Blogs

Blogs

How to invest in mutual funds? Direct plan or through distributor?

The debate continues on whether a direct plan is better for investors or should one go through a distributor to invest in mutual funds? Read my views on the same below:

The English translation is as under:

Mutual fund companies have introduced direct plans some time ago. There have been many discussions around these plans and the advantage of low-cost that these offer. Let us understand these plans and see the benefits to investors. We would also look at the other side: Are there any pitfalls? Is there anything that an investor needs to understand?

First of all, what are direct plans? How do they differ from the regular plans? As you know, mutual funds are sold through a distribution channel comprising of various individual mutual fund distributors, banks and various companies in the business of mutual fund distribution. As per the SEBI regulations, these distributors are required to recommend mutual fund products to their clients based on the analysis of suitability of the schemes to the investor’s needs and situation. For this work and to service and advice the investor on a regular basis, the distributors earn a commission from the mutual fund companies.

A few years ago, SEBI introduced a “direct” plan that would allow investors to bypass the distributors, if they feel they do not need to advice and services of these distributors. Due to this, the expense ratio for the direct plan is lower than the regular plan. The gap between expenses for the direct plan and that for the regular plan may vary from scheme to scheme and from one fund type to another.

One may be tempted to calculate that this difference could make a huge difference over the years. However, prudence requires that one always look at the cost in the context of the value received. Cost for anything can never be high or low in isolation. Does one get value commensurate with the cost?

So what value does a mutual fund distributor provide, really? Many are under the impression that a mutual fund distributor’s greatest value is in selecting the best mutual fund schemes. This cannot be farther from the truth.

First of all, what exactly is “the best scheme”? Are we looking at a scheme that would offer the highest returns in the future? What is the basis of identifying this? Past performance? If that is the way to select schemes, you do not need any help. The data is easily available on many websites – for free.

The “best scheme” is the one that is most appropriate for you – given your unique situation. More often than not, it is not one scheme, but a combination of schemes that an investor needs. A good distributor can help decide on a good combination of schemes. You see, in our regular diet also, while one needs to have varieties to get proper nutrition, one still cannot mix milk and lemon.

A seasoned distributor, a veteran, and experienced one would also be able to put things in perspective better than most investors can do themselves. A veteran is supposed to have a balanced head on the shoulders. This allows one to focus on what matters and think clearly without getting swayed away by the external turbulences. This ability to stay focused helps the distributor to get the client also to focus on what matters most in life. Such a focus then allows the investor to comfortably achieve life’s financial goals.

There are many operational issues that take away a lot of time. In case of such issues, a distributor may know how to handle critical situation since one may have handled the same case for few other clients. For an investor, each issue may present a new challenge taking away too much of precious time. If one calculates the “money value of one’s time”, it may turn out to be much more than the gap between the expenses between direct plan and regular plan.

Think about it – do a rough calculation – you might be surprised.

More Information

The English translation is as under:

“Which is the best SIP? Please recommend the best SIP. I want to start one.”
After reading my article on SIP, one of the readers wrote to me. This was not the first time that I came across this question. Many investors have wondered about this and asked the experts.

The real question is not which is the best SIP, but it is what the investor expects from the “best” SIP. Whenever I have tried to get to the bottom of the question and understand the real concern, it has thrown some interesting insights.

Returning to this question the real concern for the investors is to find out a scheme where the SIP returns would turn out to be among the highest in future. This future timeline is also uncertain or undecided – it often is a time when the investor checks the performance of one’s investments in comparison to other avenues – similar or otherwise.

So the question is: how do you look at an SIP in a mutual fund scheme? Start with the purpose of an SIP. Why should one start an SIP in a mutual fund scheme?

For that, we need to go back to understanding what an SIP in a mutual fund is. SIP, or Systematic Investment Plan, is a facility offered by mutual funds to help an investor invest regularly in a mutual fund scheme. Signing up for an SIP requires an investor to fill up just one form for multiple transactions of a fixed amount and a fixed frequency. This instills discipline as the investments happen regularly without the investor’s intervention.

