by Anand Saxena
• Large Cap: 8.9 percent/3.5 percent.
• Multi-Cap: 10.5 percent/4.9 percent.
• Mid-Cap: 13.0 percent/6.4 percent.
I have deliberately not given the names of the AMC of the mutual funds. All the data that is required to make investment decisions was available to all the fund managers and yet the fund returns over long (10-year period) term differ by 5 to 7 percent. We can easily gauge the pernicious impact a badly performing fund will have on an investor’s financial well-being. The skill and acumen of fund managers is thus a quality worth its weight in gold.
So how does this long prologue help a common investor for whom I am writing this book? To begin with, while deciding on a mutual fund, besides other factors given earlier, look for the fund manager’s tenure. If the same fund manager has been continuing during the period of good returns by the fund, go for it, provided other parameters are met. If however, the fund manager has recently changed, in a well-performing fund, there is a need to exercise caution. It is better to wait for 6 to 12 months to see the performance of the fund under new fund manager before taking the plunge.
If however, a fund manager leaves an AMC in which one is invested, don’t make hasty decisions based on this single factor. Again observe the fund performance over next 6 to 12 months and if it goes down, one can take a call.
SELECTING EQUITY MUTUAL FUNDS – VII
MUSING 30: GLOBAL EXPOSURE
There is a definite school of thought which propagates that a portion of the investment portfolio should be diversified globally. With the ready availability of investing instruments like international or global mutual funds, index funds and ETF, it’s not difficult too. Before we learn about this important investment choice, let me narrate to you a story entitled, ‘Acres of Diamonds95.’
The protagonist of the story is an Old Persian named Ali Hafed who was a rich and contended man owning a huge farm with orchards, grain fields and gardens, which generated a steady flow of income and peace of mind for him. He was once visited by a Buddhist priest who explained the preciousness and grandeur of diamonds, a commodity Ali Hafed had never known or seen. The priest told Ali that with a mine of diamonds, all the thrones in the world could be for the taking for his heirs. Ali longed for possession of diamonds and sold off his farm, left his family in the care of neighbours and set off in search of diamonds. The search, which covered a vast area containing Palestine and Europe, resulted in failure. In sheer frustration, and beset with starvation Ali committed suicide by jumping in a river in Barcelona, Spain.
Tragically, after he had died, a large mine of diamond was uncovered in the lawns of his own farm, which he had sold off to raise money to search for diamonds. “Had Ali Hafed remained at home and dug in his own cellar, or underneath his own wheat-fields, or in his own garden, instead of wretchedness, starvation, and death by suicide in a strange land, he would have had acres of diamonds96.”
Should a common investor go around looking for ‘acres of diamond’ elsewhere or content himself with the returns that the growing Indian economy is going to offer? As per Niti Aayog, the Indian economy, currently worth $ 2.5 trillion will be $10 trillion by 2030—a fourfold growth in next twelve years which is truly phenomenal. With this background, we can discuss the pros and cons of international or global investing for you to make a considered decision.
International funds are those which invest solely in international markets leaving home country out of the investment universe while global funds target the entire globe including the home country.
We have nearly 50 to 60 mutual funds and ETF which invest in all major world markets in which one can invest via SIP route with as less as ₹500-1000 per month. There are options to invest in specific world sectors like the U.S., Europe, China and Asia Pacific or in specific themes like world gold or gold mining market or world commodity market or world real estate market and so on. There are also domestic mutual funds which take a significant exposure in the global markets thus giving true diversification.
The major advantage in global diversification would be that if Indian markets fall, the global markets may still be up and running thus smoothening out the overall portfolio returns. Also, India is just about 3.65 percent of the global GDP and hence by investing abroad, one can truly diversify by taking advantage of remaining 96-97 percent of the global market.
Another advantage is that tax treatment of international funds is akin to a debt mutual fund meaning if held for more than three years, LTCG (at 20 percent) is levied with indexation benefits. “For an investment in an international fund, assuming an inflation of 5 percent and return of 10 percent per annum for a period of three years, the effective tax with indexation will be approximately 3 percent. This compares favourably against the 10 percent LTCG tax for domestic equity funds proposed from April 1, 201897.”
Beware of ‘currency risk’ though i.e. the risk that your returns from the international stocks will be reduced as a result of the Indian rupee increasing in value relative to the currencies of the countries in which you have invested. So, the international stocks may add volatility to your portfolio.
The outcome of all the discussion would be that for true diversification one must not only invest across various asset classes but also across the globe and hence some global exposure must be taken. It is better to stay away from sector or theme specific funds though and instead one should go for diversified global equity funds or ETF. The exposure should be limited to not more than 10 percent of the portfolio.
The other and better option is to go for a domestic fund with a 30 odd percent exposure in global market. This will automatically restrict the overall exposure to global markets to around 10 percent of the portfolio98. Of course, all other parameters for selection of these funds, as discussed in previous musings, will apply.
