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.

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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

Do mutual fund schemes have lock-in?

Read my article on the above subject in Mid Day, Gujarati edition today.

Here is the link to the article.

The English translation of the article is as under:

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Lock-in period in a mutual fund

“For how long does my money remain locked in a mutual fund scheme?” or “What is the lock-in period in mutual funds?” Someone asked the other day.

Well, there are many misconceptions floating around in the market regarding mutual funds. The above questions seem to be arising out of these. One of the most ignored misconceptions, yet among the most common one, is that all mutual funds are same. Many people think that all mutual funds have the same features and that they all behave in the same exact manner. Hence, an investor should expect the same experience with all mutual funds. The reality is quite different.

We have time and again highlighted in our previous columns that there are many varieties among mutual fund schemes and that investors have a huge amount of choice from the type of mutual fund schemes to various features among similar schemes.

Today, we would attempt to address the questions asked in the opening paragraph. A lock-in period is an operational feature of many investment options and schemes. Lock-in means the investor cannot access the money, or cannot sell the investment and convert into cash.

Now, certain mutual fund schemes do have a lock-in period, whereas some do not. There are also schemes without lock-in where redemption from the scheme is discouraged by putting some charges.

First of all, there are schemes like ELSS or some of the retirement funds or even children’s funds, which have a lock-in period. In case of ELSS or retirement funds, where the investor can avail of tax deduction by investing in such schemes, there is a statutory lock-in period. After the statutory lock-in period is over, the investor is free to take the money out on any business day or stay invested for as long as one wishes to. You are also allowed to add more money in the same account even during the lock-in period of the earlier investments. However, the new (or fresh) investments would attract lock-in from the day of investments. For example, in ELSS schemes, the mandatory lock-in is for three years from the date of investment. So, your investment made in March 2017 would be locked in till March 2020, but additional investment in the same account in May 2017 would be locked in till May 2020.

The next category we must understand is the close-ended funds. These funds have a defined maturity period. At the end of this period, the funds are automatically returned to the investors. Before maturity period, the investor cannot get the money back from the fund. However, as per SEBI regulations, the units of close-ended funds have to be compulsorily listed on a recognized stock exchange, which may allow liquidity to the investors.

Then come the open-ended funds. In these funds, there is no lock-in period. An investor can buy the units or redeem the funds on any working day. However, in case of some of the open-ended funds, there could be an exit load if the investor exits before a certain period from the date of investment. There are no fixed rules about such periods, and the exit load as well as the period may change for the same scheme from time to time. However, as an investor, you must know that what exit load was applicable at the time of your investment would apply to that particular investment. Any subsequent change in exit load would not be applicable to your old investments.

So, there is no general answer to the questions asked in the opening paragraph. Understand the type of fund and check the fund details at the time of investing.

Can you get bank loan against your mutual fund units?

You need not upset your long term plans in case of a short term emergency requirement of funds. You can avail loan against your mutual fund investments. Amit Trivedi writes in Mid-day Gujarati edition today:

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The English translation is as under:

Most of the good quality investment advisors would advice an investor to focus on the long-term goals and not worry about short-term market movements. Incidentally, many of us have some goals to fund far in the future. For the purpose of the investment to deliver in line with expectations, the investment should be given time.

Now, two things are required for someone to hold onto the investments for long periods without worrying about short-term performance: (1) financial ability, and (2) psychological ability. We will not talk about the psychological ability here. However, the financial ability to stay invested can partly take care of the psychological ability.

The advisors and financial planners strongly recommend taking care of the short-term requirements through creation of a contingency fund. They also strongly recommend buying enough insurance cover that takes care of your family’s expenses in case an unfortunate event takes place.

Even after that, some emergencies may crop up – something unexpected and sudden. It could be a business loss or money required by a close friend or a family member. What happens when you have invested your money for meeting long-term goals, but there is an emergency requirement for a short while?

Well, this is where one may consider a facility offered by banks – loans against security. Banks allow one to borrow against various investments for a short period. This is an overdraft facility, where there are no EMIs to be paid and one may pay the entire sum (or part of it) back to the bank as per one’s convenience. The interest is charged only to the extent of amount borrowed (or outstanding, if part of the loan is repaid) and only for the period for which the same is borrowed. You may get a limit sanctioned from the bank, but use only what is required.

Mutual fund units are approved securities to borrow against, under this scheme. Banks lend money against the collateral of MF units. The process is simple: one needs to get the units pledged in favour of the bank. This can be done through filling up some forms and getting confirmation from the respective mutual fund companies. Debt and equity funds may be treated differently. You may check with your bank.

The benefit of such a facility is: you are able to tide over the temporary cash crunch without selling your long-term holdings. the cost of such a loan is also low as it is limited to the period of borrowing and to the extent of the amount used.

We have often seen that the cash crunch and market crash come together. In such a situation, if one has to liquidate the holdings (especially the equity funds), one may not get a chance to participate in the upside that follows. Consider this facility available from banks.

At the same time, please be careful. This is a type of loan; hence use your discretion. Do not make a habit of borrowing or using this limit for trivial reasons. Use it only when it is absolutely necessary and you have run out of other options.

Wish you all a very happy, healthy and wealthy 2016.

-        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.

Volatility in the markets - friend or foe?

Small investors should take advantage of the inherent volatility in the stock markets and not get scared of the same. Read on ...


