The Concept
& Advice on Growth Investments
MUTUAL FUND INVESTMENTS
Mr. Gerard Colaco: Mutual funds are a hybrid way of investing in real
estate, debt, commodity and equity markets. Instead of investing directly, you
pool resources with other investors and invest.
As in the case of stock market investments, a lot of wrong advice is given in mutual fund investments, too. Very often, terrible products like new fund offers (NFOs) are sold, not because they are good for investors, but because mutual fund distributors earn maximum brokerage from them. Similarly, a lot of fads like sector funds are recommended, whereas the only two types of equity mutual funds worth investing are well diversified equity funds and index funds.
THE SIX AREAS WHERE WE SEE VALUE IN MUTUAL FUND INVESTMENTS
1: Emergency Funding and Short-term Parking of Funds:
The four types of funds that I would choose for these purposes are liquid funds, short-term funds, short-term floating rate funds and quarterly interval fixed maturity plans.
Liquid funds are chosen when an investor is not at all sure about the duration of investment. In other words, a liquid fund is used as a glorified savings account. It is generally recommended for investments of up to 3 months.
A short-term fund is ideal for investment of between six months and a year.
A short-term floating rate fund is good for any period of investment up to a year, especially when the investor is more or less sure that funds are not needed for the first month, but may be needed anytime thereafter.
A quarterly interval fixed maturity plan (FMP) is ideal when an investor does not know when he requires the funds but is sure that he does not require them for at least the next 3 months.
Liquid, short-term and short-term floating rate funds currently yield between 6.5% and 8% p.a. Quarterly interval funds yield approximately 7.5% p.a. Please note that these yields can change, depending upon the state of the debt market from time to time. None of the above funds have anything to do with the stock market. They invest in the inter-bank call money market, short-term government bonds, short-term corporate loans, short-term financial institution loans, etc.
Non-resident Indians (NRIs) or Persons of Indian Origin (PIOs) can make investments in mutual funds funds from their NRE accounts. When they withdraw, the redemption proceeds get credited directly to the NRE accounts. Investments in mutual funds can also be made on a non-repatriable basis, by investment from the NRO account.
2: Intermediate-term investment of between one and three years:
The second area where we see value in mutual fund investments, is in intermediate-term investment of between one and three years. Undoubtedly, here there is nothing like FMPs of more than twelve months duration, especially on the tax-efficiency front for residents, and higher returns for NRIs. We need to dwell on this a little bit, because most non-residents are totally unaware of FMPs and keep their money in low-return NRE bank fixed deposits.
Fixed maturity plans (FMPs) buy and hold a diversified portfolio of debt securities, all of which are designed to be redeemed in line with the term of the plan. There is no trading in the securities held by FMPs. The yield on each security is known in advance. The expenses of the plan are also known in advance. Therefore, mutual funds are able to indicate what the yield is likely to be just before each plan closes for subscription.
We have found the indicated yields to be quite accurate. It does not mean however that the said indicative yields are exactly what you will get. If a bank deposit stipulates that you earn 9%, you earn 9%. If an FMP indicates that you earn 9%, you could earn 8.5% or 9.5%. Generally, the variations would not be more than 0.5% of the yield indicated on the last day the FMP is open for subscription.
If all this is confusing, think of mutual fund FMPs as the mutual fund equivalent of a cumulative bank deposit of more than 12 months' duration. FMPs have zero investments in the stock market. They invest in corporate and government bonds and other debt instruments. They therefore have a safety equal to bank fixed deposits.
Now, let us assume a very low yield of just 8.25% per annum on FMPs of more than one year. Unlike NRE bank FDs, FMPs are not tax-free. They are subject to long-term capital gains tax deduction of 10.3%. So, net of tax, you get an yield of 7.4% p.a. after tax. This is appreciably higher than the tax-free yield of 4.85% or so that is being offered on NRE deposits.
Where a resident Indian is concerned, bank FDs may be better for persons who are not paying tax, if at the time you are investing, the bank FD rates are higher than the FMP indicated rates. This is also more or less true for residential investors in the 10.3% income-tax slab. But for resident tax-payers in the 20.6, 30.9 and 33.99 brackets of tax, FMPs would be significantly better.
For NRIs, they have to only compare the present NRE deposit rates with the indicative yield of intermediate-term FMPs, after deducting 10.3% from the indicative yield of FMPs.
Understand one thing - both bank FD rates and FMP yields are dynamic and not static. They change and constantly compete with each other. However, the key factor in the investment decision is the post-tax rate at the time of investment. There are times when FMP rates were higher than domestic bank deposits. Right now, BFDs average 9.25%for residents, and FMP rates are in the range of 8.25 to 8.5%. But these rates are only the starting point of analysis. The deciding factor is the post-tax rate of FMPs vs the post-tax rate of other competing investments.
A final example to illustrate the above. Let us say you are a resident Indian, in the 30.9% tax-bracket. You invest Rs 1 lakh in a 9% FMP of a year and a day. You earn Rs 9,000/- upon maturity. The long-term capital gains tax at 10.3% is Rs 927/-. So your net return is Rs 9,000/- minus Rs 927/- = Rs 8,073/-.
Now let us assume you also invest another Rs 1 lakh on the same day in a bank fixed deposit yielding 10% p.a., a clear 1% more than the FMP. You earn Rs 10,000/- as interest. You pay Rs 3,090/- as tax, being in the 30.9% tax bracket. You are left with a net return of Rs 6,910/-, significantly lower than the Rs 8,073/- that you got as net return from the FMP.
So it is this Rs 8,073/- versus Rs 6,910/- that is important, not the 10% BFD interest versus the 9% FMP yield. In financial jargon, this habit of always looking at the final yield, net of taxes and expenses, is called "LOOKING AT THE BOTTOMLINE". It is also called the post-tax rate. This is one of the best habits that an investor can cultivate.
Now, we take an example of a non-resident investing in NRE Bank deposits. The NRI invests Rs 1 lakh in an NRE bank deposit giving 4.85%. There is no income-tax on interest earned on these deposits. So, he earns Rs 4,850/- tax free. If he invests the same in a 8.25% FMP of one year, he earns Rs 8,250/- upon maturity. The long-term capital gains tax at 10.3% is Rs 850/-. So his net return is Rs 8,250/- minus Rs 850/- = Rs 7,400/-, appreciably higher than the Rs 4,850/- on the 'tax-free' NRE bank FD.
There is one other class of safe mutual funds called arbitrage funds. These funds carry on a business of buying shares in one market and selling them in another market where the prices are higher. The deals are entered into in the two markets simultaneously and so there is no speculation or risk.
For example, if a particular stock is traded at Rs 600/- in the Bombay Stock Exchange cash market and at Rs 606/- in the National Stock Exchange 30-day futures market, the stock is bought on the BSE and sold on the NSE simultaneously. If this position is settled after a month, the profits are Rs 6/- on Rs 600/- or about 1% per month or 12% per annum.
There are mutual funds that specialise in such operations. When there are no such opportunities, the funds are kept in safe debt instruments. Returns on these funds have been between 7% and 9% per annum, for an investment horizon of a year or more. Now comes the important part. Because arbitrage funds are considered 'equity funds', there is no tax whatsoever on profits made, provided the investment is held for a year at least.
