reading above 50 indicates expansion, and below 50 indicates a contraction in the economy. and reading at 50 indicates no change in the economy.
12.6 – budget
a budget is an event during which the ministry of finance discusses the country’s finance in detail. the finance minister, on behalf of the ministry, makes a budget presentation to the entire country. during the budget, major policy announcements and economic reforms are announced, which impacts various industries across the markets. therefore the budget plays a vital role in the economy.
to illustrate this further, in one of the recent budgets, the expectation was to increase the duties on a cigarette. as expected, during the budget, the finance minister raised the duties on a cigarette, so the prices increased. an increased cigarette price has a few implications:
-
- increased cigarette prices discourage smokers from buying cigarettes (needless to say, this is debatable), and hence the profitability of the cigarette manufacturing companies such as itc decreases. if the profitability decreases, investors may want to sell shares of itc.
- if market participants start selling itc, the markets will come down because itc is an index heavyweight.
in reaction to the budget announcement, itc traded 3.5% lower for this precise reason.
a budget is an annual event, and it is announced during the last week of february. however, the budget announcement could be delayed under certain special circumstances, such as a new government formation.
12.7 – corporate earnings announcement
corporate earning season is perhaps one of the important events to which the stocks react. the listed companies (trading on the stock exchange) must declare their earnings once every quarter, also called the quarterly earnings numbers. during an earnings announcement, the corporate gives out details on various operational activities, including:
-
- revenue growth
- expense trend
- finance charges
- profitability trends
- project updates
- key trends in the industry
besides, some companies give an overview of what to expect from the upcoming quarters. this forecast is called ‘corporate guidance.’
invariably every quarter, the first blue-chip company to make the quarterly announcement is infosys limited. they also give out guidance regularly. market participants follow what infosys has to say regarding guidance as it impacts the markets.
the table below gives you an overview of the earning season in india:
|sl no||months||quarter||result announcement|
|01||april to june||quarter 1 (q1)||1st week of july|
|02||july to september||quarter 2 (q2)||1st week of oct|
|03||october to december||quarter 3 (q3)||1st week of jan|
|04||january to march||quarter 4 (q4)||1st week of april|
do note that the 1st of april in india marks the beginning of the financial year. in the us, the financial year starts on 1st jan, so the first quarter starts from january through march, and so forth.
every quarter when the company declares its earnings, the market participants match the earnings with their expectations of how much the company should have earned. the market participant’s expectation is called the ‘street expectation.’
the stock price will react positively if the company’s earnings are better than the street expectations. the stock price will react negatively if the actual numbers are lower than the street expectation.
if the street expectation and actual numbers match, the stock price tends to trade flat with a negative bias more often than not. this is mainly because the company could not give any positive surprises.
12.8 – non financial events
apart from the events we discussed above, it would be best to watch out for other non-financial events to understand their impact on markets. for example, the covid crisis of 2020 had a significant effect on economies around the world, disrupting the world economic order. the supply chain took a hit across the globe leading to an inflation spike. that said, there were select pockets of the economy that did very well, mainly the online services industry.
events like the russia – ukraine war or the tension between china and taiwan have impacted world markets. geo-political affairs such as these impact various connected economies. for instance, the war between russia and ukraine affects the supply of natural gas and crude oil, which significantly impacts the energy costs in europe.
as an active trader or a market participant, you need to watch out for these events and understand how these events can impact the markets.
while the world economies are interconnected, isolated events (country specific) impact the local economy. for example, the elections in india impact only the indian economy.
so, keep an eye on these non-financial events and how they can impact the stock markets or sometimes specific industries.

- markets and individual stocks react to events. market participants should equip themselves to understand and decipher these events.
- monetary policy is one of the most important economic events. during the monetary policy, review actions on a repo, reverse repo, crr etc. are initiated.
- interest rates and inflation are related. increasing interest rates curbs inflation and vice versa
- inflation data is released every month by mospi. as a consumer, cpi inflation data is what you need to track.
- iip measures industrial production activity. an increase in iip cheers the markets, and a lower iip disappoints the market.
- pmi is a survey-based business sentiment indicator. the pmi number oscillates around 50 marks. above 50 is good news to markets, and pmi below 50 is not.
- the budget is an important market event where policy announcements and reform initiatives are taken. markets and stocks react strongly to budget announcements.
- corporate earnings are reported every quarter. stocks react mainly due to the variance in actual number versus the street’s expectation.
- keep an eye on non-financial events and how they can impact the markets.
###
momentum-portfolios
16.1 – defining momentum
if you have spent some time in the market, then i’m certain you’ve been bombarded with market jargon of all sorts. most of us get used to these jargon and start using them without actually understanding what they mean. i’m guilty of using a few jargon without understanding the true meaning of it, and i get a feeling that some of you reading this may have experienced the same.
one such jargon is – momentum. i’m sure we have used momentum in our daily conversations related to the markets, but what exactly is momentum, and how is it measured?
when asked, traders loosely define momentum as the speed at which the markets move. this is correct to some extent, but that’s not all, and we should certainly not limit our understanding to just that.
‘momentum’ is a physics term. it refers to the quantity of motion an object has. if you look at this definition in the context of stock markets, everything remains the same, except that you will have to replace ‘object’ with stocks or the index.
momentum is the rate of change of stock returns or the index. if the rate of change of returns is high, then the momentum is considered high; if the rate of change of returns is low, the momentum is considered low.
this leads us to the next obvious question i.e. what is the rate of change of returns?
the rate of change of return, as it states the return generated (or eroded) between two reference periods. for the sake of this discussion, let’s stick to the rate of change of return on an end-of-day basis. so in this context, the rate of change of returns means the speed at which the daily return of the stock varies.
to understand this better, consider this example –
the table above shows an arbitrary stock’s daily closing price for six days. two things to note here –
- the prices are moving up on day to day basis
- the percentage change is 0.5% or higher daily
consider another example –
two things need to note –
- the prices are moving up on day to day basis
- the percentage change is 1.5% or higher daily
given the behavior of these two stocks, i have two questions for you –
- which stock has a higher rate of change in daily returns?
- which stock has a higher momentum?
to answer these questions, you can look at either the absolute change in the rupee value or the percentage change from a close-to-close perspective.
if you look at the absolute rupee change, the change in stock a is higher than in stock b. however, this is not the right way to look at the change in daily return. for instance, in absolute rupee terms, stocks in the range of, say, 2000 or 3000 will always have a higher change compared to stocks in the range of 1000 or lower.
hence, evaluating absolute rupee change will not suffice, and therefore we need to look at the percentage change. in terms of percentage change, stock b’s daily change is higher, and therefore we can conclude that stock b has a higher momentum.
here is another situation, consider this –
stock a has trended up consistently daily, while stock b has been quite a dud all along except for the last two days. on an overall basis, if you check the percentage change over the 7 days, then both have delivered similar results. given this, which of these two stocks is considered to have good momentum?
well, stock a is consistent in terms of daily returns, exhibits a good uptrend, and, therefore, can be considered to have continuity in showcasing momentum.
now, what if i decide to measure momentum slightly differently? instead of daily returns, what if we were to look at the return on a 7 days basis? if we do that, stocks a and b qualify as momentum stocks.
the point i’m trying to make here is that traders generally look at momentum in terms of daily returns, which is perfectly valid, but this is not necessarily the only way to look at momentum. the momentum strategy we will discuss later in this chapter looks at momentum on a larger time frame, not daily. more on this later.
i hope by now; you do have a sense of what momentum means and understand that momentum can be measured not just in terms of daily returns but also in terms of larger time frames. high-frequency traders measure momentum on a minute-to-minute or hourly basis.
16.2 – momentum strategy
among the many trading strategies traders use, momentum is one of the most popular strategies. traders measure momentum in many different ways to identify opportunity pockets. the core idea across all these strategies remains the same, i.e., to identify momentum and ride the wave.
momentum strategies can be developed on a single-stock basis. the idea is to measure momentum across all the stocks in the tracking universe and trade the ones that showcase the highest momentum. remember, momentum can be either long or short, so a trader following a single stock momentum strategy will get both long and short trading opportunities.
traders also develop momentum strategies on a sector-specific basis and set up sector-specific trades. the idea here is to identify a sector that exhibits strong momentum; this can be done by checking momentum in sector-specific indices. once the sector is identified, look for the stocks that display maximum strength in terms of momentum.
momentum can also be applied on a portfolio basis. this involves portfolio creation with, say ‘n’ number of stocks, with each stock showcasing momentum. in my opinion, this is an excellent strategy as it is not just a plain vanilla momentum strategy but also offers safety in diversification.
we will discuss one such strategy wherein the idea is to create a stock basket, aka a portfolio of 10 momentum stocks. once created, the portfolio is held until the momentum lasts and then re-balanced.
16.3 – momentum portfolio
before we discuss this strategy, i want you to note a few things –
- the agenda here is to highlight how a momentum portfolio can be set up. however, this is not the only way to build a momentum portfolio
- you will need programming skills to implement this strategy or to build any other momentum strategy. if you are not a coder like me, then do find a friend who can help
- like any other strategy, this too has to be backtested
given the above, here is a systematic guide to building a ‘momentum portfolio’.
step 1 – define your stock universe
as you may know, there are close to 4000 stocks on bse and about 1800 on nse. this includes highly valuable companies like tcs and absolute thuds such as almost all the z category stocks on bse. companies such as these form the two extreme ends of the spectrum. do you have to track all these stocks to build a momentum portfolio?
not really. doing so would be a waste of time.
one has to filter out the stocks and create the ‘tracking universe.’ the tracking universe will consist of a large basket of stocks within which we will pick stocks to constitute the momentum portfolio. the momentum portfolio will always be a subset of the tracking universe.
think of the tracking universe as a collection of your favorite shopping malls. maybe out of the 100s of malls in your city, you may go to 2-3 shopping malls repeatedly. clothes bought from these 2-3 malls comprise your entire wardrobe (read portfolio). hence, these 2-3 malls form your tracking universe out of the 100s available in your city.
the tracking universe can be pretty straightforward – the nifty 50 or bse 500 stocks. therefore, the momentum portfolio will always be a subset of the nifty 50 or bse 500 stocks. keeping the bse 500 stocks as your tracking universe is an excellent way to start. however, if you feel adventurous, you can custom-create your tracking universe.
custom creation can be on any parameter – for example, out of the entire 1800 stocks on nse, i could use a filter to weed out stocks that have a market cap of at least 1000 crs. this filter alone will shrink the list to a much smaller, manageable set. further, i may add other criteria, such as the stock price should be less than 2000. so on and so forth.
i have randomly shared a few filter ideas, but you get the point. using custom creation techniques helps you filter out and build a tracking universe that matches your requirement.
lastly, from my personal experience, i would suggest you have at least 150-200 stocks in your tracking universe if you wish to build a momentum portfolio of 12-15 stocks.
step 2 – set up the data
assuming your tracking universe is set up, you can proceed to the 2nd step. in this step, you must ensure you get the closing prices of all the stocks in your tracking universe. ensure your data set is clean and adjusted for corporate actions like the bonus issue, splits, special dividends, and other corporate actions. clean data is the crucial building block to any trading strategy. there are plenty of data sources from where you can download the data for free, including the nse/bse websites.
the question is – what is the lookback period? how many historical data points are required? to run this strategy, you only need 1-year data point. for example, today is 2nd march 2019; then i’d need data points from 1st march 2018 to 2nd march 2019.
please note once you have the data points for the last one-year set, you can update this daily, which means the daily closing prices are recorded.
step 3 – calculate returns
this is a crucial part of the strategy; in this step, we calculate the returns of all the stocks in the tracking universe. as you may have already guessed, we calculate the return to get a sense of the momentum in each stock.
as discussed earlier in this chapter, one can calculate the returns on any frequency, be it daily/weekly/monthly, or even yearly returns. we will stick to yearly returns for the sake of this discussion; however, please note; you can add your own twist to the entire strategy and calculate the returns for any time frame you wish. instead of yearly, you could calculate the half-yearly, monthly, or even fortnightly returns.
so, you should have a tracking universe of about 150-200 stocks at this stage. all these stocks should have historical data for at least 1 year. further, you need to calculate the yearly return for each stock in your tracking universe.
to help you understand this better, i’ve created a sample tracking universe with just about ten stocks in it.
the tracking universe contains the data for the last 365 days. the 1-year returns are calculated as well –
if you are wondering how the returns are calculated, then this is quite straightforward, let us take the example of abb –
return = [ending value/starting value]-1
= [1244.55/1435.55]-1
= -13.31%
relatively straightforward, i guess.
step 4 – rank the returns
once the returns are calculated, you need to rank the returns from the highest to the lowest returns. for example, asian paints has generated a return of 25.87%, the highest in the list. hence, the rank of asian paints is 1. the second highest is hdfc bank, which will get the 2nd rank. infosys’s return, on the other hand, is -35.98%, the lowest in the list; hence the rank is 10. so on and so forth.
here is the ‘return ranking’ for this portfolio –
if you are wondering why the returns are negative for most of the stocks, that’s how stocks behave when deep corrections hit the market. i wish i had opted to discuss this strategy at a better point.
so what does this ranking tell us?
if you think about it, the ranking reorders our tracking universe to give us a list of stocks from the highest return stock to the lowest. for example, from this list, i know that asian paints has been the best performer (in terms of returns) over the last 12 months. likewise, infy has been the worst.
step 5 – create the portfolio
a typical tracking universe will have about 150-200 stocks, and with the help of the previous step, we would have reordered the tracking universe. now, we can create a momentum portfolio with the reordered tracking universe.
remember, momentum is the rate of change of return, and the return itself is measured yearly.
a good momentum portfolio contains about 10-12 stocks. i’m comfortable with up to 15 stocks in the portfolio, not more than that. for the sake of this discussion, let us assume that we are building a 12 stocks momentum portfolio.
the momentum portfolio is now the top 12 stocks in the reordered tracking universe. in other words, we buy all the stocks starting from rank 1 to rank 12. in the example we were dealing with, if i were to build a 5-stock momentum portfolio, then it would contain –
- asian paints
- hdfc bank
- biocon
- acc
- ultratech
the rest of the stocks would not constitute the portfolio but will remain in the tracking universe.
you may ask what is the logic of selecting this subset of stocks within the tracking universe?
well, read this carefully – if the stock has done well (in terms of returns generated) for the last 12 months, it implies that it has good momentum for the defined time frame. the expectation is that this momentum will continue onto the 13th month, and therefore the stock will continue to generate higher returns. so if you were to buy such stocks, you are to benefit from the expected momentum in the stock.
this is a claim. i do not have data to back this up, but i have successfully used this technique for several years. it is easy to back-test this strategy, and i encourage you to do so.
back in the day, my trading partner and i were encouraged to build this momentum portfolio after reading this ‘economist’ article. you need to read this article before implementing this strategy.
once the momentum portfolio stocks are identified, the idea is to buy all the momentum stocks in equal proportion. so if the capital available is rs.200,000/- and there are 12 stocks, the idea is to buy rs.16,666/- worth of each stock (200,000/12).
by doing so, you create an equally weighted momentum portfolio. of course, you can tweak the weights to create a skewed portfolio, there is no problem with it, but then you need a solid reason for doing so. this reason should come from backtested results.
if you like to experiment with skewed portfolios, here are few ideas –
- 50% of capital allocation across the top 5 momentum stocks (rank 1 to 5), and 50% across the remaining 7 stocks
- top 3 stocks get 40% and the balance 60% across 9 stocks
- if you are a contrarian and expect the lower rank stocks to perform better than the higher rank stocks, then allocate more to last 5 stocks
so on and so forth. ideally, the approach to capital allocation should come from your backtesting process, this also means you will have to backtest various capital allocation techniques to figure out which works well for you.
step 6 – rebalance the portfolio
so far, we have created a tracking universe, calculated the 12-month returns, ranked the stocks in terms of the 12-month returns, and created a momentum portfolio by buying the top 12 stocks. the momentum portfolio was built based on the 12-month performance, hoping to continue to showcase the same performance for the 13th month.
there are a few assumptions here –
- the portfolio is created and bought on the 1st trading day of the month
- the above implies that all the number crunching happens on the last day of the month, post-market close
- once the portfolio is created and bought, you hold on to the stocks till the last day of the month
now the question is, what happens at the end of the month?
at the end of the month, you re-run the ranking engine and figure out the top 10 or 12 stocks which have performed well over the last 12 months. do note at any point, we consider the latest 12 months of data.
so, we now buy the stocks from rank 1 to 12, just like we did in the previous month. from my experience, chances are that out of the initial portfolio, only a hand full of stocks would have changed positions. so based on the list, you sell the stocks that no longer belong in the portfolio and buy the new stocks featured in the latest momentum portfolio. in essence, you rebalance the portfolio and you do this at the end of every month.
so on and so forth.
16.4 – momentum portfolio variations
before we close this chapter (and this module), i’d like to touch upon a few variations to this strategy.
the returns have been calculated on a 12-month portfolio and the stocks are held for a month. however, you don’t have to stick to this. you can try out various options, like –
- calculate return and rank the stocks based on their monthly performance and hold the portfolio for the month.
- calculate return, rank the stocks based on fortnightly performance, and hold the portfolio for 15 days.
- rank every week and hold for a week
- calculate daily and even do an intraday momentum portfolio
as you can see, the options are plenty, and your imagination only restricts it. if you think about what we have discussed so far, the momentum portfolio is price based. however, you can build a fundamental-based momentum strategy as well. here are a few ideas –
- build a tracking universe of fundamentally good stocks
- note the difference in quarterly sales number (% wise)
- rank the stocks based on quarterly sales. company with the highest jump in sales gets rank one and so on
- buy the top 10 – 12 stocks
- rebalance at the end of the quarter
you can do this on any fundamental parameter – eps growth, profit margin, ebitda margin etc. the beauty of these strategies is that the data is available, hence backtesting gets a lot easier.
16.5 – word of caution
as good as it may seem, the price-based momentum strategy works well only when the market is trending up. when the markets turn choppy, the momentum strategy performs poorly, and when the markets go down, the momentum portfolio bleeds heavier than the markets itself.
understanding the strategy’s behavior with respect to the market cycle is crucial to this portfolio’s eventual success. i learned it the hard way. i had a great run with this strategy in 2009 and ’10 but took a bad hit in 2011. so before you execute this strategy, do your homework (backtesting) right.
having said all of that, let me reassure you – a price-based momentum strategy, if implemented in the proper market cycle can give you great returns, in fact, better more often than not, better than the market returns.
good luck and happy trading.