An investor can choose from among equity, debt, liquid, gold or hybrid funds based on one’s own unique requirements.

With the above points, an SIP should help an investor meet one’s requirements and not necessarily be the “best” – whatever that means. So often, investors seek an investment option or an investment strategy that can deliver the highest rate of return. However, as we all know, an investment is made in order to accumulate a sum of money for some future expense requirement. If the goal is to accumulate, the focus also should be on the amount accumulated and not on the rate of return.

Lower rate of return over longer term may help one accumulate much more than higher rate of return earned over short time horizon. Let us consider the following two options:

  • Investment of Rs. 1,00,000 per year invested at 8% p.a. for 10 years would help accumulate a sum of Rs. 14.50 lacs, approximately
  • Investment of Rs. 1,00,000 per year invested 1t 15% p.a. for 5 years would help accumulate a sum of Rs. 6.75 lacs, approximately

As can be seen from the above numbers, it is better to start as soon as possible and continue with the investment plan rather than chasing high returns.

By that logic, the best SIP is the one that you continue. So, start your SIP at the earliest and keep it on till your goals are reached.

Happy investing !

More Information

Whether equity or debt - invest only after considering the risks ...

The debate continues on whether a direct plan is better for investors or should one go through a distributor to invest in mutual funds? Read my views on the same below:

Whether you want to invest in equity or debt - please consider the risks involved. Understand the risks and manage these. Here is my article in Mid-day Gujarati explaining the risk involved in debt securities and debt funds:

The English translation is as under:

Last time, we discussed about one of the risks involved in debt securities and hence in debt funds. This time around, we would discuss another of the risks that exists, but majority of the retail investors are not aware of it.

In the debt market terminology, this risk is know as “interest rate risk”. In order to understand this risk, let us take the example of a debenture issued by a company.

This debenture was issued for a period of 5 years or the maturity of the debenture at the time of issue was 5 years. Two years have passed since and hence the debenture would now mature in 3 years.

Assume that this debenture is rated AAA – highest safety

Its face value is Rs. 100 and it bears coupon of 9% p.a. payable annually. This means the debenture holders would be paid Rs. 9 (9% of the face value of Rs. 100) every year for each debenture they hold.

Now assume that for some reason the interest rates in the economy come down – we have seen this happening in case of bank fixed deposits or recently in case of small savings or PPF – by 1% p.a..

This means, similar debentures (AAA rated debentures with a maturity of 3 years) would be available in the market offering a yield of 8% p.a.

Now when other debentures offer 8% p.a. and our original debenture, which was issued earlier is offering 9% p.a. That makes it more attractive compared to other debentures in the market.

Due to this attractiveness, investors would want to buy this debenture (We have assumed that such a debenture is traded in the stock market). This buying interest results in the rise in the market price of this debenture. The market price of such a debenture would rise to such an extent that now the return on investment in this debenture would fall to 8% p.a. Calculations indicate that the market price should rise to Rs. 102.58 per debenture.

This means that when you invest Rs. 102.58 in a debenture; earn interest income of Rs. 9 per year and get a maturity value of Rs. 100; the return on investment would be approximately 8% p.a.

On the other hand, had the interest rates gone up in the market to, say 10% p.a., our debenture’s market price would have fallen to Rs. 97.51.

As can be seen from the above example, the market price of an existing debenture falls when the interest rates in the economy go up. At the same time, a drop in the interest rates in the economy results in rise in the market price of existing debentures. Thus, there is an inverse relationship between the market price of existing debentures and the interest rates in the economy.

Now, assume the same company had issued another debenture at the same time, but for a maturity period of ten years. Hence, when two years passed from the issue of both these debentures, the two debentures would have a residual maturity of 3 years and 8 years, respectively.

If the interest rates fall by 1% p.a., one debenture offers higher interest for 3 years, whereas the other offers higher rate for 8 years. Thus, the relative attractiveness of the second debenture would be even higher and hence, the market price of the same would rise much more than the first one.