A mix of FMPs and arbitrage funds is the best bet for intermediate-term, risk-free investments. We hope this has thrown some light on the subject of FMP investments in particular and debt investments in general.
3: Equity Linked Savings Schemes (ELSS)
ELSS investments are more relevant to Indian residents. Section 80C of the Income-tax Act, enables an investor to get a tax exemption of Rs 1 lakh, in addition to the basic exemption of Rs 1.8 lakh given to all male assesees. For females, the basic exemption is Rs 1.9 lakhs. For senior citizens (60 years and above), the basic exemption is Rs 2.5 lakhs. What this means is, for example, if a non-senior citizen female earns Rs 15,000/- salary per month and has no other income, she does not have to worry about tax, because her total income is Rs 1.8 lakhs, which is less than the basic exemption of Rs 1.9 lakhs.
Now, non-residents are not taxed in India on their foreign income. They are also not taxed on the interest they earn on NRE bank deposits. However, Indian income-tax laws assume very great importance when non-residents decide to return to India on permanent transfer of residence. At that time if proper tax planning is not done, it can result in non-residents having to pay unnecessarily high taxes, when they start filing income-tax returns as resident Indians. Therefore, what we advise NRI couples is that both husband and wife must have individual NRE and NRO accounts.
The husband must have an NRE account and an NRO account in both of which he is the first holder, with his wife as second holder. The wife must in turn have an NRE account and an NRO account, in both of which she is first holder and the husband is second holder. This must be done even if only one of them is working and the other is not, although both are residing abroad. Before returning to India on permanent transfer of residence, the husband and wife must split their savings more or less equally between themselves and make two separate inward remittances to their respective NRE accounts, from abroad.
Now let us see the implications of not doing this as well as of doing this, by taking 2 or 3 examples.
Example 1: All investments are brought to India in the name of the husband only:
Let us say the husband invests Rs 80 lakhs in resident bank deposits at 9.5% interest per annum. He earns Rs 7.60 lakhs of income. He will pay tax as follows:
On the 1st Rs 1.8 lakh: Nil
On the next Rs 3.2 at 10.3%: Rs 32,960/-
On the next Rs 2.6 lakh, at 20.6%: Rs 53,560/-
Thus the total tax he will pay on the income of Rs 7.6 lakhs is Rs 86,520/-
Example 2: Husband and wife have split their savings and transferred them to India in equal proportions:
Each of them invests Rs 40 lakhs in 9.5% bank fixed deposits, each of them earns Rs 3,80,000/-. The total family income will be the same as in example 1, that is Rs 7,60,000 lakhs, except that it is now earned by two individual income-tax assessees equally.
The tax paid by the husband will be:
On the 1st Rs 1.8 lakh: Nil
On the next Rs 2,00,000/- at 10.3%: Rs 20,600/-
The total tax payable by the husband amounts to Rs 20,600/-.
The tax paid by the wife will be:
On the 1st Rs 1.9 lakhs: Nil
On the next Rs 1,90,000/- @ 10.3%: Rs 19,570/-
The total tax payable by the wife amounts to Rs 19,570/-.
The total, tax payable by husband and wife will be Rs 40,170/-. Compare this to the tax figure of Rs 86,520/- that would have to be paid by the husband if the inward remittance of their savings had not been split between the two of them.
Example 3: This is the same as example 2, but we now assume that from the earnings of Rs 3,80,000/- of each of them, they also invest in instruments like ELSS which give them a further exemption of Rs 1 lakh each.
In this case, the tax that each of them pays will be as follows:
The tax paid by the husband will be:
On the first Rs 2.8 lakhs: Nil
On the next Rs 1,00,000/- @ 10.3%: Rs 10,300/-
The total tax payable by the husband amounts to Rs 10,300/-.
The tax paid by the wife will be:
On the 1st Rs 2.9 lakhs: Nil
On the next Rs 90,000/- @ 10.3% : Rs. 9,270/-
The total tax payable by the wife amounts to Rs. 9,270/-
Therefore, on a total family income of Rs 7.60 lakhs, the total tax is only Rs 19,570/-.
Compare this to the tax figures of Rs 40,170/- and Rs 80,520/- in examples 2 & 3 respectively. Now you probably see the importance of good financial planning. Actually, what we have given above is an example of tax planning. Tax planning is one small part of financial planning.
For eligibility under Section 80C, ELSS is not the only available avenue. There are numerous other avenues, of which the best two are the Public Provident Fund (PPF) and ELSS. Non-resident Indians cannot open PPF accounts. Anybody can invest in ELSS. Non-resident Indians may require tax saving under Section 80C, in case their Indian income exceeds the basic exemption limit prescribed from time to time.
For example, if a non-resident Indian owns an apartment in Bangalore from which he earns rent of Rs 25,000/- per month, his total Indian income will be Rs 3 lakhs, far higher than the present basic exemption of Rs 1.8 lakhs. Such a person will definitely need tax saving avenues like ELSS. With its good long-term earnings potential, limited risk and tax saving features, ELSS schemes constitute the third area of mutual fund investment in which we see value.
4: Systematic Investment, especially into equity and balanced mutual funds
If you have read and digested our paper on equity investment, you will appreciate that for a normal investor, to have a meaningful equity portfolio today, she/he will need to purchase Rs 20,000/- worth of each stock in at least the first 30 stocks in our recommended list. That would be a one-time outlay of Rs 6 lakhs. Actually, to totally take care of the unsystematic risk in the stock market, we recommend 60 stocks and not 30. This means an outlay of Rs 12 lakhs, at the minimum.
Now if an investor wants to invest systematically in our model, he would have to purchase at least Rs 20,000/- worth of one stock per month. There are a number of small investors who will not be able to afford this amount of monthly investment. Thus, the fourth area where I see value in mutual fund investments is in systematic investments into non-ELSS equity and balanced funds, especially for small investors.
For large investors, it can probably be argued that they can purchase one or two stocks or more, of Rs 10,000/- or Rs 20,000/- each per month directly in the stock market. For example, we have several clients from whom we have standing instructions to purchase Rs 10,000/- or Rs 20,000/- worth of stocks per week/fortnight/month from our list of about 60 recommended stocks. But what about a very small investor who can only afford to salt away Rs 500/-, Rs 1,000/- or Rs 2,000/- per month? For such persons, there is nothing like a sustained systematic investment into equity/balanced mutual funds.
The value of systematic investment into a diversified equity fund is that with as little as Rs 500/- or Rs 1,000/-, you can purchase a diversified portfolio of stocks through the mutual fund route. It is time to understand the benefits of systematic investment, especially in a fluctuating avenue of investment such as the stock market. So, let me give you a primer on systematic investment.
Systematic investment is a method by which fixed or varying sums of money are invested in one or more avenues of investment at regular intervals. If you examine this definition, you find that it is quite flexible on both the amounts to be invested, as well as the avenues of investment. The only area where there is rigidity and no compromise, is in the "at regular intervals" portion of the definition. This is because the objective of systematic investment is to make investing a habit.
