by Anand Saxena
Selecting Debt Funds
It’s time now to round up our musings on debt funds with factors to keep in mind while selecting a debt fund. Most factors are akin to what we discussed in the case of equity mutual funds. So, here we go:
Duration funds give a simple yardstick for investment being aligned with the timeframe one is looking at. However, the issue of higher volatility with funds longer than 3-year maturity must be considered.
If you are looking to ramp up your returns, look for accrual funds. Investing in lower credit rating fund, for example, gives you the possibility of higher returns but with higher risk. For more stable returns, stick with corporate bond or banking and PSU funds. My take is that with debt investing one should not be taking undue risk as this part of your portfolio is there to balance out the volatility of equity instruments. So stick with safer instruments.
Look for the long-term performance of the AMC, if possible for 10 years and above and compare with peers. There are wonderful sites like Value Research and Morningstar which can be used for your research.
Look for the expense ratio of the fund and go for the lowest one. We have discussed this issue at length in our musings on equity investing. You may like to revisit the same.
The fund must not be a performer only in bond bull cycle but also should be able to protect your capital during bond bear cycle. “Today, looking back at an eight-year track record for a debt fund would cover two rate cycles. In this eight-year period, 2008, 2014 and 2016 were big bull years for bond markets, and 2009 and 2013 were bearish years. Assess if a debt fund has fared better than its peers in both the phases112.”
Armed with this knowledge now, you, the intelligent investor are now ready to pick up the right instrument for the debt portion of your portfolio—a very important part as it allows you to sleep better during market volatility.
GAINING TRACTION
MUSING 35: SYSTEMATIC INVESTMENT PLAN
THE MAGIC OF RUPEE COST AVERAGING
It is by now well-established and understood that equity remains the only investment vehicle which is capable of giving long-term inflation-beating returns. We have also understood the futility of trying direct stock picking which invariably turns out to be a loser’s game. Mutual funds thus emerge as the choice that an intelligent investor should make. The problem with mutual funds, however, is not very dissimilar to that of direct stock picking wherein one may end up investing in the fund and thus in the market at a time when the market is too high. Any returns thereafter, even in long-term, are likely to be barely satisfactory.
‘Mutual Fund Insight,’ a quality magazine from Value Research did a wonderful research on the subject of Systematic Investment Plan (SIP) in their issue of June 2017 which clearly brought out the fact that the only way not to suffer a loss and rather to have 100 percent positive returns in equity investments was by following the SIP route. I will give excerpts of the same study for our intelligent investor113.
One year SIPs had a loss percentage (negative returns) in 22.5 percent cases. However, as the duration increased, the loss percentages dropped to 16.2 percent (two-year SIP), 9.8 percent (three-year SIP), 5.9 percent (four-year SIP and almost zero i.e. 0.3 percent (ten-year SIP.))
Short-term SIP, of one year, also had the worst roller coaster ride with returns ranging between +534 percent to negative 66 percent. The similar figures for a ten-year SIP were +51 percent and negative 8 percent.
Even if one had started investing at the market tops (the worst time for an equity investor) like in the years 2000 and 2007, by the fourth year of SIP, positive returns had kicked in for 100 percent of the investors. The message is thus loud and clear—if the investment horizon is less than 4 to 5 years, equities may be the wrong investment vehicle.
Careful fund selection, however, remains the key. If one had invested in a poorly performing fund, no amount of stretching the SIP would have helped. Hence, backing a losing horse is not a good strategy in equity investment. We have already gone over the tenets of selecting a good mutual fund.
Let us do a bit of math to understand the magic of SIP. As a concept, it entails buying stocks – through mutual fund route, at fixed intervals (normally monthly) with a fixed rupee amount. As the market will keep going up and down (over which the investor has no control,) the number of shares of stock purchased will be less in market high and more in down market conditions. However, the average cost per share at the end of the period will be lower than the average share prices during the period. The example below depicts a period of three years.