- momentum is the rate of change of return and can be measured across any time frame.
- a price-based momentum portfolio consists of stocks that have exhibited the highest momentum over the desired time frame.
- the tracking universe should be carefully populated. bse 500 is a good tracking universe
- calculate the returns for the tracking universe
- rank the stocks based on highest to lowest return
- the momentum portfolio is simply the top 12 or 15 stocks
- the expectation is that the momentum will continue during the holding period
- the asset allocation technique can vary based on backtesting equally weighted portfolio is a good asset allocation technique
- momentum can be measured on fundamental data as well – growth in sales, ebitda margins, eps growth, net profit margin etc
- price-based momentum works best in an upward trending market and not in a sideways or a down trending market.
###
basics
2.1 – overview
india needs help from all of us countrymen in developing a tax culture. the fear of the income tax department can be removed only by gaining knowledge of all the basic rules and regulations. income tax rates in india have drastically reduced from over 90% in the early seventies to now (2020) where no tax has to be paid on annual income up to rs 2.5lks. but the apathy of taxpayers towards filing income tax returns and paying taxes continues till today.
with the systems used by the it department becoming sophisticated every year, the chances of repercussions in terms of notices and penalties due to non-filing, misfiling, and hiding information while filing your income tax returns (itr) is going up significantly. similar to how income-tax (it) department has access to all your bank account details, they can also check up on all your capital market activity easily through the exchanges as they are all mapped to your pan (permanent account number). with aadhar slowly getting linked everywhere the day isn’t far when the it department will be able to send you a consolidated activity (income and expenses) statement, similar to how nsdl/cdsl sends for your holdings across all demat accounts.
check this notice received by a client who hadn’t declared his trading activity on commodity exchanges in fy 2012/13. the notice was sent only in 2015 asking for an explanation. check this link that has a list of various codes in which these notices are sent by the it department.
even if the intent is there to be compliant, most people including many chartered accountants (cas) don’t understand the subject of taxation when investing & trading very well. we had put up a blog post, “taxation simplified” on z-connect many years back simplifying key aspects of taxation for market participants. we received a few thousand queries on that post. answering all of them it was obvious that we had to do a lot more to simplify all aspects around taxation while trading or investing in the markets, hence this module.
if you only invest in stocks or mutual funds filing returns is quite simple, but can get tricky if trading intraday stocks or financial derivatives (futures and options).
we will in this module break all the concepts down into small easy to understand chapters without any of that jargon typically used by ca’s or tax consultants. here is a sneak peek into what you can expect going forward in this module –
- introduction (setting the context)
- basics
- classify your market activity
- taxation for investors
- taxation for traders
- turnover, balance sheet, and p&l
- itr forms (the finale)
2.2 – what is income tax?
it is a tax levied by the government of india on the income of every person. the provisions governing the income-tax law are given in the income-tax act, 1961. in simpler words, income tax is a portion of the money that you earn paid to the government of india.
why should i pay tax?
yes, india does not offer social security and free medical facilities as being provided in some developed countries, but the government needs funds collected as taxes to discharge a number of responsibilities like government hospitals, education, national defense, infrastructure development just to name a few.
who is supposed to pay income tax?
income-tax is to be paid by every person who earns more than the minimum income slab set by the government. the term ‘person’ as defined under the income-tax act covers in its ambit natural as well as artificial persons (including corporate).
only 5 percent of over 130 crore population file income tax returns and only 1.5 crore indians (<1%) pay any income tax. if you had to compare, over 45% of the population in a developed economy like the u.s.a pay taxes. part of the reason for such an abysmally low number is also because many indians don’t earn enough to qualify to pay income tax, but the larger factor has got to do with a lack of tax culture.
taxes have to be paid based on how much income you earn every financial year. the financial year in india starts from april 1st and ends on 31st march. do note that year can be specified either as a financial year (fy) or assessment year (ay).
fy is used to denote the actual year the income was earned for which you are filing taxes. so fy 2019/20 is the financial year starting april 1st, 2019, and ending 31st march 2020.
ay is used to denote the year in which you are supposed to file your taxes. so ay 2020/21 is the year when you file the returns for income earned in fy 2019/20. so ay 2020/21 and fy 2019/20 are one and the same. so you will use itr with ay 2020/21 on it to file your taxes for the income earned in the financial year starting april 1st, 2019, and ending 31st march 2020.
2.3 – income tax slabs in india for financial year 2020/21
all indians have to pay taxes on the total income earned every year as per the below tax slabs they belong to. if you are salaried, your employer would already be paying taxes on your behalf to the government and issuing you a ‘form 16’ as an acknowledgment for having paid the taxes. your employer will not have access to all your sources of income, like bank interest, capital gains, rental income, and others. you are supposed to use the form 16, add all your other income, calculate and pay any additional tax, and file your income tax returns before due date every year. the tax slab for individuals (fy 20/21) is as below –
individual (age upto 60 years)
|income slabs||tax rates|
|0 – rs 2.5lks||nil|
|rs 2.5lks – rs 5lks||5% of the amount by which income exceeds rs 2.5lks.|
|rs 5lks – rs 10lks||rs. 12,500 + 20% of the amount by which income exceeds rs 5lks|
|10lks and above||rs. 112,500 + 30% of the amount by which income exceeds rs 10lks|
senior citizen (age 60 to 80 years)
|income slabs||tax rates|
|0 – rs 3lks||nil|
|rs 3lks – rs 5lks||5% of amount by which income exceeds rs 3lks.|
|rs 5lks – rs 10lks||rs. 10,000 + 20% of the amount by which income exceeds rs 5lks|
|10lks and above||rs. 110,000 + 30% of the amount by which income exceeds rs 10lks|
super senior citizen (age 80 years and above)
|income slabs||tax rates|
|0 – rs 5 lks||nil|
|rs 5lks – rs 10lks||20% of the amount by which income exceeds rs 5lks|
|10lks and above||rs. 100,000 + 30% of the amount by which income exceeds rs 10lks|
if total income between rs 2.5 to rs 5lks, you can claim for the 5% tax rebate and effectively paying zero tax.
surcharge for all the above age groups: 10% of income tax if income between rs 50lks to rs 1 crore. 15% if income between rs 1 crore to rs 2 crores. 25% if income between rs 2 crores to rs 5 crores. 37% if it exceeds rs 5 crores.
budget 2020 has introduced a new tax regime where the taxpayer has an option to decide either to pay taxes as per the above slabs claiming the various deductions (eg. investment in elss, house rent allowance, etc) or let go of all deductions and opt-in for the below tax slabs. the surcharge as applicable above.
|0 – rs 2.5lks||nil|
|rs 2.5lks – rs 5lks||5% of the amount by which income exceeds rs 2.5lks.|
|rs 5lks – rs 7.5lks||rs. 12,500 + 10% of the amount by which income exceeds rs 5lks|
|rs 7.5lks – rs 10lks||rs. 37,500 + 15% of the amount by which income exceeds rs 7.5lks|
|rs 10lks- rs 12.5lks||rs. 75,000 + 20% of the amount by which income exceeds rs 10lks|
|rs 12.5lks- rs 15lks||rs. 1,25,000 + 25% of the amount by which income exceeds rs 12.5lks|
|above 15lks||rs. 187,500 + 30% of the amount by which income exceeds rs 15lks|
from the next chapter, we will start focusing in detail on all aspects of taxation when trading and investing in the markets.