We are used to poor quality systematic investment plans such as recurring deposits into post office or bank recurring deposits. Actually, the greatest benefit of systematic investment is felt when it is made in investments whose values fluctuate. Let me give you an example of the difference between what a normal stock market investor does and how the same strategy would look in systematic investment.
Let us assume that there is a good stock market investor. He is not a speculator. He does the minimum amount of study required, invests in good stocks and does not panic when the stock markets falls. Let us assume he has identified a stock which is currently quoting at Rs 100/- per share in the market. He considers it a good buy and purchases 100 shares, paying Rs 10,000/- for them. Unfortunately, he has made his purchase at the market peak. The market now falls heavily and in 3 months' time, he finds the share quoting at Rs 70/- per share.
This investor does not panic. He examines the new situation. His conclusion is simple. Three months back he found the share attractive at Rs 100/-. Now he finds it quite a bargain at Rs 70/-. So he buys another 100 shares, investing Rs 7,000/- this time. Unfortunately for him, the economy of the country is going into a 2 or 3 year recession. Three years later, he finds the same stock quoting at a miserable Rs 40/- per share. Once again he does not panic, nor does he buy again blindly. By now, he is a shareholder of the company for a little over 3 years and has been receiving the company's annual reports and financial statements.
He concludes that even in a general recession, the company is making some profits and paying some dividends, although the profit and dividend levels are much lower than in the boom time. Now, our investor argues that if this company can keep its neck above the water in the bad times, it should certainly do very well when the next boom occurs. So he purchases a third lot of 100 shares, paying Rs 4,000/- for them. The summary of his investments is as follows:
Purchased 100 shares at Rs 100/- per share, investing Rs 10,000/-;
Purchased 100 shares at Rs 70/- per share, investing Rs 7,000/-;
Purchased 100 shares at Rs 40/- per share, investing Rs 4,000/-;
Therefore, purchased 300 shares totally, for a total consideration of Rs 21,000/-, or an average price of Rs 70/- per share.
Now let us convert the above example into systematic investment. In normal stock market investment, the investor's focus is generally on quantities or numbers of shares to be bought or sold. In systematic investment however, the focus is not on quantities, but on equal amounts at regular intervals. In the above example, Rs 21,000/- has been invested in 3 transactions. To convert that operation into systematic investment therefore, Rs 21,000/- should be divided into 3 equal portions of Rs 7,000/- each.
The rest of the example is the same. You invest the first Rs 7,000/- when the price of the stock is Rs 100/-. You get 70 shares. You invest the next Rs 7,000/- when the price of the stock is Rs 70/-. You get 100 shares. You invest the final Rs 7,000/-, when the price of the stock is Rs 40/-. You get 175 shares. Now when you total this 70 + 100 + 175 shares, you get a total of 345 shares for the same Rs 21,000/- as opposed to 300 shares in the normal investment that you made in the earlier example.
In the systematic investment, you end up holding 345 shares at an average price of approximately Rs 61/- per share, against 300 shares at Rs 70/- per share in lump sum investment. There is no magic in this. It is simple mathematics.
By shifting your focus from a specified quantity of shares to be purchased per transaction, to investing equal amounts at regular intervals, you automatically tend to buy a lesser number of shares when the market is high and a greater number of shares when the market is low. This helps you obtain a favorable weighted average instead of a neutral simple average, as in the first example.
When we buy the same stock or the same kind of investment (for example a particular diversified mutual fund, at different times, we will have a high price at which we purchase the stock or units and a low price. The median point between the high price and the low price will be the simple average. For example, in the first case of normal stock market investment, the high price was Rs 100/-, the low price was Rs 40/- and therefore the mid-point between these two prices, or the simple average was Rs 70/-. Here prices changed, but our quantities remained the same.
However, by using the superior technique of systematic investment, you end up with an actual price of Rs 61/-, which is below the simple average. In short, you have achieved better pricing, by an automatic process, without relying upon research and deep study. Systematic investment always and without exception enables you to get a final purchase price that is below the simple average price of the high and low rates during the period you made the investment. Here prices changed, and the quantities that we purchased also changed in response to the change in prices.
Quantities purchased were greater when prices were down and lesser when prices were up. In real life also, wouldn't we tend to consume or use more of a product when its prices are down? The same common sense is automatically applied in a technique like systematic investment.
To sum up, systematic investment plans (SIPs) in mutual funds are useful because:
1. They enable even a small investor with modest means to make systematic investments with amounts which can even be as low as Rs 500/- or Rs 1,000/- per month.
2. They afford convenience and ease of operation in making the investment. You can give standing instructions to your bank that a certain amount must be systematically invested every month into a certain mutual fund investment plan.
3. Even with very small amounts, you can achieve diversification across all major sectors and stocks. For example, three of the best diversified equity funds in India which invest in the main, large, blue chip companies are the Franklin India Bluechip Fund (from Franklin Templeton Mutual Fund), the HDFC Top 200 (from HDFC Mutual Fund), and the Fidelity Equity Fund (from Fidelity Mutual Fund). One of the best diversified mutual funds which invests in mid and small capital companies is the Sundaram Select Midcap Fund (from Sundaram Mutual Fund). At any given time, the above funds would be investing in something like 30, 50, 80, and 100 stocks respectively. Now, if a small investor is even putting Rs 500/- per month in the HDFC Top 200 through a systematic investment plan, each purchase of this Rs 500/- enables investment in the average of 50 companies that the fund is holding. Such a facility can be obtained only through mutual fund investment.
4. You have heard of diversification across sectors and companies. Systematic investment enables such diversification but also performs another very important function. It enables diversification to be complete. Systematic investment and diversification are very closely related. In fact, systematic investment is a part of diversification. Systematic investment is diversification across time.
5. Systematic investment automatically enables right pricing.
6. Systematic investment makes investment a habit.
There is an old saying in investment: If you work on an investment, it will work for you.
There is another old saying: A winner is not one who never fails, but one who never quits.
Systematic investment in diversified equity funds, especially over the long term achieves and fulfills the spirit of these two sayings.
We conclude this note on systematic investment, by tackling the most important aspect of the risk involved in systematic investment into fluctuating avenues like index or diversified equity funds. Investment in diversified equity funds carries a risk in the short-term. Equity investment is however safe in the long-run. Systematic investment certainly does not eliminate risk. But it definitely reduces risk quite significantly.
The maximum risks in equity indices almost never exceed 50%. In quality portfolios such as the ones recommended in our paper on equity investment, the risk is generally not more than 35%. But in systematic investment, the risk does not exceed 25%, 17%, and 10% in the first, second and third years. Let’s look at an example.
If you have a systematic investment of Rs 1,000/- per month into a diversified equity fund, and you have completed 12 months during which there has been a massive fall in the stock market, your maximum risk will not exceed 25% of the total of Rs 12,000/- that you have invested. 25% of Rs 12,000/- is Rs 3,000/-. This can be the maximum depletion in your investment.
In 2 years, you would have invested Rs 24,000/-. Seventeen percent of this is approximately Rs 4,000/-. This can be your maximum risk in an SIP in two years time, in a worst case stock market scenario.
In 3 years, you would have invested Rs 36,000/-. The maximum risk will not exceed 10% or Rs 4,000/- approximately.
