Saturday, October 18, 2008

Volatile Market: What should I do?

The stock market is always going to be volatile. There are going to be bull runs and bear runs. This is part and parcel of the stock market. Most investors in stock markets are illetrate when it comes to shares. They act on tips and do not know how to select stocks to invest in. They buy stocks that are are overpriced when the sentiment is good. During a bearish market, the seintiment is low and everybody is scared of the stock market and they sell. They end up losing in both cases. One will be successful if they acted the reverse. Don't we all preach buy cheap and sell expensive. But when it comes to the markets it is always fear and greed that drives investors actions and not simple logic. If one can learn to control their fear and greed, they will be successful. If they don't they will fall prey to the operators who cash in on sentiment.

Many investors also try to time the market. But the market does not listen to anyone, nor can anyone predict the market. Even some of the greatest investors could never time the market everytime (If you watch CNBC TV18, just try to check how many of these expert analysts get there calls right during volatile times like now). Instead of timing the market to maximize returns, one should focus on asset allocation to minimize risk. 

My advise for any investor would be to come up with a good investment plan. 

  1. Identify your financial goals.
  2. Identify the risk that is appropriate for you.
  3. Come up with an asset allocation strategy based on your risk.
  4. Build an investment plan catering to your asset allocation needs.
  5. Be disciplined and strictly follow the investment plan.
  6. Rebalance your portfolio atleast once every year to readjust the deviations in your asset allocation.
  7. Ignore the occasional turbulance in the market and stick to your investment plan. There are always going to be lot of stories around, but learn to ignore them and strictly follow your plan.

My Conclusion
It is essential for everyone to have a good investment plan. It will ensure your investments are aligned to your goals. It will also help you stay focused on your long term goals and do not overreact to market turbulence. If one is not sure how to build an investment plan tailor-made to ones needs, then please seek professional help.

Thursday, September 18, 2008

Should investors be worried about Mutual Funds filing for Bankruptcy

With the current financial crisis in the US, a lot of us has questions about what happens to our investments in mutual funds if the MF files for bankruptcy. To understand the implications, I would like to quote an extract from the Workbook published by Association of Mutual Funds of India.

"A mutual fund in India is constituted in the form of a Public Trust created under the Indian Trusts Act, 1882. It should be understood that a mutual fund is just a pass-through vehicle. Under the Indian Trusts Act, the Trust or the Fund has no independent legal capacity itself, rather it is the Trustee or Trustees who have the legal capacity and therefore all acts in relation to the trust are taken on its behalf by the Trustees. The trustees hold the unit-holders money in fiduciary capacity, i.e., the money belongs to the unit holders and is entrusted to the fund for the purpose of investment. In legal parlance, the investors or the unit-holders are the beneficial owners of the investments held by the Trust, even as these investments are held in the name of the trustees on a day-to-day basis."

The investments being managed by the mutual fund does not belong to them hence no one can claim them except the unit holders who invested in the fund. Investors of mutual funds need not panic about their investments even if the mutual fund files for bankruptcy.

Tuesday, August 19, 2008

Some myths about entry and exit load

A lot of us think that an entry load of 2% is reasonable but an exit load of 2% is expensive. Our reasoning is simple. The exit load of 2% is charged on the accumulated fund value (including returns earned) whereas the entry load is only paid on our initial investment. Lets us delve deeper by looking at the below two examples.

Example 1 : I invested Rs.1,00,000 in a fund XYZ. It charges an exit load of 2% but does not charge any entry load. Let us assume the fund gave returns of 18% for 20 years.

Net Amount Invested = Rs.1,00,000 (no entry load)
Rate of Return = 18%
Number of years invested = 20
Fund value after 20 years = Rs.27,39,303
Exit Load = 2% * Fund Value = 2% * 27,39,303 = Rs.54,786

Example 2 : I invested Rs.1,00,000 in a fund ABC. It charges an entry load of 2% and does not charge any exit load. Let us assume the fund gave returns of 18% for 20 years.

Entry Load = 2% * 1,00,000 = Rs.2,000

Initial Interpretation : At the first glance one will obviously think that entry load of Rs.2,000 is reasonable but an exit load of Rs.54,786 is expensive.

The Bigger Picture
Now lets take a look at the bigger picture and revisit the same examples.

Example 1 : I invested Rs.1,00,000 in a fund XYZ. It charges an exit load of 2% but does not charge any entry load. Let us assume the fund gave returns of 18% for 20 years.

Net Amount Invested = Rs.1,00,000 (no entry load)
Rate of Return = 18%
Number of years invested = 20
Fund value after 20 years = Rs.27,39,303
Exit Load = 2% * Fund Value = 2% * 27,39,303 = Rs.54,786
Redemption Value = Fund Value - Exit Load = Rs.26,84,517

Example 2 : I invested Rs.1,00,000 in a fund ABC. It charges an entry load of 2% and does not charge any exit load. Let us assume the fund gave returns of 18% for 20 years.