This is another fact that one should remember in case of debentures. Debentures with longer maturity witness bigger price changes when interest rates in the economy change.

The investors, who hold the debentures till maturity, do not have to worry about these changes in the market prices. They are unaffected by such changes. However, if someone needs to sell the debentures in the market before maturity, such an investor would be concerned with changes in the market prices – especially if the interest rates rise, causing the market price of the debentures to fall. At the same time, if the same investor continues to hold the debenture maturity, one would get the maturity value, as this is the contracted value.

While the debenture holders may hold the debentures till maturity to avoid the interest rate risk, debt mutual funds cannot. As we have seen earlier, the investors in (open-ended) mutual funds are allowed to transact at NAV linked price on all business days, the calculation of fair price must happen on a daily basis. For this purpose the NAV calculated on a daily basis must value all the debentures at the prevailing market price. Hence, an investor investing in a debt fund may witness frequent changes in the NAV of the fund. Having said that, such an investor would be better off holding the fund units for a recommended holding period in order to reduce the impact of interest rate risk.

A debt fund investor can also decide how much interest rate risk one wants to take. As we saw some time ago, debentures with longer maturity are more sensitive to changes in interest rates compared to those with shorter maturities. An investor can check the average maturity of a debt fund and decide to invest in one with low average maturity in order to avoid interest rate risk. An aggressive or a savvy investor, willing to take the interest rate risk may choose a debt fund with long average maturity. The details of a fund’s average maturity may be seen from the fund’s fact sheet.

Understand the risk in debt funds and take an informed investment decision.

More Information

Are debt funds totally safe?

Are debt funds totally safe? Or do they carry some risk? Click on the link below to read my article in Mid-day Gujarati today.

The English translation is as under:

Debt mutual funds – are they totally safe?

Is there a mutual fund option for someone, who does not want to take any risks? Well, there are many investors that keep asking this question. Very often, they also think that only equity funds are risky and that there is no risk in debt funds. Since debt funds invest in debt securities, these funds are exposed to the risks associated with such securities.

Today we will discuss a very important risk related to debt securities and other fixed income investments. In the language of investments, this risk is known as the default risk or credit risk. This risk is strongly associated with debt securities and other fixed income investment options.

As we understand, when someone invests in a debt security, i.e. a debenture or a bond or a similar instrument, e.g. a fixed deposit, one is lending money to someone in need of it. In case of debentures, bonds and fixed deposits, the borrower would generally be a company, a bank or a Government.

The borrower is required to pay interest to the lender, i.e. the investor. This interest is the income for the investor. This interest payable is agreed upon right in the beginning, along with the time schedule of the payment.

However, there is a possibility that the borrower may not return the money in time. This possibility is known as the default or credit risk. Such a risk is inherent whenever the borrower is anyone other than the government of the investor’s country. The risk, simply stated, is the possibility that the borrower does not pay up the dues as per the agreed schedule. The key phrase here is “as per the agreed schedule”, which means both non-payment and delayed payment are covered.

There are two factors leading to this risk – the ability and the willingness of the borrower. While willingness is difficult to measure, the ability can be measured through the financial statements, especially in case of a company. This is done by the credit rating agencies and they assign credit rating to the various debt papers issued by the borrowers for the purpose of lending. Please remember, the rating is assigned to a paper and not to the issuer.

Between short term and long term borrowing, one may consider the long term borrowing to be riskier as the uncertainties rise with the increase in the term of borrowing. Similarly, if the borrowing amount is small, the ability is higher than if the same is large. Companies may also issue debentures backed by the security of asset. Such secured debentures may enjoy higher rating than an unsecured paper issued by the same issuer.

Though credit rating could be a good starting point to evaluate whether to invest in certain debt papers, the risk does not completely go away even with the highly rated papers. The risk keeps rising with the drop in credit rating. A proven and time-tested method to reduce such risk is to diversify across various issuers. The ability to repay is less likely to suddenly drop across different companies operating in different businesses and industries.