- filing correct income tax return is the duty of every indian
- the income-tax department has access to your market activity
- only 5% of indians file income tax returns and ~1% pay any income tax.
- financial year (fy) is the year when income was earned, assessment year (ay) is the year you file your taxes on the income earned
- the financial year is between 1st of april of the current year and 31st march of the following year
- the income tax applicable to you depends on the income tax slab you belong to
- the income tax slabs vary based on your age group
disclaimer – do consult a chartered accountant (ca) before filing your returns. the content above is for your general knowledge only. content meant for individual retail investors/traders in india.
###
sector-analysis-overview
1.1 – introduction
welcome to another  module!
this module on  explores sectors as an investment avenue. we all know that a well-diversified portfolio is the key to building a successful stock portfolio. the diversification should be across sectors and market capitalizations.
if we are looking at picking stocks from different sectors, we need to understand sectors from a stock-picking perspective. the objective of this module is just that, i.e., to help you understand what to look for in each sector as a stock picker or an equity investor.
each chapter will focus on one sector. so after reading this chapter, you can jump across to any sector you are curious to learn about without worrying about losing the chain of thought.
by the way, my name is vineet rajani; i hold a cfa charter and have four years of experience in researching equities. i recently joined the zerodha  team to help karthik develop content, and the sector analysis module is the first module i’ll be working on. i hope you all will like this module as much as you’ve liked all the previous modules 🙂
1.2 – what is a sector, and what is an industry?
a sector is a set of companies engaged in similar business activities. for example, infosys, tcs, and hcl are similar businesses, forming the information technology sector. hdfc bank, icic bank, and sbi are banks, and these companies belong to the banking sector. sun pharmaceuticals, apollo hospitals, and dr. lal path labs are all companies belonging to the healthcare sector.
sectors can have sub-sectors or industries. sectors and industries are often used interchangeably. each industry has a distinct business at a granular level, but at a broader level, many industries can make one sector. while banking, insurance, and mutual funds are all distinct industries, collectively, they are financial services and make up the financial services sector. similarly, the healthcare sector comprises sub-sectors such as hospitals, diagnostics, pharmaceuticals, pharmacies, preventive healthcare, and wellness.
the following table classifies various industries in a limited set of sectors. there are about 3-4 globally accepted standards for industry classification. this table shows how refinitiv classifies the sectors and industries.
an investor would want to analyze a particular sector when they see a factor or phenomenon influencing it. for instance, an investor investing in the fertilizer or packaged foods sector would want to take note of the monsoon season’s data as it tends to impact those sectors as a whole. or an investor in the it sector may want to keep an eye on the usd-inr exchange rate as the sector makes a significant part of revenues in usd.
investors also take an interest in the sector of their occupation – a doctor might want to invest in healthcare stocks, or a software engineer might be confident about their understanding of the technology sector. investor frenzy in a particular sector also stimulates the interest of other investors in that sector.
1.3 – what is sector analysis?
sector analysis involves looking for factors, features, events, and metrics that impact the businesses in a given sector. a factor might positively impact one sector while a negative impact on another. the idea of sector analysis hinges on the fact that certain aspects or events are specific to sectors and do not impact the overall market.
sector analysis is a part of fundamental analysis. while our module on fundamental analysis explains the approach to researching a particular company, sector analysis focuses on the features and operational or performance metrics unique to a sector. the exercise becomes meaningful when several companies within a sector are compared based on these metrics.
1.4 -different approaches for different sectors
no two sectors are the same; therefore, no two sectors can be analyzed the same way. banks, for instance, are analyzed using key performance indicators such as npas, capital adequacy ratios, and interest margins. insurance companies are analyzed for solvency ratio, claims settlement ratio, expense ratio, persistence ratio, etc. airlines look at revenue per seat kilometer, cost per seat kilometer, fuel costs, and occupancy rates to understand performance. these metrics depict the operational efficiency of the players in an industry and how those players stack against each other.
for industries in the heavy manufacturing space – cement, steel, aluminum, and the like – production capacity, production volume, and sales volume are important comparables. volume metrics are significant for automobiles and electronics too. companies in fmcg, or fast moving consumer goods, focus significantly on distribution, brand awareness, packaging, etc.
when an investor begins studying a sector, understanding the value chain could be a good starting point (i will explain the concept of “value chain” soon). a study of the value chain provides more insights into a particular sector’s unique dynamics. the exercise could also unearth certain industry players’ competitive advantages or disadvantages.
1.5 – what is a value chain?
simply put, a value chain begins with the sourcing of raw materials and goes up to the point of end consumption. for example, the textile industry’s value chain would include fiber production, spinning yarn, fabric production, dying and printing, garment manufacturing, packaging, distribution, and retail. cement’s value chain starts with limestone mining, followed by clinkerization, blending, grinding, packaging, and distribution. this value chain might be extended if the cement manufacturer processes it further into ready-mix concrete (rmc) before selling it in the market.
dissecting the value chain in this manner enables an investor to identify which steps drive costs or improve or hamper productivity. a value chain typically has many steps. here, the investor must put on a business owner’s hat to understand what steps along the value chain add value to the business and what do not. cement companies generally own the limestone mines and all the processes up to distribution. the cement industry is predominantly vertically integrated. let me introduce three new concepts: vertical integration, backward integration, and forward integration.
-
- vertical integration: a company is considered vertically integrated if it owns several operations across the value chain. as mentioned above, cement companies carry out all the processes, from limestone mining to cement production and distributing it to customers. cement makers might go further and even convert it to concrete before delivering it to the customers.
- backward vertical integration: acquiring supply-side processes in the value chain is called backward integration. steel companies such as tata steel and jsw steel can be called backward integrated as they own iron ore mines. this helps them control inventory supply and costs.
- forward vertical integration: acquiring distribution side processes is called forward integration. a cosmetics company selling products through owned stores is forward-integrated. indian oil and bharat petroleum could also be considered forward integrated because they operate some fuel stations apart from franchising out most.
- lean organizations: a fourth concept, lean organizations specialize in only one or very few steps in the value chain. many fmcg companies neither manufacture their product nor sell it to end consumers. they focus mainly only on distribution and marketing. they are very low on vertical integration.
although a rare phenomenon, a fully vertically integrated company owns all the processes from raw material production to end consumer retail sales. samsung, a global leader in consumer electronics, is essentially a vertically integrated business. it produces semiconductors, memory chips, and screens that go into making mobile phones, then assembles mobile phones at its plants and even sells them through its own retail stores. while samsung also sells through other retailers and e-commerce channels, its retail stores symbolize some level of vertical integration.
most companies within an industry exhibit similar business structures across the value chain. fmcg companies in india can hardly be backward integrated. palm oil, a key ingredient in many food products, personal care, and cosmetic goods, is primarily sourced from malaysia and indonesia. packaging for these products uses petroleum derivatives which have their source in oil-producing countries. it does not make business sense for an fmcg company to own supply-side processes.
the case of the fmcg sector suggests that the geography of the value chain also influences a business’ vertical integration, costs, and material availability. automobile companies are mostly assembly companies. the thousands of parts that go into making a car are all sourced from vendors that may be geographically located far apart.
the significance of packaging in a value chain depends on the nature of a product, its application, size, shape, and perishability. it also depends on where the end consumer is located and what modes of transport will be used to deliver the product. regulatory requirements must also be met concerning packaging material, dimensions, eco-friendliness, etc.
1.6 – framework
these concepts above can be put into a framework for an investor researching a particular sector. this framework can act as a checklist for the investor to ensure that adequate efforts have been dedicated to comprehensively understanding a sector.
political factors: the political will of the ruling government can influence the overall business sentiment in an economy as a whole. businesses engaged in sin goods such as liquor and tobacco and necessities such as grains and oil often carry large political overhangs.
economic factors: the strength of an economy and the stage of economic development can present different opportunities for different sectors. high-interest rates could limit corporate growth, while low-interest rates could enable easy borrowing and faster growth. however, low-interest rates could encourage excessive retail borrowing and spur inflation. the ability of the economic authorities to balance growth and control inflation is of the essence here. economic factors such as inflation, exchange rates, fdi, and money supply play along with interest rates to influence the business environment.
socio-cultural factors: festivals can stimulate seasonal buying for specific sectors. socio-cultural shifts can create long-term trend growth for certain products while a decline in others. the gradual move from coal-fired stoves to gas stoves results from economic development and social acceptance of a new cooking method.
demographic features and changes are a major influence on demand creation. the vast size of india’s youth population, in both absolute and percentage terms, has led to the creation of various products and brands meant to attract the young crowd. a decline in the average fertility rate suggests a decline in population growth. the aging of today’s young population could boost the demand for old-age products after three-four decades.
technological factors: the stories of nokia and blackberry losing market share to apple and samsung have been discussed every time the impact of technological change has to be depicted. innovations in technology can create new sectors and even wipe out some. all industries related to e-commerce were built upon the internet. the internet was a technological breakthrough. on the other hand, typewriters and telegram are technologies that died as better ones replaced them.
legal factors: the duties, tariffs, quotas, and other restrictions have an impact on the import-export trade of a country. legal factors often create entry barriers for new players to enter a particular industry. for example, the heavy licensing requirements and different state-wise laws make liquor manufacturing a capital-intensive and difficult industry to get into. pollution control, labor laws, and regulators like sebi, rbi, and irdai constitute an economy’s legal machinery.
environmental factors: the natural environment of a country can present opportunities for some sectors while discouraging others. mining businesses are possible only if a country has minerals under its earth.
pollution and environmental deterioration result in imposing restrictions and requirements on industries. water and effluent treatment plants have become a regulatory mandate for various chemical and industrial goods companies. natural calamities could purge industries while displacing civilizations. insurance companies carry a huge risk on account of natural disasters.
these factors also influence each other. economic development could lead to social development and shifts in culture. issues related to society and the environment could be behind the development of certain legal barriers. some legal factors can also be politically influenced.
these factors make the pestle analysis (political-economic-social-technological- legal-environmental), a framework commonly taught in colleges and business schools.
1.7 – how companies within a sector can differ?
beyond the pestle framework, as an investor, you must also study how a particular company competes with its peers. by the way, competition is much more than just outselling each other. a company also competes during the sourcing of raw materials. two dairy companies, for example, will compete with each other to source milk from farmers.
companies also compete with new players in the industry. new players can disrupt the industry. a large influx of new players can change the industry’s competitive landscape. industries also have to worry about being replaced by substitutes.
a company’s ability to outrun its competition and negotiate with external factors depends on what differentiates it from its peers. let us look at a few differentiating factors.
size: size is essentially about the capital of the company. being big or small comes with its advantages and disadvantages.
larger companies managed to stay afloat through the covid-related lockdowns while many smaller companies shut down. why did this happen? business activity was mostly dull through the lockdowns. so regular operations were not yielding profit. larger companies survived by using capital reserves. remember how large retailers survived while many smaller retailers closed shops?
huge capital reserves also open opportunities that are otherwise out of reach. for example, the huge capital and licensing requirements to set up a telecom business are a barrier. smaller businesses or individuals with small capital do not even consider starting a telecom business. but the deep pockets of reliance industries enabled it to pump in loads of capital to set up jio. its war chest was huge enough to wipe out some existing players (remember aircel, uninor) while others were forced to merge (vodafone and idea).
larger companies also enjoy economies of scale. ever wonder why a readymade shirt generally costs lower than a tailor-made one? makers of readymade shirts source everything in bulk to get deep discounts. these discounts can be passed down to customers in the form of lower prices. conversely, a tailor cannot compete with the quick turnaround of automated sewing machines. a tailor charges a higher price to make up for the hours dedicated to a single shirt.
being small also has its advantages and disadvantages. a newly set-up business generally has limited funds, workers, and resources. but the ability to disrupt is high mostly because larger companies do not consider smaller companies a threat, and smaller companies do not have legacy issues.
let me break this down. for example, the brushless dc (bldc) technology has been used for 50 years in electricals to save electricity. however, it was first used in ceiling fans in the us only in 2009. and a few years later, smaller players like versa drives and atomberg adopted the technology and made it big. the incumbent players had been improving upon the existing technology but did not consider an alternative technology as an energy-saving solution. once the smaller players disrupted the space, all larger players introduced the bldc range of fans under their brand names.
why didn’t the larger players act first? introducing a new technology could mean re-training the production staff and introducing new machinery. existing skills and systems make the management averse to changes. these are known as legacy issues. decision-making often slows down in larger organizations. so even if they were aware of better technology, its adoption took time. small companies are not considered a threat because even if they have a superior product, their ability to sell it and scale it up is limited. a few that do manage to scale up become the disruptors.
age: with age comes experience. it is a commonly known concept. it is applicable to businesses too. sometimes experience helps businesses avoid the same mistakes. sometimes, experience makes them averse to trying new methods, techniques and technologies.
just by the virtue of being around for years, businesses have a network of suppliers, distributors, and allies that a new business will take some time to build. however, new businesses with huge capital can overcome this obstacle. ola and uber disrupted other cab services mainly due to the large venture capital that they spent on technology, networking, and marketing.
long-standing relationships with vendors are useful when the supply of inputs is limited. they could also allow easier payment terms. a long-standing distribution network can be used to launch new products. for example, polycab used its wide network of wire distributors and retailers to launch its electrical goods. tata consumer products has been launching several new products that it can distribute using the existing tata tea and tata salt network.
these long-standing relationships can also become a hurdle in making objective business decisions. for example, hul and colgate-palmolive had to face disputes with their long term distributors for offering differential pricing to b2b e-commerce platforms. hul also faced boycott threats in madhya pradesh when it was looking for distributors in addition to the existing ones.
newer consumer brands established their online channels before exploring physical retailing. they do not have long-standing relationships with any distributor. therefore, they are unlikely to face protests like hul and colgate-palmolive did.
focus: focus can be related to products, target market, costs, or pricing.
the product focus sounds very basic. every business is focused on its product. however, some businesses have multiple products. some organizations have multiple businesses. reliance industries has three large businesses – oil, retail, and telecom. its next bet is going to be on financial services. similarly, itc is a large fmcg company with a presence in hospitality, technology, packaging, and agri-exports.
so when you study conglomerates like these as part of a sector, you must consider what drives the business and profitability. you might even want to consider each business as a separate organization to draw proper comparisons with relevant peers.
a company operating in a single sector might be better equipped to innovate and scale up than a peer conglomerate with other business interests. the difference is mainly about focus. a conglomerate has diluted focus across divisions. this is also why some analysts assign a conglomerate discount when valuing a conglomerate business.
the target market is the target customers. both maruti suzuki and mercedes are automobile companies but are incomparable because they focus on different markets. maruti will not be able to charge as high for its cars as mercedes does. similarly, mercedes will not be able to sell as many cars as maruti does. their different market focus is also visible in their marketing tools. maruti uses tv commercials to spread the word about its car. it wants the maximum population to buy its cars. mercedes understands that millions may watch tv commercials, but only some can afford their cars. therefore, it does not spend on tv commercials.
some businesses focus on attaining cost leadership. indigo airlines has managed to stay afloat while so many airlines are struggling or have perished. indigo’s flight tickets may be priced similarly to its competitors, but its focus on cost controls has led to profitability.
other businesses focus on pricing. fmcg companies often price their products competitively, meaning they keep the prices low to maintain and increase the customer base. ever wondered why many biscuits and chocolates still sell in ₹5-packs despite all the inflation after so many decades? it is because a consumer with limited means finds the ₹5 price point psychologically comforting. round figures such as ₹5 or ₹10 sell more than odd figures such ₹6 or ₹7. also, they might not be willing to spend ₹10 or higher when their budget is ₹5.
price leadership is not always about the lowest prices. apple has become the world’s most valuable smartphone brand by always pricing its phones at a premium. such pricing power is achieved with a heavy focus on the product and branding.
regulations also impact a company or sector’s pricing power. one can argue that the healthcare sector has strong pricing power. but because of its essential nature, the government regulates medicine prices.
substitutes: substitutes come in various forms. tea and coffee are each other’s substitutes. mobile phones have substituted personal cameras, computers, diaries, and watches. in the case of luxury goods, a vacation, watch, car, handbag, and chandelier are all substitutes for each other. so when i pointed out earlier that mercedes and maruti may not be comparable, mercedes could compare with other luxury goods.
substitutes are a challenge because they can come from a different sector or even create a new one altogether. there can also be regulatory support for substitutes in certain industries – solar and wind energy getting favorable policies over coal. electric vehicles are also getting incentives over combustion engine (conventional) vehicles.
certain businesses, mostly large ones, can identify substitutes and even own them. for example, petrol and diesel pumps are now setting up ev charging and gas stations. since substitutes can render an industry obsolete, an analyst must try to ascertain the magnitude of the threat from substitutes.
competition from substitutes pushes businesses to expand into the substitute business as well. new entrants in a sector often increase the competitive intensity in the market. this causes businesses to sell at lower prices. the advent of e-commerce has forced physical stores to give comparable discounts. competition from jio forced telecom operators to offer 1 gb of data per day for a price point they would otherwise charge for a monthly limit of 1 gb.
1.8 – conclusion
sector analysis could help you as an investor understand whether a sector appears attractive or not. accordingly, you may bet on the whole sector or a few selected stocks. either way, valuations must be justified. a good business at a high price is likely a bad investment. therefore, you must combine sector analysis with a proper valuation analysis to improve the likelihood of investment returns. a comprehensive study would also include fundamental analysis.
i shall delve into understanding each sector in depth in the subsequent chapters of this module.
the first sector i will cover is cement. stay tuned!
key takeaways:
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- a sector is made up of similar businesses. sectors may be further divided into sub-sectors or industries.
- to understand specific sectors, one needs to understand their value chain
- several regulated sectors like stock broking, banking, and insurance are understood with the help of key performance indicators
- you could also study sectors with the help of frameworks such as pestle. you could also build your own framework.
- companies within a sector could differ in size, age, focus, and substitutes. each of these features comes with its advantages and disadvantages.
- valuations are critical. an attractive industry or business must also have favorable valuations to be investible.
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cement
2.1 – cement – an introduction
we laid down a basic foundation for sector analysis in the previous chapter. in this chapter, we will discuss the cement industry. i have picked cement as the first sector because cement is an inherent part of modern civilization. the concrete jungle, as we call our cities, is made of cement.
india is the world’s second-largest cement producer, with a 7% global market share. surprisingly, the largest producer, china, accounts for over half of the total global cement production. china produced 2.1 billion tonnes in 2022, while india produced ~370 million tonnes.
the vast difference between china’s and india’s share in cement production perhaps shows the long runway ahead that india’s infrastructure has to cover and the opportunity for the cement sector. india has an installed capacity of over 570 million tonnes per annum (mtpa). another ~150 mtpa in capacity is expected to be added by 2027.
owing to the housing and infrastructure boom in eastern india, the region is expected to get a third of the total capacity additions. it also accounts for 80% of houses constructed under the pmay-g scheme. pradhan mantri awas yojana (gramin), or pmay-g, is the central government’s scheme to subsidize the construction of pucca houses with basic amenities in villages.
generally speaking, there are two types of cement – portland cement and non-portland cement. all cement we generally see being used around is portland cement and its various blended forms. non-portland cement is not commonly used due to its corrosive nature. although a value-added product in itself, cement is essentially a commodity. its all-pervasive use has made the cement an industry of its own, and its peculiarities warrant an analysis unique to the sector.
2.2 – how is cement manufactured?
let us have a glimpse of the portland cement manufacturing process to identify the various sources or steps that could impact the cost of production, its selling price, and profitability.
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- the first step is mining limestone from quarries, the key ingredient in cement production. most cement makers own limestone quarries.
- limestone and clay are mixed in an 80:20 ratio and ground into fine powder. limestone content could be lesser, depending on the desired cement properties.
- this fine powder is mixed with water in a 65:35 ratio to form a slurry
- the resultant slurry is fed into a kiln to be heated at 1400-1500 degree celsius to make clinker
- clinker comes out of the kiln in the form of grey balls
- the clinker is then cooled. about 3-4% content gypsum is added to it. it is blended with fly ash, ggbs, or other such materials depending on the type of cement required. (fly ash is a waste residue from thermal power plants, and ggbs or ground granulated blast furnace slag is waste residue from iron production.) most cement sold in india is in blended variants.
- the mixture is ground into fine powder. this powder is cement.
you can also understand cement production in this video by vox. it is interesting for two reasons: one, it graphically explains the cement manufacturing process, and two, it discusses the possible solutions to the environmental concerns around cement manufacturing. but more on the environmental concerns later.
as you can see, the process of manufacturing cement remains the same across companies. as an investor in the sector, you should analyze which steps in the manufacturing process consume more cash and where a company can save costs. also, remember, although belonging to the same sector, no two companies are the same. you need to analyze if a factor impacts the whole sector or is specific to a company. in fact, this is the end objective of a typical sector analysis, i.e. to understand a sector and its nuances and eventually zero in on companies that thrive within the sector so that you can make wise investment decisions. it may sound complex at this stage, but eventually, you will realize this is a common sense approach without rocket science.
2.3 – the three major cost centres
- input cost
this is basically the cost of goods sold, a concept we learned in the fundamental analysis module.
limestone is the most important ingredient in cement. cement companies own limestone quarries to control costs. they mine limestone from their quarries and process it to make clinker at plants that are generally set up close to the quarries.
water is another major input in the process. consistent water supply is also a major challenge in many parts of our country. therefore, many cement companies have water recycling, rainwater harvesting, and groundwater recharging systems in place. this ensures regular water availability and better visibility of costs.
- power and fuel cost
most cement manufacturers maintain captive power plants to bring down fuel costs. let me introduce the concept of captive plants or units. if a manufacturing company can produce power for its own use, it is said to have a captive power plant.
another example would be a pizza chain owning a small tomato farm to produce fresh organic tomatoes for its pizzas. in this case, the tomato farm is called a captive farm. a captive unit’s product is not sold but used in-house for producing another product.
larger players like ultratech cement, ambuja cement, and acc have captive thermal, wind, and solar power plants. despite captive power plants, fuel costs for these major players can be as high as 25% of the revenues. some cement makers even own coal mines to insulate from the impact of coal price fluctuations. ultratech and ambuja both have captive coal mines to support their requirements partially.
sourcing coal can often be a challenge. for instance, whenever there is a coal shortage, the government could ask domestic coal producers to sell coal only to power generation companies. cement producers that own coal mines or other forms of captive power plants are at an advantage here. others will have to import coal from international markets. steel and aluminium industries are also heavy coal users and compete with cement in the international market to import coal, pushing prices up.
this is not to say that coal mine owners are always better off. during a down cycle when the demand for cement is low, owned coal mines are a fixed cost that the manufacturer must bear amid slow production and sales. or if there came a time when coal prices were abysmally low, buying coal from the market would become cheaper than mining at owned quarries.
given that coal is a dirty fuel, the possibility of a regulatory ban on its industrial use will only increase. owned mines would become a dead cost if that were to happen.
“controlling wastage and climate change
all cement producers have waste heat recovery system (whrs) plants in place. whrs is good for two reasons – fuel cost savings and reducing carbon footprint. the tremendous heat generated in clinker production is channelled to generate steam. this steam is passed through turbines to generate electricity. this electricity can cater to 25-30% of the cement plant’s power requirements.
the increasing focus on reducing fuel costs and carbon footprint has given rise to an interesting metric known as the clinker factor. it represents the proportion of clinker in a cement recipe. the lower the clinker factor, the better. this may seem paradoxical – how can having less of the primary component be better? it is because clinker is also the most fuel-consuming step in the process of cement production.
but wouldn’t that hurt the quality of cement? manufacturers have been innovating recipes that augment the features of cement while retaining its strength. fly ash, gypsum, silica fume, volcano ash, and other industrial by-products are common ingredients of blended cement. the vox video after the manufacturing process above explains this well.
- freight costs
cement is a perishable product. it typically has a shelf-life of just 90 days. therefore, the distribution of cement has to be fast and efficient. it is also perhaps why cement producers own the entire value chain beginning with limestone quarries. it enables them to be in control of the inventory and costs.
since perishability is a concern, cement companies might also own warehouses and trucks to monitor costs, time, and wastage.
another industry hack is to have grinding facilities closer to the market. according to ultratech cement’s annual report for 2021-22, it has 23 integrated plants, 27 grinding plants, and over 175 ready-mix concrete plants.
let me break this down. an integrated plant crushes limestone, makes clinker, and grinds it into cement. such plants are mostly close to the raw material source – the limestone quarries, in cement’s case.
to solve the perishability problem, grinding units are set up closer to the market. the grinding unit will cater to a market which is more likely a state or comparable region. these facilities receive clinkers from the clinker plants that are set up near the quarries. other components to be blended into the cement are procured directly at this grinding facility. the clinker with other components is ground to make the final cement. the grinding unit’s proximity to the market means a shorter time spent transporting the cement to the market.
further closer to the market are rmc plants. rmc, or ready-mix concrete, is a mixture of cement, sand, gravel, water, and other ingredients that make a paste used to bond the bricks in a wall. rmc has a very short shelf-life of a few hours. therefore, rmc plants are smaller than grinding units and cater to small clusters of markets or just cities.
not all cement is sold in the form of rmc, but it is growing in popularity. as a business, cement companies would love to sell rmc; it is a value-added product and hence can improve margins. but it also adds capital expenditure. for construction companies, rmc is convenient because of the limited spaces available in cities and because it is one less job to do.
2.4 – distribution of cement
distribution of cement, or bringing it to the market, requires its own study. cement is a “low value, high volume” product. as of this writing in may 2023, a 50 kg bag of cement costs roughly ₹400. compare that with a bag of grains or cloth or cosmetics or gold. transporting a unit of any of these items from one point to another will surely bring higher revenues than transporting the same unit of cement. perishability, as discussed earlier, is a challenge too. an efficient distribution system is key to maintaining profitability in the cement business.
at a time when urbanization has picked up pace, cement has become a necessity. if the market had only a small number of manufacturers, they could dictate prices, effectively impacting infrastructure growth and real estate prices. but the industry has several large players; over 25 are listed. however, the top five players account for almost half the national capacity. huge capacity additions have been driving competition. competition is also pushing the players to innovate and develop more ways of cutting costs and improving margins. some are spending on branding and marketing to boost sales.
2.5 – demand drivers for cement
the next step is to understand the uses or users of cement. in other words, let us understand what drives the demand for cement.
cement is used in building houses, roads, dams, and other infrastructure. the cement users could be classified into three broad categories – housing, infrastructure, and industrial.
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- keeping aside unconventional building techniques, every residential building uses cement. therefore, growth in the real estate sector is usually perceived as a positive sign for the cement sector. when tracking the growth of the cement sector, be careful not to mistake growth in house registrations as growth in the real estate sector. resale is a big part of registrations. there is also a strong likelihood of urban housing behaving differently than rural housing.
- infrastructure encompasses roads, bridges, railways, airports, dams, and irrigation facilities, among other public facilities, mostly built by the government. the more the government spends on infrastructure, the higher the demand for cement from this sector.
- the industrial application of cement is in building factories, processing plants, kilns, and other industrial structures. large corporations generally do these kinds of capital expenditures. corporations spend when they see potential demand for their products and have the ability to make such expenditures. one must, therefore, check if the demand is growing and if corporations are willing to cater to that demand.
seasonality also impacts the demand for cement. all forms of construction activities usually slow down during the monsoon season, thereby impacting the demand for cement.
studying manufactured bulk commodities like cement requires a deeper focus on the entire value chain, from production to distribution and sales. the asset-heavy nature of the value chain also makes cement manufacturers prone to take on more debt. an investor studying the sector must also look at the debt levels of the companies and the sector at large. a structure to the above discussions to simplify studying the sector could be very useful. let me suggest a checklist that you could use when studying the cement industry.
2.6 – the checklist
you can find these metrics in cement companies’ quarterly presentations and annual reports.
now why do metrics matter? these metrics are specific to the cement sector. if you are interested in investing in cement, combining these metrics with the regular company-based fundamental analysis can ensure complete sector research. let us have a look at each metric one by one.
regional presence: diversification helps reduce risk. a company with its operations and market spread out across the country is more likely to continue operating despite any challenges. if one plant cannot operate for any reason, the others can fill in.
market share: a larger market share usually results from a strong distribution network. customers might want to buy a specific cement brand but will usually buy one easily available near their location.
production capacity: the larger the production capacity, the larger orders the cement maker can serve. cement makers want to add capacity if the economy is seeing a boom in infrastructure and real estate sectors. however, the cost of adding capacity must also be justified with the expected projected income from that capacity.
capacity utilization: let’s say a cement maker has an annual capacity of producing 100 mtpa worth of cement, but they produce only 70 mtpa. effectively, they operate at a 70% capacity, or capacity utilization was 70%.
as an investor, you must determine why the full capacity was not utilized. external factors such as natural calamities, pollution controls, and regulations could limit full utilization. for example, if heavy rains were to shut down production for three months, operating at 100% capacity for the remaining nine months would also mean only 75% utilization. internal factors such as the unavailability of raw materials or labour could also hamper production.
sales volume: not all that is produced is sold. in fact, some cement makers sell more than what they produce. they may buy volumes from other cement makers to fulfil their commitments to customers.
realization ₹/mt: realization is the average selling price per unit. higher prices lead to higher revenues. comparison of the realization numbers of cement players can lead to various insights. the one with the highest number could be commanding a solid premium in the market or must be servicing locations others have not been able to service. the highest number could also suggest a larger share of value-added products in the total sales volume.
this snapshot from ultratech cement’s q4 presentation for fy23 shows that grey cement realizations have slightly moderated compared to the previous quarter.
input / power and fuel / freight cost ratios: you can compute these ratios by dividing the cost item by revenues.
the smaller these ratios, the better. looking for each of these ratios separately can help identify what part of the business is driving costs and which one is improving margins. cement companies typically try to control all these costs by having these activities in-house – captive quarries, power plants, and fleets.
that is about it. this checklist should equip you well to comprehensively understand the cement industry and the companies operating in it.
in the next chapter, we will discuss the highly regulated and frequently disrupted insurance industry.
key takeaways
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- understanding the cement sector requires understanding its value chain and cost centres.
- the three costs – input, power and fuel, and freight costs – make up the largest portion of expenses
- while cement companies try to improve margins by selling value-added products and improving branding, they focus mostly on costs.
- the cement sector does not have direct regulations. however, its heavy carbon footprint makes it a likely target of strict regulations. complying with regulations could be an additional cost. investors need to monitor the space constantly.
- be on the lookout for startups disrupting the cement industry with environmentally friendly solutions.
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understanding-insurance-sector-part-2
4.1 – studying the different types of insurance companies
the previous chapter set the tone for the overall insurance industry. it spoke of the market structure, sales channels, and the risks involved. in this chapter, we will understand the industry with the help of two insurers – hdfc life and icici lombard.
just like stock broking or banking, insurance is a highly regulated sector; insurance companies have to disclose many data points and financial ratios on a regular basis. these data points and ratios are calculated using irdai-prescribed formulas. there are two advantages here –
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- the scope for data manipulation is low as the disclosure formats are fixed
- you, as an investor analyzing the sector, don’t have to crunch numbers 🙂
you only have to know how to interpret these numbers and ratios mean and figure out if they are good or bad. and that’s exactly what we will discuss in this chapter!
4.2 – how to study a life insurance company?
to help you understand the insurance sector better, i’ll work with the numbers of hdfc life and explain the same. note i’ve got the fourth quarter (fy 2023) numbers here. you can download the entire presentation from hdfc life’s website; look for it in the investor relation section.
the executive summary gives a glimpse of the most critical parameters to be reviewed. the subsequent pages will show insights into some of these metrics. let us dig.
premium income: this one is straightforward. if you’ve ever bought insurance in your life, then you’d have paid a premium. the premium you pay becomes the ‘premium income’ for the insurance company. one might wonder if the premium income is the same as revenues because an insurance company’s business is primarily collecting premiums. the answer is no because the insurance company also earns other income which comes from investments.
do note that total premium income is of two types: gross premium and net premium. gross premium is the premiums that policyholders pay. net premium is the premium an insurance company is left with after reinsuring part of its issued policies. further, premium income is of two types: new business premiums and renewal premiums.
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- new business premium: it is the premium earned from issuing new policies. continuous growth in new business premiums indicates the sales team’s continuous ability to attract new business.
- renewal premium: it is premium earned when policies issued in the previous years were renewed. why is this metric important? a higher share of renewal premiums in total premiums suggests that the company has been able to retain old customers. retaining old customers is always cheaper than acquiring new customers. effectively, if selling expenses go down, the insurer can get higher profits.
i’ve taken this snapshot from hdfc life’s presentation. it shows the trend in new business premiums and renewal premiums.
annualized premium equivalent (ape): when you buy an insurance policy, you can pay premiums every month, quarter, or year. there is another option – you pay one lumpsum premium to get coverage on a multi-decade basis. for example, check the insurance plan by hdfc life in this snapshot – here, i will have to pay ₹2.4 lakhs for ₹1 crore insurance for 40 years.
the lumpsum premium has to be annualized in order to make it comparable with the regular premium receipts, and also give a perspective on premium collection. conventionally, ape is calculated by summing all the annualized first-year premiums with 10% of all single-premium policies.
in this snapshot, you can see how different the total premium and ape figures are.
value of new business (vnb): vnb measures the profitability from the new policies sold during the year. it is the present value of expected future profits from new policies issued during the year. you can learn how to calculate pv. but for studying insurance companies, you do not have to compute vnb, as they declare it with their quarterly results. each insurer will have its own actuarial assumptions around expected policy life, future profits, and the discount rate applied to arrive at the present value. more conservative assumptions could lead to understatement of vnb, while loose assumptions could overstate the vnb. therefore, comparing the vnb of two life insurers might not be helpful.
however, comparing with the previous year’s performance could show how an insurer has been able to grow profitability. this snapshot from hdfc life’s presentation shows vnb has nearly doubled between fy20 and fy23.
i used the term “actuarial” in the previous paragraph. insurers hire “actuaries” who employ statistical techniques to measure and manage risks. accordingly, they decide on the right premium price for all policies. the techniques and assumptions used to measure risks and premiums differ across insurers.
new business margin / vnb margin: vnb is divided by ape for a given year to arrive at the vnb margin. it is similar to the profit margins of any business. again, since this is based on each insurer’s subjective management assumptions, comparing with peers may not help, but comparing with past performance could be useful.
an insight to draw from these metrics would be to check the growth of ape and vnb. for example, an increasing ape with a declining vnb suggests that new business is coming at lower margins. you could further dig to find out if the lower margins are due to higher selling expenses or due to selling low-margin policies.
the expense of management ratio / operating expense ratio: it is the ratio of operating expenses to gross premiums received. operating expenses include all expenses incurred as part of normal business operations – selling and distribution, administrative, servicing claims, bad debts, depreciation, etc. interest expense is excluded.
since this is an expense ratio, the smallest possible ratio is more desirable. and when i said earlier that the regulations are tricky, i was referring to how regulations can alter a formula. for example, irdai has stipulated limits on the expenses made toward selling policies. expenses in excess of that limit have to be borne by the shareholders/owners of the business.
underwriting profit: it is the profit generated from the core insurance operations. out of the premium collected, the insurer has to pay commissions, brokerage, other selling expenses, and claims. what remains after paying all that is underwriting profit. the underwriting profit ratio is calculated by dividing the underwriting profits by gross premiums.
for an insurer to make underwriting profits, it must have strong underwriting practices. in simple words, the insurance seller must sell policies where the chances of claims are minimal. they cannot just reject high-risk customers, but they can charge higher premiums to accept high risks. insurance companies also have to avoid getting defrauded.
shareholder surplus: it is the part of profits that can be assigned to shareholders / added to equity after paying all the benefits to policyholders and setting aside a provision for future appropriations. appropriation is used to allocate profits to specific purposes. for example, splitting profits to share with policyholders and shareholders is an act of appropriation of profits.
i got this snapshot from the fy2022 annual report of hdfc life to show the appropriation of shareholder surplus.
assets under management (aum): it is the current market value of all investments made by the insurer. remember, this is not just the surplus from the most recent p&l, it is the accumulation and growth of all investments made so far in all previous years. aum is made up of both shareholders’ and policyholders’ funds.
this slide from hdfc life’s presentation shows a break-up of the aum on two parameters:
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- asset allocation: it shows the ratio of debt to equity
- beneficiary composition: it shows the ratio of unit-linked plans to traditional plans. basically, unit-linked aum belongs to policyholders; it comes from ulips. the share of traditional comes from all other types of insurance policies.
growth in aum could be because of large surpluses during the year or a growth in the market value of the investments. similarly, a decline in aum could mean a loss in the market value or redemption of investments to service claims. if the premiums earned in a period were inadequate to service the claims, funds from investments could be used. a larger reservoir of aum can help the insurer stomach losses for several quarters or years. therefore, the larger the aum, the better.
claims settlement ratio: claims settlement ratio speaks of the credibility of the insurer. the approach to understanding the claims settlement ratio is a bit nuanced. a high ratio could mean either poor underwriting or strong business practice. insurers always market their claims settlement ratio. a high claims settlement ratio instils a sense of trust among the customers – they believe when the time comes, their claims will be honoured. as an investor, you need to dig deeper, though.
let’s say there are two insurers: a and b. a has a 97% claims settlement ratio, while b has 95%. is a the better insurer? not necessarily. if a is a small insurer and has settled 97000 claims out of 100,000 claims received while b has settled 95 lakh claims out of a crore received, perhaps b is a better insurer because of its size and experience.
this snapshot is from irdai’s annual report for fy22. you can find the annual reports on irdai’s website. you can see how pramerica has received ~1000 claims while sbi life has received over 50000 claims. the larger size of business operations comes with a greater number of claims. what matters is the organization’s ability to honour claims.
solvency ratio: the solvency ratio checks the ability of the insurer to be able to pay all its liabilities. it is calculated as the ratio of the available solvency margin to the required solvency margin.
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- required solvency margin (rsm) is the expected total payable amount arising from insurance claims.
- available solvency margin (asm) is the excess of aum over all the liabilities, including claim-related liabilities.
you do not have to compute this as it is part of every insurer’s quarterly financial results. irdai mandates all insurers to have a minimum solvency ratio of 150%. the following snapshot from irdai’s fy22 annual report shows the solvency ratios of life insurers.
let me elaborate on the concept of solvency ratio using this snapshot from hdfc life’s presentation. the “mar 31, 2023” column shows the required solvency margin (rsm) worth ₹72.1 billion. this is also the size of liabilities. the regulatory requirement of a 150% solvency ratio means its needs a cover of ₹108.2 billion (₹72.1 billion * 150%). the red-colored part of the column is this additional mandatory cover.
further, the grey-colored part of ₹38.4 billion is extra cover hdfc life has over the regulatory requirement. the total of the three portions is the available solvency margin of ₹146.6 billion against the required solvency margin of ₹72.1 billion. the ratio of asm to rsm is the solvency ratio of 203%.
persistency ratio: persistency depicts the percentage of policies that continue to be active after a certain period of time. persistency is generally checked for the 13th month or the 61st month. let me simplify this with an example.
suppose an insurer sold 1000 policies in one year. if only 800 of those policies were renewed or held on after one year, i.e., 12 months, the persistency ratio for the 13th month would be 80%. if 550 policies were renewed for the sixth year, the 61st-month persistency ratio would be 55%. if you noticed, the 13th month is the beginning of the second year, 61st month is the beginning of the 6th year. insurance companies disclose persistence for several periods. make sure you compare them with peers for the correct period.
in this snapshot from hdfc life’s presentation, it is evident that about half of the total policies are abandoned by customers by the 61st month or after five years.
the persistency ratio might also be calculated for the total premium earnings and not just the number of policies. a higher premium-based persistency ratio than that based on the number of policies suggests that higher premium-paying customers are being able to hold on to their policies. or that low-income customers are falling back on their premium payments.
this table is a summary of the metrics one must look at when analyzing companies in the life insurance sector.
4.3 – how to study general insurance companies?
we have so far looked at a life insurance company. let’s move our attention to general insurance companies. general insurance companies include – health, auto etc.
the concepts of solvency ratio and claims settlement ratio are applicable to general insurers too.
i will use snapshots from icici lombard’s fourth-quarter investor presentation for fy23 to discuss other key concepts of general insurance companies.
premium income
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- revenue from the insurance business is also called gross direct premium income (gdpi). it consists of the actual premiums collected from selling insurance policies.
- gross written premium (gwp) is the sum of gdpi and reinsurance inward premium. it includes the premium received for reinsuring the obligations of some other insurer.
- net written premium (nwp) is calculated as gwp minus the premium paid for buying reinsurance.
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underwriting expense ratio: underwriting expenses are incurred while selling or renewing policies. commissions, brokerage, incentives, processing, verification, etc are all part of underwriting expenses incidental to selling or renewing policies. the ratio is calculated by dividing underwriting expenses by gross premium collections. a lower underwriting expense ratio is important to achieve better profitability.
loss ratio: the ratio of total claims payout to gross premium. a smaller loss ratio is desirable. a high loss ratio suggests that maybe the premiums are priced too low or the basket of policyholders is not adequately diversified.
combined ratio: combined ratio is the sum of underwriting expense and loss ratios. a combined ratio of less than 100% suggests that claim payouts are less than the premiums received. therefore, a smaller combined ratio is preferable. a combined ratio of more than 100% suggests underwriting losses – claim payouts are higher than the premiums received. this is the case for icici lombard too.
however, this does not necessarily mean net losses for the insurance company. the company could be making gains on investments, thereby having a positive bottom line. a combined ratio of more than 100% for several quarters, however, could be a red flag. you could also compare the combined ratio of a company with the industry average to understand its position with respect to peers.
this table summarizes the metrics one could look at while studying non-life insurers.
key takeaways:
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- life insurance companies have to manage long-term risks and liabilities. therefore, the critical metrics are also long-term – renewal premium, persistency, aum, the value of a new business, and embedded value.
- general insurance companies have to manage short-term liabilities. therefore, the critical metrics are related to revenue and cost components.
- solvency and claim settlement ratios are critical for both types of insurers.
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episode-1-ideas-by-the-lake
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1. ideas by the lake
00:13:32
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2. the vegetable list
00:15:44
22 commentsview all comments →
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video was quite fascinating matching with my current village situation. same black and white 70’s village and coreograpy was also fascinating .
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my son enjoyed this, when are the next episodes getting published, it adds a lot of value to childrens learning
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the content is amazing. you are making finance concepts so much easy to understand by this interesting way.
thank you karthik sir and team.
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hi karthik
you have highlighted the importance of compounding in education and finance.
the characters are relatable, and the sprinkle of humor was well enjoyed by my child.
thank you for introducing finance concepts for kids.
i appreciate what you and your team at zerodha are doing for the future generation.
best wishes,
bee.
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this is a beautiful piece of content for kids and grownups as well. thank you,  team, for making time and resources to simplify financial knowledge🙌🙌one small recommendation. it would be more engaging if the cartoon is in the color format.
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why-do-stock-prices-fluctuate


