Monday, December 29, 2014

Index funds - a good idea for a first time equity investor

My article on Index Funds in Gujarati Mid-day, Mumbai edition

The English translation is as under:

Top of Form
Index funds
“What do you suggest for a first time investor in equity markets?”
One has seen many a first-timers start with penny stocks – the stocks of small companies quoting below Rs. 10. Some of these investors lose money, have a bad experience and then pledge never to return to equity markets. Some others make money in the short run and learn incorrect lessons – for example, some become overconfident about their skills. Some others lose money in the beginning, but learn the right lessons – by paying too high a fee to the ultimate teacher – the stock market. All these experiences are avoidable.
Someone entering the equity markets for the first time would be well advised to take the mutual fund route, learn about investing and then, if at all, try hands at stocks. However, even within the equity mutual funds, there are too many choices and it becomes difficult for one to make a good selection.
That leads to another set of questions: “Which fund manager is better?” “What if a good fund manager turns out poor performance?” well, to make things simpler, one may consider investing in an index fund. In this way, there is no question of selection or fund manager performance. How does an index fund work?
An index fund is designed to track the movement of a market index. This makes it easier for an investor to track the portfolio performance. For example, a fund tracking the popular index Sensex would move in line with the movement of Sensex. If Sensex moves up by 10%, the fund’s NAV should also move up by around 10%. We mentioned the word “around” in the previous line, since there would always be some difference between the performance of the fund and the index. This difference is called “tracking error”. A good index fund would have low tracking error.
Though there are many factors contributing to the tracking error, one important factor is the expenses charged by the mutual fund company.
SEBI has prscribed limits beyond which a fund cpompany cannto charge the scheme. For index funds, the ceiling of expenses is lower than than the actively managed schemes. The reason for this is simple: in an index fund, there is no role of a fund manager in selection of securities to buy/sell or the timing of such decisions.
An index fund could track a popular index like Sensex or Nifty, or it could track a wider index like S&P 500. We also have index funds tracking an industry – Bank Index or a PSU Bank Index. There are funds in the Indian market that help investors invest in international markets, e.g. NASDAQ, Hang Seng, etc. In developed markets, there are index funds tracking even the bond indices.
Today, with the available variety in this segment, an investor can conveniently and cheaply get exposure to variouis different segments of the market or different markets.
While selecting an index fund, one should consider the following points:
1.     The index being tracked,
2.     Tracking error of the fund – this indicates how the scheme has been managed in the past – lower the better
3.     Expense ratio – this would contribute to the future tracking error – lower the better
There is no need to look at any other factor while selecting an index fund.
In the end, let us consider the question regarding out- or under-performance. Will an index fund generate superior returns over actively-managed funds? The answer is very clear. The index is nothing but an average and an average will always generate average performance.
There will always be some funds that will do better than the index. The problem is that it is almost impossible to identify future winners in advance.
Amit Trivedi
The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.

Bottom of Form

Seven point prescription for investors in 2015 - my article on

This is again that time of the year when the business and investment world considers doing the following:
1. Looking back at the year gone by 
2. Preparing a list of resolutions for the coming year
3. Predicting what lies in store in the coming year

Let us also indulge into the same exercise.

Read on ...

Monday, December 15, 2014

Balanced funds - a good option for a first time investor

My article in Mumbai edition of Gujarati Mid-day today

The English translation is as under:

“What are balanced funds? I heard an expert recommending these funds for a conservative investor.” Someone asked. “As the name suggests, such funds should be expected to maintain balance. Am I correct?”
Well, a balanced fund should be understood as a hybrid fund that invests larger portion in equity and some in fixed income securities. The word “balanced” might have been used as in the beginning one would have tried to maintain equal allocation to the two assets, viz., equity and fixed income. However, later on, the allocation changed due to changes in the Income Tax Act (the Act).
As per the Act, a fund is categorized as an equity fund if at least 65% of the fund’s assets are invested in equity shares listed in India. Equity funds enjoy better tax treatment as compared to the other categories. Due to this, the balanced funds invest more than 65% of the fund’s assets in equity shares.
Having said this, these funds are still less risky as compared to the equity funds and hence the same might be a good starting point for a new investor. Let us look at the performance of these funds, especially when the equity markets fell.
We looked at calendar year data of performance of scheme categories – these numbers are added for all schemes in a particular category.
In the last 10 years, there were two calendar years in which equity markets fell: 2008 and 2011.
BSE Sensex fell by more than 52% in 2008 and by more than 24% in 2011. In these two years, the balanced fund category lost 37.14% and 15.41%, respectively as compared to equity multicap funds category, which lost 53.90% and 24.60%, respectively.
As can be seen, the balanced funds lost much less than the pure equity funds in the falling markets. However, in rising markets, equity funds did better than balanced funds in 7 years whereas balanced funds outperformed the equity funds in 1 year.
Thus, we can see that in the rising equity markets, balanced funds do not rise as much as the equity funds, but they provide reasonable protection in falling markets.
It is this characteristic of the balanced funds that make them suitable for a beginner. The equity allocation provides potential of capital appreciation, debt provides cushion against steep fall and classification as equity funds result into better tax-efficiency.
Coming back to the numbers, it is important to note that these funds may also exhibit steep fall in value as can be seen from the performance in the year 2008. Balanced funds as a category fell by as much as 37% during the year. This is quite a steep fall by any standards. Hence, one should not expect these funds to provide complete protection when the markets fall. Even in 2011, when the Sensex fell by roughly 25%, balanced funds lost around 17% for the year.
However, there is a hidden benefit here. When the markets fall, the equity allocation loses value, but the debt allocation would not. This results into the equity allocation being lower than what one started with.
Let us say, the scheme started with Rs. 70 allocation to equity and Rs. 30 to fixed income. After a year, equity had lost 25% and fixed income had earned 9%.
This means, the year-end values of equity and fixed income allocations would be Rs. 52.50 and fixed income allocation would be Rs. 32.70. This means the equity allocation is below 65%. In order to maintain the fund’s status as an equity fund, the equity portion needs to be increased. This can be achieved by selling some part of fixed income component to buy equity. This process is also known as rebalancing.
This rebalancing results into the fund buying equity when the prices are low.
Balanced funds are good for beginners. However, as explained, one must understand the limitations of the same. Some of the biggest limitations would be:
1.     In rising markets, balanced funds may underperform equity funds
2.     In falling markets, the NAV of balanced funds may fall, though not as much as equity funds
3.     Long term returns from balanced funds could be lower than equity funds, if equity markets exhibit a long term rising trend.
Happy investing.
Amit Trivedi
The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.