This risk is present in all debt securities, as already mentioned earlier. The only issuer that is considered to be free of this risk is the government of a country, since it is authorized to print currency in case the need arises. For any other entity, the risk is higher than zero.

Debt mutual funds invest in debentures, which carry this credit risk. Hence, the debt fund investors are also exposed to this risk, indirectly. If a debenture in which a debt fund has invested defaults, i.e. does not return the money in time, the NAV of the debt fund would drop to that extent.

However, there are two major reasons that reduce this risk for debt funds:

  • A professional fund management team evaluated which securities to invest in. being a professional, the fund manager is likely to do a better job than most individual investors.
  • By regulation, the debt fund portfolio needs to be diversified across issuers. As we discussed earlier, diversification also reduced the risk of default.

Apart from that, an investor can evaluate which schemes to invest in based on (1) the investment objective as defined in the offer document and (2) the portfolio as disclosed in the monthly fact sheet of the fund.

A very important piece of information in the fact sheet is the rating profile of the fund, which shows how much is the scheme’s exposure in what type of credit rating. If the investor is uncomfortable with high exposure in lower rated papers, one may avoid the scheme altogether.

Debt funds, though not risk free, are a great way to invest for the conservative investor, as the risk of default is managed through professional fund management and diversification.

More Information

Mutual Fund Investors in India – Some unknown mistakes

Recently I received a mail from a reader that his friend has invested in equity mutual funds since 5 years. Returns are around 20%. His friend showed his fascinating investment history to this guy. Therefore, now he is also very much eager to invest in mutual funds (specifically in equity mutual funds) where his friend invested.

But he does not know why his friend investing, what is his risk taking capacity, what prompted him to invest in equity mutual funds since 5 years and whether his style suitable to him or not. A blind following and starting of investing in equity mutual funds or in any product.

Such type of investment is called as decisions based on peer comparison. We never understand what is best for us. But we compare our friends, relatives or colleagues and jump into investing.

It is such a dangerous mistake, which many Mutual Fund Investors in India unable to understand. I tried to represent such acts in below image.

First, I receive queries regarding which product to invest. They need a specific product name from me. However, when I question them about the time horizon of the goal, then their answer is so random that it scares me to suggest anything.

The tenure of their financial goals is like 5-10 or 15-20 years away from today. But sadly they don’t know that there is a BIG 5-year gap in their assumptions of goals.

It is hard to suggest or guide anyone who don’t know the exact tenure of their financial goals. However, in a few cases, I can understand that we have to assume but can’t specify perfectly. But what if all goals are so random.

Just observe the below image.

Here, I took HDFC Top 200 as an example. Because it is in the market since 3rd September, 1996. You notice that returns of 3 months are shown as 16.88% and 6 months as 30.5%, which is very, very impressive than the returns of 5 years (14.46%), 7 years (13.58%) and 10 years (14.57%).

Six months returns showing 30.5% returns. Which product in India gives us 30% returns for 6 months of investment? So we MUST invest in HDFC Top 200 Fund, am I right?

Hold on….this is where many of us make mistakes. We forget the first thumb rule that equity investment is for long term (in my view if your goal is 5+ years). The second mistake what we do is eye-catching short term returns. So we jump and invest in such equity funds with an expectation of around 30% for 6 months of investment.

We assume that equity is not good for the long term. But definitely best products for the short term. However, the reverse is true. When you assume a 30% return for 6 months of investment, you must be ready to expect the negative return of 30% also. Are you ready? If so, then go ahead. Either you receive +30% or -30%. Sadly we fail to understand the risk and volatility in such short-term equity market.

Note-Less than a year returns are absolute returns and more than a year returns are expressed in CAGR.

