Share Market

A common myth about mutual funds is that any reputable fund will perform well and fetch returns according to investor’s expectations, or even exceeding them for some of the investors. However, not all funds are created equal. When one buys a mutual fund, one has to pay some various kinds of charges.

All funds charge investors for expenses, which include management fees and other costs of doing business, such as legal charges, accounting charges, marketing expense, etc.. Those fees are expressed in a term known as the annual expense ratio — the percentage of assets that go toward operating a fund. These expenses are subtracted directly from a fund’s assets. The higher the ratio, the less is left over for an investor.

S&P recently did some research evaluating the performance of low-cost funds vs. that of the higher-costs funds. In eight out of nine categories, the low-cost fund outperformed their higher-cost counterpart. The average low-cost fund outperformed the typical fund by an average of 20 percent.

In order to see how much it affects mutual funds returns, let’s compare a few different domestic stock mutual funds:

Fund A: A Total Stock Market Index Fund which charges no sales load and has an annual expense ratio of 0.15%.

Fund B: An actively managed Mutual Fund with a 5.75% sales load and an annual expense ratio of 0.59%.

Fund C: An actively managed Mutual Fund with no sales load and an annual expense ratio of 2.03%.

In other words, Fund A is no-load, with low costs. Fund B does charge a sales load, but it has fairly low annual costs. And Fund C charges no sales load, but it has substantially higher annual costs.

Assume that you invest Rs. 10,000 in each of these funds and that over the next 30 years the market earns a 9% annual rate of return, the investor in each fund would end up with the following amounts:

Fund A: Rs. 127,307

Fund B: Rs. 106,258

Fund C: Rs. 75,485

An investor in Fund A would have almost 70% more money than an investor in Fund C. This example shows that costs really do matter!

Hedge funds are generally regarded as non-traditional funds that posses different characteristics and utilize different investment strategies from traditional funds. There is no standard definition of a hedge fund, but most industry insiders would agree on the following key points:

• Non-institutional and evolutionary nature

• Incentive based compensation

• Absolute return or non traditional market correlated return

• Superior risk adjusted returns

There are a number of different classifications of hedge funds. Some simultaneously buy stocks that are thought to be undervalued while selling short (selling stock not actually owned yet) other stocks thought to be too expensive. Other hedge funds seek out complex strategies on borrowing money in one currency to buy fixed income investments in other currencies.

In every strategy, the process is opaque. Each hedge fund manager claims to have a special talent and insight into the process of investing that they utilize. Disclosure of investments and the costs of investing are poor.

In addition, trying to determine whether hedge funds are good investments is difficult. Funds that do poorly and close (estimated by some at 20% of all hedge funds yearly) are removed from the databases that track fund performance-lending to what is called subtraction bias. If only the funds that do well are left to monitor, the results are falsely tilted as showing good performance as an asset class.

Hedge fund fees are very high. The standard fee is known as “2 and twenty.” This means that the yearly fee is 2% of all assets under management plus 20% of all profits.” The 2% yearly fee is charged regardless of fund performance, and the 20% of profits only are assessed on profitable years. Some funds won’t charge the 20% of profits until prior losses are made up. However, remember that almost 1/5th of funds close each year-suggesting that in many cases investors pay their 2% in fees only to lose money.

Like the rare actively managed mutual fund, some hedge funds markedly outperform the “markets.” These funds are news for that very reason-they are unusual. Much as is the case with the mutual funds, knowing which hedge funds will do well in advance is impossible.

Most hedge funds are not registered with the SEC. For this reason, they are only open to investors with a large amount of assets and/or income who sign appropriate waivers. Brokerage houses have attempted to get around these barriers by packaging “funds of funds” in which a mutual fund composed of various hedge funds is packaged in smaller chunks for the “average investor.” Unfortunately, another layer of fees is now added to the already extraordinary cost of the underlying hedge funds. You don’t have a chance to do well.

With changing economic conditions, one has to plan his investments properly to have a contended life. Unforeseen expenses and future uncertainty could be unmanageable and thus investments have become a fundamental requirement for all of us.

Mutual Funds, being a good opportunity of investment have become very popular in the recent past. Mutual Funds are the portfolio of stock market shares and collection of other financial products, run by Government trusts, public and private financial institutions. The money is collected from various investors and the capital raised is then invested in various options like gold, bond, equity etc

Mutual funds vary in their investment objectives, thus providing you with the suppleness to create an investment plan based on personal financial goals. Investment experts advise growth investments such as equity funds and stocks as a good choice for funding needs that are five years or more away, income funds to fulfill medium-term needs and liquid funds for short-term requirements.