Ever since the modern era of the Indian stock markets began in 1979, we have not seen any risk in SIPs of more than 3 years. Once you start, however, it is good to continue an SIP for at least the equity time horizon of 5 years.
5: SYSTEMATIC TRANSFER PLANS:
This area involves an asset allocation strategy that has been described in Option 3 of our paper on good investment avenues in the Indian equity and debt markets. The strategy is called a 'ZERO RISK SYSTEMATIC TRANSFER PLAN.' It addresses a very important issue that most investors confront, and that is risk in equity investments.
There are many investors who shy away from equity investments because of the risk involved. What they don't realize is that the stock markets have a history of slightly more than 400 years. During this period, not a single stock market system of any country has ever collapsed. On the other hand during the same period, countless banks, including some of the best banks in the world have gone under.
When we talk about risk in the stock market, the so called risk is only in the short-term. History has shown repeatedly that there is absolutely no risk in equity investments in the long-term, especially in a well diversified portfolio of even reasonably good stocks.
What if a stock market investor is given an opportunity to invest in equity without the accompanying risk? This was a question that fascinated us when we started our career sometime in 1985. We then came across many studies worldwide, which established that using an asset allocation strategy which combined both, debt and equity investments, risk could be fine tuned to the level desired by the investor.
You will understand this better with a simple example. Assume that Rs 100,000/- is invested in a safe avenue of investment which gives a return of 5% p.a. Now, 1% of this principal that is Rs 1,000 /- per month is transferred to a reasonably well diversified bunch of stocks. If such a strategy is put in place, there will be no risk to the capital of the investor, regardless of the state of the stock market over any period of time.
Using this strategy therefore, an investor can participate in the market without taking a risk to his capital. The systematic transfer plan (STP) combines all the benefits of systematic investment, and in addition makes use of the asset class of debt, which is non-correlated to equity. Non-correlated means that equity and debt will generally not move together, where their returns are concerned. Short-term debt, which is the safest form of debt, will give low and steady returns. Equity can move up or down in the short-term, but gives higher returns in the long-term. To sum up, the rationale behind an STP can be explained in the following table:
Asset Class Short-term (< 5 years) Long-term (> 5 years)
----------------------------- ------------------------------ ------------------------------
Short-term Debt Safe Safe
Diversified Equity Risky Safe
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What you see above is that debt is safe whether in the short-term or the long-term. Equity is safe in the long-term, but can be quite risky in the short-term. Therefore, the table shows 3 areas of safety and one area of risk. The systematic transfer plan attempts to avoid this one area of risk by placing the corpus available (in our example Rs 100,000/-) in a short-term debt fund and systematically transferring 1% of this corpus per month to an avenue of investment that is safe in the long-term, namely equity. While debt is also safe in the long-term, it should be borne in mind that equity gives far higher returns than debt, in the long-term.
Investing in an asset allocation strategy whereby a corpus is placed in a safe debt avenue of investment, and 1% of the corpus per month is transferred to a diversified equity avenue, is called a "zero risk systematic transfer plan." This discussion brings us to an interesting point. Risk can be of two types. You can have a risk to capital. You can have a risk to return. Let us assume you have invested Rs 1 lakh in equity. After one year, your investment is worth Rs 90,000/-. This is a risk to capital.
Now, let us assume that you have invested Rs 1 lakh in a zero risk STP strategy and another Rs 1 lakh in a resident bank deposit. After one year, the stock market performs very badly. Your STP strategy is worth Rs 1.03 lakhs. Your bank deposit has earned you 9% p.a. and is worth Rs 1.09 lakhs. If you argue that you earned lesser returns of Rs 6,000/- in the STP strategy, the extent to which you earned lesser returns than a competing avenue of investment, is your risk to return. This example is given for illustrative purposes only, as an STP strategy involving debt and equity is totally different from a pure debt investment like a bank deposit.
Over period of 5 years or more, STP strategies have repeatedly proved that they will give higher returns than most other avenues of investment, without taking a risk to capital. Hence to earn higher returns in a longer time frame, it is worth taking a risk to return. First time investors in the stock market would certainly do well to avoid a risk to capital at all costs.
There are many risk-averse investors who do not mind a short-term risk to return, if they can be compensated by long-term returns which will beat almost all other avenues. Their main fear is of a risk to capital, not a risk to return. We fully support any investor who does not want to take a risk to capital. As Warren Buffett put it so beautifully: "The first rule of investing is: do not lose. And the second rule is: do not forget the first rule. And that's all the rules there are."
The zero risk STP has one other outstanding feature. At any time during the period of your investment, if the stock market falls by more than 25% from its last peak and remains below this level for at least a month, then we advise you to double your monthly systematic transfer from Rs 1,000/- to Rs 2,000/-. Generally, you get a chance to do this at least once in a period of 5 years. If you do avail of this opportunity, it can substantially enhance your returns.
As things stand in India at present, zero risk systematic transfer strategies are designed to quadruple your money in a period of 10 years, even if you do not get an opportunity to double your systematic transfer when the markets fall by 25% from their peak. If you do, the returns will of course be higher.
Viewed from any angle, the zero risk STP remains one of the best strategies in mutual fund investment. Its value lies in first, enabling a risk-averse investor to invest in the stock market without taking a risk to capital. Second, while capital is protected, returns are not compromised. Third, there will generally be an opportunity to substantially increase your returns when the markets descend 25% or more from their last peak.
6:INVESTMENTS:
The definition of a mutual fund is that it is a common pool of money to which investors contribute, for investment in accordance with a stated objective. Therefore, mutual funds are not limited only to financial assets such as equity shares, government bonds, corporate bonds and other debt instruments. Mutual fund plans can also be formulated to invest in real estate, bullion, other precious metals, derivatives and so on.
When we study the history of investments, we find that where long-term, investment-beating and wealth-enhancing returns are concerned, the only two worthwhile avenues of investment are equity and real estate. Since real estate requires a lot of capital and considerable expertise, real estate mutual funds can offer a good alternative for investment. Similarly, there are certain asset allocation funds which rebalance between various types of assets on a periodical basis.
For example we can have a fund that follows Benjamin Graham's 50:50 rebalancing strategy. To understand this strategy, let us assume that the mutual fund has a corpus of Rs 2 lakhs. Rs 1 lakh is invested in let us say the Nifty Index and the other Rs 1 lakh is invested in a liquid fund, thereby maintaining a 50:50 balance between debt and equity. Let us say 6 months down the line, the debt component has grown to Rs 1.04 lakhs and the equity component has grown to Rs 1.10 lakhs. The total portfolio value is now Rs 2.14 lakhs. To maintain a 50:50 balance now, there should be Rs 1.07 lakhs in debt and Rs 1.07 lakhs in equity.
So, the fund now shifts Rs 3,000/- from equity to debt, in order to realign itself to the 50:50 balance. Such a fund would certainly be worth investing in, especially if it has a regular programme for rebalancing its portfolios at fixed intervals of say 6 months or a year. Regular rebalancing is perhaps the finest way of investing. It takes care of all normal questions of an investor like when to invest, where to invest, when to book profits, what is the quantum of profits to be booked, etc.