Entry Load = 2% * 1,00,000 = Rs.2,000
Net Amount Invested = Investment - Entry Load = Rs.98,000
Rate of Return = 18%
of years invested = 20
Fund Value after 20 years = Rs.26,84,517
Redemption Value = Rs.26,84,517 (no exit load)

The redemption value in both the cases are exactly the same. What this tells us is the impact of an entry load of 2% is equal to an exit load of 2%.

My Conclusion
It is essential to look at the bigger picture to understand numbers related to investments. Like in our example an entry load of Rs.2,000 turned out to be equal to an exit load of Rs.54,786.

Thursday, August 14, 2008

How to select a mutual fund scheme to invest in?

A simple way to select a mutual fund scheme to invest in is to select a 5 star or 4 star rated fund from one of the following portals.
Each of these portals have there own logic for rating funds. For instance Money Control's ratings historically gave more relevance to short/mid term performance. Value research gives more importance to consistency and long term performance. I am not going to debate which method is the best as the experts behind each of these portals have there own logic/reasons for there ratings. There is no harm in selecting star rated funds based on any of these portals as each of these ratings have there own relevance.

For a more informed investor who has the time to research, I would recommend selecting mutual fund schemes to invest in based on the following criteria.
  1. Longterm Performance , consistency in Returns
  2. Short Term Performance (though a fund has performed well in the past, is there a let down in short to mid term performance)
  3. Performance across market cycles, like during bullish and bearish phases (how well did the fund perform during the bearish phases)
  4. Fund Corpus (When selecting midcap funds, the corpus size is very important)
  5. Fund Managers performance with the scheme(If a fund just got a new fund manager, I would observe the performance under this new manager before I select the fund)
  6. For equity mutual funds, one will also need to evaluate risk. (Exposure to midcaps, Standard Deviation of the fund)
  7. For debt mutual funds, apart from risk one also need to examine entry/exit loads and expense ratio are very important.

In these days it is very difficult to find an unbiased financial advisor. Always validate the advise your receive by doing some research online so you know you are not being taken for a ride. Please stay away from NFO's as much as possible.

Monday, August 11, 2008

Some common misconceptions about Mutual Fund Dividends

Lot of people think dividends in mutual funds is equivalent to dividends received from shares. In shares, the dividend you receive is because the company wishes to share some of their profits with its share holders in the form of dividends. What you are getting is something extra. Dividends in Mutual Funds is a very different. The mutual fund companies are not sharing any profits by declaring dividends. All they are doing is returning a portion of your investments in the form of dividend.

Let me explain this with an example: You own 100 units of a mutual fund ABC Equity. The current NAV of the the fund is Rs.14. The company declares a dividend of 40% or Rs.4 per unit.

Stage 1: Prior to declaration of Dividend
NAV prior to dividend = Rs.14
Your Fund Value = Rs.14 x 100 units = Rs.1,400

Stage 2: Dividend is paid to the unit holders.
The fund pays dividend of 40% or Rs.4 per unit
The dividend you receive = Rs.4 x 100 units = Rs.400

Stage 3: Post dividend NAV adjustments.
In mutual funds, the NAV of the fund is adjusted based on the dividend given by the fund.
New NAV post dividend = Rs.14(Old NAV) - Rs.4 (Dividend Paid) = Rs.10 (New NAV)
Your Fund Value post dividend = Rs.10 x 100 units = Rs.1,000

Prior to dividend you had Rs.1,400 invested. Post dividend you have Rs.1,000 invested and Rs.400 in your bank account. In short dividends in mutual funds is equivalent to selling a portion of your investment and returning it back to you.

When does it make sense to opt for dividend payout?

  1. ELSS (Tax Saving Schemes): All your investments in ELSS are locked for 3 years. By opting for dividend payout, you are receiving a certian amount of your investment prior to 3 years.
  2. Debt Mutual Funds (Short-Term): Debt funds pay a dividend distribution tax of 12.5%. Short term capital gains from debt funds are added to your taxable income. So a short term investor who falls in the 30% tax slab can save tax by investing in a debt fund with dividend payout option. Indirectly you are paying a 12.5% dividend distribution tax rather than 30% tax on your shortterm capital gains.
  3. Mutual Funds which offer free Insurance (FIP): You loose your insurance cover when you make partial withdrawals in FIPs. By opting for dividend payout, you are liquidating a portion of your investment and at the same time your insurance cover continues.
  4. Profit Booking: If one wishes to book profits at intervals.(This can actually be handled by investor himself by selling a portion of his investments)
  5. Asset Allocation: Some funds offer you the flexibility to sweep dividends into another scheme of the same fund house. This facility can be used for moving the dividends declared from equity to debt schemes. On the long run this helps adust your equity/debt ratio in turn minimizing your risk.

Disadvantages of Dividend Payout?

One invests in mutual funds for creating wealth over time. By receiving dividends, you are actually liquidating your investments. Hence you are losing out on the earning potential of the amount liquidated (unless you reinvest this amount somewhere).