If you choose right, mutual funds sahi hai ...

In the last article, we saw that many investors are flocking to mutual funds since the interest rates on fixed deposits have come down. So often, the investors do not understand the risks and invest in equity related mutual fund schemes, while shifting money out of fixed deposits, where the risk levels are very different.

Someone wrote to us asking if the money may be shifted from fixed deposits to debt mutual funds. Good idea. Both debt mutual funds and fixed deposits may appear to have similar risk profile as both are debt assets. However, it would be important to understand whether such an assumption is safe enough. ...

Click on the link below to read my article on this subject
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The English translation is as under:

In the last article, we saw that many investors are flocking to mutual funds since the interest rates on fixed deposits have come down. So often, the investors do not understand the risks and invest in equity related mutual fund schemes, while shifting money out of fixed deposits, where the risk levels are very different.

Someone wrote to us asking if the money may be shifted from fixed deposits to debt mutual funds. Good idea. Both debt mutual funds and fixed deposits may appear to have similar risk profile as both are debt assets. However, it would be important to understand whether such an assumption is safe enough.

The big difference between debt mutual funds and bank fixed deposits is the flexibility of investing. In case of fixed deposits, the tenure is fixed, which means money is invested in a fixed deposit for a predefined time period. On the other hand, an open-ended fixed income fund (or debt fund) does not have a fixed term and hence money can be invested in a debt fund for any time horizon. In the same scheme of a debt fund, an investor may come in for one year, whereas another might have invested for two years. This has some major implications: each fixed deposit is treated as a unique product, whereas debt funds are pooled investment vehicles.

When investors can come in and get out of the scheme on any business day, there must be a mechanism to offer fair price to each. This price is linked to the NAV of the scheme, which is calculated on a daily basis. Since the NAV is dependent on the daily market prices of the securities in which the scheme has invested, the same may be subject to fluctuations as per the investments made.

This exposes a debt fund investor to daily fluctuations. Due to this, the investment returns are unpredictable for an investor in a debt fund. On certain occasions, some schemes may also see drop in the NAV for brief periods of time – yes, it is true even for debt funds. (We have written about this in some of our earlier articles and hence one should take care to choose a debt fund scheme that is appropriate for one’s situation).

An investor does not witness such uncertainties or fluctuations in a bank fixed deposits. An investor coming in a debt fund must understand this.

This is where it becomes crucial to understand that all mutual funds are not the same, and also that all debt funds are not the same. There are various types of debt fund schemes, suitable for different needs of investors. If you make a proper choice, there are reasonably good chances that you would get good results.

Knowledge is power – understand debt funds and then invest. After all, if you understand and choose well, mutual funds sahi hai.

Interest rates are falling ...

Interest rates are coming down. What should one do?

This has been a common question in various forums these days. As we all know, in the calendar year 2017, the interest rates have come down by a good number. Bank deposits offer lower rates as compared to last year. Even there are discussions regarding reduction in the interest paid on the savings bank account...

Click on the link below to read the article:

Interest rates are coming down. What should one do?

Whether in equity fund or debt fund - all can benefit from the disciplined investing through SIP

A lot has been written about the benefits of SIP in equity funds. However, little has been discussed about the same in the context of debt funds. Click on the link to understand how SIP in debt funds can be useful to you:

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The English translation of the article is as under:

“My daughter is studying in the 10^th standard now. She would be ready for the college in a few years. I want to be financially ready to fund her education.” A proud father of a daughter was talking to his friends. Let us analyse the situation.

The daughter is going to college for higher education in just three years. There is a possibility that they have figured out what kind of course and college that she may attend. It does not matter whether the girl and the parents have decided on the course. Whether they have decided or not - whatever the case, there is a need to be financially ready. If one has not done anything so far, one needs to start investing as soon as possible.

However, in this situation, the goal is very close – just three years away and a serious one at that. Due to such a short time period, it would be unwise to take an exposure to equity. That means, one should avoid investing into equity mutual fund in such a case. At the same time, one has 36 months to accumulate the money. Such an investor should consider investing through SIP.