To conclude, real estate mutual funds and certain clear cut asset allocation and rebalancing funds are definitely to be considered in the overall investment portfolio of an investor.
As in the case of stock market investments, a lot of wrong advice is given in mutual fund investments, too. Very often, terrible products like new fund offers (NFOs) are sold, not because they are good for investors, but because mutual fund distributors earn maximum brokerage from them. Similarly, a lot of fads like sector funds are recommended, whereas the only two types of equity mutual funds worth investing are well diversified equity funds and index funds.
THE SIX AREAS WHERE WE SEE VALUE IN MUTUAL FUND INVESTMENTS
1: Emergency Funding and Short-term Parking of Funds:
The four types of funds that I would choose for these purposes are liquid funds, short-term funds, short-term floating rate funds and quarterly interval fixed maturity plans.
Liquid funds are chosen when an investor is not at all sure about the duration of investment. In other words, a liquid fund is used as a glorified savings account. It is generally recommended for investments of up to 3 months.
A short-term fund is ideal for investment of between six months and a year.
A short-term floating rate fund is good for any period of investment up to a year, especially when the investor is more or less sure that funds are not needed for the first month, but may be needed anytime thereafter.
A quarterly interval fixed maturity plan (FMP) is ideal when an investor does not know when he requires the funds but is sure that he does not require them for at least the next 3 months.
Liquid, short-term and short-term floating rate funds currently yield between 6.5% and 8% p.a. Quarterly interval funds yield approximately 7.5% p.a. Please note that these yields can change, depending upon the state of the debt market from time to time. None of the above funds have anything to do with the stock market. They invest in the inter-bank call money market, short-term government bonds, short-term corporate loans, short-term financial institution loans, etc.
Non-resident Indians (NRIs) or Persons of Indian Origin (PIOs) can make investments in mutual funds funds from their NRE accounts. When they withdraw, the redemption proceeds get credited directly to the NRE accounts. Investments in mutual funds can also be made on a non-repatriable basis, by investment from the NRO account.
2: Intermediate-term investment of between one and three years:
The second area where we see value in mutual fund investments, is in intermediate-term investment of between one and three years. Undoubtedly, here there is nothing like FMPs of more than twelve months duration, especially on the tax-efficiency front for residents, and higher returns for NRIs. We need to dwell on this a little bit, because most non-residents are totally unaware of FMPs and keep their money in low-return NRE bank fixed deposits.
Fixed maturity plans (FMPs) buy and hold a diversified portfolio of debt securities, all of which are designed to be redeemed in line with the term of the plan. There is no trading in the securities held by FMPs. The yield on each security is known in advance. The expenses of the plan are also known in advance. Therefore, mutual funds are able to indicate what the yield is likely to be just before each plan closes for subscription.
We have found the indicated yields to be quite accurate. It does not mean however that the said indicative yields are exactly what you will get. If a bank deposit stipulates that you earn 9%, you earn 9%. If an FMP indicates that you earn 9%, you could earn 8.5% or 9.5%. Generally, the variations would not be more than 0.5% of the yield indicated on the last day the FMP is open for subscription.
If all this is confusing, think of mutual fund FMPs as the mutual fund equivalent of a cumulative bank deposit of more than 12 months' duration. FMPs have zero investments in the stock market. They invest in corporate and government bonds and other debt instruments. They therefore have a safety equal to bank fixed deposits.
Now, let us assume a very low yield of just 8.25% per annum on FMPs of more than one year. Unlike NRE bank FDs, FMPs are not tax-free. They are subject to long-term capital gains tax deduction of 10.3%. So, net of tax, you get an yield of 7.4% p.a. after tax. This is appreciably higher than the tax-free yield of 4.85% or so that is being offered on NRE deposits.
Where a resident Indian is concerned, bank FDs may be better for persons who are not paying tax, if at the time you are investing, the bank FD rates are higher than the FMP indicated rates. This is also more or less true for residential investors in the 10.3% income-tax slab. But for resident tax-payers in the 20.6, 30.9 and 33.99 brackets of tax, FMPs would be significantly better.
For NRIs, they have to only compare the present NRE deposit rates with the indicative yield of intermediate-term FMPs, after deducting 10.3% from the indicative yield of FMPs.
Understand one thing - both bank FD rates and FMP yields are dynamic and not static. They change and constantly compete with each other. However, the key factor in the investment decision is the post-tax rate at the time of investment. There are times when FMP rates were higher than domestic bank deposits. Right now, BFDs average 9.25%for residents, and FMP rates are in the range of 8.25 to 8.5%. But these rates are only the starting point of analysis. The deciding factor is the post-tax rate of FMPs vs the post-tax rate of other competing investments.
A final example to illustrate the above. Let us say you are a resident Indian, in the 30.9% tax-bracket. You invest Rs 1 lakh in a 9% FMP of a year and a day. You earn Rs 9,000/- upon maturity. The long-term capital gains tax at 10.3% is Rs 927/-. So your net return is Rs 9,000/- minus Rs 927/- = Rs 8,073/-.
Now let us assume you also invest another Rs 1 lakh on the same day in a bank fixed deposit yielding 10% p.a., a clear 1% more than the FMP. You earn Rs 10,000/- as interest. You pay Rs 3,090/- as tax, being in the 30.9% tax bracket. You are left with a net return of Rs 6,910/-, significantly lower than the Rs 8,073/- that you got as net return from the FMP.
So it is this Rs 8,073/- versus Rs 6,910/- that is important, not the 10% BFD interest versus the 9% FMP yield. In financial jargon, this habit of always looking at the final yield, net of taxes and expenses, is called "LOOKING AT THE BOTTOMLINE". It is also called the post-tax rate. This is one of the best habits that an investor can cultivate.
Now, we take an example of a non-resident investing in NRE Bank deposits. The NRI invests Rs 1 lakh in an NRE bank deposit giving 4.85%. There is no income-tax on interest earned on these deposits. So, he earns Rs 4,850/- tax free. If he invests the same in a 8.25% FMP of one year, he earns Rs 8,250/- upon maturity. The long-term capital gains tax at 10.3% is Rs 850/-. So his net return is Rs 8,250/- minus Rs 850/- = Rs 7,400/-, appreciably higher than the Rs 4,850/- on the 'tax-free' NRE bank FD.
There is one other class of safe mutual funds called arbitrage funds. These funds carry on a business of buying shares in one market and selling them in another market where the prices are higher. The deals are entered into in the two markets simultaneously and so there is no speculation or risk.
For example, if a particular stock is traded at Rs 600/- in the Bombay Stock Exchange cash market and at Rs 606/- in the National Stock Exchange 30-day futures market, the stock is bought on the BSE and sold on the NSE simultaneously. If this position is settled after a month, the profits are Rs 6/- on Rs 600/- or about 1% per month or 12% per annum.
There are mutual funds that specialise in such operations. When there are no such opportunities, the funds are kept in safe debt instruments. Returns on these funds have been between 7% and 9% per annum, for an investment horizon of a year or more. Now comes the important part. Because arbitrage funds are considered 'equity funds', there is no tax whatsoever on profits made, provided the investment is held for a year at least.
