Mutual Funds - Do's and Don'ts

In the past few weeks I have written two posts on mutual funds, namely “Mutual Funds – What Are They?” and “Mutual Funds - Part II”. After those two posts I felt as if there was still a lot more that regular investors need to know about mutual funds. And that is why I am here. I will be writing about some things that an investor should remember/know before investing in a fund. Also, I notice, that there are a lot of myths associated with mutual funds which I would like to clear here.

Things to Remember

Diversify: Remember to diversify your portfolio. Invest in 3-4 different funds out of which at least 60-70% of your money is in well diversified funds. DO NOT put all your eggs in one basket. Do not invest all your money in only sectoral/thematic funds.

Portfolio of the Fund: Before investing your money, see the portfolio of the fund you are investing in. Make sure that about 80% of the fund’s total corpus is invested in fundamentally strong blue chip companies and only about 20% is invested in opportunistic/risky stocks. Once you have examined the portfolio, you should have conviction in it. Growth can sometimes be painfully slow but over the longer term, blue chips are more likely to outperform than any other class of stocks. All information about mutual funds is available on the internet and a screenshot of the portfolio finder section on one such site is given here.

Past Performance: While past performance is no guarantee to future performance, it acts as a good indication. A fund which has consistently performed well in the past is also likely to do so in the future. Odd spikes like an annualized return of 70% in 15 days or 30 days is not a very reliable indicator but a return of 30% annualized in a period of 3 or 5 years is usually a good indication. Invest your money in funds showing good consistent growth rates. A screenshot to check the past performance is shown here. Also important to look at is the rating of the fund given by various rating agencies.

Choose Undervalued Funds: Mutual Funds can also be overvalued or undervalued and NAV is not the deciding factor. A fund may have an NAV of 20 and still be overvalued as compared to another fund which may have an NAV of 200 and be undervalued. The important factor is the Price to Earnings (P/E) of the fund. Funds also have P/Es and a fund with a lower P/E will be considered as undervalued as compared to a fund with a higher P/E. Compare the fund’s P/E with the P/E of the benchmark index, namely Sensex or the Nifty. P/E of a fund is nothing but the weighted average of the P/Es of all individual stocks in the fund’s portfolio. If you go to this site you can see various attributes, of any mutual fund in India, like the rating of the fund, fund facts, NAV, risk and return and the portfolio of the fund. The P/E of the fund can be found in the portfolio section, as can be seen in the screenshot with the portfolio write-up.

Monitor Your Performance: Once you have done the above things and have invested the money into mutual funds of your choice, just sit back and relax. All you have to do is to come out of your slumber at least once a month and see the performance of your funds. If your funds are not giving you any returns or have returns much lower than the broader market then it may be time to change your fund. A good way of comparing the returns of your fund is to compare it with the returns of the Nifty or the Sensex (if your fund is an equity fund).


Some Common Myths

Dividends Give Extra Money: All dividends are tax free. So, all the money that you get from dividends is tax free. That is good, but then why do I say that dividends giving extra money is a myth? Let us understand with a simple example. I have invested Rs.20000/- in a fund at an NAV of Rs.150/- and the fund has now declared a dividend of 20%. Since the dividend is on the face value, which happens to be Rs.10/-, I would get a dividend of Rs.2/- per unit. I had only 133.3333 units with me (20000/150) and I would get a cheque of Rs.266.67 as dividend, which works out as 1.33% of Rs.20000/-. At the same time the NAV would also come down by Rs.2/-. So, effectively I’m withdrawing a small amount from my own funds, contrary to the notion that I had that I was getting something extra. I can’t put these Rs.267/- to any productive use. Had I left them in the mutual fund and withdrawn after 20 years, they probably would have become Rs.10000/- which would both be substantial and at the same time could be put to some productive use too. Some people instead opt for dividend reinvestment option so that the dividend amount can be used to purchase additional units in the same fund so that the money remains in the fund. But on this purchase you have to pay an entry load of 2.25% again thus paying Rs.3.55 as charges. So you end up withdrawing Rs.266.67 and reinvest only Rs.263.12. In my opinion, it is anyday better to let your money stay invested in the growth option.