Now let us have a look at the advantages and disadvantages of investing in Mutual Funds.

Key Advantages:

Convenience- In case of most mutual funds, buying and selling shares, changing distribution options, and obtaining information can be easily done by telephone, by mail, or online. Still, investors should always read the prospectus carefully before investing in any mutual fund.

Diversification- The risk is spread out by owning shares in a mutual fund instead of owning individual stocks or bonds,. The diversification helps to invest in a large number of assets so that a loss in any particular investment is minimized.

Professional Management: Mutual funds are managed and supervised by investment professionals. The mutual fund manager decides when to buy or sell securities. This eases the investor’s job and he gets a full-time manager to monitor his investments.

Low initial investment- Since, a mutual fund buys and sells large amounts of securities at a time, its transaction costs are very low.

Key Disadvantages:

Professional Management- Many investors are unsure about the performance of their fund managers. And, even if the fund loses money, the manager still takes his commission.

Costs – Tough financial jargons are associated with hidden costs! It is very difficult for general public to understand properly, what they are actually paying for!

Dilution – Dilution is the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.

Taxes – Your personal tax situation is not considered by the fund managers, when making decisions about your money.

Like picking up the right kind of fund, we should also know the right time to sell them off! Here, we would learn when we should sell our Mutual Funds.

Fund doesn’t meet its objective

When we buy a particular fund, the objective says a lot about how the fund plans to invest. If the objective is not being met, it is one of the depart points worth considering.

Poor performance

If a fund is not performing well in the long run, we must sell it off. Here, we are talking about relative performance and not absolute performance. A short-term observation cannot tell us about the actual performance of the fund. It could lead to committing hara-kiri.

A change in investor’s life stage

Our needs differ with our changing life stages. What we would like to have as a return, when we are young may not be similar to what we would need as we would age. Similarly, a young investor may be quite ready to take up risks than an elderly person, who is probably retired! So a change in life stages would be one such reason to consider switching into a fund that matches with one’s needs.

A major change in any fundamental attribute of the fund

Changes like a change in Asset Management Company or in investment style of fund or change of structure say from closed-end to open-end etc. are likely to affect the performance of a fund. In that case, we should make up our mind to make an exit. . Even SEBI has provided for an exit route being made available to the investors.

The Fund’s Expense Ratio Rises

If the Mutual Fund’s Expense Ratio rises significantly, we might be under loss. It would be the right time to sell the fund.

Change in management

If your fund manager has changed and you are not quite satisfied with the new management, you could consider in selling off the fund. However, if it is an actively managed fund, then has to keep the eyes on the new manager.

Good earning/returns

If you are happy with your returns, in short term, do not wait to sell the fund. It is not advisable to spend more time and wait for more and more returns, once you have gained enough.

We are all familiar with the adage “No Risk, No Return!” However, imprudent investing or investing without sound financial knowledge leads an investor to “All Risk and No Return” situation. Mutual Funds help an investor who does not have expert technical knowledge about the financial market to reap the benefits of excess returns, than risk-free assets, obtained from investing in the financial market. However, mutual funds are not risk free and investors are subject to both systematic and unsystematic risks. According to Adam Smith, investors are rational animals. That is, they do not accept more risk for the sake of it and they’ll do so only if compensated by higher expected return.

The risk a security arises because actual return may turn out to be different from expected return. The expected return is usually estimated from past prices and from additional non-price information (if any). Usually the standard deviation of past returns is used to estimate risk.

A portfolio of securities is a combination of more than one security. Hence a mutual fund can be considered to be a portfolio. The (expected) return on a portfolio of securities is the weighted average of (expected) returns on individual securities. However the risk of a portfolio cannot be computed with the weighted average of standard deviation of individual stocks because the stocks co-vary with each other.

For example, lets consider a mutual fund has investments in 2 securities in the proportion of ‘a’ and ‘b’, whose expected returns are X & Y respectively. Also ?X and ?Y are the risks of stocks 1 & 2. Then the risk of the portfolio can be calculated by

Due to some degree of covariance between any two stocks, the risk of the portfolio is usually less than the weighted average of risks of individual stocks. That means, a portfolio of equities is usually less risky than a single equity. That is, risk can be minimized by including larger and larger number of stocks in the portfolio. Hence diversification reduces risk, helping investors to achieve their return objectives.

All mutual funds have a stated investment mandate that specifies whether the fund will invest in large companies or small companies, and whether those companies exhibit growth or value characteristics. It is assumed that the mutual fund manager will adhere to the stated investment objective. When investing in mutual funds, investors make two critical assumptions: 1) that skilful managers exist, and 2) that they have the ability to recognize them.