The option now for the investor is to consider doing a regular monthly investment in a fund that is not risky, i.e. one may consider a debt fund (especially short term debt fund or an ultra short term debt fund). Such funds invest in debt securities issued by various companies, banks and even government. since the investments are in debt securities, the funds are a lot safer than equity mutual funds.

Since most of the discussions on SIP end up talking about long term goals and SIP in equity funds, many are not aware that it is possible to fund near-term goals through SIP in fixed income funds, too. While discussing the benefits of SIP, majority of the experts highlight two benefits (1) Rupee cost averaging, and (2) Power of compounding. The former is derived due to the volatility inherent in equity, whereas the latter too is a function of the nature of equity to potentially provide high returns in the long run. As can be seen, both the major benefits talked about are related to equity. However, some of the underplayed benefits of SIP are as under:

·      SIP brings discipline to one’s savings approach

·      SIPs allow large sums to be accumulated even by saving small

·      It helps automate the savings approach

In the situation described earlier in this article, or any such similar situation, it is possible to accumulate the required amounts through SIP in debt funds.

How do fund managers manage debt funds

Debt funds, also known as income funds or fixed income funds invest in a mix of government securities, certificates of deposits of banks, corporate debentures, and some other debt and money market securities. These investments are safer than equity securities in that these do not exhibit the price fluctuations as much as stock markets.

While we have talked about various categories of debt funds, some features of these as well as the risks involved. Today, we will discuss how these funds are managed by the fund managers.

Click here to read further ...

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The English translation of the article is as under:

How do fund managers manage debt funds?

Debt funds, also known as income funds or fixed income funds invest in a mix of government securities, certificates of deposits of banks, corporate debentures, and some other debt and money market securities. These investments are safer than equity securities in that these do not exhibit the price fluctuations as much as stock markets.

While we have talked about various categories of debt funds, some features of these as well as the risks involved. Today, we will discuss how these funds are managed by the fund managers.

The function of fund management team is to generate higher returns for the risk taken or to reduce risk for a given level of risk. In other words, they have to reward the investors for the risks taken. The reward should be higher than what an investor would be able to achieve by oneself.

For that purpose, the fund managers need to manage the risks. Or in other words, they need to take calculated risks. In debt funds, there are three major risks that the fund managers manage in order to generate desired fund performance in line with the scheme objective.

These three risks are:

1.     Credit risk:

When you lend money to someone, there is a contract that the principal amount as well as the interest on it would be returned at a pre-agreed time. However, in certain cases, the borrower is not able to honour this commitment. The possibility of such an event is known as credit risk. In other words, the risk can be mentioned as: “what if the principal or interest payments are not received in time or not received at all?”

The companies where such a risk is high, is expected to pay higher interest, else nobody would lend money to them.

The fund managers understand this risk through a careful study of the financial statements and business of the company, as well as an analysis of overall economic situation. With this analysis, they try to find out securities where the future returns could be higher for the suggested risk.

2.     Interest rate risk:

When interest rates in the economy fall, the existing debentures become more attractive, as they carry higher interest rates. Due to this, investors queue up to buy these debentures from the secondary market, which pushes their market prices up. Thus, as interest rates in the economy went down, the prices of existing debentures went up. The opposite of this is also true.

This sensitivity of debentures to changes in interest rates is called “interest rate risk”. Securities with short maturity period are less sensitive as compared to those with longer maturities.

Fund managers may take a view on the possible change in interest rates in the economy and shift the portfolio accordingly. When the rates are expected to rise, the fund managers sell securities with long maturity and buy those with short maturity. When the rates are expected to fall, they do exactly reverse. In this way, they try to reduce the negative impact of rising rates and maximize the impact of falling rates.

3.     Liquidity risk:

When any investor wants to sell a security, there should be a buyer in the secondary market. In the absence of a buyer, there is no liquidity, or one would be required to sell the same security at a discount. At the same time, if a security is known to be illiquid or less liquid, the interest rate is normally high to compensate for this lack of liquidity.

Most mutual fund managers buy illiquid securities only (1) if the scheme’s objective allows it, or (2) the expected redemptions are less than the liquid component of the portfolio. By maintaining proper balance between liquid and illiquid securities, the fund managers are able to get higher interest income as well as provide redemptions without hassles to investors.