NAV is Immaterial: A lot of people I have come across prefer to invest in funds whose NAV is lower, rather than investing in high NAV mutual funds. That is a myth. They do not want to invest in a scheme having a history of 8 years and whose NAV is Rs.200/- per unit but they don’t mind investing in a similar scheme with a similar portfolio having an NAV of Rs.25/- per unit with negligible history. The NAV, as mentioned in the earlier post, is calculated as the Sum of the Value of all stocks held by the fund and then divided by the total number of units issued by the fund. Thus, two fund schemes having exactly the same portfolio with equal weights will deliver exactly the same return. Let us assume that both the schemes talked about above earn a return of 28% in two years. And if Rs.20000/- were invested in both today then we would be issued 100 units in the first scheme and 800 units in the second. The NAV of both schemes 2 years hence would be 256 and 32 respectively. The value of the first scheme would be Rs.25,600/- (100*256) two years from now and the value of the second scheme would be …. Any guesses??? Yes, Rs.25,600/-.

NFOs Give Better Returns: NFOs mean New Fund Offers. All NFOs are priced at Rs.10/- and that is an arbitrary figure. They could have very well priced it at Rs.1/- or Rs.100/- or Rs.1000/- and it would have made no difference to them. As mentioned in the point above, the NAV does not matter but it is the performance of the fund over a period of time that matters. And why would anyone want to invest in a fund with no history rather than in a fund having an excellent three year track record? In the 1980s and early 1990s, all shares in the equity markets were also issued at Rs.10/- or Rs.100/- depending on the book value of the shares. Irregular pricing (at discount or premium) or via the book building route was not there. So, it used to make sense in those days to buy shares in the Initial Public Offer (IPOs) at Rs.10/- and sell it in the markets when they listed for Rs.50/-. Nowadays, most IPOs are so heavily overpriced that it does not make sense to invest in them at all. Holders of Reliance Power IPO shares would vouch for it. These days almost 90% of the IPOs do trade below their issue price within 6 months of listing. An NFO at Rs.10/- is neither overvalued nor undervalued. In fact it has no value at all till the time the NFO closes and it constructs a portfolio. This is exactly the reason why the NAV is declared 30 days after the NFO closes, because till that time there is no portfolio, hence no change in value and hence no NAV. It is a total myth that at Rs.10/- the NFO is highly undervalued.

Timing the Market Can Save Money: This is, probably, the biggest myth of all times. It is impossible to time the markets. You may be successful in catching the exact highs or the lows one or two times but will be wrong in the remaining 8-9 times. If you have conviction that markets will do well in the next two years then today is the time to invest. The key point is the ‘time in the market’, not ‘timing the market’. This article will help you more to understand about investing for the long term. And since timing the markets is impossible, the best route to invest at the cheapest rates is to continue investing small amounts for a longer time, in short – follow the SIP route.

I hope that clears all doubts regarding mutual funds. In case you still have any questions, you can post them in the comments section and I’ll answer them there. And if there are too many questions, I’ll probably write another post answering all the questions.

More tomorrow.

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Markets Move in Expected Direction

As expected, the Nifty did come below the upward sloping trendline and is now ready for a (hopefully, small) downmove. As discussed yesterday, the Relative Strength Index (RSI) of the Nifty has also now confirmed the bearish head and shoulders pattern. We can hope for the Nifty to cool down for sometime but upto what level that is a little difficult to say.

Hopefully, we can come to know about the possible levels with the help of the chart below, which is the 60 minutes chart of the Nifty. If we see the chart we can see that this upmove started on 18th March 2008 from a level of 4468.55 and the high was made yesterday at 5298. If we apply the Fibonacci Retracements to it, we can see that the 23.6% retracement is at 5102.25 and the 38.2% retracement at 4981.15. At the moment we are not looking at a move below this level, though, I feel 5100 should be a good level to bounce back from. Of course, conditions may change, circumstances may change.

Note: I still remember about my promise about writing more on Fibonacci in one of the weekend posts. Let me finish with my series on the Mutual Funds first and then I’ll do it. Maybe I’ll do a webinar on it.

No stocks being discussed today. Let us wait for the market retracement to finish and see where support is found.

Okay, and just before I sign off for the day, a small quiz for you. Do you know why we keep using the terms ‘Bulls’ and ‘Bears’ in the stock market? I found the answer at Digital Inspiration, which says that “According to Motley Fool, a bear market earned its name because bears tend to swat at things with their paws in a downward motion (as in "the market's going down"). A bull market, on the other hand, got its name because bulls swing their horns upward when they strike (as in "the market's going up").”

More in the next newsletter.

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Mutual Funds: Part II

Last week I had written a post on mutual funds titled "Mutual Funds: What They Are?" Since that post had become very lengthy I had promised to add more to it. So, here I am.