A mix of FMPs and arbitrage funds is the best bet for intermediate-term, risk-free investments. We hope this has thrown some light on the subject of FMP investments in particular and debt investments in general.
3: Equity Linked Savings Schemes (ELSS)
ELSS investments are more relevant to Indian residents. Section 80C of the Income-tax Act, enables an investor to get a tax exemption of Rs 1 lakh, in addition to the basic exemption of Rs 1.8 lakh given to all male assesees. For females, the basic exemption is Rs 1.9 lakhs. For senior citizens (60 years and above), the basic exemption is Rs 2.5 lakhs. What this means is, for example, if a non-senior citizen female earns Rs 15,000/- salary per month and has no other income, she does not have to worry about tax, because her total income is Rs 1.8 lakhs, which is less than the basic exemption of Rs 1.9 lakhs.
Now, non-residents are not taxed in India on their foreign income. They are also not taxed on the interest they earn on NRE bank deposits. However, Indian income-tax laws assume very great importance when non-residents decide to return to India on permanent transfer of residence. At that time if proper tax planning is not done, it can result in non-residents having to pay unnecessarily high taxes, when they start filing income-tax returns as resident Indians. Therefore, what we advise NRI couples is that both husband and wife must have individual NRE and NRO accounts.
The husband must have an NRE account and an NRO account in both of which he is the first holder, with his wife as second holder. The wife must in turn have an NRE account and an NRO account, in both of which she is first holder and the husband is second holder. This must be done even if only one of them is working and the other is not, although both are residing abroad. Before returning to India on permanent transfer of residence, the husband and wife must split their savings more or less equally between themselves and make two separate inward remittances to their respective NRE accounts, from abroad.
Now let us see the implications of not doing this as well as of doing this, by taking 2 or 3 examples.
Example 1: All investments are brought to India in the name of the husband only:
Let us say the husband invests Rs 80 lakhs in resident bank deposits at 9.5% interest per annum. He earns Rs 7.60 lakhs of income. He will pay tax as follows:
On the 1st Rs 1.8 lakh: Nil
On the next Rs 3.2 at 10.3%: Rs 32,960/-
On the next Rs 2.6 lakh, at 20.6%: Rs 53,560/-
Thus the total tax he will pay on the income of Rs 7.6 lakhs is Rs 86,520/-
Example 2: Husband and wife have split their savings and transferred them to India in equal proportions:
Each of them invests Rs 40 lakhs in 9.5% bank fixed deposits, each of them earns Rs 3,80,000/-. The total family income will be the same as in example 1, that is Rs 7,60,000 lakhs, except that it is now earned by two individual income-tax assessees equally.
The tax paid by the husband will be:
On the 1st Rs 1.8 lakh: Nil
On the next Rs 2,00,000/- at 10.3%: Rs 20,600/-
The total tax payable by the husband amounts to Rs 20,600/-.
The tax paid by the wife will be:
On the 1st Rs 1.9 lakhs: Nil
On the next Rs 1,90,000/- @ 10.3%: Rs 19,570/-
The total tax payable by the wife amounts to Rs 19,570/-.
The total, tax payable by husband and wife will be Rs 40,170/-. Compare this to the tax figure of Rs 86,520/- that would have to be paid by the husband if the inward remittance of their savings had not been split between the two of them.
Example 3: This is the same as example 2, but we now assume that from the earnings of Rs 3,80,000/- of each of them, they also invest in instruments like ELSS which give them a further exemption of Rs 1 lakh each.
In this case, the tax that each of them pays will be as follows:
The tax paid by the husband will be:
On the first Rs 2.8 lakhs: Nil
On the next Rs 1,00,000/- @ 10.3%: Rs 10,300/-
The total tax payable by the husband amounts to Rs 10,300/-.
The tax paid by the wife will be:
On the 1st Rs 2.9 lakhs: Nil
On the next Rs 90,000/- @ 10.3% : Rs. 9,270/-
The total tax payable by the wife amounts to Rs. 9,270/-
Therefore, on a total family income of Rs 7.60 lakhs, the total tax is only Rs 19,570/-.
Compare this to the tax figures of Rs 40,170/- and Rs 80,520/- in examples 2 & 3 respectively. Now you probably see the importance of good financial planning. Actually, what we have given above is an example of tax planning. Tax planning is one small part of financial planning.
For eligibility under Section 80C, ELSS is not the only available avenue. There are numerous other avenues, of which the best two are the Public Provident Fund (PPF) and ELSS. Non-resident Indians cannot open PPF accounts. Anybody can invest in ELSS. Non-resident Indians may require tax saving under Section 80C, in case their Indian income exceeds the basic exemption limit prescribed from time to time.
For example, if a non-resident Indian owns an apartment in Bangalore from which he earns rent of Rs 25,000/- per month, his total Indian income will be Rs 3 lakhs, far higher than the present basic exemption of Rs 1.8 lakhs. Such a person will definitely need tax saving avenues like ELSS. With its good long-term earnings potential, limited risk and tax saving features, ELSS schemes constitute the third area of mutual fund investment in which we see value.
4: Systematic Investment, especially into equity and balanced mutual funds
If you have read and digested our paper on equity investment, you will appreciate that for a normal investor, to have a meaningful equity portfolio today, she/he will need to purchase Rs 20,000/- worth of each stock in at least the first 30 stocks in our recommended list. That would be a one-time outlay of Rs 6 lakhs. Actually, to totally take care of the unsystematic risk in the stock market, we recommend 60 stocks and not 30. This means an outlay of Rs 12 lakhs, at the minimum.
Now if an investor wants to invest systematically in our model, he would have to purchase at least Rs 20,000/- worth of one stock per month. There are a number of small investors who will not be able to afford this amount of monthly investment. Thus, the fourth area where I see value in mutual fund investments is in systematic investments into non-ELSS equity and balanced funds, especially for small investors.
For large investors, it can probably be argued that they can purchase one or two stocks or more, of Rs 10,000/- or Rs 20,000/- each per month directly in the stock market. For example, we have several clients from whom we have standing instructions to purchase Rs 10,000/- or Rs 20,000/- worth of stocks per week/fortnight/month from our list of about 60 recommended stocks. But what about a very small investor who can only afford to salt away Rs 500/-, Rs 1,000/- or Rs 2,000/- per month? For such persons, there is nothing like a sustained systematic investment into equity/balanced mutual funds.
The value of systematic investment into a diversified equity fund is that with as little as Rs 500/- or Rs 1,000/-, you can purchase a diversified portfolio of stocks through the mutual fund route. It is time to understand the benefits of systematic investment, especially in a fluctuating avenue of investment such as the stock market. So, let me give you a primer on systematic investment.
Systematic investment is a method by which fixed or varying sums of money are invested in one or more avenues of investment at regular intervals. If you examine this definition, you find that it is quite flexible on both the amounts to be invested, as well as the avenues of investment. The only area where there is rigidity and no compromise, is in the "at regular intervals" portion of the definition. This is because the objective of systematic investment is to make investing a habit.
We are used to poor quality systematic investment plans such as recurring deposits into post office or bank recurring deposits. Actually, the greatest benefit of systematic investment is felt when it is made in investments whose values fluctuate. Let me give you an example of the difference between what a normal stock market investor does and how the same strategy would look in systematic investment.
