How to invest wisely for your children

29 August, 2007:

Be it for adults or kids, our investment choices remain the same: Public Provident Fund, fixed deposits, and insurance policies. We just cannot think beyond these traditional avenues. They are definitely good when it comes to tax efficiency and safety. However, are they the best avenues for investment for your children? “Parents should keep traditional avenues like PPF and tax-saving avenues for themselves and invest money in children’s plan with mutual funds for their children,” says a financial advisor.

Unfortunately, the only children’s product that has caught the imagination of parents is children’s insurance policy. However, financial experts consider it a bad choice. According to them, children do not need insurance cover, as they do not have any financial value. Insurance is meant to compensate financial losses you suffer due to the death of the policyholder. But the child is not earning and there are no financial losses on its death. Also, the entire premium is not invested, as insurance companies deduct insurance and administrative cost from the premium.

Now, why do financial experts ask you to keep traditional avenues like PPF, ELSS, insurance polices, etc. for you? It is simply because every earning member has to make full use of tax exemptions and rebates to build a corpus for his retirement. On the other hand, if you are picking up a long-term investment vehicle like child mutual fund plan with growth option, there is no incidence of tax. This is because the tax liability will fall on your child when the maturity proceeds passes to s/he as a major.

Another major reasons are the power of compounding and exposure to equity. “The exposure to equity is very good because equity beat every other investment avenue in the long term,” says a child fund manager. His theory is that studies have proven that if you are investing in stock with a long-term horizon the risk goes down. Moreover, your chances of pocketing substantial return also increases. The power of compounding will also add a few zeroes to your final figure.

Another reason why investment experts advocate a child fund is that even if there is a downside to your investment, you always have the option of taking the money out and investing it elsewhere. Also, since you have a longer time horizon, you can always recover the losses.

If you are interested, let us look at how children’s plan work. To begin with, they are almost like a balanced fund, which has a portfolio of both equity and debt. Mostly, children’s mutual fund caps the equity exposure to 60%. And most good funds restrict their investment mostly to very good large and mid-cap stocks. Since there are no redemption pressures, these funds can book full benefits of holding on to good stocks. Their debt investment is also on very good-quality (AAA and AA rated) papers, to minimize credit risk.

As you can see, that seems like a neat strategy to build a decent corpus – be it for your child’s education or as a start-up capital for his future endeavors. Why, it can even be our great Indian curse of wedding expenses for the daughters.

Does that mean that they do not have any downside at all? Not really. Since these funds have equity exposure, they are risky. Sure, the long-term holding can minimize risk, but they are not risk-free. Also, your capital is not protected like in PPF or bank fixed deposit. There is no government backing or insurance cover like in a bank fixed deposit. Another drawback is that you have to pay an exit load at the time of redemption.

How do you pick the right fund for your child? The selection process is always the same. Always, look at the performance record of the fund. The longer the duration the better. Check its performance against peers and various benchmark indexes. Also, enquire about the reputation and transparency of operations of the fund house. Examine the portfolio and make sure that the investments are only on quality equity and debt. Another crucial aspect is to resist the temptation of withdrawing money from the child plan. This will mean lost opportunities and losing the help of compounding rate of interest.