By analyzing the sector weights of a fund and the fund manager’s attributions to performance, an investor can better understand the historical performance of the fund and how it should be used within a diversified portfolio of other funds.

Sometimes fund managers will gravitate toward certain sectors either because they have deeper experience within those sectors, or the characteristics they look for in companies force them into certain industries. A reliance on a particular sector may leave a manager with limited possibilities if they have not broadened their investment net. The investor must compare the fund to its relevant indexes to determine where the fund manager increased or decreased his allocation to specific sectors relative to the index. This analysis will shed light on the manager’s over/underexposure to specific indexes (relative to the index) in order to gain additional insight on the fund manager’s tendencies or performance drivers.

An investor can also break down the portfolio into market cap groupings and determine whether the fund manager is particularly skilled at picking companies with certain size characteristics. In order to determine whether a fund manager is actually adding any value to performance based on asset allocation or stock picking, an investor needs to complete an attribution analysis that determines a fund’s performance driven by asset allocation versus performance driven by stock selection. Attribution analysis, for example, can reveal that a manager has placed incorrect bets on sectors but has picked the best stocks within each sector.

Statistical measures like Tracking error, which is which is the volatility (standard deviation) of excess return is also used to analyze risk. All things equal, the less volatile the excess returns the greater the chance the manager is skilful rather than lucky. Tracking error is used to calculate a risk-adjusted measure of performance called the “information ratio.” The information ratio is the annualized excess return divided by the tracking error.

These days between work, family, and friends, most of us do not have the time to make or monitor personal investment decisions on a regular basis. Mutual funds have competent professionals who do all this for you. This is the reason why, the world over, they have become the most accepted means of investing.

Mutual funds curtail risk by creating a diversified portfolio while providing the essential liquidity. Additionally, you benefit from the expediency of not having to bother with too much paperwork or repeat transactions. It is our belief that investors vary in their investment needs based on their individual financial goals.

There are six key things someone needs to evaluate when considering a mutual fund:

1. Performance

2. Fees

3. Turnover

4. Manager Tenure

5. Key Holdings

Performance

• Track record: how did the fund perform over the last Year, 3yrs and 5yrs.

• How does the fund rank & compare to others in its sector.

• How did the fund do when compared to what is known as “the benchmark.”

Fees

How much you have to shell out in terms of the fees involved in a particular fund.

Turnover

This deals with the amount of trades the fund manager is doing per year. 100% turnover means during the year he or she changed the entire portfolio to a new set of stocks. Some funds have very high turnover, 200% is not completely uncommon. It means every time the fund manager makes trades, you are incurring the TAXES. Many people hold funds with high turnover in their “non IRA” accounts which makes no sense, because you are then paying taxes unnecessarily. Those funds with high turnover should be in IRA accounts to reduce taxation. Taxes eat away returns and failure to not address this only means less money in your pocket year after year.

Manager Tenure

It may happen that everything looks good: performance is strong, fees are low, low taxes, looks great. Investors put money into the fund and they get slaughtered. How can that happen? One of the more common ways is that the investor didn’t know to check to see who the fund manager is. One very popular fund had a great track record for 10+ years. The fund manager left, a new guy came in and the next year was a disaster. Knowing your Fund Manager is a key commandment in the world of picking mutual funds.

Key Holdings

People invest in mutual funds to get diversification, but often, funds have significant “overlap” in their holdings. For true diversification, you should at least check to see what the top 10 holdings are. Imagine investing in 5 mutual funds thinking you are diversified, only to later find out that all 5 funds have very similar holdings. And thinking you were diversified, the market tanks and all of your holdings drop. Checking holdings is a very important factor in selecting the portfolio of funds.

A debt fund is an investment pool, such as a mutual fund or exchange-traded fund, in which core holdings are fixed income investments. A debt fund may invest in short-term or long-term bonds, securitized products, money market instruments or floating rate debt. The fee ratios on debt funds are lower, on average, than equity funds because the overall management costs are lower.

The main investing objectives of a debt fund will usually be preservation of capital and generation of income. Performance against a benchmark is considered to be a secondary consideration to absolute return when investing in a debt fund. The different types of Debt Funds are given below:

1. Monthly Income Funds – These are funds that primarily invest in debt instruments, and try to give investors a monthly income in the form of dividends. The income is not guaranteed of course, and they only pay out a dividend if they are profitable for that time period. This type of a debt fund is for people who have a big corpus initially, and would like to generate a monthly income for them with low to moderate risk.