Let us assume that there is a good stock market investor. He is not a speculator. He does the minimum amount of study required, invests in good stocks and does not panic when the stock markets falls. Let us assume he has identified a stock which is currently quoting at Rs 100/- per share in the market. He considers it a good buy and purchases 100 shares, paying Rs 10,000/- for them. Unfortunately, he has made his purchase at the market peak. The market now falls heavily and in 3 months' time, he finds the share quoting at Rs 70/- per share.
This investor does not panic. He examines the new situation. His conclusion is simple. Three months back he found the share attractive at Rs 100/-. Now he finds it quite a bargain at Rs 70/-. So he buys another 100 shares, investing Rs 7,000/- this time. Unfortunately for him, the economy of the country is going into a 2 or 3 year recession. Three years later, he finds the same stock quoting at a miserable Rs 40/- per share. Once again he does not panic, nor does he buy again blindly. By now, he is a shareholder of the company for a little over 3 years and has been receiving the company's annual reports and financial statements.
He concludes that even in a general recession, the company is making some profits and paying some dividends, although the profit and dividend levels are much lower than in the boom time. Now, our investor argues that if this company can keep its neck above the water in the bad times, it should certainly do very well when the next boom occurs. So he purchases a third lot of 100 shares, paying Rs 4,000/- for them. The summary of his investments is as follows:
Purchased 100 shares at Rs 100/- per share, investing Rs 10,000/-;
Purchased 100 shares at Rs 70/- per share, investing Rs 7,000/-;
Purchased 100 shares at Rs 40/- per share, investing Rs 4,000/-;
Therefore, purchased 300 shares totally, for a total consideration of Rs 21,000/-, or an average price of Rs 70/- per share.
Now let us convert the above example into systematic investment. In normal stock market investment, the investor's focus is generally on quantities or numbers of shares to be bought or sold. In systematic investment however, the focus is not on quantities, but on equal amounts at regular intervals. In the above example, Rs 21,000/- has been invested in 3 transactions. To convert that operation into systematic investment therefore, Rs 21,000/- should be divided into 3 equal portions of Rs 7,000/- each.
The rest of the example is the same. You invest the first Rs 7,000/- when the price of the stock is Rs 100/-. You get 70 shares. You invest the next Rs 7,000/- when the price of the stock is Rs 70/-. You get 100 shares. You invest the final Rs 7,000/-, when the price of the stock is Rs 40/-. You get 175 shares. Now when you total this 70 + 100 + 175 shares, you get a total of 345 shares for the same Rs 21,000/- as opposed to 300 shares in the normal investment that you made in the earlier example.
In the systematic investment, you end up holding 345 shares at an average price of approximately Rs 61/- per share, against 300 shares at Rs 70/- per share in lump sum investment. There is no magic in this. It is simple mathematics.
By shifting your focus from a specified quantity of shares to be purchased per transaction, to investing equal amounts at regular intervals, you automatically tend to buy a lesser number of shares when the market is high and a greater number of shares when the market is low. This helps you obtain a favorable weighted average instead of a neutral simple average, as in the first example.
When we buy the same stock or the same kind of investment (for example a particular diversified mutual fund, at different times, we will have a high price at which we purchase the stock or units and a low price. The median point between the high price and the low price will be the simple average. For example, in the first case of normal stock market investment, the high price was Rs 100/-, the low price was Rs 40/- and therefore the mid-point between these two prices, or the simple average was Rs 70/-. Here prices changed, but our quantities remained the same.
However, by using the superior technique of systematic investment, you end up with an actual price of Rs 61/-, which is below the simple average. In short, you have achieved better pricing, by an automatic process, without relying upon research and deep study. Systematic investment always and without exception enables you to get a final purchase price that is below the simple average price of the high and low rates during the period you made the investment. Here prices changed, and the quantities that we purchased also changed in response to the change in prices.
Quantities purchased were greater when prices were down and lesser when prices were up. In real life also, wouldn't we tend to consume or use more of a product when its prices are down? The same common sense is automatically applied in a technique like systematic investment.
To sum up, systematic investment plans (SIPs) in mutual funds are useful because:
1. They enable even a small investor with modest means to make systematic investments with amounts which can even be as low as Rs 500/- or Rs 1,000/- per month.
2. They afford convenience and ease of operation in making the investment. You can give standing instructions to your bank that a certain amount must be systematically invested every month into a certain mutual fund investment plan.
3. Even with very small amounts, you can achieve diversification across all major sectors and stocks. For example, three of the best diversified equity funds in India which invest in the main, large, blue chip companies are the Franklin India Bluechip Fund (from Franklin Templeton Mutual Fund), the HDFC Top 200 (from HDFC Mutual Fund), and the Fidelity Equity Fund (from Fidelity Mutual Fund). One of the best diversified mutual funds which invests in mid and small capital companies is the Sundaram Select Midcap Fund (from Sundaram Mutual Fund). At any given time, the above funds would be investing in something like 30, 50, 80, and 100 stocks respectively. Now, if a small investor is even putting Rs 500/- per month in the HDFC Top 200 through a systematic investment plan, each purchase of this Rs 500/- enables investment in the average of 50 companies that the fund is holding. Such a facility can be obtained only through mutual fund investment.
4. You have heard of diversification across sectors and companies. Systematic investment enables such diversification but also performs another very important function. It enables diversification to be complete. Systematic investment and diversification are very closely related. In fact, systematic investment is a part of diversification. Systematic investment is diversification across time.
5. Systematic investment automatically enables right pricing.
6. Systematic investment makes investment a habit.
There is an old saying in investment: If you work on an investment, it will work for you.
There is another old saying: A winner is not one who never fails, but one who never quits.
Systematic investment in diversified equity funds, especially over the long term achieves and fulfills the spirit of these two sayings.
We conclude this note on systematic investment, by tackling the most important aspect of the risk involved in systematic investment into fluctuating avenues like index or diversified equity funds. Investment in diversified equity funds carries a risk in the short-term. Equity investment is however safe in the long-run. Systematic investment certainly does not eliminate risk. But it definitely reduces risk quite significantly.
The maximum risks in equity indices almost never exceed 50%. In quality portfolios such as the ones recommended in our paper on equity investment, the risk is generally not more than 35%. But in systematic investment, the risk does not exceed 25%, 17%, and 10% in the first, second and third years. Let’s look at an example.
If you have a systematic investment of Rs 1,000/- per month into a diversified equity fund, and you have completed 12 months during which there has been a massive fall in the stock market, your maximum risk will not exceed 25% of the total of Rs 12,000/- that you have invested. 25% of Rs 12,000/- is Rs 3,000/-. This can be the maximum depletion in your investment.
In 2 years, you would have invested Rs 24,000/-. Seventeen percent of this is approximately Rs 4,000/-. This can be your maximum risk in an SIP in two years time, in a worst case stock market scenario.
In 3 years, you would have invested Rs 36,000/-. The maximum risk will not exceed 10% or Rs 4,000/- approximately.
Ever since the modern era of the Indian stock markets began in 1979, we have not seen any risk in SIPs of more than 3 years. Once you start, however, it is good to continue an SIP for at least the equity time horizon of 5 years.