So, go ahead and enjoy the fruits of professional management by investing through debt funds.

- Amit Trivedi

Estimation of Debt Fund Returns…

“Kitna return milega?” This is a very common question majority of investment advisers and distributors of investment products face. Very regularly. Many simply look at the historical numbers and gave some projections based on the past. Some others stick to various thumb rules, e.g. equity returns = GDP growth plus inflation. In the case of fixed income mutual funds, many assume that the fund should return net YTM to the investors (Net YTM = YTM – fund expenses)...

Click here to read my article on www.networkfp.com's blog

Chat transcript - build wealth through mutual funds - master your money

Click on the link below to read the transcript of the chat on www.moneycontrol.com

Moneycontrol - Master Your Money chat transcript

Equity investments simplified - chat transcript

Readers questions answered today. See the transcript below:

http://www.moneycontrol.com/news/mgmtinterviews/chats/detail_new.php?chatid=2796

When bond fund SIP beats equity fund SIP ...

When bond fund SIP beats equity fund SIP… Investors must understand why such a situation exists and the lessons it leaves for the investors.

Read more at: http://www.moneycontrol.com/news/mf-experts/when-bond-fund-sip-beats-equity-fund-sip%E2%80%A6_8151621.html?utm_source=ref_article

When bond fund SIP beats equity fund SIP: Investors must understand why such a situation exists and the lessons it leaves for the investors.

Investors must understand why such a situation exists and the lessons it leaves for the investors

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When bond fund SIP beats equity fund SIP…

Chat transcript 12-Dec-2016

Click on the link below to read the transcript of my chat on www.moneycontrol.com today:


http://www.moneycontrol.com/news/mgmtinterviews/chats/detail_new.php?chatid=2775

How do you know which scheme you have invested in?

"How do you know where the mutual fund scheme invests our money?"

To understand the answer to this basic question, click here to read my article in today's Mid-day Gujarati, Mumbai edition.

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The English translation is as under:

Recently, after an investment seminar, someone approached me and asked a very basic question: “How do I know if a mutual fund scheme is an equity fund, a balanced fund, a debt fund or a liquid fund?” Well, for someone who has spent more than a decade and a half in mutual fund industry, this was unthinkable. However, the question only reflects that there is still a lot of work required to spread the awareness about a good investment vehicle.

Well, let us come back to the question that the person asked. How does one know what type of a fund it is?

A mutual fund is a portfolio of investments. All of us have a portfolio built by ourselves. We invest some money in bank deposits, some in company deposits, we buy some debentures, we buy some small savings schemes, and we also buy some shares or even a real estate property. We refer to a combination of all these investments together as an investment portfolio.

Similarly, a mutual fund scheme is another portfolio with a few differences. For one, the portfolio referred earlier is self-managed by the investor; whereas the mutual fund portfolio is managed by a professional fund management team. Second difference is huge. While constructing our self-managed portfolios, we normally do not start with some guidelines regarding how we would manage the same. In case of a mutual fund, the scheme’s investment objective, investment style and the investment universe have to be clearly defined in a legal document called the offer document.

It is this offer document that one must refer to in order to understand the details of the scheme. Let us introduce this particular document. An offer document is like a janam-kundli. It is the legal document that binds the fund management company and the fund management team. The fund management team has to manage the scheme in accordance with this document. This is why details like the scheme’s objective, investment style and details of where the money can be invested – are all part of this document. Apart from this basic scheme related details, this document also gives details of the fund management company as well as its promoters, which includes their financial details. This helps one assess the financial and technical strengths of those who manage your money. One can also access information (including the past track record) regarding other schemes managed by the same fund management team. The service and operational details are also a must.

Since the single document was becoming too bulky with too much information, SEBI made an investor friendly change – breaking the document in two parts, viz., Scheme Information and Statement of Additional Information. The former carries details regarding the scheme one is considering, whereas the latter details information regarding the fund management company and other general details.

An investor is required to have read the offer document before investing in the scheme. Please follow this advice as it is always in your benefit to “look before you leap”.

Happy investing

- Amit Trivedi

PPF or debt mutual funds?

