Sunday, February 28, 2016

What to see while selecting a liquid fund to invest in ...

What should one consider while selecting a liquid fund? Read my article in Mid-day Gujarati edition on 22nd February here ...

The English translation is as under:

Sometime ago, we saw what to look for if one wants to compare two or more different equity funds. Today, we will discuss how to choose a liquid fund (or ultra-short term bond fund – most retail investors may be fine with the latter and in this article, we will use a common term “liquid fund” for both these categories). In order to decide on the selection criteria, it is important to first identify the objectives for parking money in a liquid fund.
Primarily, there are three reasons why people use liquid funds, (1) as a contingency fund, (2) to park money which would be used for some expenses in the short term, or (3) to temporarily park money meant for investment in equity funds later (at an opportune time or through systematic transfer).
To begin with, let us understand one thing common in all the above objectives: one is looking at (1) safety of capital and (2) easy and convenient liquidity. If the returns are high, it is an additional benefit, but not the primary purpose for investing in liquid funds.
Let us first look at the third of the three objectives listed above, “to temporarily park money meant for investment in equity funds later (at an opportune time or through systematic transfer).” In this case, the objective is to earn higher returns through equity investment. The liquid fund is used only for the purpose of temporary parking. The question here is not about selecting a liquid fund, but of selecting an equity fund. Once you have done that, you need to invest in the liquid fund of the same fund house to enable smooth transfer whenever required. You need not spend too much time on selection of the liquid fund in such a case.
That leaves the first two objectives of putting money in liquid funds. In both cases, the critical point is to get the money as and when needed, without loss in value. Hence, the critical factors to evaluate the schemes should be (1) safety, (2) convenient liquidity, (3) ease of transaction, (4) timely and hassle-free credit of the money in your account when needed.
Let us start with evaluating safety in a liquid fund. We have highlighted earlier that mutual funds are structurally superior to most products on this count. However, even within that, different liquid funds may have different risk levels.
First of all, liquid funds invest predominantly in debt and money market securities issued by companies and banks. These corporate papers carry a risk that the companies may default on their commitments. In such a case, it is wise to check the credit rating profile of the funds. The second thing you need to look at is the average maturity of the portfolio. The lower the average maturity, the safer the fund. You must check this in case of ultra-short term bond funds, but need not worry about the same if you are investing in a liquid fund. In case of liquid funds, SEBI regulations do not allow the fund to invest in any paper having maturity beyond 90 days.
Points no. 2, 3 and 4 would be almost the same for all the funds, except you may want to be doubly sure that the fund does not have any exit load even for a very short period. Since you are investing for an unknown period, exit load may be avoided. You need to check the exit load only at the time of your investment, as the same is applicable for all prospective investments and not on retrospective basis.
Many fund houses these days offer SMS based or App based transactions. These allow extra convenience as you can seamlessly transfer money from your bank account (if registered for the same purpose) to the fund and vice versa.
One more thing, expenses matter in case of liquid funds. Check the expense ratio before investing.
Liquid funds are the easiest products among the mutual funds to understand and benefit from.
So go ahead, and make use of these funds when you have surplus money to be parked for short periods.
-        Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

Monday, February 8, 2016

Equity investments simplified - chat transcript - 8th Feb, 2016

Here is the link to the transcript of the chat

Equity investments simplified

Understanding risk-adjusted returns

How do you know whether you are compensated enough for the risk taken? Read my article to find out ...

The English translation is as under:

Risk-adjusted returns
Last time, we saw standard deviation and beta as measures of risk to compare two or more equity funds. These parameters measure the risk of volatility involved in the equity funds. This volatility could be on account of various factors. However, in most cases, the fund managers take the risk of volatility with an objective to generate high long term returns.
In such a case, it may not be proper to look at returns or risk in isolation. It would be prudent to see if the risk has been duly rewarded or not. Did the fund manager succeed in generating high returns for taking on higher risk?
Investment managers evaluate this question through what is known as “risk-adjusted return”. There are various ways to measure this parameter. The most popular among these is known as “Sharpe ratio”, named after Economist William Sharpe.
Assume there is an investor, who does not want to take any investment risk. Such an investor would have to be satisfied with “risk-free” rate of return. However, in order to earn higher than the “risk-free” rate, one will have to take some risk. Since we are discussing equity funds (a well-diversified equity portfolio) here, the only risk to consider is volatility. Now, by investing in equity fund, the fund manager has taken the risk of price volatility or fluctuations. Is he able to get returns higher than the risk-free rate? If yes, how much? This is what Sharpe ratio captures.
The equation for calculation of Sharpe ratio is as under:
Sharpe ratio = (portfolio return – risk-free rate) / standard deviation of the fund
Higher Sharpe ratio is considered to be better than a lower ratio, as the fund manager rewarded the investors for the risks taken.
As can be seen from the above equation, the excess return generated by the fund is in the numerator, whereas the standard deviation (as we saw last time, standard deviation is a measure of volatility – higher SD means higher risk) is in the denominator.
Higher standard deviation would reduce the Sharpe ratio. So, if the fund manager who takes higher risks gets a lower score. Similarly, higher returns would increase the Sharpe ratio. Thus, someone who can generate higher returns by taking lower risk would have a better Sharpe score compared to others. However, someone generating higher returns by taking high risk might get a similar score as someone who generates lower returns by avoiding risks.
Let us also understand that the numerator is excess return over risk-free rate and not just the return generated by the fund. Even if the fund has generated positive but less than risk-free return, the Sharpe ratio would be negative. This also means that the fund manager could not even generate risk-free returns in spite of taking the risk. Due to this, Sharpe ratio is not always the best indicator since when the overall market is down, most equity funds would also deliver negative or low returns. In such a case, the Sharpe ratio would be negative. Please do not judge this as incompetence of the fund manager. It would be prudent to compare two similar funds on this scale rather than looking at the Sharpe ratio of one fund and arriving at a conclusion.

-        Amit Trivedi
The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.