I noticed that a few have 1-2 financial goals. But holding 10-15 equity funds. But at the same time, few holding only one equity fund like sector funds. I am not against the person who hold a single fund like an equity-oriented balanced fund, which gives you enough exposure to debt and equity. However, I found that few are holding sector funds as they are very much optimistic about the particular sector. But they forget that any negatives about particular sector means they must be ready to bear the heat of negative returns or loss in their portfolio.

Holding too many funds create overlapping. At the same time, holding a single fund for the sake of fancy returns is also not good.

In 99% of mutual fund investors, I found no proper asset allocation. It is may be due to illiteracy towards investment or scarcity of proper guidance. I found that many investors investing 100% of their investable surplus in equity. Because their goals are long term. Hence, why to satisfy for less by investing in other asset class (like debt).

During the period of the bull run, all experts or funds give you positive news. However, the real test will be when there is a downtrend in the market or free fall in the market. During such falling market, the asset allocation will protect you.

If you have the proper debt to equity exposure based on your timeframe of goal, then it is always the best investment strategy.

Everyone running behind BEST returns. But they don’t know or hard to fail to define what is BEST return. For me, it may be 10%, for others best returns means 30%. First, you must define your expected return from your investment. Also, such expected return must not be any fancy number. It must be realistic. For example, from equity, you can expect a 12% return (for long term goals) and from the debt, it may be around 7%.

If your funds are generating the expected return, then you no need to worry about other funds star ratings or returns. Because you are getting what you are expecting. So why to worry??

It is the biggest mistake many investors believe and start to invest in debt funds like Income Funds or Long Term Gilt Funds. However, while selecting debt funds, you must concentrate on two aspects.

So you must understand the risk involved in debt funds. Funds like Income Funds or Gilt Funds are riskier than Short Term, Ultra-Short Term or Liquid Funds.

However, it does not mean that Short Term or Ultra Short Term Funds are safest. But the volatility will be lesser. We may easily compare the volatility of Liquid Fund to Income Fund from below images.

I selected above fund because I can show you the return movement of long term. Because this fund was launched in the year of 2001.

See the return lines of Birla Sun Life Gilt Fund. Compare this volatility with the liquid fund volatility. You notice the difference. Below is the modifified duration and average maturity of both liquid fund and income fund.

Modified Duration of Reliance Liquid Fund-Cash Plan-0.11 Vs Modified Duration of Birla Sunlife Gilt Fund-8.33.

Average Maturity of Reliance Liquid Fund-Cash Plan-0.12 Vs Average Maturity of Birla Sunlife Gilt Fund-15.91.

Hence, if you have enough equity exposure, then try to restrict your investment to short-term or ultra short-term debts or to the maximum of Gilt Short Term. But don’t go beyond that.

Recently, I came across this below eye catching advertisement about Liquid Funds.

This is something called weekend investment. Seems to be eye catching. Such returns may or may not be possible. However, the advertisement perfectly shows how much returns you will generate. Liquid funds over a year may generate 9% or less than your savings account also. The above advertisement not explaining of on what basis they arrived at this final value. So never ever believe on any one. Especially if someone claiming GAURANTEED returns from mutual funds (whether it is debt funds or equity funds).

Asset allocation funds - reduce volatility without compromising on the returns

Is it possible to reduce volatility of the scheme NAV without reducing the fund returns? Read my article in Mid-day Gujarati edition today ....

The English translation is as under:

“Stock markets likely to be volatile next week” – we often see such headlines in the newspapers or similar stories on the television. Volatility, though natural for the stock market, scares majority of investors. In order to reduce the volatility without compromising much on the potential upside, the mutual fund houses have innovated. First they came up with hybrid products. We covered two types of hybrid products – the more popular ones – Balanced Funds and Monthly Income Plans in our earlier articles. Due to the allocation in debt as well as equity, these funds exhibit lower volatility. However, the scheme returns may be lower than equity funds, especially during a secular bull market.

Today, we will discuss about some other strategies adopted by certain fund houses. Such strategies allocate money between equity and debt assets, but change the allocation based on certain parameters.