PERIOD INVESTMENT PRICE OF SHARE SHARES PURCHASED
1 ₹10000 ₹100 100
2 ₹10000 ₹75 133.33
3 ₹10000 ₹125 80
Total Cost ₹30000
Average Price ₹100
Total Shares Owned 313.33
Average Cost ₹95.74
Thus, we see that though the average price per share works out to be ₹100 but the average cost to the investor works out to only ₹95.74, a net gain of ₹4.26 per share. However, as is evident, the magic will only work if the investor continues to deploy money towards SIP, through thick and thin, through good and bad market conditions.
An argument could be made that if the investor had purchased all the shares in the second year when they were available at the price of ₹75, he would have had 400 Shares instead of 313.33. There are two counter-arguments. One, that it is impossible to know in advance when the market will rise or fall and hence an investor who intends to time the market may keep on waiting and remain out of the market when shares are available on discount. Secondly, the opportunity cost of not deploying the first ₹10000 in the market for one full year would have been incurred. Market timing is a loser’s game which an average investor like you or me will find prohibitively costly to play.
In a study, Professor Nejat Seyhun studied 7802 trading days from 1963 to 1993 in the US Stock market and found that 95 percent of the market gains of these three decades happened in only 90 trading days—an average of three days in a year114. How would one know in advance which are those three days of the year? The answer lies in remaining invested in the market round the year. SIP offers the easy solution.
And finally, the biggest positive of SIP investing is that it brings in discipline in investing and takes emotions out of it. The ability to sock away a fixed amount month after month will invariably result in generous long-term returns due to the magic of compounding.
MUSING 36: REBALANCING
Remember what we discussed during our musing on asset allocation—it remains the single most important decision that a common investor will make. But what happens after you have made this decision? Is it that you work on a ‘fill it, shut it and forget it’ model or keep reviewing it every day, week or month? Actually, the answer is none of the above. The asset allocation done by our protagonist Anshreya of 75:25 (equity: debt) at the age 25 has to change at periodic intervals as time goes by, but it must change by design and not default. The answer lies in rebalancing the portfolio at regular intervals.
After initial asset allocation of 75:25 when Anshreya looked at her portfolio after six months, she realised that the equity component of portfolio had grown to 90 percent due to a roaring bull market. Happy times; who minds riding on the bull so long it’s giving you a joyride? Sorry to be a spoil sport, but Anshreya needs to bring down her equity component back to 75 percent, her well-deliberated asset allocation percentage.
As per the concept of rebalancing, Anshreya has to readjust her equity component from 90 percent down to 75 percent and invest that money into debt component to bring it up from 10 percent to 25 percent. It appears pretty counterintuitive; you sell something that is making profit and buy something that is a loss-making proposition. But in the long run, this investing discipline is going to make you a lot of money.
First, how do you rebalance? There are three possible ways to do it115:
• Shift your regular contributions (SIP) of equity compone
nt to debt component till they again reach the original asset allocation.
• Divert some or all of the profits you have made on equity component to debt.
• Sell some of the equity investment and reinvest that money to debt component.
The reason for rebalancing is very elementary. Remember you make profit only by buying low and selling high. There is no other way to make profit. When you rebalance, you sell your portfolio component, equity in our example, which has made profit (that’s why it has risen in value) and buy more of the portfolio component which is available on a bargain i.e. low price, debt in our example (that’s why it has gone down in value.) You have thus stuck to the fundamental profit-making principle.
The next issue is how much of deviation from your original asset allocation should trigger rebalancing? “If the asset allocation has only shifted 2 to 3 percent it does not call for any rebalancing116.” We can put a figure of 5 percent to trigger rebalancing.
How often one should rebalance? As per Burton Malkiel, author of the iconic book, ‘A Random Walk Down Wall Street,’ once a year is an ideal duration. “I don’t want to be trigger happy and sell something just because it’s going up. I like to give my good asset class at least a year in the run117.” And what do you do for rest of 364 days in the year? Enjoy your life because you are a long-term investor who has planted seeds for a future shady banyan tree which will also bear fruits.