- a stock market is where a trader or an investor can transact (buy, sell) in shares.
- a stock market is a place where the buyer and seller meet electronically
- different opinions make a market
- the stock exchange electronically facilitate the meeting of buyers and sellers
- news and events move the stock prices daily
- demand supply mismatch also makes the stock prices move
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why-should-you-invest
download the excel here.


- risk and return go hand in hand. higher the risk, the higher the return. lower the risk; lower is the return.
- invest in securing your future
- the corpus you intend to build at the end of the defined period is sensitive to the return rate the investment generates. a slight variation in rate can have a significant impact on the corpus.
- choose an instrument that best suits your risk and return appetite.
- equity should be a part of your investment if you want to beat inflation in the long run.
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who-are-the-different-actors-in-market


- the stock market is where to go if you want to transact in equities.
- stock markets exist electronically and can be accessed through a stockbroker.
- there are many different kinds of market participants operating in the stock markets.
- every entity operating in the market has to be regulated, and they can operate only within the framework as prescribed by the regulator.
- sebi is the regulator of the securities market in india. they set the legal framework and regulate all entities operating in the market.
- most importantly, you need to remember that sebi is aware of what you are doing, and they can flag you down if you are up to something fishy in the markets!
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why-and-how-do-companies-list-and-what-is-an-ipo
we recommend reading these part 1 and part 2 chapters of ipo markets on  to learn and understand the concepts in-depth.

- companies go public to raise funds, provide an exit for early investors, reward employees and gain visibility.
- merchant banker acts as a critical partner with the company during the ipo process.
- sebi regulates the ipo market and has the final word on whether a company can go public or not
- as an investor in the ipo, you should read through the drhp to know everything about the company.
- most of the ipos in india follow a book-building process.
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clearing-and-settlement-process-2


- the day you make a transaction, the trade date, is represented as ‘t day.’
- the broker is required to issue you a contract note for all the transactions carried out by the end of t day.
- when you buy a share, the same will be reflected in your demat account by the end of t+2 days.
- all equity/stock settlements in india happen on a t+2 basis.
- the shares are blocked immediately when you sell shares, and the sale proceeds are credited again on t +2 days.
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understanding-corporate-actions-like-dividends-bonuses-and-buybacks


- corporate actions have an impact on stock prices.
- dividends are a means of rewarding shareholders. the dividend is announced as a percentage of the face value.
- if you aspire to get the dividend, you must own the stock before the ex-dividend date.
- a bonus issue is a form of the stock dividend. this is the company’s way of rewarding the shareholders with additional shares.
- a stock split is done based on the face value. the face value and the stock price change in proportion to the change in face value
- a rights issue is how the company raises fresh capital from the existing shareholders. subscribe to it only if you think it makes sense
- buyback signals a positive outlook of the promoters. this also conveys to the shareholders that the promoters are optimistic about the company’s prospects.
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understanding-the-various-order-types


- you need to invoke a buy order form by pressing the ‘b’ key to buying a stock. likewise, you need to gather a sell order form by pressing the ‘s’ key to sell a stock.
- you choose a limit order type when you are keen on transacting at a particular price; else, you can opt for a market order.
- you choose cnc as a product type if you want to buy and hold the stock across multiple days. if you want to trade intraday, you choose nrml or mis.
- an order book lets you track orders that are both open and completed. you can modify the available orders by clicking on the change button at the order book’s bottom.
- once the order is completed, you can view the trade details in the trade book. in the case of a market order, you can view the exact trade price by accessing the trade book.
- you can press the f6 key to invoke the market depth or snap quote window. the market watch enables you to see bid and ask prices.
- the bid & ask prices refer to the price you can transact. by default, the top 5 bid and ask prices are displayed in the market depth window at all times.
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what-is-a-stock-market-index


- an index acts as a barometer of the whole economy.
- an index going up indicates that the market participants are optimistic.
- an index going down indicates that the market participants are pessimistic.
- there are two main indices in india – the bse sensex and nse’s nifty
- an index can be used for a variety of purposes – information, benchmarking, trading and hedging.
- index trading is probably the most popular use of the index.
- india follows the free-float market capitalization method to construct the index.
- there are sector-specific indices which convey the sentiment of specific sectors.
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how-does-a-trading-platform-work


- a trading terminal is your gateway to markets. you must know the operations of a trading terminal if you aspire to become an active trader.
- you can load the stock you are interested in on the market watch to track all the relevant information.
- some of the basic information on a market watch is – ltp, % change, ohlc, and volumes.
- you need to invoke a buy order form by pressing the ‘b’ key to buying a stock. likewise, to sell a store, you need to gather a sell order form by pressing the ‘s’ key.
- you choose a limit order type when you are keen on transacting at a particular price; else, you can opt for a market order.
- you choose cnc as a product type if you want to buy and hold the stock across multiple days. if you want to trade intraday, you choose nrml or mis.
- an order book lets you track orders that are both open and completed. you can modify the available orders by clicking on the change button at the order book’s bottom.
- once the order is completed, you can view the trade details in the trade book. in the case of a market order, you can view the exact trade price by accessing the trade book.
- you can press the f6 key to invoke the market depth or snap quote window. the market watch enables you to see bid and ask prices.
- the bid & ask prices refer to the price you can transact. by default, the top 5 bid and ask prices are displayed in the market depth window at all times.
###
fundamental-analysis-vs-technical-analysis


- technical analysis is a popular method to develop a point of view on markets. besides, ta also helps in identifying entry and exit points.
- technical analysis visualizes the actions of market participants in the form of stock charts.
- patterns are formed within the charts, and these patterns help a trader identify trading opportunities.
- ta works best when we keep a few core assumptions in perspective.
- ta is used best to identify short term trades.
###
setting-realistic-expectations


- technical analysis is a popular method to develop a point of view on markets. besides, ta also helps in identifying entry and exit points.
- technical analysis visualizes the actions of market participants in the form of stock charts.
- patterns are formed within the charts, and these patterns help a trader identify trading opportunities.
- ta works best when we keep a few core assumptions in perspective.
- ta is used best to identify short term trades.
###
types-of-charts


- conventional charts can’t be used for ta as we must plot 4 data points simultaneously.
- a line chart can be used to interpret trends only.
- bar charts are unpopular as they’re unappealing, and patterns aren’t easily identifiable.
- candlesticks types – bullish & bearish. the structure of the candlestick, however, is unchanged.
- close > open = bullish candle. close < open = bearish candle.
- time frames are crucial in defining trading success.
- the number of candles grows as the frequency rises.
- traders should discard noise from relevant information.
###
timeframes


- conventional charts can’t be used for ta as we must plot 4 data points simultaneously.
- a line chart can be used to interpret trends only.
- bar charts are unpopular as they’re unappealing, and patterns aren’t easily identifiable.
- candlesticks types – bullish & bearish. the structure of the candlestick, however, is unchanged.
- close > open = bullish candle. close < open = bearish candle.
- time frames are crucial in defining trading success.
- the number of candles grows as the frequency rises.
- traders should discard noise from relevant information.
###
key-assumption-of-technical-analysis


ta is based on a few core assumptions.
- markets discount everything.
- the how is more important than why.
- price moves in trends.
- history tends to repeat itself.
###
understanding-candlestick-patterns


- history tends to repeat itself – we modified this assumption by adding the factor angle.
- candlestick patterns can be broken down into single and multiple candlestick patterns.
- there are three critical assumptions specific to candlestick patterns.
- buy strength and sell weakness.
- be flexible – quantify and verify.
- look for a prior trend.
###
single-candlestick-patterns


- remember the rules based on which candlesticks work.
- marubozu is the only pattern that violates rule number 3, i.e. look for the prior trend.
- a bullish marubozu indicates bullishness.
- buy around the closing price of a bullish marubozu
- keep the low of the marubozu as the stoploss
- a bearish marubozu indicates bearishness.
- sell around the closing price of a bearish marubozu
- keep the high of the marubozu as the stoploss
- an aggressive trader can place the trade on the same day as the pattern forms.
- risk-averse traders can place the trade on the next day after ensuring that it obeys rule number 1, i.e. buy strength, and sell weakness.
- abnormal candle lengths should not be traded.
- a short candle indicates subdued activity.
- long candle indicates extreme activity; however, placing stop loss becomes an issue.
###
multiple-candlestick-patterns
<


- multiple candlestick patterns evolve over two or more trading days.
- the bullish engulfing pattern evolves over two trading days. it appears at the bottom end of a downtrend. day one is called p1, and day two is called p2.
- p1 is a red candle in a bullish engulfing pattern, and p2 is a blue candle. p2’s blue candle completely engulfs p1’s red candle.
- a risk-taker initiates a long trade at the close of p2 after ensuring p1 and p2 together form a bullish engulfing pattern. a risk-averse trader will start the business the day after p2, near the close of the day.
- the stop loss for the bullish engulfing pattern is the lowest low between p1 and p2.
- the bearish engulfing pattern appears at the top end of an uptrend. p2’s red candle completely engulfs p1’s blue candle.
- a risk-taker initiates a short trade at the close of p2 after ensuring p1 and p2 together form a bearish engulfing pattern. after confirming the day includes a red candle, the risk-averse trader will start the business the day after p2.
###
support-and-resistance


- s&r are price points on the chart.
- support is a price point below the current market price that indicates buying interest.
- resistance is a price point above the current market price, indicating selling interest.
- to identify s&r, place a horizontal line to connect at least three price action zones, well-spaced in time. the more price action zones (well spaced in time) the horizontal line associates, the stronger is s&r.
- s&r can be used to identify targets for the trade. for a long trade, look for the immediate resistance level as the target. for a short trade, look for the immediate support level as the target.
- lastly, comply with the checklist for optimal trading results.
###
technical-indicators


- indicators are independent trading systems developed and introduced by successful traders.
- indicators are leading or lagging. leading indicators signal the possible occurrence of an event. lagging indicators, on the other hand, confirms an ongoing trend.
- rsi is a momentum oscillator that oscillates between 0 and 100 levels.
- a value between 0 and 30 is considered oversold. hence the trader should look at buying opportunities.
- a value between 70 and 100 is considered overbought. hence the trader should look at selling opportunities.
- if the rsi value is fixed in a region for a prolonged period, it indicates excess momentum. hence, the trader can consider initiating a trade in the same direction instead of taking a reversed position.
- a macd is a trend following system.
- macd consists of a 12 day, 26 days ema.
- macd line is 12d ema – 26d ema.
- the signal line is the nine days sma of the macd line.
- a crossover strategy can be applied between the macd line and the signal line.
- the bollinger band captures the volatility. it has a 20-day average, a +2 sd, and a -2 sd.
- one can short when the current price is at +2sd, expecting that the price reverts to the average.
- one can go long when the current price is at -2sd, expecting the price to revert to the average.
- bb works well in a sideways market. the bb’s envelope expands in a trending market and generates many false signals.
- indicators are good to know, but they should not be treated as a single decision-making source.
###
your-trading-checklist
 also, visit the complete module here to know some more theories.
 also, visit the complete module here to know some more theories.
very useful for me and explained clearly
really simple and useful. thanks
simple and effective. to the point explanation. watching videos and going through the theory module definitely teaches you a lot. honestly, so much better than paying 25-40k to these youtube trainers out there. the stock market is the same around the world. there is nothing extra or new someone is gonna teach. thank you zerodha, karthik, and prathik for putting out efforts to spread the rightful knowledge without being selfish.
it was awesome, attended so many youtube classes, bought so many classes over udemy but could get even a single thing there, you explained very clearly the things, it was so interesting classes with clear examples, that’s why i finished it within single shot of sitting
thank you so much for all thins
thank you sir very helpful
###
moving-averages-2


- a standard average calculation is an estimate of a series of numbers.
- moving average uses the most recent data and excludes the oldest.
- the sma gives equal weightage to all data points in the series.
- in ema, recent data gets the max weightage over the oldest.
- i prefer ema over sma because ema gives more weightage to the latest data points more weight.
- current market price > ema = optimistic outlook.
- current market price < ema = bearish outlook.
- ma’s can cause whipsaws in a non-trending market, resulting in losses. to overcome this, ema is used.
- the shorter ema is faster to react, while the longer ema is slower to respond in a crossover system.
- but when the faster ema is above, the slower ema. the trade will continue until the faster ema falls below, the slower ema.
- the longer the time frame for a crossover system, the lesser the trading signals.
###
introduction-to-fundamental-analysis


- fundamental analysis is used to make long term investments.
- investment in a company with sound fundamentals creates wealth.
- using fundamental analysis, one can separate an investment-grade company from a junk company.
- all investment-grade companies exhibit a few common traits. likewise, all junk companies exhibit common characteristics.
- fundamental analysis helps the analysts identify these traits.
- both technical analysis and fundamental analysis should coexist as a part of your market strategy.
- to become a fundamental analyst, one does not require any particular skill. common sense, basic mathematics, and a bit of business sense are all that is needed.
- a core-satellite approach to capital allocation is a prudent market strategy.
- the tools required for fa are generally fundamental; most of these tools are available for free.
###
mindset-of-an-investor


- the mindset of a trader and an investor is different.
- the investor has to develop an investment mindset if he is serious about investing.
- the investor should stay invested for an extended period for the returns to compound.
- the speed at which the money doubles increases drastically the more you stay invested. this is one of the properties of compounding.
- every investment has to be evaluated on two aspects – qualitative & quantitative.
- qualitative aspects revolve around the non-numeric information related to the company.
- the quantitative aspects involve analyzing numeric data. financial statements are an essential source of finding quantitative data.
###
how-to-read-the-annual-report-of-a-company


- the annual report (ar) of a company is an official communication from the company to its investors and other stakeholders.
- the ar is the best source to get information about the company; hence ar should be the default choice for the investor to source company-related information.
- the ar contains many sections, with each section highlighting a certain aspect of the business.
- the ar is also the best source to get information related to the qualitative aspects of the company.
- the management discussion and analysis is one of the most important sections in the ar. it has the management’s perspective on the country’s overall economy, their outlook on the industry they operate in for the year gone by (what went right and what went wrong), and what they foresee for the year ahead.
- the ar contains three financial statements – profit & loss statement, balance sheet, and cash flow statement.
- the standalone statement contains the financial numbers of only the company into consideration. however, the consolidated numbers contain the company and its subsidiaries financial numbers.
###
understanding-the-pl-statement


- the financial statement provides information and conveys the financial position of the company.
- a complete set of financial statements include the profit & loss account, balance sheet and cash flow statement.
- a fundamental analyst is a financial statement user, and he needs to know what the maker of the financial statements states.
- the profit and loss statement gives the company’s profitability for the year under consideration.
- the p&l statement is an estimate, as the company can revise the numbers later. also, by default, companies publish data for the current year and the previous year, side by side.
- the revenue side of the p&l is also called the top line of the company.
- revenue from operations is the primary source of revenue for the company.
- other operating income includes revenue incidental to the business.
- the other income includes revenue from non-operating sources.
- the revenue from operations (net of duty), other operating income, and other incomes give the ‘net revenue from operations.
###
understanding-the-balance-sheet-statement


- the assets side of the balance sheet displays all the company’s assets.
- assets are expected to give an economic benefit during their useful life.
- assets are classified as non-current and current assets.
- the useful life of non-current assets is likely to last beyond 365 days or 12 months.
- current assets are expected to pay off within 365 days or 12 months.
- assets inclusive of depreciation are called the ‘gross block.’
- net block = gross block – accumulated depreciation
- the sum of all assets should equal the sum of all liabilities. only then the balance sheet
- is said to have balanced.
- the balance sheet and p&l statement are inseparable. they are connected in many ways.
###
understanding-the-cash-flow-statement


- the cash flow statement gives us a picture of the company’s actual cash position.
- a legitimate company has three main activities: operating, investing, and financing.
- each activity either generates or drains money for the company.
- the company’s net cash flow is the sum of operating activities, investing activities, and financing activities.
- investors should specifically look at the cash flow from the company’s operating activities.
- when the liabilities increase, the cash level increases and vice versa
- when the assets increase, the cash level decreases and vice versa.
- the net cash flow number for the year is also reflected in the balance sheet.
- the statement of cash flow is a valuable addition to a company’s financial statements because it indicates its performance.
###
the-connection-between-balance-sheet-pl-statement-and-cash-flow-statement


- essential items to look at under the p&l are;
- revenue
- -heavy expenses
- -tax rate
- -pat
- essential items to look at under the balance sheet are;
- -long-term borrowings
- -accounts receivable
- -cash in hand/bank
- profit after tax flows from p&l to balance sheet.
- cash & cash equivalents flow from the cash flow statement to the balance sheet.
###
the-financial-ratio-analysis


- a financial ratio is a useful financial metric of a company. on its own merit, the ratio conveys very little information
- it is best to study the ratio’s recent trend or compare it with the company’s peers to develop an opinion
- financial ratios can be categorized into ‘profitability’, ‘leverage’, ‘valuation’, and ‘operating’ ratios. each of these categories gives the analyst a certain view on the company’s business.
- ebitda is the amount of money the company makes after subtracting the operational expenses of the company from its operating revenue
- pat margin gives the overall profitability of the firm
- return on equity (roe) is a precious ratio. it indicates how much return the shareholders are making over their initial investment in the company
- a high roe and high debt is not a great sign
- return on assets is an indicator of how efficiently the company is utilizing its assets
- return on capital employed indicates the overall return the company generates considering both the equity and debt.
- for the ratios to be useful, it should be analyzed compared to other companies in the same industry.
###
quick-note-on-relative-valuation