2. Capital Protection Plans: These are debt instruments that guarantee your capital, and then invest a portion of the funds in equity in the hopes of generating excess returns.

3. Gilt Funds: They invest in government debt viz. the debt issued by Reserve Bank of India on behalf of the government. They also invest in securities issued by state governments. Gilt funds can be short term gilt funds, or long term gilt funds. The short term Gilt Funds are meant for people looking to invest their money for shorter durations of say 3 – 6 months.

4. Fixed Maturity Plans (FMPs): FMPs are quite similar to fixed deposits in the sense that these funds are usually close ended, which saves you from interest rate risk, and even if rates move upwards the fund NAV doesn’t go down. They provide a sort of a tax advantage where interest on fixed deposits is charged at a higher tax rate than dividends from FMPs.

5. Liquid Funds: These are funds that are used by investors for extremely short time durations, and in most cases instead of a savings account.

6. Floating Rate Funds: These are funds that invest in predominantly floating rate debt instruments, and can invest in government and corporate securities.

Index funds are a type of mutual fund with a portfolio constructed to match or track the apparatus of a market index, such as the Standard & Poor’s 500 Index (S&P 500), BSE Sensex, or the NSE 50 (NIFTY). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

An Index Fund holds all of the securities in the index, in the same proportions as the index. For Example, if there is an Index Fund replicating the BSE Sensex; it will invest in all those 30 securities that make the Sensex. Its feat is then expected to mirror the Sensex and the NAV will amplify when Sensex rises and vice versa. Other schemes include statistically sampling the market and holding “representative” securities. Many index funds rely on a computer model with little or no human input in the decision as to which securities are purchased or sold and is therefore a form of passive management.

Economists cite the efficient-market hypothesis (EMH) as the fundamental principle that justifies the creation of the index funds. The hypothesis implies that fund managers and stock analysts are continually looking for securities that may out-perform the market; and that this competition is so effective that any new information about the fate of a company will quickly be incorporated into stock prices. It is postulated therefore that it is very tricky to tell ahead of time which stocks will out-perform the market. By creating an index fund that mirrors the whole market the inefficiencies of stock assortment are avoided.

Synthetic indexing is a modern technique of using a combination of equity index futures contracts and investments in low risk bonds to copy the performance of a similar overall investment in the equities making up the index. The bond portion can hold higher compliant instruments, with a trade-off of corresponding higher risk, a method referred to as improved indexing.

The advantages of Index Funds are given below:

• Low Costs – Because the composition of a target index is a known quantity, it costs less to run an index fund.

• Simplicity – The investment objectives of index funds are easy to understand.

• Lower Turnover – Because index funds are passive investments, the turnovers are lower than actively managed funds.

• No style Drift leading to accurate portfolio diversification.

Systematic Investment Plan (SIP) is a way of investing specifically designed for those who are interested in building wealth over a long-term. It is useful for those who want to get their investments going, but don’t have a large sum of money to invest at one particular point of time. The cardinal rule of building your corpus is to stay focused, invest regularly and maintain discipline in your investing pattern.

In developing economies like India, where securities markets (equities and fixed income instruments) can be volatile and it is rarely possible to time the markets and predict the future. We can seldom accurately predict when a particular stock will move up or where the interest rates are headed. Systematic Investment Plan makes the volatility of the securities markets work in your favor. Since the amount invested per month is a constant, the investor ends up buying more units when the price is low and fewer units when the price is high. Therefore, the average unit cost will always be less than the average sale price per unit, irrespective of the market rising, falling, or fluctuating. This concept is called Rupee Cost Averaging (RCA). With a sensible and long-term investment approach, rupee cost averaging can smooth out the market’s ups and downs and reduce the risks of investing in volatile markets.

So, how does one decide when is a good time to start investing in a SIP? The answer is simple. Anytime is good if one can maintain the discipline of making regular monthly investments.

Let’s look at an example where an investor started at possibly the worst time in the recent history of our markets – February 2000 – at the peak of the dot-com bull market. He started investing Rs. 1000 every month in a composite fund and continued investing till Sep 2008.With the hindsight knowledge of the huge fall from the dot-com/technology driven high of year 2000, it’s a good bet that nobody would have advised the investor to start a SIP at that time. But he still had annualized returns of 29% compounding even after starting just before the market crashed! 2001 to 2003 was a sticky bear market. But that meant that the investor was actually buying units of the mutual fund at very low prices. His patience and discipline got rewarded when the market finally took off in 2003.