Automatic Rebalancing
The emergence of newer variety of equity mutual funds has given the investors an easy way to reap the benefits of rebalancing without bothering themselves about it. This is possible by investing in mutual funds categorised as ‘hybrid funds’ which have a predetermined percentage of equity and debt component in them. The further breakdown, as per SEBI118, is as below:
Serial Category of Scheme Scheme Characteristics Description of Scheme
1 Conservative Hybrid Fund Investment in equity and equity related instruments— between 10 percent and 25 percent of total assets;
Investment in debt
Instruments—between 75 percent and 90 percent of total assets
An open-ended hybrid scheme investing predominantly in debt instruments
2 Balanced Hybrid Fund Equity and equity related instruments— between 40 percent and 60 percent of total assets;
Debt instruments— between
40 percent and 60 percent of total assets
An open-ended balanced scheme investing in equity and debt instruments
3 Aggressive Hybrid Fund Equity &equity related instruments— between 65 percent and 80 percent of total assets;
Debt instruments – between
20 percent to 35 percent of total assets
An open-ended hybrid scheme investing predominantly in equity and equity related instruments
4 Dynamic Asset Allocation or
Balanced Advantage
Investment in equity or debt that is managed dynamically An open-ended dynamic asset allocation fund
The advantages of investing in this category of funds are quite evident. Let’s say Anshreya has decided an asset allocation of 75:25 (equity: debt) as per the yardsticks provided in this book. She then invests in an ‘Aggressive Hybrid Fund’ which matches her asset allocation. As the time passes, one of the categories of the fund—equity or debt, is bound to outperform the other and hence the fund portfolio will get skewed from its original 75:25 allocation. The fund manager will automatically rebalance the portfolio to bring it within the laid down parameters, subject to some leeway that is inherent in the fund category itself (the equity and debt components are flexible within laid down percentages.)
Another advantage of investing in hybrid funds is that, despite a significant debt component, they receive tax treatment akin to an equity mutual fund i.e. LTCG at 10 percent after one year and not like debt funds where one needs to hold for 3 years for LTCG to be applicable. So, it turns out to be a win-win situation for an investor.
MUSING 37: THE CHIMERA OF RETURNS
“Surprise... The returns reported by mutual funds aren’t actually earned by Mutual Fund Investors.119”
The very first thing a common investor looks for in a prospective investment vehicle is its advertised ‘rate of return (ROR).’ We are taken in by what is being claimed by the AMC as its ROR. But it could well be a chimera because the returns claimed by the mutual funds are not the one that an investor gets. Let’s look at various kinds of returns one hears about and what should be our methodology to calculate real returns.
Average Returns: If the stock market goes up 50 percent in one year, then goes down 50 percent in the next, what is the average return for these two years—0 percent? No, actually one has lost 25 percent. Let’s do the math with an example. If you invest ₹100 in the market and it goes up by 50 percent, your capital appreciates to ₹150. The next year stock market tanks by 50 percent so your capital is now only ₹75, a net loss of 25 percent. Also remember, if you lose 50 percent in a year, you need to gain 100 percent next year just to break even. So, the average returns pedalled by fund houses are illusionary and should not be used for making investing decisions.
Absolute Returns: These are the returns achieved over any period of time. If you invest ₹1,000 in a financial instrument and it grows to ₹1,200 after six months, your absolute returns are 20 percent. It is a common mistake to consider a large absolute return as a great return120.
Annualised Returns: These are the absolute returns adjusted for twelve month period or in other words the total percentage gains of the fund divided by the number of years. To take an example, if one invests ₹1 lakh in a fund and over next 5 years it grows to ₹1.75 lakhs (gain of 75 percent,) the annualised returns will be 15 percent (75 percent/5=15 percent.) One would often find fund houses showing this ROR on their documents or sites but these too are misleading as they give an impression of a uniform ROR, which is not the actual case. One should instead look for something called Compounded Annual Growth Rate (CAGR.)