SELECTING EQUITY MUTUAL FUNDS – VIII
MUSING 31: PUTTING IT ALL TOGETHER
Before we put together the tenets of investing in equity mutual funds it is good to recap the alchemy of asset allocation. If you are a beginner to equity investing it is better to stick to the thumb rule percentages of debt portion of portfolio equal to one’s age (or minus 10 percent) and remaining in equity. As you gain proficiency and confidence, do look at the model portfolios given under the musing ‘The masters are calling.’ Direct stock picking is an absolute NO so we will restrict ourselves to diversified equity funds in this musing.
How many funds? If we recall our earlier musing on risk-reward paradigm, a figure of around twenty stocks in one’s portfolio should give adequate diversification, beyond which no significant benefit accrues so far as risk-adjusted returns are concerned. An average diversified mutual fund will have at least 20-30 stocks in its portfolio (focused equity funds will have a maximum of 30 stocks) and hence theoretically, owning just one mutual fund will give you the required diversification. This is though not recommended as you would have put all your eggs in one big basket of a particular AMC, run by a particular fund manager with his distinctive investing style of growth, value, large-cap, mid-cap and small-cap, which may, well, not succeed. To obviate this fallacy, Dhirendra Kumar of Value Research recommends between 3 and 7 well-diversified funds in the portfolio, which I too think, is a fair number.
Large, mid, small To get the full benefit of equity one has to invest across the spectrum of large, mid and small-cap funds. In general, for a young investor like Anshreya or even an older one with a high-risk appetite, it is better to keep a higher percentage of mid or small-cap funds. For a risk-averse investor, higher percentage should go towards large and multi-cap funds. In other words, one should look at large-cap funds for cost-efficient, market plus returns but for high alpha, turn to multi and mid-cap categories. Within multi and mid-cap funds too, look for funds that have delivered significant alpha99. The overall figure of 3 and 7 funds must still prevail.
Value, Growth or Blend Style For kick-starting your investments some portion of your portfolio must contain value funds.
In fact, Small Value funds will act as an afterburner for your portfolio. For the percentage of value and growth funds, generally, follow the tenets given for small cap and large cap above. Your large cap should have a blend of value and growth. A study covering the data from 1928 to 2013 (86 years) in the U.S. showed that value funds had outperformed growth funds by a margin of 4.99percent100.
Essentially, group the mutual funds under four segments—large growth, large value, small growth and small value101 It will become easier to decide on the portfolio allocation.
ELSS Equity Linked Savings Scheme (ELSS) is another category which is essentially a closed-end mutual fund (three-year lock-in period) which invests minimum 80 percent in equity. This category should be looked at by investors for their tax saving purposes if their contribution of ₹1.5 lakhs under IT section 80 C is not fully utilised. However, from 01 Apr 2018, ELSS also invites a 10 percent LTCG tax and hence, lost some of their sheen. If your 80C contributions are already at ₹1.5 lakhs, it is better to avoid ELSS.
Sector-specific or thematic funds These funds are best avoided as the sector cycles are short and one can make money only if one gets inside the cycle at the right time. They also tend to be fad based like tech funds in 2000 and infrastructure funds in 2007. In both cases, investors lost heavily102. A good diversified mutual fund will have exposure to various sectors or themes if the fund manager finds them winning prospects, so one will automatically get the advantage of that booming sector.
The mutual fund portfolio should be reviewed once a quarter. It is just a review duration but not action duration. If a fund is underperforming the benchmark for three consequent quarters, it should be a cause for concern. If it continues to underperform for 5-6 quarters, it is time to get rid of the fund103. If you recollect our previous musings where we had established a minimum holding period of 366 days, the above guideline reinforces the same.
Investment Owner’s Contract104
To end my series of musings on equity investment, I hereby reproduce an investment owner’s contract, which I find absolutely magical. Anshreya, HoneyCool or indeed any investor would do well to read it deliberately and follow it in letter and spirit. It is in fact, worth taking a printout of this contract and pasting on your bedroom wall so that you see it every day and don’t deviate from it. I reproduce here verbatim.
I, _____________ ___________________, hereby state that I am an investor, who is seeking to accumulate wealth for many years into the future. I know that there will be many times when I will be tempted to invest in stocks or bonds because they have gone (or “are going”) up in price, and other times when I will be tempted to sell my investments because they have gone (or “are going”) down.
I hereby declare my refusal to let a herd of strangers make my financial decisions for me. I further make a solemn commitment never to invest because the stock market has gone up, and never to sell because it has gone down. Instead, I will invest $______.00 per month, every month, through an automatic investment plan or “dollar-cost averaging programme,” into the following mutual fund(s) or diversified portfolio(s):
_________________________________,
_________________________________,
_________________________________.
I will also invest additional amounts whenever I can afford to spare the cash (and can afford to lose it in the short run). I hereby declare that I will hold each of these investments continually through at least the following date (which must be a minimum of 10 years after the date of this contact): _________________ _____, 20__.
The only exceptions allowed under the terms of this contract are a sudden, pressing need for cash, like a healthcare emergency or the loss of my job, or a planned expenditure like a housing down payment or a tuition bill.