The English translation is as under:

A newspaper article caught my attention recently. The headline said, “Stock market might remain volatile”.

The word “volatile” or “volatility” often evokes negative emotions and many associate the term with falling prices. However, the word itself means the prices can move in either direction – up and down. In that case, is this really news? Stock markets have always been volatile. As I have written n my book, “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”, “As long as decision-making is involved with different people having different motives, their opinions, decisions and actions themselves are going to move the financial markets in either direction.

Remove that from the market and voila, you don’t have a market at all. If all the individuals have the same information, same motives, same actions to perform, no trade can happen. For someone to buy, there should be someone to sell and vice versa.

The presence of a large number of people in the market, transacting on the basis of different motives and biases, makes the markets what they are.

Many get scared of volatility. Many stay away from the stock markets due to the inherent volatility of the markets. The fact is, normal markets are volatile and volatile markets are normal.

It is crucial to accept this fact.

The volatility is not bad. It simply exists. While, one can lose money on account of it, it gives profit opportunities for the traders and speculators; it also provides liquidity to the long-term investors, whenever they require. In the absence of volatility, the traders would not be interested in trading. The reduction in trading volume would kill the liquidity. This would have severe implications for long-term investing.

In such a case, it is upto one to decide whether to be scared of it or use it to one’s advantage.

So the question is: how can a small investor use volatility to one’s advantage?

There are a few proven strategies that one may adopt.

At the outset, let us understand that in stock markets, short-term price movements are more volatile than long-term movements. At the same time, the potential to offer higher-than-inflation is high if you hold your investments for long period (Assuming you hold a diversified portfolio of good quality stocks). With that in mind, stay away from equity markets, if you are going to need the money in the short-term. This will reduce the impact of volatility on your portfolio.

Second, if you are in your earning years, you should focus on saving some of your earnings regularly. Keep an eye on your expenses. The savings thus generated can be invested in the form of systematic investing (popularly known as SIP). This is a wonderful investment plan. On one hand, it allows one to invest one’s regular savings in a productive manner; it also makes the inherent stock market volatility to work for the investor. Since one is investing a fixed sum of money regularly, the units acquired each month are a function of the fund’s NAV.

An investor is allotted units based on the amount invested and the fund’s NAV. When someone invests Rs. 50,000 when the NAV of the scheme is Rs. 250, one gets 200 units (Rs. 50000 / Rs. 250 = 200). However, at the time of the next investment if the NAV has gone down to Rs. 200; the investor would be allotted (Rs. 50000 / Rs. 200) 200 units. As you can see, the investor got more units when the NAV was low and fewer when it was high. Thus, the average cost of purchase comes down. SIP makes the volatility work in the favour of the investor.

Next time you read about volatility, laugh it off. Volatility in stock markets is like the seasons, there would be summers and winters. You don’t wish them away. You learn to enjoy the beauty in the seasons. Same applies to investment markets. So don’t get scared of volatility. Simply set up an investment plan and stay put.

-        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.

What is the greatest safety feature in an investment?

Below is the link to my article in Mid-day Gujarati, Mumbai edition today:

The greatest safety feature in an investment

The English translate is as under:

What is the greatest safety feature in an investment?

One of the most important safety features for any investor would be to be able to get timely information and the ability to out of the investment, if required. A mutual fund offers these two benefits – transparency and liquidity.

Let us look at some incidents to understand the point.

One fine morning in 2001, people of a particular city opened the newspaper to read about problems at a particular co-operative bank. Those who had deposits with this bank, immediately rushed to the nearest branch. The branch never opened. Here the information was available, but just a little late and the investors could not take any action.

Then, in the year 2009, a certain company reported to the stock exchanges that a large sum of money was missing in their bank accounts and the management had misrepresented the company’s accounts. The information was immediately flashed across the stock exchange terminals and the media. People rushed to sell the stocks they held, but the price went down by 90% in one trading session. The information was available in time, and people could act, too. But what did they get? The impact on the price was too much for the investor to feel any good about the transparency and liquidity.

What is the point in getting such information? Well, this is where mutual fund scores over all the other avenues.

The transparency that you get from mutual fund allows you to take a decision to invest in a particular scheme, monitor the progress of your investment, and periodically check if your investments are aligned to what you understand the scheme would do.

The question is, what happened to the share price of the company mentioned above – can that not happen in case of mutual funds? The good news is, “no, such a thing cannot happen to mutual funds.” Why? This is because an investor in a company is directly participating in the fortunes of the company. Hence, if the company performs well, the shareholder gains, but if the company fails, the shareholder loses. However, in case of a mutual fund, the investor hires the services of a professional fund manager. The failure of a fund manager would result in poor portfolio performance. However, the impact may not be as much as that of a poor manager can have on a company’s stock, since a mutual fund portfolio is diversified into many unrelated securities.

While bad judgment of the management may lead to collapse of the company, bad judgment of the fund manager would result into underperformance. Collapse of a company may mean total loss of investment, but scheme underperformance still allows the investor to get out of the scheme and get into something else. Since the scheme holds various investments, the exit of the investor would not impact the prices of the fund’s investments. And hence the 90% drop we discussed earlier will not happen in case of mutual fund scheme.

Consider this combination of transparency (availability of relevant information in time) and liquidity (ability to act on this information) before choosing your investments. You will find that no investment avenue comes anywhere close to mutual funds on this count.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Views expressed here are his personal views.