CAGR: This is the year over year growth rate of an investment over a specified period of time and calculated as below:
CAGR = (Ending Value/Beginning Value) ^ (1/Number of years) – 1
Taking the above figures used for calculation of annualised returns and calculating CAGR:-
CAGR = (1, 75,000/1, 00,000) (1/5) – 1 = 11.84 percent121. Notice how far away this ROR is from the annualised returns of 15 percent.
IRR: Internal Rate of return (IRR) also called ‘money-weighted return’ is a more accurate measure when there are inflows and outflows during the period concerned, as is bound to be the case in mutual fund investing through SIP. IRR scores on this count over CAGR as the latter just factors in the starting and ending amounts during the time period but not the inflows and outflows.
The take away is that to calculate the ROR on any investment; use CAGR (if there are no inflows or outflows from the fund) and IRR if there are inflows or outflows. But let us simplify this issue even further in a manner that a common investor like you and me can regularly calculate the ROR on a simple excel sheet as given by a financial master122.
If your portfolio has no additions or withdrawals, simply divide the end value by the beginning value and subtract one. For example, if you started the year with ₹10,500 and ended with ₹12, 000, your return is (12,000/10,500) – 1 = 0.143 or 14.3 percent.
If your portfolio had inflows or outflows during the year: First calculate the net inflow. In the above example, if you added ₹1,000 and then took out ₹700 during the year, then your net inflow was ₹300.
You subtract half of this or ₹150, from the top of the fraction and add one half to the bottom. So, (12,000 – 150)/(10,500 + 150) = 1.113; your return was 11.3 percent.
If you had a net outflow of ₹300, then you do the reverse—add to the top, subtract from the bottom. So, (12,000+ 150)/(10,500 – 150) = 1.174; your return was 17.4 percent.
Simple, isn’t it? This is exactly my purpose, to give a common invest
or the distilled wisdom of all financial masters for their regular use.
MUSING 38: PLANNING FOR CHILDREN’S EDUCATION
In 1999–2001, a two-year MBA at any of the IIMs used to cost about three lakh rupees. Fifteen years later the same degree costs ₹twenty-five lakhs. What’s interesting is that while the expenses for the degree have increased by over eight times, the average starting salary of an IIM graduate has increased by only four times123.
The Times of India, on 02 Feb 2018, ran an interesting article entitled, ‘How much does it cost to raise a child?’ The costs, from conception to college, included expenses on education, healthcare, food, clothing, entertainment, transportation, housing and other miscellaneous ones. The current calculated cost was ₹67.4 lakhs, which with inflation at 6 percent factored in, would translate to ₹1.7 crores. Of this cost, the highest expenditure was on education (59 percent of total cost) amounting to more than ₹1 crores. Remember that the inflation rate for education is much higher than CPI and estimated around 10-12 percent. As per National Sample Survey Office (NSSO), between 2008 and 2014, the annual cost of professional and technical education increased by 96 percent124.
Just take a moment and let these figures sink in. Even if we consider that all the costs towards raising a child, less the education, will get subsumed in the regular home expenditure (though this increase, with a child, need to be factored in the household budget), the cost for a professional undergraduate (UG) degree, after the child completes her 12th standard, needs to be planned separately.
Before one gets about planning for a child’s education, it will be worth our while to look at the current costs of a UG degree in India: MBA up to ₹25 lakhs, MBBS ₹70 lakhs and B. Tech. ₹20 lakhs, just to name a few mainstream and popular courses. Since parents would not know the interest of the child at birth, let’s work on an average cost of the three courses which comes to ₹38 lakhs. If one factors education inflation at 10 percent, for a child born in 2018 and pursuing UG degree at age 18, the corresponding cost will be approximately ₹2 crores. This amount will be required over a period ranging between 2 and 5 years depending on the course and we can again work on an average of 3-year course which translates into requirement of ₹65 lakhs per year (₹2 crores for 3 years).