I am, by signing below, stating my intention not only to abide by the termsof this contract, but to re-read this document whenever I am tempted to sellany of my investments.
This contract is valid only when signed by at least one witness, and mustbe kept in a safe place that is easily accessible for future reference.
Signed: Date:
_______ _____________ ___________________ _______________ ____, 20__
And finally, what should one do as an equity mutual fund investor if the bottom falls out of the market? William J O’ Neil in his book ‘How to make money in stocks’ writes, “Each time the economy goes into a recession, and the newspapers and TV are saying how terrible things are, consider adding to your fund when it’s 30 percent or more off its peak.”
DEBT INVESTING
MUSING 32: FIXED INCOME INSTRUMENTS
We are by now (hopefully), clear about the nuances of investing in three of the four major asset classes: equity, real estate and gold. What now remains to be understood is the art of investing in debt instruments. Remember, it is the debt component of your portfolio which provides stability during volatile market cycles. Having a debt component in your portfolio is not an either/or choice: it has to be there, albeit in the percentages you have decided upon as per your risk capacity and asset allocation strategy. Debt investing is variously referred to as ‘fixed income’ or ‘bond investing’ too and hence it is important to first get some fundamentals out of the way before we learn how to go about investing in debt instruments.
Just to recap, the biggest difference between equity and debt investing is that in equity you own a part of the underlying business and hence partake in the profit or loss that the business makes. Debt investing, on the other hand, is a loan that you are extending to the government, corporate, banks and other financial institutions who in return promise you a fixed rate of return at a particular periodicity. The inherent stability of debt investment is due to this fundamental difference. Our parents (and people of my age) as also the generation born in pre-liberalisation era used to have most, if not all, investments in this category. The old wisdom of investment in fixed deposits (FD) and recurring deposits (RD) still persists to certain extent. We tackle these instruments one by one.
Fixed Deposits (FD) or Company Deposits (CD)
• When we open an FD with a bank or a CD with a Non-Banking Financial Company (NBFC) we loan our money to the bank (or NBFC) for a fixed tenure for which bank promises us a fixed rate of return. The money gets locked for the designated period and one incurs a penalty if it is withdrawn before the period. At the end of designated period (could be from 7 days to 10 years,) the bank/NBFC returns the principal amount and the interest accrued.
• The interest income one earns is taxable and hence the actual returns are going to be lesser than the one promised by the bank and this tax (tax deducted at source or TDS) is deducted by the bank automatically when the FD matures.
• FDs have inherent safety to an extent due to the Deposit Insurance and Credit Guarantee Corporation (DICGC) which insures each account holder for a maximum sum of ₹1 lakh. So, if the bank liquidates or defaults, amount of your FD, up to ₹1 lakh, will be returned to you.
• A big problem with investing in FDs is that the returns barely beat inflation and hence they should not be counted as a long-term investment vehicle, however for the breathing fund, these are suitable instruments. We will subsequently discuss the ways to get better long-term returns than FD through debt investing.
Fixed Maturity Plans (FMP)
• FMP is a closed-ended debt mutual fund. Such a fund invests only in instruments whose duration is similar to its own term i.e., it aligns its term with that of its underlying assets. For example, an 1115-day FMP would invest in instruments that mature in 1115 days or slightly before that105. The FMPs normally invest in bonds (we will learn about bonds in the next musing) and hence manage to give market-linked returns.
• The biggest advantage of FMP over FD is the tax treatment it receives if held for a period over 3 years. Unlike FDs where the interest income is fully taxable, in FMPs, one pays LTCG tax of 20 percent with indexation benefits (meaning that the inflation of the period is accounted for.) Let�
��s understand with an example106.
• The parameters considered are as follow: Investment of ₹1 lakh (done on 18th March 2018) which has a maturity period of 1140 days (matures in Apr 2021.) The annualised returns are 7.5 percent and inflation rate is 5 percent. The key figures for an FD and FMP are as under:
o Value of investment in Apr 2021: ₹1.24 lakhs.
o Capital gains (from FMP)/Interest income (from FD): ₹24,000.
o Indexed cost of acquisition for FMP (after adjusting for inflation): ₹1.21 lakhs.
o Capital gains for FMP after indexation: ₹3,000.
o LTCG Tax @ 20 percent (of ₹3,000) for FMP: ₹600.
o Tax on income from FD (no indexation benefit): ₹7,200.
o Post Tax Returns from FMP: 7.33 percent.
o Post Tax Returns from FD: 5.27 percent.
The risks of FMP investing are firstly, lack of liquidity (cannot be liquidated instantly like an FD) and secondly the risks associated with bond investing that is credit and interest rate risks (being covered in the next musing.)
Recurring Deposits (RD) RDs are an earlier variant of SIP wherein one can deposit small amounts every month for a fixed period and get a lump sum amount on maturity (principal plus interest.) The issues of taxation and not beating inflation are similar to an FD.