- a stock idea can come from any source.
- circle of competence and general observation is a great way to start.
- it is advisable to have a watch list that includes stocks that look interesting.
- once a stock is identified, we should look for sustainable moats.
- the due diligence process involves understanding the business, running the checklist to understand its financial performance, and the valuation exercise.
- when it comes to an understanding the business, one should be completely thorough with its operation.
- the checklist should be improvised as and when the investor gains investment experience.
- the dcf method is one of the best techniques to identify the intrinsic value of the business
###
fundamental-investment-checklist

congratulations, you can now be proud to understand various financial statements. now that you understand the concepts and techniques, we hope you apply them to your trading strategies and take mindful trading decisions. but before you get started, read our innerworth module to understand trading psychology and the impact of events on a trader’s mind.
happy trading 🙂
###
introduction-to-forwards-market


- the forwards’ contract lays down the essential foundation for a futures contract.
- a forward is an otc derivative that is not traded on an exchange.
- forward contracts are private agreements whose terms vary from one contract to another.
- the structure of a forwards contract is pretty simple.
- in a forward agreement, the party agreeing to buy the asset is called the “buyer of the forwards contract.”
- in a forward agreement, the party agreeing to sell the asset is called the “seller of the forwards contract.”
- a variation in the price would impact both the buyer and the seller of the forwards’ contract.
- settlement occurs in two ways in a forward contract – physical and cash settlement.
- a futures contract reduces the risk of a forward contract.
###
introducing-the-futures-contract


- the forwards and futures markets give you a financial benefit if you have an accurate directional view of an asset’s price.
- the futures contract is an improvisation over the forwards contract.
- the futures price generally mimics the underlying price in the spot market.
- unlike a forwards contract, the futures contract is tradable.
- the futures contract is a standardized contract wherein all the agreement variables are predetermined.
- futures contracts are time-bound, and the arrangements are available over different timeframes.
- most of the futures contracts are cash-settled.
- sebi in india regulates the futures market.
- the lot size is the minimum quantity specified in the futures contract.
- contract value = lot size times the futures price.
- to enter into a futures agreement, one must deposit a margin amount, a sure % of the contract value.
- every futures contract has an expiry date beyond which the agreement would cease. upon expiry, old contracts terminate, and new ones are created.
###
margins


- zerodha’s margin calculator is a simple tool that lets you calculate the margin required for a futures contract.
- the margin calculator has many versatile features inbuilt.
- the margin calculator gives the split up between the span and exposure margin.
- at any given point, nse ensures there are three contracts of the same underlying, which expire on three different (but consecutive) months.
- a trader can choose the contract of his choice based on the expiry date.
- the contract belonging to the current month is called ‘current month contract’, the next month contract is called ‘mid month’, and the 3rd one is called “far month contract.’
- the current month contract expires on every expiry, and a new far month contract is introduced. the mid-month contract would graduate to the current month contract in the process.
- a calendar spread is a trading technique that involves buying a particular month contract and selling another month contract simultaneously for the same underlying.
- when a calendar spread is initiated, the margins required are lower since the risk is drastically reduced.
###
leverage-and-payoff


- leverage plays a key role in futures trading.
- margins allow us to deposit a small amount of money and take exposure to a large value transaction.
- margins charged is usually a % of the contract value.
- spot market transactions are not leveraged; we can transact to the extent of our capital.
- under leverage, a small change in the underlying results in a massive impact on the p&l.
- the profits made by the buyer is equivalent to the loss made by the seller and vice versa.
- the higher the leverage, the higher is the risk and, therefore, the higher the chance of making money.
- futures instrument simply allows one to transfer money from one pocket to another. hence it is called a “zero sum game.”
- the payoff structure of a futures instrument is linear.
###
futures-trade-2


- if you have a directional view on an assets price, you can financially benefit from it by entering into a futures agreement.
- to transact in a futures contract, one needs to deposit a token advance called the margin.
- when we transact in a futures contract, we digitally sign the agreement with the counterparty; this obligates us to honour the warranty.
- the futures price and the spot price of an asset are different; this is attributable to the futures pricing formula (we will discuss this topic later)
- one lot refers to the minimum number of shares that needs to be transacted.
- once we enter into a futures agreement, there is no obligation to stick to the agreement until the contract expires.
- every futures trade requires a margin amount; the margins are blocked when you enter a futures trade.
- we can exit the agreement anytime, which means you can leave the deal within seconds of entering the contract.
- when we square off an agreement, we essentially transfer the risk to someone else. once we square off the futures position, margins are unblocked.
- the money you make or lose in a futures transaction is credited or debited to your trading account the same day.
- in a futures contract, the buyer’s gain is the seller’s loss and vice versa.
###
settlement

no key takeaways from this video 🙂

no key takeaways from this video 🙂
what will happen to my balance/trade if i don’t close by position during end of the expiry day
hi karthik,
as it is said in the video, that as we approach the expiry date of the futures contract, the margin required increases. therefore, will the margin become equal to the total contract size of our position on the day of the expiry, since we have to ensure physical delivery on the expiry date?
i sold igl 400 pe @ 3 and currently somewhere at 9 due to sharp fall. lets say if it goes further down to 380 and by the expiry how the settlement happens exactly. will i get the stock price at 380 or 400 as i sold the 400 contract. also how the losses will be adjusted. please explain with some examples.
please explain me about currency option settlement. for example,
usdinr contract expirey date october 30 , 2021
spot price on expiry 77
i sold 78 put , 1 lot
my question is that, how much i need to pay for settlement on expiry.
hi karthik,
can you help to understand last sentence from video “if you are short seller you have to make sure you have those share in your dp account” in futures perspective ?
###
open-interest-2


- open interest (oi) is a number that tells you how many contracts are currently outstanding (open) in the market.
- oi increases when new contracts are added. oi decreases when contracts are squared off.
- oi does not change when contracts are transferred from one party to another.
- unlike volumes, oi is continuous data.
- on a stand-alone basis, oi and volume information does not convey information; hence it makes sense always to pair it with the price to understand the impact of their variation.
- abnormally high oi indicates high leverage. beware of such situations.
###
shorting-futures


- shorting requires us to sell first and buy later.
- the short trade is profitable only when the closing price is lower than the entry price.
- there would be a loss when the price goes higher than the price at which one has shorted.
- the stop loss in a short trade is always higher than the price at which one has shorted.
- one can only short on an intraday basis in the spot market.
- the short positions cannot be carried overnight in the spot market.
- the short position in the futures market can be carried forward overnight.
- the margins requirement for both short and long trades are similar.
- the m2m computation is also similar for both short and long trades.
###
overview-of-contracts
and with this, we would like to conclude this video series on futures trading. we hope you enjoyed watching and learning from this module as much as we enjoyed curating it!
in the next series, we will discuss options.
visit this link to learn more about currency and commodity futures.
no key takeaways from this video. 🙂
###
introduction-to-options


- options are traded in the indian markets for over 15 years, but the real liquidity was available only since 2006
- an option is a tool for protecting your position and reducing risk
- a buyer of the call option has the right, and the seller must make delivery
- the optionhttps://zerodha.com//chapter/call-option-basics/ is only given to one party in the transaction (the buyer of a vote)
- the option seller is also called the option writer
- at the time of the agreement, the option buyer pays a certain amount to the option seller; this is called the ‘premium’ amount
- the deal happens at a pre-specified price, often called the ‘strike price.’
- the option buyer benefits only if the asset’s cost increases higher than the strike price.
- if the asset price stays at or below the strike, the buyer does not benefit; for this reason, it always makes sense to buy options when you expect the price to increase.
- statistically, the option seller has a higher odds of winning in a typical option contract.
- the directional view must pan out before the expiry date; otherwise, the option will expire worthlessly.
###
option-jargons


- it makes sense to buy a call option only when one anticipates an increase in the price of an asset
- the strike price is the anchor price at which both the option buyer and option writer enter into an agreement
- the underlying price is simply the spot price of the asset
- exercising an option contract is the act of claiming your right to buy the options contract at the end of the expiry
- similar to futures contracts, options contracts also have an expiry. options contracts expire on the last thursday of every month
- options contracts have different expiries – the current month, mid-month, and far month contracts
- premiums are not fixed, in fact, they vary based on several factors that act upon it
- options are cash-settled in india.
###
long-call-payoff-and-short-call-trade


- it makes sense to be a buyer of a call option when you expect the underlying price to increase.
- if the underlying price remains flat or goes down, then the call option buyer loses money.
- the money the buyer of the call option would lose is equivalent to the premium (agreement fees) the buyer pays to the seller/writer of the call option.
- the intrinsic value (iv) of a call option is a non-negative number
- iv = max[0, (spot price – strike price)]
- the maximum loss the buyer of a call option experiences is to the extent of the premium paid. the loss is experienced as long as the spot price is below the strike price.
- the call option buyer has the potential to make unlimited profits, provided the spot price moves higher than the strike price.
- though the call option is supposed to make a profit when the spot price moves above the strike price, the call option buyer first needs to recover the premium he has paid.
- the point at which the call option buyer completely recovers the premium he has paid is called the breakeven point.
- the call option buyer truly starts making a profit only beyond the breakeven point (which naturally is above the strike price)
###
put-buy-and-put-sell


- buy a put option when you are bearish about the underlying prospects. in other words, a put option buyer is profitable only when the underlying declines in value.
- the intrinsic value calculation of a put option is slightly different from the intrinsic value calculation of a call option.
- iv (put option) = strike price – spot price
- the p&l of a put option buyer can be calculated as p&l = [max (0, strike price – spot price)] – premium paid
- the breakeven point for the put option buyer is calculated as strike – premium paid
###
summarizing-call-put-options-2


- buy a call option or sell a put option only when you expect the market to go up.
- buy a put option or sell a call option only when you expect the market to go down
- the buyer of an option has unlimited profit potential and limited risk (to the extent of the premium paid)
- the seller of an option has an unlimited risk potential and limited reward (to the extent of the premium received)
- majority of options traders prefer to trade options only to capture the variation in premiums
- option premiums tend to gyrate drastically – as an options trader, and you can expect this to happen quite frequently.
- premiums vary as a function of 4 forces called the option greeks
- black & sholes option pricing formula employs four forces as inputs to give out a price for the premium
- markets control the option greeks and the greek’s variation itself
###
moneyness-of-option


- the intrinsic value is equivalent to the value of money the option buyer makes provided if he were to exercise the contract.
- the intrinsic value cannot be negative; it is a non zero positive value.
- the intrinsic value of call option = spot price – strike price
- the intrinsic value of the put option = strike price – spot price.
- any option with an intrinsic value is classified as an ‘in the money’ (itm) option.
- any option that does not have an intrinsic value is classified as an ‘out of the money (otm) option.
- if the strike price is almost equal to the spot price, the option is considered the ‘at the money (atm) option.
- all strikes lower than atm are itm options (for call options)
- all strikes higher than atm are otm options (for call options)
- all strikes higher than atm are itm options (for put options)
- all strikes lower than atm are otm options (for put options)
- when the intrinsic value is very high, it is called the ‘deep itm’ option.
- likewise, it is called the ‘deep otm’ option when the intrinsic value is the least.
- the premiums for itm options are always higher than the premiums for otm options.
- the option chain is a quick visualisation to understand which option strike is itm, otm, atm (for both calls and puts), and other information relevant to options.
###
the-option-greeks-delta


- option greeks are forces that influence the premium of an option
- delta is an option greek that captures the effect of the direction of the market
- call option delta varies between 0 and 1; some traders prefer to use 0 to 100.
- put option delta varies between -1 and 0 (-100 to 0)
- the negative delta value for a put option indicates that the option premium and underlying value move in the opposite direction
- atm options have a delta of 0.5
- itm option has a delta of close to 1
- otm options have a delta of close to 0.
###
gamma


- financial derivatives are called financial derivatives because of their dependence on calculus and differential equations (generally called derivatives)
- delta of an option is a variable and changes for every change in the underlying and premium
- gamma captures the rate of change of delta, it helps us get an answer to a question such as “what is the expected value of delta for a given change in underlying”
- delta is the 1st order derivative of premium
- gamma is the 2nd order derivative of premium
- gamma measures the rate of change of delta.
- gamma is always a positive number for both calls and puts.
- large gamma can translate to large gamma risk (directional risk)
###
theta-2


- option sellers are always compensated for the time risk
- premium = intrinsic value + time value
- all else equal, options lose money on a daily basis owing to theta
- time moves in a single direction hence theta is a positive number
- theta is a friendly greek to option sellers
- when you short naked options at the start of the series you can pocket a large time value but the fall in premium owing to time is low
- when you short option close to expiry the premium is low (thanks to time value) but the fall in premium is rapid
###
vega-2
<


- historical volatility is measured by the closing prices of the stock/index
- forecasted volatility is forecasted by volatility forecasting models
- implied volatility represents the market participants’ expectation of volatility
- india vix represents the implied volatility over the next 30 days period
- vega measures the rate of change of premium with respect to change in volatility
- all options increase in premium when volatility increases
- the effect of volatility is highest when there are more days left for expiry
###
options-m2m-and-pl-calculation


- neither option buying nor selling entails mark to market; m2m is only for futures
- margins charged for option selling is a function of both price movement and volatility
- as volatility increases, so does the option premium
- option positions closed before expiry can be generalized to the difference between buying and selling price of premium multiplied by lot size
- the option positions held to expiry are physically settled
###
physical-settlement-of-futures-and-options

there are no key takeaways in this chapter 🙂

there are no key takeaways in this chapter 🙂
i purchased x shares 1000 nos.( equivalent of one lot ) for rs.1000 per share in equity segment.
i sell call option at strike price 1050 for premium of rs.80.
during contract expiry the underlying value becomes rs.1200.
kindly clarify what will be my profit / loss.
also clarify whether brokerage charges will be charged for selling as well as for equity delivery.
also kindly clarify whether entire margin paid will be re-credited into my trading account or any part only.
thanks.
hello ,
by mistake i sold ce (which is illiquid) instead of pe of stock but to hedge i bought future of stock same expiry .
real life example 🙂 :
aarti ind was at 750 at starting of month , i want to sell it’s aug pe but by mistake sold it’s aug ce at 50 [contact is illiquid only single contact ]
to hedge i bought aarti aug future at 749.50
but on the day of expiry aarti trading at 799
i do have enough margin available till end but just like to know is what will be extra charges after 0.1% of stt of net delivery values in my case it will be 799 x 850 + 700 * 800 ‘s 0.1% if i am not wrong
i had purchased 4 lot for futures for about 4 laks,but i didn’t exist on the last day.what happens in this case.
give your views about physical settlement of currency option trading on the expiry day. is it same as that of index option trading i.e. cash settlement.
what exactly is physical settlement?
do we need to do anything extra?
unable to understand this concept
###
bull-call-spread-2


- a moderate move would mean you expect a movement in the stock/index, but the outlook is not too aggressive
- one has to quantify ‘moderate’ by evaluating the volatility of the stock/index
- bull call spread is a basic spread that you can set up when the outlook is moderately bullish
- classic bull call spread involves buying atm option and selling otm option – all belonging to same expiry, same underlying, and equal quantity
- the theta plays an essential role in strike selection
- the risk-reward gets skewed based on the strikes you choose
###
the-straddle