Now that the interest rate in PPF has come down and with the debt funds offering double digit returns, should one shift from PPF to debt mutual funds?

Click here to get the answer.

The English translation of the article is as under:

“Should I continue to invest in PPF at reduced interest rates or invest in debt funds to earn between 9% to 12%?” Asked someone recently.

Looking at the question, it seemed he is a keen follower of the financial markets. He was aware of the interest rates on PPF, which have been recently lowered as well as the returns generated by various categories of debt funds.

However, there is a small observation on what he observed. He was referring to what interest rate would be earned in future on the investments in PPF, the debt fund returns were those generated in the past. Aren’t high past returns sustainable? Aren’t professional fund managers supposed to generate high returns? Well, in order to get answers to these questions, it is important to understand the reason why past returns are so high.

As of November 7^th 2016, the returns generated by various categories debt funds are as under:

Fund category	1 year return (%)
Debt: Gilt Medium & Long Term	12.26
Debt: Dynamic Bond	10.85
Debt: Income	10.20
Debt: Credit Opportunities	10.18
Debt: Short Term	9.33

Data as on Nov 07, 2016

Source: www.valueresearchonline.com

As you can see, certain categories of debt funds have delivered handsome returns given that the interest rates last year were below 10% in bank deposits as well as Government Securities. So what caused the debt funds to deliver such returns?

In the last one year, there was one factor that positively impacted the investment returns – drop in interest rates. You may recall that we had covered the impact of interest rate changes on debt securities and hence on debt funds.

Interest rates and bond prices have an inverse relationship, i.e. when the interest rates drop, bond prices rise and vice versa. When the bond prices rise, the NAV of debt funds would also go up.

Now that is one of the components that contribute to debt fund returns. The other component is the interest rates earned on the bonds or debentures that fund has bought.

Let us take an example:

Say a mutual fund invested in the debenture of a company. The debenture was available for purchase for Rs. 1,000 and it carried interest rate of 9% p.a. After a year, similar debentures available in the market were offering interest of 8.5% p.a. The earlier bond looks more attractive due to higher interest rate. It is this increased attractiveness that results in rise in price.

The bond fund would have gained from two things, (1) the 9% interest earned on the bond, and (2) the rise in market price of the bond.

However, the moment the price goes up, the future earnings are now adjusted in line with the new interest rates, i.e. from now onwards, the earnings would be at the rate of 8.5% p.a.

In other terms, the future earnings gap between 9% and 8.5% has been adjusted in the current price of the bond giving a capital gain.

With such an adjustment already completed, the future returns would be a function of (1) current interest rates, and (2) any capital gain or loss on account of change in interest rates in future.

In the above example, the interest rates reduced giving rise to bond prices. If the interest rates in economy move up, the prices of bonds would go down.

For the bond funds to deliver such high returns as the past one year, the interest rates in the economy must drop further. Now that is something I cannot predict.

Keep your expectations low. The past returns may not be sustained in future. After having low expectations, if you get higher returns, enjoy.

At the same time, let us not forget some major benefits offered by debt mutual funds. These are:

·      Diversified portfolio

·      Professional management of the funds

·      Easy and convenient liquidity

·      Flexibility to invest in the same folio

·      Flexibility to redeem full or part of the investments

·      Tax efficiency

It is not just the investment returns, there are many other factors that one must keep in mind before taking an investment decision.

- Amit Trivedi

Get answers to your questions on mutual funds

Do you have questions regarding mutual funds? Get answers during the live chat on www.moneycontrol.com on 7th November, 2016 at 4:00 PM to 4:30 PM

Why mutual funds do not guarantee returns? And why is it good?

Though guarantee is a sought after factor for many investors, it still makes sense not to go for it.

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Equity investments simplified - a chat session on www.moneycontrol.com

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Transcript of chat on Master Your Money segment on 28th July 2016

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Build wealth with mutual funds

Master your money - live chat

Live chat on www.moneycontrol.com at 4:00 to 4:30 PM on 28th July, 2016

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

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

http://epaper.gujaratimidday.com//epaperpdf/gmd/25072016/25072016-md-gm-12.pdf


The English translation is as under:

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

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

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

Assume that this debenture is rated AAA – highest safety

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

-        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.