5: SYSTEMATIC TRANSFER PLANS:
This area involves an asset allocation strategy that has been described in Option 3 of our paper on good investment avenues in the Indian equity and debt markets. The strategy is called a 'ZERO RISK SYSTEMATIC TRANSFER PLAN.' It addresses a very important issue that most investors confront, and that is risk in equity investments.
There are many investors who shy away from equity investments because of the risk involved. What they don't realize is that the stock markets have a history of slightly more than 400 years. During this period, not a single stock market system of any country has ever collapsed. On the other hand during the same period, countless banks, including some of the best banks in the world have gone under.
When we talk about risk in the stock market, the so called risk is only in the short-term. History has shown repeatedly that there is absolutely no risk in equity investments in the long-term, especially in a well diversified portfolio of even reasonably good stocks.
What if a stock market investor is given an opportunity to invest in equity without the accompanying risk? This was a question that fascinated us when we started our career sometime in 1985. We then came across many studies worldwide, which established that using an asset allocation strategy which combined both, debt and equity investments, risk could be fine tuned to the level desired by the investor.
You will understand this better with a simple example. Assume that Rs 100,000/- is invested in a safe avenue of investment which gives a return of 5% p.a. Now, 1% of this principal that is Rs 1,000 /- per month is transferred to a reasonably well diversified bunch of stocks. If such a strategy is put in place, there will be no risk to the capital of the investor, regardless of the state of the stock market over any period of time.
Using this strategy therefore, an investor can participate in the market without taking a risk to his capital. The systematic transfer plan (STP) combines all the benefits of systematic investment, and in addition makes use of the asset class of debt, which is non-correlated to equity. Non-correlated means that equity and debt will generally not move together, where their returns are concerned. Short-term debt, which is the safest form of debt, will give low and steady returns. Equity can move up or down in the short-term, but gives higher returns in the long-term. To sum up, the rationale behind an STP can be explained in the following table:
Asset Class Short-term (< 5 years) Long-term (> 5 years)
----------------------------- ------------------------------ ------------------------------
Short-term Debt Safe Safe
Diversified Equity Risky Safe
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What you see above is that debt is safe whether in the short-term or the long-term. Equity is safe in the long-term, but can be quite risky in the short-term. Therefore, the table shows 3 areas of safety and one area of risk. The systematic transfer plan attempts to avoid this one area of risk by placing the corpus available (in our example Rs 100,000/-) in a short-term debt fund and systematically transferring 1% of this corpus per month to an avenue of investment that is safe in the long-term, namely equity. While debt is also safe in the long-term, it should be borne in mind that equity gives far higher returns than debt, in the long-term.
Investing in an asset allocation strategy whereby a corpus is placed in a safe debt avenue of investment, and 1% of the corpus per month is transferred to a diversified equity avenue, is called a "zero risk systematic transfer plan." This discussion brings us to an interesting point. Risk can be of two types. You can have a risk to capital. You can have a risk to return. Let us assume you have invested Rs 1 lakh in equity. After one year, your investment is worth Rs 90,000/-. This is a risk to capital.
Now, let us assume that you have invested Rs 1 lakh in a zero risk STP strategy and another Rs 1 lakh in a resident bank deposit. After one year, the stock market performs very badly. Your STP strategy is worth Rs 1.03 lakhs. Your bank deposit has earned you 9% p.a. and is worth Rs 1.09 lakhs. If you argue that you earned lesser returns of Rs 6,000/- in the STP strategy, the extent to which you earned lesser returns than a competing avenue of investment, is your risk to return. This example is given for illustrative purposes only, as an STP strategy involving debt and equity is totally different from a pure debt investment like a bank deposit.
Over period of 5 years or more, STP strategies have repeatedly proved that they will give higher returns than most other avenues of investment, without taking a risk to capital. Hence to earn higher returns in a longer time frame, it is worth taking a risk to return. First time investors in the stock market would certainly do well to avoid a risk to capital at all costs.
There are many risk-averse investors who do not mind a short-term risk to return, if they can be compensated by long-term returns which will beat almost all other avenues. Their main fear is of a risk to capital, not a risk to return. We fully support any investor who does not want to take a risk to capital. As Warren Buffett put it so beautifully: "The first rule of investing is: do not lose. And the second rule is: do not forget the first rule. And that's all the rules there are."
The zero risk STP has one other outstanding feature. At any time during the period of your investment, if the stock market falls by more than 25% from its last peak and remains below this level for at least a month, then we advise you to double your monthly systematic transfer from Rs 1,000/- to Rs 2,000/-. Generally, you get a chance to do this at least once in a period of 5 years. If you do avail of this opportunity, it can substantially enhance your returns.
As things stand in India at present, zero risk systematic transfer strategies are designed to quadruple your money in a period of 10 years, even if you do not get an opportunity to double your systematic transfer when the markets fall by 25% from their peak. If you do, the returns will of course be higher.
Viewed from any angle, the zero risk STP remains one of the best strategies in mutual fund investment. Its value lies in first, enabling a risk-averse investor to invest in the stock market without taking a risk to capital. Second, while capital is protected, returns are not compromised. Third, there will generally be an opportunity to substantially increase your returns when the markets descend 25% or more from their last peak.
6:INVESTMENTS:
The definition of a mutual fund is that it is a common pool of money to which investors contribute, for investment in accordance with a stated objective. Therefore, mutual funds are not limited only to financial assets such as equity shares, government bonds, corporate bonds and other debt instruments. Mutual fund plans can also be formulated to invest in real estate, bullion, other precious metals, derivatives and so on.
When we study the history of investments, we find that where long-term, investment-beating and wealth-enhancing returns are concerned, the only two worthwhile avenues of investment are equity and real estate. Since real estate requires a lot of capital and considerable expertise, real estate mutual funds can offer a good alternative for investment. Similarly, there are certain asset allocation funds which rebalance between various types of assets on a periodical basis.
For example we can have a fund that follows Benjamin Graham's 50:50 rebalancing strategy. To understand this strategy, let us assume that the mutual fund has a corpus of Rs 2 lakhs. Rs 1 lakh is invested in let us say the Nifty Index and the other Rs 1 lakh is invested in a liquid fund, thereby maintaining a 50:50 balance between debt and equity. Let us say 6 months down the line, the debt component has grown to Rs 1.04 lakhs and the equity component has grown to Rs 1.10 lakhs. The total portfolio value is now Rs 2.14 lakhs. To maintain a 50:50 balance now, there should be Rs 1.07 lakhs in debt and Rs 1.07 lakhs in equity.
So, the fund now shifts Rs 3,000/- from equity to debt, in order to realign itself to the 50:50 balance. Such a fund would certainly be worth investing in, especially if it has a regular programme for rebalancing its portfolios at fixed intervals of say 6 months or a year. Regular rebalancing is perhaps the finest way of investing. It takes care of all normal questions of an investor like when to invest, where to invest, when to book profits, what is the quantum of profits to be booked, etc.
To conclude, real estate mutual funds and certain clear cut asset allocation and rebalancing funds are definitely to be considered in the overall investment portfolio of an investor.
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