- short straddle requires you to sell the atm call and put option simultaneously. the options should belong to the same underlying, same strike, and same expiry
- by selling the ce and pe – the trader is placing the bet that the market won’t move and would essentially stay in a range
- the maximum profit is equal to the net premium paid, and it occurs at the strike at which the long straddle has been initiated
- the upper breakdown is ‘strike + net premium’. the lower breakdown is ‘strike – net premium.’
- the deltas in a short straddle add up to zero
- the volatility should be relatively high at the time of strategy execution
- the volatility should decrease during the holding period of the strategy
- short straddles can be set around significant events, wherein before the event, the volatility would drive the premiums up, and just after the announcement, the volatility would cool off, and so would the premiums.
###
insurance-part-1
3.1 – insurance – an introduction
in a broad sense, businesses can be into either manufacturing or services. the previous chapter was about cement, a manufacturing business. in this chapter, we will study how to analyze the insurance sector, a service business.
this chapter will mainly cover the following:
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- the insurance landscape in india
- types of insurance companies
- the sales channels used to sell insurance
- risk management by insurers and reinsurance
insurance, in the simplest terms, is protection against risk. if your family depends on your regular income, you would prefer to insure your life. vehicle insurance could pay for damages in case of an accident. health insurance could cover your medical expenses if you have a health-related issue. any unforeseen event that could cost you dearly becomes easier to deal with if you had insured it.
if insurance can make life so easy, why don’t all of us have insurance? lack of awareness and inability to afford premium payments are common reasons. those who can afford to pay premiums mostly use insurance only to save taxes. even those who understand that insurance is essential may not see it as an urgent need. so they keep delaying the purchase of insurance. for many people, it is a psychological barrier – how can i put value into my life? why should i think about what will happen if i meet with an accident or die? and how to discuss my death with my family? an easy way out is not having any insurance at all.
to think that psychological barriers might be more visible among the older, conservative indians may be a fallacy. about 83% of millennials do not have life insurance. millennials are now of working age and likely have dependents. if education and awareness, or any other solutions, do manage to bring about wider acceptance of insurance, there is tremendous potential for insurance companies to grow their business. if 83% of millennials do not have life insurance, only 17% do. it also means there is a five-fold market waiting to be tapped.
if you are an investor, the insurance sector indeed seems a hot and ripe investible opportunity. however, insurance is a tricky business. and it is regulated by irdai or the insurance regulatory and development authority of india. irdai attempts to safeguard customer interests, along with regulating selling practices, risks, and financial strength of insurance companies.
as an investor in the insurance sector, you must realize that insurance companies are in the business of acquiring risks. the risk that a policyholder is insuring is the risk that an insurance company is acquiring. so the question is, how does an insurance company make money from these risks?
the answer is twofold. insurance companies make money from underwriting profits and investment gains. underwriting profits occur when the premiums earned by the insurer exceed the total amount paid out in claims. the insurance company may not immediately need the funds from premiums to service claims. until then, it can invest these funds to make investment gains, the second money-making stream for insurers.
while money-making happens primarily from just two sources, insurance companies differ in the type of insurance they offer. this also impacts the insurer’s approach to managing risks. let us delve deeper.
3.2 – types of insurance companies
at the top, insurance companies are classified into two categories: life and general insurance.
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- life insurers offer insurance on life and related products. term plans, endowment plans, ulips, and annuities are all products from a life insurance company.
- general insurers offer medical insurance, vehicle insurance, and property insurance. a particular general insurance company might offer some or all types of general insurance.
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the industry comprises both private and public players. lic alone commands two-thirds of the life insurance market in india. it is also the only government-owned life insurer. the general insurance segment is crowded with private players. the government also promotes six general insurance companies. these are the general insurance corporation of india, the new india assurance company, the united india insurance company, the oriental insurance company, the national insurance company, and agriculture insurance company of india.
when studying the insurance sector, it is essential to understand why and how the two types of insurance companies (life and general) are different.
life insurers typically have obligations that are long-term in nature. let me break this down. life insurance policies span years or even decades. people keep paying premiums for several years. so there is a considerable gap between the time an average policy is bought and when its claim is settled. hence, the long-term nature of obligations.
during this gap, the collected premiums are lying idle. these idle funds are called “float”. the life insurance company can invest the float to make investment gains. it can also take on additional investment risk because the time horizon is long. higher risk, as you know, is taken in search of higher returns.
general insurers mostly have short-term obligations. whether medical, vehicle, or property insurance, most general insurance policies have a maximum duration of one year. for example, you paid a medical insurance premium today. this policy will be in force until one year from today. let’s say you did file a claim after six months. the insurer will have to pay you. for general insurance companies, any liability will arise in less than one year. therefore, investments are also for a short duration and must carry minimal risk. of course, if the insurance was not claimed, it is a gain for the insurer.
by the way, if you have read about warren buffett’s success, you have likely heard of the advantage his investments get from float money. buffett’s holding company, berkshire hathaway (bh), is a large multinational corporation. its main business is insurance. insurance gives bh a large pool of float money. float is free money – no borrowing cost or obligation to share investment gains with premium payers. a larger float gives more room to take investment risks. however, if there are losses on the float, the insurer will have to pay for it out of its own capital.
now let’s stop and ponder a bit. the ability to invest comes only if the premiums earned are more than the payments made toward claims. as an investor trying to understand the insurance sector, you must analyze where the premiums are coming from, if they are growing, whether there is any surplus after settling claims, whether all investments yield positive returns, and how the balance sheet is holding up to sustain long-term growth.
let us first see where the premiums can come from or what are the sales channels.
3.3 – how are insurance policies sold?
insurance is heavily reliant on selling efforts. when there is a lack of awareness around a product, marketing and selling become a significant force for increasing awareness and adoption. and those who do not look at insurance as an urgent need may require a little bit of nudge from insurance sellers. insurance companies use multiple channels to sell their policies.
the snapshot from hdfc life’s fourth-quarter investor presentation for fy23 shows the various channels hdfc life uses to sell its life insurance products.
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- the insurer might have a direct sales team to sell policies to the customers. this is naturally the most profitable channel. however, insurance companies do not have a far-reaching presence across cities, towns, and villages. therefore, they rely on channel partners or agents.
- many individuals become agents for insurance companies. lic has the largest pool of agents spread across the length and breadth of the country. many financial planners or distributors of financial services act as agents for insurance companies. banks also act as insurance agents but are considered separate sales channels.
- among all financial services businesses, banks have the broadest geographical coverage. therefore, banks are the largest distributors of insurance products. the channel of selling insurance through banks has a name for itself – bancassurance. despite the growing digital presence of insurance companies and emerging digital distributors such as policybazaar.com and acko, bancassurance remains the largest channel.
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in fact, insurance companies that are part of banking groups rely the most on bancassurance and have an advantage over other standalone insurers. hdfc bank, sbi, icici bank, and kotak mahindra bank have affiliated life and general insurance companies. these banks are also the largest bancassurance partners for these affiliates.
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- group insurance, mainly in the case of health insurance by corporate employers, is a common channel. this route takes care of the issues related to lack of awareness or affordability. employees get health coverage for themselves and their families as part of their salary package. while this type of health insurance is cheap for an average person, the insurance company also diversifies its risk by offering coverage to a large group of people. the cost of sales is also low for the insurer as most of the selling efforts have to be made only initial stage of signing up with an organization. once signed up, all their employees become customers. and renewal is continuous too.
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- the latest technique is to sell insurance policies through plug-ins or add-ons. when booking a flight or hotel on a travel site, have you seen the “add a travel insurance of ₹50000 only for ₹25”? this option is usually on the final billing page. you might not even notice it. and often, it is auto-selected, so you have to uncheck the option if you don’t want travel insurance. i think it is an exciting and shrewd cash-generation technique. the amount is not significant enough to warrant everyone’s attention. even if you don’t like it, you may not want to spend your energy protesting a ₹25 issue. the risk for the insurer is high. but the probability of the payout becoming due in the few hours or days of that insurance is very low.
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the concept is similar to chocolates placed next to the cashier’s counter at a retail store. while billing, you impulsively pick a few chocolates while not worrying about the small expense.
3.4 – taxation on insurance customers
tax saving is a powerful motivation for people to buy insurance. premiums up to ₹1.5 lakh paid towards life insurance are tax-exempt under section 80(c). endowment plans, which come with some level of savings along with providing insurance, have been trendy. taxpayers choosing the old tax regime are using these exemptions. however, taxpayers do not need these exemptions if they choose the new tax regime. a more significant number of people choosing the new regime could hurt the demand for insurance.
similarly, exemptions under section 10(10d) have been scrapped for annual premium payments of over ₹5 lakhs. section 10(10d) makes maturity benefits tax-free if they are at least ten times the annual premium payment. budget 2023 amended this provision. if annual premium payments are over ₹5 lakhs, the benefits become void. essentially, the amendment took away tax benefits from insurance that the wealthy could enjoy.
when you are an investor in the insurance sector, you want to know how a tax policy is impacting the insurance business. the scenario can change every year with the annual budget.
3.5 – diversification of insurance business
as i mentioned earlier, the business of insurance is about taking on risks. so it makes business sense to diversify these risks. diversification has to be across geographies, age groups, customer profiles, investment assets, and the timeline of committed payouts. let us discuss why each of these is important.
geographies: high mortality rate in one region could be compensated for by the low mortality rates in other areas. violence or natural calamities tend to increase the number of claims being filed; if policyholders are situated far apart, not all will have suffered the calamity of filing claims.
age groups: certain age groups may be more vulnerable to diseases or pandemics. for example, most cases of swine flu were in children, while the coronavirus mainly affected adults. insuring across age groups would help life and health insurers to earn premiums from the unaffected group while settling claims from the affected groups.
investment assets: this point is about asset allocation. given the nature of the business risk that an insurer carries, it must carefully allocate investment assets to make optimum returns. this point is similar to the asset allocation chapter we discussed in the personal finance module of . the insurer must spread investments across asset classes and issuers to minimize risk and maximize returns.
liability schedule (or timeline of committed payouts): the annuities are a fixed cost for insurers. there may also be annuities or pensions that the insurer must start paying out on pre-set future dates. the investment decisions have to account for these future cash outflows. insurers also borrow funds to run their business. repayment of this also needs to be taken care of. spreading these obligations over multiple years could make it easier to honour them.
this is not an exhaustive list. your analysis could show more ways of diversifying premium inflows.
3.6 – what is reinsurance?
apart from diversification, insurance companies also cover their risks by reinsuring the policies they have sold. they might reinsure all or part of their obligations. it is a great tool to protect against unusually high-payout events. for example, if there were a major earthquake in a region, homeowners’ claims could go up significantly. if the insurer had reinsured part of their obligations, the hit from the payout could have been mitigated.
reinsurance is also used to comply with the regulator’s capital requirements. insurers are required to maintain a minimum solvency ratio of 150%. what if an insurer’s liabilities are too high? its solvency ratio could fall below the minimum limit. here, reinsurance is of great use. the insurer could transfer part of its claim-related liabilities by reinsuring some policies.
general insurance corporation of india, promoted by the government of india, is the largest reinsurer in the country.
in this chapter, we covered the business of insurance and its industry landscape. the next chapter is part-2 of this one. we will use real examples to look at how to study a life insurance company and a non-life insurance company. we will look at metrics that show the effectiveness of selling efforts, cost management, and capital maintenance.
key takeaways:
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- insurance penetration is very low in india, and hence, there is a huge untapped market potential
- irdai regulates the insurance sector
- there are two types of insurance companies – life and general
- insurance companies make money from two sources – insurance premiums and investment gains
- insurance is sold through various channels – direct sales, agents, banks, group insurance, plug-ins
- investors in the insurance sector have to monitor tax policies on insurance
- being in the business of acquiring risks, insurance companies diversify risks by selling policies across age groups and geographies. investments are diversified across asset classes.
- reinsurance is another tool for controlling risks.
###
the-ipo-markets-part-1
4.1 – overview
this chapter was updated on 15th november 2022. a few comments in the query section may seem out of place. kindly ignore those comments. the essence of the chapter remains the same.
the initial three chapters set the background on basic market concepts you need to know. it becomes necessary to address a fundamental question at this stage – why do companies go public? a good understanding of this topic lays a sound foundation for all future topics.
in this and the next chapter, we will learn about why companies go public and, in the process, also learn a few financial concepts.
4.2 – origin of a business
before we seek an answer as to why companies go public, let us figure out a basic concept – the origins of a typical business. we will build a familiar story around this concept to understand ipos better. let us split this story into several scenes to understand how the business and the funding environment evolve and the circumstances that lead a company to list in the public market.
scene 1 – the angels
let us start our story. imagine a passionate entrepreneur with a business idea – to manufacture highly fashionable, organic cotton t-shirts. the designs are unique, priced attractive, and the best quality cotton is used to manufacture these t-shirts. the entrepreneur is confident that the business will click and is enthusiastic about starting the business.
as you’d imagine, the entrepreneur will face a typical problem – how to fund the idea? assuming the entrepreneur has no business background, he/she will not attract any serious investors initially. chances are, the entrepreneur will approach the family and immediate friends to pitch the idea and raise some money.
let us assume that the entrepreneur pools some of his money and convinces two good friends to invest in his business. these two friends invest in the business based on their trust in their friends. the two friends in this context are referred to as the angel investors. please note that angel money is not a loan but an investment in the business.
so let us imagine that the promoter (entrepreneur) and the angels raise inr 5 crore in capital. this initial money the business gets to kick start operations is called ‘the seed fund.’ sometimes, it is also called a ‘friend & family round.’ it is important to note that the seed fund will not sit in the entrepreneur’s bank account but the company’s bank account.
angel funding need not always come from friends; there are professional angel investors who invest money in companies that they think are good.
in return for the initial seed investment, the original three (promoter plus two angels) will be issued share certificates of the company, which entitles them to certain ownership. the only asset that the company has at this stage is cash. hence the value of the company is only to the extent of the cash they own. in this case, the valuation is 5crs. of course, one can argue that the company’s value is cash plus the company’s unique business idea, and therefore the valuation is beyond 5crs, but we will not get into that.
issuing shares is quite simple; the company assumes that each share is worth rs.10, and because there is rs.5 crore as share capital, there have to be 50 lakh shares, with each share worth rs.10. in this context, rs.10 is called the ‘face value’ (fv) of the share. the face value could be any number between rs.1 to sometimes even above rs.10 per share as restricted by sebi dib guidelines to protect investors. if the fv is rs.5, the number of shares would be one crore, and so on.
backed by the seed fund, the promoter kick-starts business operations. the entrepreneur moves cautiously, hires the right people, establishes the right process, and starts manufacturing high-quality t-shirts. at this stage, the entrepreneur has one small manufacturing unit and one store to retail the product.
scene 2 – the venture capitalist
the entrepreneur’s hard work pays off, and the business generates a steady revenue stream. the company starts to break even at the end of the first two years of operations. the promoter is no longer a rookie business owner. instead, he is more knowledgeable about the business and, of course, more confident. backed by confidence, the promoter wants to expand the business by adding one more manufacturing unit and a few additional retail stores in the city. the entrepreneur chalks out the plan and figures out that the fresh investment needed for business expansion is inr 7 crs.
the entrepreneur is now in a better situation when compared to two years ago. the big difference is the fact that the business is generating revenues. the healthy inflow of revenue validates the business and its offerings. the entrepreneur can now access reasonably savvy investors for investing in the business. the investor who typically invests in such an early stage of business is called a venture capitalist (vc), and the money that the business gets at this stage is called series a funding.
assume the entrepreneur raises the 7 crs required to expand the business. typically when new investment flows into the business, the following happens –
- there is a dilution of shares by the promoter.
- the valuation of the business increases
- all the previous investors (in this case, the two angles) tend to make notional profits on their initial investment.
with the vc’s money coming into the business, the notional value (valuation) increases, and therefore, notional wealth is created for early investors.
as we advance with our story, the promoter now has the capital required for the business. as planned, the company gets an additional manufacturing unit and a few more retail outlets in the city. things are going great; the product’s popularity is growing, translating into higher revenues. the management team gets more professional, thereby increasing operational efficiency, which translates to better profits.
scene 3 – the banker
three more years pass by, and the company is phenomenally successful. the company decides to have a retail presence in at least three more cities. to back the retail presence across three cities, the company plans to increase its production capacity and hire more resources. whenever a company plans such expenditure to improve the overall business, the expenditure is called ‘capital expenditure’ or simply ‘capex’.
the management estimates 40crs towards their capex requirements. how does the company get this money, or in other words, how can the company fund its capex requirements?
there are a few options for the company to raise the required funds for their capex:
- the company has made some profits over the last few years; a part of the capex requirement can be funded through the profits. this is also called funding through internal accruals.
- the company can approach another vc and raise another round of vc funding by allotting shares; if they do, it’s called series b funding.
- the company can approach a bank for a loan. the bank would be happy to tender this loan as the company has been doing fairly well. the loan is also called ‘debt.’
assume the company exercises all three options to raise funds for capex. it plows back 15crs from internal accruals, plans a series b – divests some equity for a consideration of 10crs from another vc, and raises 15crs debt from the bank.
note that the company’s valuation again increases with 10crs coming in from series b. with the increase in valuations, the previous investors tend to make bigger notional profits. also, i would encourage you to think about the wealth created over the years. this is exactly what happens to entrepreneurs with great business ideas and a highly competent management team.
real-world examples of such wealth creation stories are companies like infosys, page industries, eicher motors, titan industries, bajaj finserve, hdfc bank, and internationally, one could think of google, apple, amazon, etc. the list is quite exhaustive.
scene 4 – the private equity
a few years pass by, and the company’s success continues to grow, and with the growing success of this 8-year-old company, ambitions swell. the company decides to raise the bar and branch out across the country. they also diversify the company by manufacturing and retailing fashion accessories, designer cosmetics, and perfumes.
the capex requirement to fuel the new ambition is now pegged at 60 crs. the company does not want to raise money through debt because of the interest rate burden, also called the finance charges, bites into the company’s profits. for example, suppose the company generates rs.100 as profit and pays rs.20 towards finance charges; the profitability is reduced to rs.80. we will discuss more on this in the fundamental analysis module.
the company decides on series c funding. they cannot approach a typical vc because vc funding is usually small and runs into a few crores. this is when a private equity (pe) investor comes into the picture. think about the pe as a big brother of a vc. here are a few differences between a pe and vc –
- vcs tend to cut smaller cheques, while pe typically invests large amounts.
- vc invests in early-stage businesses and takes a much higher risk than pe. pes invest at a mature stage and take on lesser risk compared to a vc
- pes, upon investment, also take up a board seat in the company and oversee the company’s functioning.
pe investors are quite savvy. they are highly qualified and have an excellent professional backgrounds. they invest large amounts of money to provide the capital for constructive use and place their people on the board of the investee company to ensure the company steers in the required direction.
usually, when a pe invests, they invest in funding large capex requirements. besides, they do not invest in the early stage of a business; instead, they prefer to invest in companies that already have a revenue stream and have been in operation for a few years. deploying the pe capital and utilizing the capital for the capex requirements takes a few years.
let us assume that the company raises funds via a private equity company and expands its business.
scene 5 – the ipo
fast forward 5 years after the pe investment, the company has progressed well. they have successfully diversified their product portfolio and have a presence across all the country’s major cities. revenues are good, profitability is stable, and the investors are happy. the promoter, however, does not want to settle in for just this.
the promoter now aspires to go international! the company now wants the brand available across all the major international cities, with at least two outlets in each major city worldwide.
the company needs to invest in market research to understand the demographics of other countries, invest in people, and increase manufacturing capacities. besides, they also need to invest in real estate space across the world. the capex requirement is huge; the management estimates this at 200 crs. the company has few options to fund the capex requirement –
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- fund capex from internal accruals
- raise series d from another pe fund
- raise debt from bankers
- float a bond (this is another form of raising debt)
- file for an initial public offer (ipo)
- a combination of all the above
for convenience, let us assume the company decides to fund the capex partly through internal accruals and the rest via an ipo. when a company files for an ipo, they have to offer its shares to the general public. the general public will subscribe to the shares (i.e., if they want to) by paying a certain price. now, because the company offers the shares for the first time to the public, it is called the “initial public offer’.
we are now at a crucial juncture where a few questions need to be answered.
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- why did the company decide to file for an ipo? in general, why do companies go public?
- why did they not file for the ipo when they were in series a, b, and c situations?
- what would happen to the existing shareholders after the ipo?
- what does the general public look for before they subscribe to the ipo?
- how does the ipo process evolve?
- which of the financial intermediaries are involved in the ipo markets?
- what happens after the company goes public?
in the following chapter, we will address each of the above questions plus more, and we will also give you more insights into the ipo market. hopefully, from this chapter, you should have developed a sense of the sequence of events that would typically drive a company to raise funds via an ipo.