Monday, December 1, 2014

SWP - part two

This article, second of the two articles on the subject, explains two important features of SWP:

  1. Tax benefit, and
  2. Impact of NAV fluctuations on the withdrawals
Happy reading ...


English translation is as under:

Last time, we talked about a convenience offered by mutual funds for those seeking regular income. In that article, we also mentioned the following words of caution: “… please consider this discussion only in the context of liquid and short-term debt funds and no other categories. “
Why is such a caution required? To answer this question, we have to understand how mutual funds work.
A mutual fund is a pooled investment vehicle, which means small amounts are pooled from a large number of investors to create a big corpus. This means, there could be differences between the investment horizons of various investors. Some may invest for a short period, while some may invest for a longer time.
One of the benefits of investing in open-ended mutual funds is the liquidity – any investor can enter the scheme or get out of it on any working day. However, this also means that at all times, there could be three different categories of investors: (1) those entering the scheme, (2) those exiting the scheme and (3) those old investors staying with the scheme.
It is also important to ensure that all the investors get a fair price at all times. This is why the buy and sell transactions in a mutual fund scheme happen at NAV – the Net Asset Value, which is calculated in a transparent and fair manner to be as close as possible to the realizable value.
This NAV is a function of the market value of securities in which the fund has invested. These market prices may fluctuate on a daily basis. Due to this, the mutual fund schemes witness fluctuations in the NAVs.
It is important to understand the above in order to understand why we recommended SWP of fixed amount in a liquid or ultra-short term fund. These categories of funds exhibit very low NAV volatility.
Now, let us go back to the basic objective behind setting up a SWP – it is for an investor who is seeking regular income from the investments. These regular withdrawal transactions, as we saw earlier, happen at the NAV linked prices. Let us see what happens in the below mentioned hypothetical case:
Amount withdrawn
Units redeemed
Rs. 10,000
Rs. 15
Rs. 10,000
Rs. 13
Rs. 10,000
Rs. 14
Rs. 10,000
Rs. 16

As can be seen from the above table, at the NAV of Rs. 14, the investor had to redeem 714.286 units, as compared to 625 units when the NAV was Rs. 16. Lower NAV meant withdrawal of more units. Now, if the NAV was constantly growing, such a situation may not pose any trouble. However, fluctuating NAV would mean that at lower prices, one might end up withdrawing more units. This would hurt when the NAV starts to recover after a fall.
While SWP is a good facility, one must also understand its limitations.
From a limitation, let us move onto a benefit of SWP. This might be the favourite of all – Tax efficiency.
Let us assume that an investor has Rs. 1.50 cr to invest and needs regular income of Rs. 12 lacs per year.
If one were to get such income through investment in traditional interest bearing investment option, one would get into the highest income tax slab. Interest income is added to one’s income and taxed at the marginal rate applicable at the respective income level.
On the other hand, let us consider SWP for such an investor. In case of SWP, as we saw in the table earlier, there is a redemption of units. When a unit is redeemed, the amount received consists of two components – principal invested as well as earnings thereof.
Let us say, the investment was made when the NAV was Rs. 12. As per the table above, the first withdrawal happened at NAV of Rs. 15.
Each of the units thus withdrawn was purchased at Rs. 12. The same was redeemed at Rs. 15. Hence, there would be a profit of Rs. 3 per unit. As can be seen, the amount of Rs. 15 has two components: Principal value of Rs. 12 and profit of Rs. 3. Thus, in this case, while the investor gets Rs. 15 per unit, the taxable component is only Rs. 3 – the profit. Principal withdrawal is non-taxable.
Each transaction might have a different combination of principal and profit, which one needs to carefully calculate. However, while interest income of Rs. 12 lacs a year would attract good amount of tax, SWP would result into a much lower taxation.
SWP will not help you get rid of the tax completely. However, it is a tax-deferral scheme. Each Rupee of deferred tax allows one to earn till the time the tax becomes payable. Evaluate your situation and consider the options very carefully.
(The author is not a tax-practitioner and hence one would be advised to consult a tax adviser for further details.)
Amit Trivedi
The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.