First of all, let us spend some time on understanding one important principle related to investments. If you combine two or more asset categories, which may be individually risky (volatile) but each one may partly cancel the volatility of the other. Thus, the portfolio would exhibit lower volatility.

This is where the fund houses came up with schemes that invest both in equity as well as debt. Both these asset categories exhibit different price movements at different points of time and in turn partly cancel out each other’s volatility.

Let us say, we start with allocating 50% in each equity and debt. After some time, if the equity market has run up, the percentage allocation to equity would be more than 50%. In such a case, the portfolio must be rebalanced to the original levels, i.e. 50% in each asset class. On the other hand, if the equity market is down, the allocation would be higher than 50% in debt. This time, one would have to sell debt and buy equity.

In either case, one is buying the asset priced lower by selling the one that has appreciated and hence is priced high. This is the classic “buy low, sell high” strategy in action. Now, a fund with static allocation between equity and debt would be achieving this through rebalancing on a regular basis.

The balanced funds and MIPs have delivered reasonably good performance over the years. Rebalancing, as explained above, has played a good role in that performance. Through reduction in volatility, the funds have been able to deliver performance that was average of the two categories.

Now comes the next question. Is it possible to do better than that? That is where funds have launched schemes that do not stick to a desired percentage allocation, but change the allocation based on some formula. This formula depends on the valuation of one or both the asset classes.

Some of the schemes in the market use equity valuation parameters like Price-to-Earnings ratio, or Price-to-Book Value ratio, or a combination of both. One of the schemes uses Price-to-Earnings ratio for equity while simultaneously comparing it with the yield on 10-year Government Securities.

These funds have lived up to the promise – lowering the volatility without reducing the returns too much.

It’s a good category to explore for investors. However, a deeper analysis is warranted since the alternatives can have significant differences among them.

More Information

Should you invest in equity funds since these are more tax-efficient?

The other day I received a query from someone. This person was advised to invest his money in fixed income funds since the money was needed in around two years’ time. He wanted a second opinion.

His question was: “Should I not look at equity funds since the returns on fixed income funds would be taxable, whereas capital gains on equity funds after a holding period of one year would be exempt from long term capital gains tax. Similarly, I can also opt for dividend option, too as dividends are also tax-free.”

He quoted an oft repeated line “It is not what you make, it is how much you take home after taxes that counts”.

He was also convinced that equity funds have potential to offer higher returns that fixed income funds.

This combination of potential higher returns coupled with lower (zero, in this case) tax makes equity funds appear far superior to fixed income funds.

Both the arguments in favour of equity funds are right – potential for higher returns and that the tax-efficiency is far superior. What is missing here is the risk involved. The risk is very high that even a well managed and well diversified portfolio of equity shares may lose value periodically. Though such drops in value may be temporary, they do exist and sometime for long periods of time.

It is this risk that should be considered first before worrying about paying taxes. Many investors make this mistake of looking at the taxation first. This results in highly tax-efficient but sometimes highly risky portfolios. It is not just in case of equity, we have seen this fascination towards saving tax in many other areas of personal finance. However, we shall restrict our discussion in this article only to the question we started with.

While equity funds have the potential for providing higher returns than fixed income funds, such a statement is more likely to be true if the holding periods are long. The price fluctuations in the short term would render the fund vulnerable. One is likely to experience a highly volatile NAV in case of an equity fund as compared to a fixed income fund.

These fluctuations may result into a situation that the value of investments could be lower when one needs money. Our investor had a need for taking money out of investments in around two years.

To answer the investor above, what he was advised was the correct investment option. With a two year investment horizon, it is prudent to invest in fixed income funds. To put it another way, it would be too risky to consider investing in equity funds if the investment horizon is two years.

Consider the nature of investment first – the risk involved before you look at the taxes.if the value of the portfolio is down at the time of redemption, there would be no taxed, anyway. It is often better to pay taxes on investment income than to see a situation when the investment loses money.

Use equity funds for your long term needs and fixed income funds if the need is short term in nature.