- before understanding why companies go public, it is important to understand the origin of business.
- the people who invest in your business in the pre-revenue stage are called angel investors.
- angel investors take the maximum risk. they take in as much risk as the promoter.
- the money that angels give to start the business is called the seed fund.
- angel’s invests a relatively small amount of capital
- the valuation of a company signifies how much the company is valued by considering the company’s assets, liabilities, and future growth prospects.
- face value is simply a denominator to indicate how much one share is originally worth. face value is also called the notional value of a share.
- the money the company spends on business expansion is called capital expenditure or capex
- series a, b, and c are funding the company seeks as it evolves. usually, the newer the series, the higher the company’s valuation.
- beyond a certain size, vcs dont invest, and hence the company seeking investments will have to approach private equity firms.
- pe firms invest large sums of money, usually at a slightly more mature stage of the business.
- in terms of risk, pes have a lower risk appetite as compared to vcs or angels.
- typical pe investors post their people on the investee company’s board to ensure business moves in the right direction.
- the company’s valuation increases as and when the business, revenues, and profitability increase.
- an ipo is a process using which a company can raise funds from the general public. the funds raised can be for any valid reason – for capex, restructuring debt, rewarding shareholders, etc
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information-technology
5.1 introduction
in the previous chapter, we studied the parameters unique to the insurance industry. here, we will explore the performance metrics specific to the information technology (it) industry. while insurance was tricky due to the regulations in the sector, it is tricky because of its global nature.
among all sectors, indian it was perhaps the first to achieve global prominence. from exporting it services worth a little over $6 billion in 2000-01 to about $245 billion in 2022-23, indian it has come a long way. interestingly, while the sector has grown 40x in usd terms, it has grown ~80x in inr terms. this is because the inr has depreciated against the usd over these decades. for a business engaged in exports, a depreciating currency is like a cherry on the cake – earn foreign exchange and then convert it to extract even more value in inr.
the it sector had its humble beginnings in the 1990s when it mainly exported services such as insurance claim processing, payroll and hr maintenance, and call centers. fast forward two decades to 2023, and the sector has become a behemoth. digitalization, cloud computing, ai-driven insights, consulting, and cybersecurity are some of the many sophisticated services the it sector provides. from less than 2% about two decades ago, india’s share in global it revenues has soared to about ~35%.
the it sector is also a major employment generator. indian it employed over 51 lakh employees in 2021-22. this figure does not include the lakhs of employees working at the foreign offices of prominent players like tata consultancy services and infosys. remuneration is, in fact, the biggest cost for it companies.
over the years, automation and ai have largely replaced repetitive services like call centers and payroll maintenance. a key driver for the success of indian it firms in the face of automation is their ability to stay relevant. they have constantly spent on new technologies, upskilled their workforce, and focused on innovation.
5.2 features of indian it
service business: indian it is almost entirely service oriented. they hardly sell any hardware. software used to be a product, but the cloud transition has made it a service. remember saas or software as a service? previously businesses would buy software packages from it companies to digitalize their processes. now they buy subscriptions for regular payments so that the it company can continuously improve and update the product. it companies also prefer this arrangement as it is not just a one-time software sale but a subscription service that brings regular revenues.
tethered to global events: about three-fourths or 75% of the total revenues of indian it come from outside india, with the us alone commanding ~60% share. an economic boom in these countries triggers it spending, and indian it gets a boost in revenues. an economic downturn, on the other hand, hits revenues. a large part of it has become essential to the operations of many businesses. during a downturn, the demand for augmented or experimental services mainly declines while that for essential services remains stable. therefore, a significant revenue decline due to a recession may be rare.
exposure to foreign exchange: you may call this feature a derivative of the previous one, as both are mostly related. forex exposure is mostly seen as a good feature for an indian exporter. india is a developing country witnessing a steady depreciation in inr.
how does an exporter benefit from a depreciating currency? let’s say infosys sold a service for us$ 1,000 in 2013 when the usd/inr exchange rate was ~₹50. when converted into inr, infosys made ₹50,000 in 2013. if the same service were sold for us$ 1,000 today when the exchange rate is ~82, infosys would make ₹82,000. effectively, infosys made more money simply on account of inr depreciation.
the inr could depreciate for reasons internal or external to india. if high inflation has caused inr depreciation, it is mainly an internal issue. but when the russia-ukraine war pushed up the demand for usd, the inr depreciated due to external factors.
please also be mindful of any inr appreciation, which could show muted growth. the point to take home is that the slow growth could be due to currency fluctuations rather than a slow business.
regulations: every country or region is developing its version of laws around cyber security, data management and ownership, and digital privacy. since it companies cater to customers in tens or even hundreds of countries, they must navigate each of these laws. the cost of compliance can be high. monitoring an it company’s litigations in foreign countries might be prudent.
5.3 key performance metrics of it companies
as a sector, it is mostly organized, formalized, and structured. the value chain is also not too big – the company hires talent to develop products that business clients consume. therefore, a basic fundamental analysis should ideally be adequate for studying the it sector or its companies. however, i also seek the following information to gain deeper insights.
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- growth and constant currency growth: here is a snapshot of tcs’ investor presentation for fy2023. the graph on the right shows revenue growth in two terms – reported and cc. cc means constant currency. constant currency growth shows business performance without any effect of exchange rate fluctuations. reported growth accounts for currency fluctuations. as you can see in this particular fact sheet, cc growth of 10.7% is lower than the reported growth of 16.9% in q4fy23. the difference between cc and reported growth numbers is indicative of inr depreciation over the year. and if you actually check the exchange rates, the inr depreciated 8.2% against usd, 6% against eur, and 1.6% against gbp. by implication, the actual business grew 10.7%, but it was magnified to 16.9% due to inr depreciation.
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- order book: let’s assume you are a baker. you sell each cake for ₹500. today, you received orders for 25 cakes. of those, you have to deliver ten cakes today, five tomorrow, and the rest the day after that. today, your revenue will ₹5000 (₹500*10), but your order book will be ₹12,500 (500*25). similarly, it companies have an order book. they receive projects that have to be delivered over time. the total value of the project goes into the order book. the part that was delivered during the reporting period is recorded as revenues. in the case of tcs in fy23, it earned revenues worth $27.9 billion and received orders worth $34.1 billion. here, the order book is 1.2x the size of fy23 revenues. an order book size larger than revenues suggests strong demand.
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- unearned revenues: certain customers might make advance payments. just like orders can be placed in advance, customers can also make advance payments. if the work against these payments was not delivered when the payment was received, those payments could not be recorded as revenues. therefore, they make a separate liability item on the balance sheet.
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- unbilled revenues: a project, or a part of it, could be delivered in advance. the invoice for such projects is not raised yet, and the client has not paid up. such revenues are recorded as assets in the balance sheet. unbilled revenues from time-based contracts are classified as trade receivables. unbilled revenues from fixed-price contracts are classified as non-financial assets.
part or all of these unbilled revenues may or may not be recovered. therefore, there is credit risk. the size of unbilled revenues also gives visibility into future revenues.
- unbilled revenues: a project, or a part of it, could be delivered in advance. the invoice for such projects is not raised yet, and the client has not paid up. such revenues are recorded as assets in the balance sheet. unbilled revenues from time-based contracts are classified as trade receivables. unbilled revenues from fixed-price contracts are classified as non-financial assets.
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- number of clients / new clients: it companies offer b2b services. their clients are primarily other businesses. businesses spend massive amounts of money on it. therefore, each new client is a big boost to the revenues. and every client lost is a dent in the revenues. a good measure of growth is finding the number of new clients added in a given quarter or year. you could further understand the quality of these additions from the value brought by these clients. a client billing $10 million annually is surely more profitable than a client billing $1 million. this snapshot from infosys’ fy23 year-end results shows that $1 million+ clients increased from 853 in mar-2022 to 922 in mar-23. similarly, $100 million+ clients grew from 38 to 40. concentration risk seems high given that only 25 out of 1872 clients make up ~35% of total revenues. losing any of these top 25 clients could perhaps hurt more than losing all of the bottom 25 clients.
- number of clients / new clients: it companies offer b2b services. their clients are primarily other businesses. businesses spend massive amounts of money on it. therefore, each new client is a big boost to the revenues. and every client lost is a dent in the revenues. a good measure of growth is finding the number of new clients added in a given quarter or year. you could further understand the quality of these additions from the value brought by these clients. a client billing $10 million annually is surely more profitable than a client billing $1 million. this snapshot from infosys’ fy23 year-end results shows that $1 million+ clients increased from 853 in mar-2022 to 922 in mar-23. similarly, $100 million+ clients grew from 38 to 40. concentration risk seems high given that only 25 out of 1872 clients make up ~35% of total revenues. losing any of these top 25 clients could perhaps hurt more than losing all of the bottom 25 clients.
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- attrition rate: the attrition rate is the percentage of employees who left the organization in a given period. every organization has an attrition rate. but why is it a critical metric for it? talent is the primary input at it companies. employees are their highest cost. employees leaving the organization are an even higher cost.
when employees leave, expenses that the organization must have incurred on training and upskilling them become a sunk cost. the management has to find their replacement. finding, training, and inducting replacements costs time and money. a high attrition rate could make it companies desperate to fill positions by offering higher salaries, thereby increasing costs.
a high attrition rate across the industry, as was seen in 2022, suggests high demand for talent. increased digitalization after covid-19 led to higher demand for it services. it companies, in turn, hired more employees. higher demand led to employees switching jobs for higher salaries. organizations started poaching each other’s employees, thereby pushing up the overall industry attrition rate.
attrition rates might differ across sectors or industries. a 10% attrition rate might be too high for one sector but acceptable for another. therefore, studying the attrition rate is more meaningful when compared with other it companies.
you could use the following table as a guide for the key performance metrics for it companies.
apart from the kpis mentioned above, some it companies might also mention net recurring revenues (nrr), which measures how much the repeat customers of last year spent this year. an nrr of more than 100% suggests that repeat customers have spent more on the company’s services this year than they did last year. it basically shows customer loyalty. it is a good measure to highlight revenue growth when decent and consistent profitability may not have been achieved.
5.4 – risks
in the previous chapters on cement or insurance, studying the value chain and ratios helped identify risks. certain risks, which are qualitative, have a higher probability of occurrence in the it sector. this is perhaps because of the b2b nature of the business. insurance, cement, or toothpaste can be sold to millions and millions of consumers. however, it services are generally sold to organizations. the global nature of the sector also adds to the complexity. let us explore the risks thus associated.
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- concentration risk: concentration risk arises when there is excess dependence on something to run the business. in the case of it, concentration can be of at least three types:
- region: indian it is global but has excess dependence on countries or regions where it makes most of the revenues. for most it companies, the us is a large source of revenue. an economic downturn in the us or a negative regulation could seriously dent the business.
- client: excess dependence on a few clients could reduce the business to being at the mercy of those clients. as we saw earlier, only 25 clients contributed to 35% of infosys’ business in the fourth quarter of fy23. infosys’ revenues could be badly hit if any of these top 25 clients go bankrupt or decide to look for another service provider.
- sector: you will see that it companies disclose segment-wise revenues in their filings. this snapshot shows tcs’ revenue break-up based on the sector their clients are from. here, concentration risk comes from excessive dependence on a sector. a sector cannot go bankrupt like a client. however, a slowdown in a sector could cause clients from those sectors to curtail their it spending.
- concentration risk: concentration risk arises when there is excess dependence on something to run the business. in the case of it, concentration can be of at least three types:
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- foreign exchange fluctuations: excess concentration of revenues in one country or region also exposes the business to their currency. so there is a risk of concentration in one foreign currency. additionally, excessive currency rate fluctuations can impact the profitability of the business. we know that appreciation in foreign currency is favorable for indian it companies, but depreciation could cause an adverse impact.
let’s say a customer has agreed to pay $1,000 for a project. when entering the contract, usd/inr was at ~82. so the expected collection was ₹82,000. by the time the project was completed, inr had appreciated, and usd/inr was at ~78. the actual collection turned out to be just ₹78,000. this will impact profitability. while it companies have dedicated teams to use derivatives to manage the impact of currency fluctuations, maintaining the teams is also a cost. and extreme fluctuations might be hard to insulate from.
- foreign exchange fluctuations: excess concentration of revenues in one country or region also exposes the business to their currency. so there is a risk of concentration in one foreign currency. additionally, excessive currency rate fluctuations can impact the profitability of the business. we know that appreciation in foreign currency is favorable for indian it companies, but depreciation could cause an adverse impact.
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- technological obsolescence: it companies are in the business of technology. one thing that is constant in technology is change. technological changes can be fast. ai has given a power boost to these changes. still, their offerings could become obsolete. there are also legacy issues – while a cheaper technology might be available, replacing the older one with a newer one might be expensive and cumbersome.
it companies maintain enormous budgets to train and upskill their employees to keep up with the latest advancements. however, there is always a risk of these efforts falling short. if you are an investor in the sector, watch how companies react to and participate in technological changes.
- technological obsolescence: it companies are in the business of technology. one thing that is constant in technology is change. technological changes can be fast. ai has given a power boost to these changes. still, their offerings could become obsolete. there are also legacy issues – while a cheaper technology might be available, replacing the older one with a newer one might be expensive and cumbersome.
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- cybersecurity: the entire business of it companies is digital. everything is connected. therefore, everything is also facing cyber threats. it companies themselves offer cybersecurity solutions to their clients. cyberattackers often want to attack cybersecurity providers. if they strike an it company, it could open access to all their clients. the consequences of such a mishap could range from small to tremendous.
it companies might create redundancies to protect themselves, their data, and their clients. for example, they could maintain a data warehouse that exactly copies every data and action of the main business operations. so if the primary operations are under attack, the backup at the data warehouse could be used to revive operations.
backups are called redundancies because extra resources are employed just to copy and store the data. but redundancies are important in the face of extreme events. some organizations also maintain redundancies of redundancies.
5.5 – conclusion
indian it is largely an organized sector. it draws a significant part of its business from foreign clients. therefore, whether good or bad, the impact of geopolitics, regulations, and foreign exchange fluctuations is more pronounced. being a service business, it is heavily dependent on its human resources. due to its b2b nature, client addition is a critical factor.
in this chapter, we studied the it sector, which is service oriented and where new clients are an important indicator of business performance. in the next chapter, we will examine the automotive sector, which is mainly product-oriented and where volume sales are an important performance indicator.
key takeaways:
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- the indian it industry has grown from $6 billion in 2000-01 to $245 billion in 2022-23. india’s share in global it revenues is 35%.
- indian it is mostly a service-oriented business.
- about 75% of the indian it industry’s revenues come from outside india. the industry is largely impacted by global economic conditions, especially the us economy.
- most of the revenues are earned in foreign exchange. so, inr depreciation is beneficial for it companies.
- due to their global presence, indian it companies must comply with several regional laws and regulations.
- key performance metrics of it companies include revenue growth, order book, unearned revenues, unbilled revenues, new client addition, and attrition rate, among others.
- concentration risk, foreign exchange fluctuations, technological obsolescence, and cybersecurity are major risks for the sector.
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foreign-stocks-and-taxation
in the previous chapters, you learned how investing and trading in the indian stock market are taxed as per the income tax act. we also touched upon maintaining books of accounts and rules of the tax audit.
those chapters were written by @nithin kamath himself, that too, from an investor/trader’s perspective, giving you a clear picture of indian markets and taxation.
in this chapter, i, @satya sontanam, look at how investments in foreign stocks are taxed in india.
if you think the tax rules of indian investments are overwhelming, tax laws for foreign investments can get tricky and complicated.
the main challenge comes when the investments are taxed in a foreign country as well. on top of it, the tax laws of all countries differ from one another.
here, we tried to simplify as much as we could to give you a brief understanding of what to consider when it comes to taxing income from foreign assets. we focus on investments in the stock market abroad and not on other forms of assets, including real estate.
8.1 – first things first: rules for global investing
when we hear about a few international stocks like meta, microsoft, tesla, and alphabet, it is totally natural to want to own a piece of these companies, isn’t it?
lately, indian investors have caught on to buying international stocks and diversifying their portfolios.
but how to invest in these stocks?
many fintech platforms in india made investing in some of the foreign country’s stocks and etfs (exchange-traded funds) simpler for retail investors compared to a few years ago.
but here’s the thing, investing in international stocks isn’t as straightforward as dealing with the indian stock market. there are a few rules we have to keep in mind before taking the leap.
first, your overseas investments fall under the liberalised remittance scheme (lrs). this is a scheme by the indian government that lets you send up to 2.5 lakh dollars annually abroad. that’s about rs 2 crore in indian currency at the current exchange rate of rs 82. so, you must keep your investments, along with other foreign trip expenses, abroad education costs, etc.. within that limit.
next comes the tax collection at source (tcs) at 20% (5% before october 2023) if your foreign spending or investments exceed rs 7 lakh per year. that is, even before you invest rs 100, a tax of rs 20 is deducted, and the balance is invested. of course, you can use that rs 20 to set off with your other tax liability later that year or claim a refund. but the point is, your money is stuck until then.
here’s another – when you sell your investments, any money you get from the sale must be brought back to india within 180 days unless invested back. funds can’t lie idle in foreign bank accounts.
oh, and one more thing: when you file your income tax return in india, do not forget to disclose your foreign assets separately. the income tax department wants to know about all your global assets.
remember that these restrictions apply when buying foreign stocks or etfs directly. if you do not want to deal with lrs, tcs, tax disclosure and remittance rules, you can also invest through indian mutual funds investing in select international stocks and etfs.
in this chapter, the focus is on direct investments.
8.2 – residency status
an indian resident must pay taxes on his/her global income, the taxman says.
what does it mean? if you are an indian resident, you have to pay taxes on any income you earn, whether from india or abroad – be it in the us, uk, australia, singapore, or any other country.
but if you are a non-resident, the indian government does not care about your foreign income. our friends and family residing abroad investing there would not pay any taxes in india, right?
the taxman has specific rules to decide who is a resident and who is not. basically, it depends on the period of stay in india. the definition of ‘resident’ is a bit technical. you can refer to the definition in the annexure to this chapter at the end to understand who qualifies as a resident.
the simplistic explanation is that if you are like many – live and work in india – and take occasional trips abroad – you are a resident.
8.3 – tax in india
when it comes to investments in stocks, there are two types of income to consider: capital gains and dividends.
let’s talk about capital gains first. the taxability of capital gains depends on the holding period of the stocks. if you hold foreign company shares for more than 24 months, the gains are considered long-term capital gains and are taxed at 20% (plus applicable surcharge and cess). moreover, you may also get the benefit of cost indexation that adjusts the purchase cost for inflation (more about this later).
on the other hand, if you hold the shares for up to 24 months, any resulting gains are considered short-term capital gains. these are added to your total income and taxed according to the applicable slab rates.
now, let’s consider an example to understand how this works. suppose you invested rs. 1,00,000 in foreign stocks on april 1, 2018, which was equivalent to, say, $1,500.
when you sold your investment on april 31, 2023, say, you received $2,500.
as the stocks are held for more than 24 months, it qualifies for a long-term capital gains tax rate of 20%.
for tax purposes in india, you need to convert the sale amount into indian rupees. you must use the exchange rate (telegraphic transfer buying rate provided by the state bank of india) on the last day of the month prior to the month in which the sale happened.
in our example, since the sale happened in april, take the exchange rate at the end of march 2023. it was around rs. 82.
so, your sale value, as per indian tax rules, would be about rs. 2 lakh (rs. 82 * $2,500).
now, to calculate the indexed cost of acquisition, you need to use the cost inflation index (cii) published by the indian government. say, the cii for the financial year 2018-2019 (when you bought the stocks) was 280, and for the financial year 2023-2024 (when you sold), it was 400.
the formula for indexed cost of acquisition is –
cost of acquisition * (cii of the year of sale / cii of the year of purchase).
in our example, the adjusted cost would be rs. 1,42,857 (rs. 1,00,000 * (400 / 280)).
next, let’s calculate the taxable capital gains: capital gains = rs. 57,143 (rs. 2,00,000 – rs. 1,42,857).
therefore, tax to be paid = rs 57,143*20%, about rs 11,430.
if not for indexation, your profit would have been rs 1,00,000 (rs 2,00,000 sale value – rs 1,00,000 cost) and the tax liability would be rs 20,000 (rs 1 lakh*20%)
basically, indexation escalates your cost to the tune of inflation in the economy and lowers your profit.
moving on to dividend income, it is treated as ‘income from other sources’ that has to be added to the taxpayer’s total income.
just like with capital gains, you need to convert dividend income into indian rupees using the exchange rate on the last day of the month prior to the month you received the dividend.
this will be added to your total income and taxed at your slab rate.
so far, we have discussed tax on investing in foreign stocks.
if you invest in foreign etfs instead, for investments to be qualified as long-term capital gains, the period of holding will be increased to 36 months (from 24 months).
on the other hand, if you have invested in indian mutual funds investing in foreign stocks and etfs, regardless of your period of holding, profits will be taxed at your income slab rate. this is for all the money invested from 1st april 2023.
thus, if you are in a higher tax bracket, investing via mutual funds attracts higher tax liability, at 30% (excluding cess and surcharge).
if you’ve noticed, investing through mutual funds comes with a higher tax rate but minimal operational requirements, while it’s the opposite when investing in foreign stocks directly.
both paths have their pros and cons. you got to choose wisely based on what fits your investing style.
8.4 – foreign tax
don’t breathe easy just yet. the toughest nut to crack is up next.
just like non-residents investing in india are taxed in india, indians investing abroad might face taxation in the foreign country too. you might wonder why you have to pay taxes twice, right?
well, most governments, too, agree that taxing income twice isn’t fair.
the indian government offers relief if you are taxed abroad. you might either be exempted from tax in india or receive a tax credit that you can use to pay your taxes here. to figure out which one applies, we have to dig into the double taxation avoidance agreements (dtaa) that india has with other countries.
now, if finance stuff is not your cup of tea, these agreements can be pretty overwhelming, especially on the first read. you will need the expertise of a tax consultant to decipher it all.
your broker or fintech platform might provide tax details on your investments, but you would be better off understanding how it works.
in many dtaa treaties, india follows the credit method to avoid double taxation. this means they give credit for taxes paid in the foreign country. this can set off tax liability on the same income in india. you can claim this credit by submitting form 67 when filing the income tax return.
let’s take the example of dtaa with the us-
for capital gains, the dtaa between the us and india states that each country may tax as per the provisions of its domestic law. this implies that both countries can charge tax.
but the us income tax laws do not charge capital gains tax on non-residents. so, the gains of indians on us stocks are taxed only in india; hence, no double taxation.
now, dividends. as per the dtaa between the us and india, dividends received from a us company are taxed only in india.
but here comes the catch – there’s a 25% withholding tax on gross dividends in the us. that means 25% is deducted at the source by the us, and you get the rest in your account.
no matter how much you receive, the entire gross dividend (converted into indian rupees) will be taxed in india. in such cases, you need to submit form 67 to claim credit for the withholding tax paid in the us.
remember, these dtaa provisions and available tax credits can vary from country to country. if you are investing in countries other than the us and your broker isn’t helping with precise information, consider consulting your tax advisor. they will guide you through this tax maze!
8.5 – reporting of foreign assets in itr
if you hate paperwork and endless documentation, reporting foreign assets and income in your tax return won’t be a walk in the park.
as a resident, you must disclose all foreign assets, like bank and depository accounts, stocks etc., held outside india while filing your income tax return. but if you fail to disclose them, you’ll face penalties and possibly even imprisonment under the provisions of black money (undisclosed foreign income and assets) and imposition of tax act, 2015.
the income tax returns have dedicated schedules to fill in the detail of foreign assets, including foreign stocks.
as of now, there are three schedules (fsi, fa and tr) and one form (form 67 discussed above to claim credit for tax paid abroad). select the correct itr form to fill in these details.
while we cannot discuss every aspect of these schedules, here are a few key points to keep in mind before reporting foreign assets and income. note that these details are as per the rules as of fy23.
- the calendar year is relevant for reporting, while the financial year matters for taxing the income. so, don’t mix them up!
here’s an example –
say, you bought a stock of microsoft in september 2022, which issued a dividend in november 2022. take a share of another company – alphabet – which was bought in january 2023 that gave dividends in march 2023.
for reporting assets and income for fy23, calendar year 2022 would be applicable.
microsoft stock: you bought the stock in september 2022. since the purchase was made in the calendar year 2022, you would need to disclose this investment in your income tax return for the financial year 2022-2023. even if you sell the company as of the date of filing the return, you still must report it as you held the company at least for a day in the year 2022. if the stock was bought in 2021 or before, and you own it at least for a day in 2022, you still have to report it in the itr.
the dividend from the stock, which was received in november 2022, has to be reported in schedules as it was received in calendar year 2022. the dividend amount has to be considered for taxability in fy23 since it falls within the financial year period from april 2022 to march 2023.
alphabet stock: you bought the stock in january 2023. as you do not hold the stock in the calendar year 2022, you do not need to disclose this investment in the schedules.
the dividend from alphabet stock received in march 2023 would be considered for taxability in 2022-2023 (fy23). but it need not be disclosed in schedules as it was not received in the calendar year 2022.
income earned from assets held outside india will be taxable as per the provisions of the income tax act, even if it is not required to be disclosed in schedules.
- the schedules may ask for details such as peak balance, opening balance, closing balance, and amount debited and credited from the accounts and assets you have abroad. keep all the details handy.
- you also need to provide the tax details paid in the other country and how much you are claiming as a tax credit in india.
- to report details in schedules, the rate of exchange for conversion is the telegraphic transfer buying rate of the foreign currency on the specified dates. while most of these details could be provided by the fintech platform through whom you are buying the stocks, always do your due diligence.
- if your total income exceeds rs 50 lakh per annum, you may also need to provide details of assets (indian and foreign) held as on march 2023 again in ‘schedule al.’
annexure
definition of ‘resident’ as per the income tax act
a taxpayer will qualify as a resident of india if he/she satisfies one of the following two conditions:
- stayed in india for 182 days or more in a financial year; or
- stayed in india for at least 60 days in the financial year and 365 days or more in the immediately four preceding years
if you are a citizen of india or a person of indian origin who leaves india for employment or visits india during a financial year, the conditions are a bit different and also depend if your total income from india is more or less than rs 15 lakh in that year.
further, if an indian citizen is considered ‘stateless’ and earns a total income in india exceeding rs 15 lakh during a financial year, he/she will be treated as a resident in india for that year.
for example, say you are an indian citizen who works in a country where people are not subjected to income tax as per local tax laws (for example, uae). if your income from india during the financial year exceeds rs 15 lakh, you will be considered a deemed resident in india, even if you haven’t set foot in india throughout the year.