Types of Mutual Funds

There are, essentially, and broadly, the following types of mutual funds:

1. Debt Funds
2. Equity Funds
3. Balanced Funds

Debt Funds: Debt Funds are those which invest a major portion of their corpus in government securities, bonds having varying durations, company fixed deposits and call and money markets. Between 90 to 95% of the total corpus is invested into such instruments. Since these are considered as safe instruments, therefore, the returns from such funds are also low but capital, in most cases, is protected, unless the investor stays invested in them for a very short period of time and there have been violent interest rate fluctuations in that period. One can expect a return of about 8-10% from such funds. One should stay invested in such funds for a minimum of 1 year for capital protection.

Equity Funds: Equity Funds invest a major portion (80% and above) in direct equities. Since the equity class is considered to be risky and returns are highly volatile, only those should invest who have the risk appetite to pass through volatile phases. There is a possibility that some investors may lose a part of their capital if they stay invested for a short period of time or if they invest in a bear market. To reap maximum benefits of an equity fund, one should plan to stay invested for a minimum of 4-5 years. One should expect a return of 18-20% from such funds.

Balanced Funds: As the name suggests, such funds invest about 50-60% of their total corpus in debt instruments and the remaining in equity instruments. This is done to reap advantages of both types of funds and to better the return as compared to debt funds and to reduce the risk which is there in classic equity funds. To lower the risk, one has to compromise on the returns, which are usually between 12-15% in such funds.

Loads

To run a Mutual Fund, there are costs and these costs are ultimately recovered from the investors in the form of loads. While most of the debt funds are no load funds, most equity funds have entry loads. In general, all equity funds charge an entry load of 2.25 to 2.5% while debt funds do not charge any. Both equity and debt funds are exit loaded on an early exit. While an equity fund charges 1% load on an exit within 6 months, a debt fund charges 0.5%. Debt funds are load free after 6 months whereas equity funds charge 0.5% if withdrawn between 6 and 12 months.

What Funds to Invest In?

Each investor has to see her own risk appetite. If you are the kind of person who would not like to take any risk whatsoever, then debt funds are the right choice. A person with a high risk appetite can go in for equity funds for higher returns while one can follow the ‘middle of the road’ approach by choosing balanced funds.

Equity funds come in different styles like thematic funds, sectoral funds, funds based on market capitalization etc. An investor should choose to invest a major portion of her portfolio in funds which are ‘evergreen’ like large cap funds or blue chip funds or well diversified funds. A part of the portfolio can go into other funds to take advantage of the ‘flavour of the season’. Keep your funds portfolio well diversified to reduce risk and get reasonable returns. Divide your money into 3-4 different funds but not so many that it becomes difficult to keep a track.

Today there are various funds like mid cap funds, small cap funds, power sector funds, media funds, banking funds, infrastructure funds and various others. All these concentrate on stocks of a particular sector or a particular capitalization and leave a lot to be desired from the power of diversification.

SIP is the Way to Go

Since timing the markets is a futile game (as one can never be right all the time), the best way to invest is to invest systematically. SIP is an acronym for Systematic Investment Plan. Under this plan, you set aside a particular amount (which could be as low as Rs.500/- with no upper limit) every month for investment in a fund. That amount is used by the fund to allot units to you based on the NAV of that day.

As an example, let us say you invest Rs.2000/- every month on the 15th. On 15th of last month, the NAV was Rs.20/- so you were allotted 100 units. On 15th of this month, with the improvement in the markets, the NAV increased to Rs.25/-, thus allotting you only 80 units. Then we witness a heavy crash and on 15th of next month the NAV falls to Rs.16/- which would then allot you 125 units. This means that you are buying lesser units when the price goes up and buying more when the price is low, thus decreasing the average price of holding. This way you acquire a total of 305 units for Rs.6000/- thus bringing your average to Rs.19.67/-. Alternatively, if you were buying 100 units each time, you would have spent Rs.6100/- and still bought only 300 units giving you an average cost of Rs.20.33 per unit. Thus, SIP helps you in bringing your average lower, which is also known as Rupee Cost Averaging.

Another advantage of SIPs is that you automatically save a small amount every month rather than a lumpsum every year. It will be easier for you to save Rs.5000/- every month rather than Rs.60000/- every year.

You can read more about SIPs on this page.

There is still a lot I need to talk about mutual funds but I guess I need one more post for that. Will upload it sometime next week.

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Mutual Funds: What Are They?

Do you invest in mutual funds? If you do, you know what they are and what they can do for you. If you don’t know about them, it is high time you should. This post gives you from the most basic to the technical aspects of a mutual fund.