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- direct investing in foreign stocks is not as straightforward as investing in the indian stock market. you need to take into account the lrs, tcs, remittance to india and disclosure rules.
- if you are a ‘resident’ in india, your global income (including gains and dividends from foreign stocks) is taxed in india.
- if you are taxed on those profits in the foreign country as well, you can claim either an exemption or get a tax credit in india on the same income while filing the income tax return.
- whether an exemption or tax credit is known only by checking the double taxation avoidance agreement (dtaa) entered by india with the other country. this may need an expert’s help to .understand the rules.
- do not forget to disclose your foreign assets separately in the itr. the income tax department wants to know about all your global assets.
disclaimer – consult a chartered accountant (ca) before filing your returns. the content above is in the context of taxation for retail individual investors/traders only.
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exchange-traded-funds-etf
please note, this is a guest chapter, and i’ve not authored this. this chapter on etfs is authored by my colleague, bhuvan. however, i’ll try and answer all the follow on queries that you’d post.
happy learning,
-karthik rangappa.
29.1 – overview
in chapter 7, we looked at what a mutual fund is and how it works. to recap, a mutual fund is a pooled investment vehicle that collects the money from various investors, invests and manages that money on their behalf. when you invest in a mutual fund before the order placement cut-off time, you will get the units as per the same day’s nav which is disclosed by midnight. if you invest after the order placement cut-off time, you’ll get the allotment of units per the next day’s nav. basically, everything happens at the end of the day.
now, what if those mutual funds units could be traded on the stock exchange just like stocks like reliance or infosys? just like a mutual fund, an exchange-traded fund (etf) is a pooled investment vehicle that holds a basket of securities like stocks, bonds, and commodities and trades on the stock exchanges. you can buy and sell an etf anytime, just like a stock.
there are a few more nuances to an etf than a mutual fund, but before we dive in, i hope you have a working idea of what an etf is.
29.2 – history of etfs
mutual funds have been around in some form for well over 100-years. the first open-ended mutual fund in the us was launched in 1924 and is still in existence today. the first mutual fund in india was launched in 1964. mutual funds have democratized access to stocks, bonds, real estate and commodities globally to common investors. exchange-traded funds (etf) were the next evolution of mutual funds.
etfs, on the other hand, are relatively new. the spdr s&p 500 trust, arguably the first etf, was launched in 1993 in the us. coincidentally, it is today the largest traded security in the world. niftybees an etf tracking the nifty 50 index was the first etf in india and was launched in 2002. it was launched by benchmark amc, which goldman sachs later acquired, which reliance later acquired, which nippon india mutual fund later acquired 🙂
29.3 – etfs in india
though etfs have been around for a while in india, they haven’t really popular among retail investors. etfs, have mostly been used by hnis and institutions. for example, the sbi nifty 50 etf with rs 89,441.55 cr is the largest mutual fund in india. this is almost entirely because this is one of the etfs in which the employees’ provident fund organisation (epfo) invests.
a large part of the etf aum growth is due to:
- epfo investing in nifty & sensex etf
- government divestment through cpse etf and bharat 22 etf
- introduction and the govt push for bharat bond debt etfs. most of the aum in these etfs is non-retail.
though still a small piece of the pie, the retail participation has been growing steadily over the years and so has the trading turnover on the exchanges.
#etfs saw transactions by 32.2 lakh investors in cy20, a jump of 200% over cy19, maintaining the growth trend for the 5th consecutive year, since 2016. average daily turnover at rs 241 crores also increased by 15% in cy20 over cy19.#nse #happy2021 #etf #mutualfunds pic.twitter.com/6m02ehpsfr
— nse india (@nseindia) january 7, 2021
niftybees which is 20 years old, just has about rs 2800 crores of aum. there are a lot of reasons for the under penetration of etfs:
- india is still a tiny market. we just have about 1.7 crore active demat accounts, and unlike a mutual fund, you can only buy an etf if you have a demat account.
- investment products, be it mutual funds or etfs are push products. one of the reasons why mutual funds are larger than etfs is because amcs can pay distributors & platforms commissions to sell their mutual funds. but etfs don’t have commissions like mutual funds.
- etfs are also relatively trickier to understand initially compared to mutual funds. but we’ll take care of that with this chapter.
- most amcs, rarely push etfs because they have low margins and don’t make sense with small aums.
29.4 – what is an etf?
an exchange-traded fund (etf), just like a mutual fund is a basket of securities, but this is where the similarity with a mutual fund ends. unlike a mutual fund, an etf trades throughout the day on the stock exchanges. you can buy and sell an etf anytime you want just like a stock.
for example, if you search for “nifty etf” on kite, you’ll see a list of all etfs that track the nifty 50 index.
29.5 – how does an etf work?
when you buy a mutual fund, the amc takes money from you and buys the securities and discloses the nav at the end of the day. similarly, when you redeem your mutual funds, the amc sells the securities and returns your money. this is quite straightforward. however, when you buy an etf, you don’t really interact with the amc most of the times because most buying and selling happens on the stock exchanges. it’s just an exchange of units between buyers and sellers.
29.6 – creation and redemption mechanism
i said when you buy an etf, you “mostly” don’t interact with the amc and i’ll explain what that means. if you remember chapter 6, we discussed all the entities involved in an mf transaction — the amc, custodian and the rta. but what makes an etf unique is something called the creation and redemption mechanism. but before we talk about it, you need to know a couple of things.
- nav, inav, the market price
- market makers and authorized participants
- creation units
- premiums & discounts
- tracking error
market price
when you buy a mutual fund, you look at the nav. similarly, when you are buying an etf, you look at the etf market price on kite.
these prices are determined by the demand, supply and the trading activity on the exchanges. but how do you know if the price you see on kite is the fair price you are paying for an etf? here’s where the net asset value (nav) comes in.
net asset value (nav)
like a mutual fund, an etf also has an end of the day net asset value (nav). just to refresh your memory, nav tells you the total value of all the fund’s assets and yours. the formula for calculating nav is nav = (value of all the assets – the expenses)/number of shares (units). but remember, an etf trades real-time, whereas navs are only announced at the end of the day. so how do you figure out if the price you are paying for an etf is fair in real-time? enter inav
intraday or indicative net asset value (inav)
given that etfs trade real-time, you need a reference point to see if the market price you see on your trading platform is a fair one and the indicative or intraday nav (inav) serves as that reference. amcs usually calculate this every 10-15 seconds and publish it on their websites. inav = last traded price of all the securities in the etf basket x number of shares in the etf creation basket + cash component (i.e. cash which is not deployed in the etf) divided by total etf shares in the creation basket. put simply; this serves as a real-time nav so that you can use this as a fair value reference to compare it with the current market price on the stock exchanges.
creation unit
like buying etf units on the stock exchange, you can also buy units directly from the amc. i’ll explain why you’d want to do that later. but, unlike the exchanges, you cannot buy 1 or 2 units directly from the amc. you can only create and redeem units in what’s called the creation size that the amc defines. a creation unit is nothing but a representative basket of all the securities in the same proportion as the underlying index. for example, the creation unit size of the icici nifty 50 etf is 50,000 units, and as of this writing, it’s about rs 80 lakhs. meaning, you need 80 lakhs to buy all the stocks in nifty 50 in the same weight.
market makers and authorized participants (aps)
unlike mutual funds, there’s another entity called market markers or authorized participants in the etf ecosystem. the role of these guys is to provide liquidity on the stock exchanges. you don’t have to worry about liquidity in a mutual fund because there’s no real-time trading. but since an etf trades real-time on the exchange, market makers are appointed by the amc to provide liquidity continuously. they do this by providing continuous two-way quotes on the exchange, meaning they buy at the bid and sell at the offer, and the difference is the profit they make. even though these are small amounts, since they keep doing this, it tends to add up.
market makers typically tend to be large brokers in india.
premiums and discounts
since an etf trades real-time on the exchanges, their price is influenced by demand and supply—the prices of liquid etfs trade in line with the nav of the etf most of the time. but sometimes, particularly during volatile market phases, the price of an etf can trade away from the nav of the etf. if the price of an etf is above its nav, it’s called a premium and if the price is below it’s nav, it’s called a discount.
tracking error
tracking error is the annualized standard deviation of the difference between the etf nav returns and the index that it tracks. in simple terms, it shows you how closely an etf tracks its underlying benchmark. a simple example would be if nifty 50 returned 10% and nifty etf gave 9.8%, the tracking error would be 0.2%. an etf or an index fund will have lower returns than the index because they have an expense ratio and an index doesn’t.
a lower tracking error indicates that an etf or an index fund is tracking the index better. but this is not really an intuitive measure to understand and we’ll discuss that later.
with these concepts in mind, let’s get back to the concept of creation and redemption mechanism
there are a few reasons why the creation and redemption mechanism is important. for one, you need not always buy an etf on the stock exchange. if you are buying in multiples of the creation unit size, buying it directly from the amc is way better because you might face liquidity issues and impact costs when you buy large quantities on the exchange.
so, in the example i mentioned above, the icici nifty 50 etf’s creation size is roughly 80 lakhs. if you are investing in multiples of 80 lakhs, you can directly contact icici, and they will create units, in this case, 50,000 units and credit them to your demat. the amc will create units at the inav. similarly, you can redeem them by transferring the etf units to icici, and they will credit the cash to your bank account or you can also get the underlying shares instead of cash.
the second reason why creation and redemption mechanism important is for etf arbitrage. like i mentioned earlier, etfs can trade at premiums and discounts to the nav. market makers are essential in the etf ecosystem because they are responsible for correcting these premiums and discounts. they do this through the creation and redemption mechanism.
typically etfs trade close to their navs. here’s a comparison of nifty bees, sbi nifty etf, icici etf and nifty 50.
but during a volatile market phase, for example, like the covid crash in 2020, there can be wide premiums and discounts. here’s how even a popular etf like niftybees and sbi nifty 50 etf, india’s largest mutual fund performed during the volatile market phase of march-april 2020.
now, here’s where the market makers come in. if there’s a premium, the authorized participant (ap) will buy all the underlying securities that make up the etf creation unit. in this case, the ap will buy all the 50 nifty stocks of the same weight; this is also called the creation basket and give them to the amc. in turn, the amc will create etf shares and give them to the ap, who will then sell them on the exchange.
similarly, if there’s a discount, the ap will buy the etf units on the exchange and give them to the amc. in return, the amc will give the underlying shares of the etf to the ap, who will, in turn, sell them in the market. the difference between the premium, discount, and the nav will be the ap/market maker’s profit.
perhaps, the best example of this would be the motilal oswal nasdaq 100 (n100). during 2017-2018, the etf was trading at a huge premium to the nav. the premiums were as high as 20%+. this was probably because the market makers weren’t active in providing liquidity. value research allows you to compare the nav and price, here’s a chart, notice the huge difference between the nav and the price.
someone could have taken advantage of this premium by going to motilal amc and asking them to create units, which happens at the nav and sell them at the market price on the exchange. the difference would’ve been the profit.
this premium persisted for a long time. then motilal, if i’m not wrong, appointed new market makers and launched a fund of fund (fof) for the etf, which corrected the premium. so the market maker around 2018 would have created motilal units at the nav and sold them on the exchange at the market price and corrected the premium.
this is how creation and redemption mechanism in an etf is used to ensure liquidity and arbitrage premiums and discounts.
29.7 – etf liquidity
this is the most important thing when buying or selling an etf because they trade real-time. when choosing an etf, most people tend to look at the aum of an etf and the trading volumes to decide if an etf is liquid. although these 2 things should be considered, the size of an etf or the daily trading volumes alone don’t indicate liquidity.
let’s unpack what etf liquidity really means. it’s essential to remember at this point that even though etfs trade like stocks, they are not the same.
secondary market liquidity: this is what you see on your trading platform. the spread between the bids and offers give you an idea of the available liquidity, but that’s not all. take a look at this image, comparing mirae nifty 50 etf and lic nifty 50 etf. the lic etf has an aum of rs 618 crs, and the mirae etf has about 483 crs. as of writing this post, both the etfs had just traded 500+ units.
typically, you’d ignore both etfs assuming that they are too small and don’t trade much. but that would be an incorrect assumption because on-screen liquidity isn’t everything.
etf market depth: if you look at the mirae etf, nearly 60,000 shares are available for purchase. that means, even if you place a market order, which is a really terrible mistake when buying an etf, you will get a good fill at rs 157.44. this is probably a market maker posting a bid and an offer. the lic etf, on the other hand, has no liquidity at all. if you’d have placed a market order for 100 unit by chance, your average price would have been way higher than the last traded price, given that there are no volumes and your order would’ve been continuously executed at higher and higher prices.
so, aum and trading volumes don’t tell you everything. market markers typically hold units that don’t show up in the market depth. if you place a limit order to buy, your order will be executed as the market makers place an order to sell. but yeah, not all etfs have active market makers, this has to be part of your etf due diligence which we’ll talk about in a bit.
here’s how the mirae etf and lic etf have tracked nifty 50. while mirae has closely tracked nifty 50, lic has been all over the place trading at premiums and discounts.
primary market: the third layer of etf liquidity is the primary liquidity. remember, a stock has a fixed number of shares on offer, but even though an etf trades like a stock, it’s not a stock. market makers and investors can create new etf units. large institutions, hnis, typically don’t buy etfs on the exchange. they directly reach out to the amc and create units that don’t show up on your trading platforms’ market depth.
liquidity of the underlying stocks: the last and the most important layer of etf liquidity is how liquid the underlying stocks that make up an etf are. remember, an etf is just a wrapper that holds all the stocks that make up the etf or an index. so, an etf can only be as liquid as the underlying stocks.
this might be a little confusing, so let’s take an example. today, in india, we don’t yet have a small-cap etf, have you ever wondered why? in the indian markets, the liquidity quickly starts disappearing after the 200 largest stocks. as we go down the market cap, the smaller stocks tend to have less outstanding shares, less trading volumes, and usually keep hitting upper and lower circuits.
so, assuming there was a small-cap etf and that there was a sudden spike in demand, the market maker would have had to create units to satisfy the demand. now if some of the underlying stocks are not liquid or have hit circuits, which is quite common in small-caps, he wouldn’t have been able to create units. in such a case, the etf will probably trade at a premium to the nav because there will be more demand for the existing units. not just, small-caps, even mid-cap stocks in india have liquidity issues. so, an etf can only be as liquid as it’s underlying stocks. but this isn’t a problem in a large-cap etf like a nifty 50 etf because these are the biggest and the most liquid stocks.
to summarize, trading volumes and aum are factors, but they don’t tell you everything about an etf.
29.8 – etf choices in india
like i mentioned at the start of the chapter, etfs are pretty new in india, we have about 88 etfs today. a majority of them are equity etfs. here are your etf choices:
- equity etfs
there broadly 2 sub-categories of equity etfs. you have your plain vanilla market-cap-weighted etfs that track indices like the nifty 50, nifty 100, sensex etc. and then you have smart beta etfs which target factors such as value, quality, low-volatility, momentum etc.
- debt etfs
we have debt g-sec etfs, bharat bond etf which just holds bonds issued by psus, and then you have an etf like the cpse+sdl etf by nippon which holds psu bonds and state development loans (sdls).
- commodity etfs
for now, we just have gold etfs.
here’s a list of all indian etfs.
are all etfs passive?
this is a common question that keeps coming up. today, the biggest etfs we have are passive etfs that track either the nifty 50 or sensex 30. but smart beta etfs aren’t passive, even though the etfs track an index. they are more of a hybrid of active & passive like we discussed in the smart beta chapter. globally, 80-90% of all etfs are passive, but we see the first traditional active etfs in the us. maybe, we’ll eventually see them in india as well. so etfs need not be all passive, it’s just that they are passive today.
etf due diligence
i know this has been a little long, but the idea was to give you the full context you need before investing in an etf and help you avoid rude surprises. and i hope at this point; you have a clear understanding of how an etf works and its mechanics. with that in mind, let’s now look at some things you should consider before you buy an etf.
always use limit orders
i cannot stress this enough but never use market orders when buying an etf, always use limit orders. this is one mistake i see investors constantly make. we saw this earlier but let me reiterate this with an example. take a look at the market depth of aditya birla sun life nifty next 50 etf. if you placed a market order for 200 units, your order would be executed at prices starting from rs 350, which is above the ltp, to begin with, and finally, at rs 374, that’s 8.7% higher than the ltp. so, always use limit orders.
always check the inav
always look at the inav on the amc website and place a limit order at that level. don’t just place a limit order without looking at the inav. the other issue is that sometimes amc websites don’t update their inavs or their websites might be down. if there is a big difference between the last updated inav and the current market price, that’s a sign that there is something wrong. so, make sure to compare the etf with the intraday chart of the underlying index of the etf on kite, and that will give you an indication if the price is correct. check with the amc in such a case before placing an order.
compare the nav and the price of an etf and see how it has performed
you should always buy an etf that tracks the underlying index as closely as possible. here’s how nippon niftybees etf has tracked it’s nav, it’s pretty close. you can compare the price and the nav on value research; we’ll try having this feature on coin.
picking up on the earlier point about the tracking error, amcs disclose the tracking error on their factsheets. but if you see a tracking error as 0.02%, it’s hard to understand what it means. moreover, amcs calculate the tracking error on the nav, but you buy and sell based on the price, which can be totally different. so the best way to analyse an etf is to look at the difference between etf prices and the underlying index. you want the price of etf to track the index consistently without huge differences.
note: always compare the etf price with the total returns index (tri) and not the price returns the index (pri). the tri includes dividends. all the index data you see on kite is pri. since etfs track tri indices, they re-invest the dividends which reflects in the nav of the etf.
look at the average volumes
look at the average volumes over a period of time and see how an etf has traded. you should invest in an etf that trades regularly. you should avoid etfs that just have a brief spike in volumes and then don’t trade. the edelweiss etf – nifty 100 quality 30 is an example. the monthly average volumes are about 150 units. you can check the average volumes by applying a moving average on the volume chart on kite. so assuming you had bought this etf and had to exit, you most likely wouldn’t have been able to.
avoid buying and selling at market open
most etfs don’t trade much for 30 mins to 1 hour of the market open. they also tend to trade at abnormal prices because of the low volumes, even orders for a few units can move prices. if you can, avoid trading in the open. and if you have to, check and verify the inav and use limit orders.
is the amc focussed on etfs?
today, most of the amcs offer etfs but doesn’t mean they are serious about them. most of the etf volumes are in etfs offered by nippon, icici, and sbi largely. other amcs like mirae, edelweiss with their debt etfs do seem serious about building out their etf offerings. so, along with the other things on the due diligence list, you’ll also have to look at whether an amc is serious about the etfs it offers. for example, if you look at some of the etfs by aditya birla mutual fund, idbi, lic, indiabulls etc., they have horrible tracking errors and almost no volumes.
creating units with the amc for higher-value investments
if your investments in etfs are equal to or more than the creation basket value, it’s better if you approach the amc to create units rather then buying on the stock exchange.
29.9 – etf vs index funds
this is another question that keeps coming up. hopefully, this table should help answer these questions. in short, if you want to have active control or if you are actively using passive etfs, then etfs are a better choice. but if you are lazy like me and want to make as fewer choices as possible, then index funds are a better choice.
with etfs, you can express tactical strategies better than index funds because you can’t buy and sell index funds immediately.
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|
index funds
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exchange-traded funds
|end of the day nav||real-time pricing. can be bought and sold anytime|
|no issue of spreads because execution happens at the end of the day||you might see wide spreads in certain etfs and during market volatility.|
|liquidity isn’t an issue and can be managed.||certain etfs don’t trade much, and underlying liquidity of stocks can impact aps and market-making|
|can create sips||possible with zerodha, may not be possible with other brokers|
|expense ratio is all-inclusive—no additional charges||you have to pay a brokerage (free at zerodha) & other charges & taxes separately|
|not possible to have tactical strategies. less flexible compared to etfs||with etfs since you can buy & sell anytime, you can express tactical views. etfs are much more flexible|
|index funds tend to hold more cash and hence have a slightly higher tracking error||etfs don’t hold much cash and hence have a lower tracking error|
|lesser choice at-least as of now. but amcs are launching a fund of funds for etfs||pretty much all of the smart-beta products are etfs. you have a wider choice|
29.10 – performance of etfs vs actively managed funds
we discussed this earlier in the index funds chapter as well. in the last decade or so, index funds and etfs have become increasingly popular around the world. one reason is that investors have increasingly realized that a vast majority of actively managed mutual funds don’t beat their benchmarks. in a developed market like the us, ~90% of active funds don’t beat their benchmarks.
the indian markets have grown a fair bit and have become increasingly professionalized; institutional investors are a big part of today’s market. this means that most of the informational edges and asymmetries have been arbitraged away. today, pretty much everyone has access to the same information. the odds of someone finding some piece of information that can move a stock, at least in the large-cap space, for example, is pretty much zero. but perhaps the biggest reason why active funds underperform is that they charge too much.
actively managed large-cap funds on an average charge~1.5% whereas a nifty 50 index fund is available for 0.10%. and we see this in the performance. s&p publishes a report called spiva, which measures the performance of active funds. for any period, over 70% of all large-cap funds fail to beat their benchmarks.
traditionally, the view was that the mid-cap and small-cap space was inefficient, and this was where stock pickers thrived. while this was true, it seems like this is increasingly becoming less so. in the last 5 years since the sebi categorization exercise, active mid-cap funds have had a tough time keeping up with a broad mid-cap benchmark like the nifty 50 or bse/nse mid-cap 150 index and even nifty next 50 etc. here’s a quick look, this is just for illustration, and ideally, you should look at the rolling returns.
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fund name
|3 yr ret (%)||5 yr ret (%)||10 yr ret (%)|
|kotak emerging equity fund regular plan||12.09||19.16||17.89|
|dsp midcap fund – regular plan||10.97||18.49||16.63|
|invesco india mid cap fund||13.24||18.07||17.95|
|edelweiss mid cap fund – regular plan||9.85||17.92||18.28|
|nippon india growth fund||10.68||17.65||13.27|
|bse midcap 150 index||9.07||17.6||12.94|
|taurus discovery (midcap) fund – regular plan||9.44||17.59||15.3|
|tata midcap growth fund – regular plan||11.2||16.91||16.93|
|hdfc mid-cap opportunities fund||8.03||16.44||17.41|
|l&t midcap fund||5.39||16.33||16.15|
|franklin india prima fund||8.86||15.79||17.27|
|icici prudential midcap fund||6.98||15.28||15.07|
|uti mid cap fund – regular plan||8.68||15.27||17.2|
|baroda bnp paribas midcap fund||8.44||14.94||17.59|
|baroda midcap fund||8.52||14.51||3.73|
|motilal oswal midcap 100 exchange traded fund||5.8||14.36||12.11|
|sbi magnum midcap fund||9.36||13.97||17.37|
|sundaram mid cap fund – regular plan||3.56||13.25||14.98|
|quant mid cap fund||12.15||13.01||11.29|
|aditya birla sun life mid cap fund||2.77||12.28||12.94|
the bottom line is that most actively managed funds don’t outperform a simple broad-market etfs or index funds like nifty 50, nifty next 50 and nifty midcap 150. this is due to a combination of high costs, increasing market efficiency, and internal fund mandates to not deviate too much from the indices. moreover, it’s tough to pick those funds & managers that beat their benchmarks. and even if you figure out how to pick a winning manager, there is very little persistence in performance. the best performing fund often ends up being the worst-performing fund over a period of time.
today, it’s a no-brainer to look at index funds in the large-cap space. there’s increasing evidence that it’s the same in the mid-cap space as well. as for small-caps, these are severely risky and buy and hold may not be an optimal strategy, and active management both in a fund and in timing is needed.

- etfs trade real-time on the stock exchanges and you can now set-up sips in etfs to invest every month
- blindly choosing an etf is a bad idea. etf due diligence before investing is extremely important
- etf liquidity is an issue in india because our markets are still small and this needs to be kept in mind when buying and selling
- always use limit orders and compare the market price of the etf with the intraday or indicative nav (inav) before buying and selling
- you can check the inav on the respective amc’s website
- sometimes the inavs on amc sites may be wrong. if the difference between inav and the price is huge, it’s a red flag.
- compare the etf price with the underlying index or check with the amc in cases where the etf prices are way off from the inavs/navs
- large-cap and mid-cap index etfs make a lot of sense vs actively managed large-cap and mid-cap index funds
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