Who Needs Mutual Funds?

With the markets rising, as they have in the past four years, everybody wants to take advantage of the markets. There are two or three options available. The first one, but not the easiest, is that you get yourself registered with some broker, set aside some money for buying stocks and you’re on. But most people, with long working hours and stressful jobs do not have the time to monitor markets and that makes one lose a lot of opportunities.

Some people do not have the knowledge or the aptitude for stocks but still want to take advantage of it. The most convenient option for them is to give the money to a friend or an Uncle to invest on their behalf. But these friends or Uncles are sometimes scared to invest on your behalf because they don’t want to ride the guilt of you losing money if one of their decisions went wrong. Alternatively, even if they don’t feel scared or guilty and some of their decisions do go wrong, which inevitably will (because nobody is perfect), you won’t hold them in very high esteem.

The third option, and undebatably the best for such people, is to invest their money with a mutual fund. That way even if the mutual fund loses you money, the only loss of relationship you have is that you won’t invest money in that mutual fund anymore. As it is, you have a lot of other options available.

The third problem that usually comes is that you do not have enough money to properly diversify your portfolio and we all know the advantages of diversification to get good low risk returns. To properly diversify her portfolio, the investor would need to invest at least Rs.2-3 lakhs.

What Is A Mutual Fund?

Let us understand this with a very simple example. Suppose there are 10 investors, each with a capital of Rs.50,000/- to invest. None of them has a big enough capital to properly diversify their portfolio. So, they make a syndicate and invest jointly because then the combined portfolio of Rs.5 lakhs can be well diversified. But the problems that usually come with such a syndicate is that you can never trust the person completely who is in charge of all the funds. Secondly, you will always feel cheated or will always suspect the division of the profits, specially, if the investment amount of each investor is different.

So, they appoint a person who they all trust, and who has the knowledge of the markets and they pay him to invest on their behalf, and who divides the profits equally and fairly among all investors after deducting his own expenses for the time and the effort he has to put in. That, in a way, is a small mutual fund.

But Mutual Funds AMCs (Asset Management Companies) have thousands of investors and have crores of rupees to invest. That gives the fund manager control over his investments and can stay invested in stocks for a longer duration (assuming that not all investors will withdraw funds at the same time). The fund manager has a full research team backing him and he himself is knowledgeable about the markets and the AMC ensures that all profits are divided equally among all investors.

How Are The Profits Divided?

On each day, except Saturdays, Sundays and holidays, a Net Asset Value (NAV) is calculated which is nothing but the value of all the securities held by the mutual fund in its portfolio. Any investor who invests into a mutual fund is allotted units. The number of units to be allotted is calculated by dividing the amount invested by the NAV of that day. For example, if an investor is investing Rs.50,000/- in a mutual fund and the NAV on that day is Rs.150/- then she would be allotted 333.3333 units (50000/150). Unlike shares, where only whole numbers can be purchased, units can be allotted in decimals too.

Since the NAV is calculated on each day, any investor entering on any day can be allotted the exact number of units based on the value of the portfolio on that day. Similarly, any investor exiting on any day can be given the money as per the value of the portfolio on the day of exit. The amount to be paid to this investor is calculated by multiplying the NAV of that day with the number of units held by him. So, in the above example, if our investor decides to exit on a day when the NAV is Rs.200/-, she would be given a cheque of Rs.66,666/67- (333.33333 x 200), thus making a profit of Rs.16,666/67- in the transaction.

NAV Calculation

A very simple example of calculation of NAV. Suppose I have a mutual fund in which 100 people have invested (each investing Rs.10000/-), which gives me a total corpus of Rs.10 lakhs. I allot a total of 1 lakh units, each unit at Rs.10/-. Next day I go out into the market and buy shares worth Rs.9.5 lakhs and keep Rs.50000/- as cash. Suppose the value of the shares after 10 days is Rs.10 lakhs (which has since increased from Rs.9.5 lakhs). Now, the total value of my portfolio is Rs.10 lakhs in shares and Rs.50000/- in cash, thus making Rs.10.5 lakhs. Dividing this by 1 lakh (the total number of units issued) I get an NAV of Rs.10/50- per unit after 10 days.

There is a lot more to know about mutual funds but, I suppose, this post is going to become very lengthy if I delve any deeper into it. I will write another post about mutual funds in the days to come, which will talk about what types of mutual funds are there, what are the costs, what mutual funds to buy and some common mistakes people make when investing in mutual funds.

Update: This article was also published on the business and investing page of Reuters.

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