Invest in an international mutual fund to take advantage of the weak rupee

The sharp decline in the value of the rupee against the dollar in recent weeks has made consumers and investors anxious. 

The rupee has steadily weakened to touch an all-time low of 72.5 a dollar, hit by concerns over a global trade war and a widening current account deficit. 

However, investors can actually benefit from the sliding rupee over the medium to long term by parking some money in an international fund. 

Nullify currency impact 

When you put money in an international fund, the money is invested in that particular overseas market in dollar denominated assets. The change in price of these assets—foreign equities or bonds—during the period of your investment primarily drives the return of the fund. But apart from the performance of the underlying portfolio itself, the movement in the dollar-rupee exchange rate also contributes to the fund’s return. 

Since the final net asset value of the international fund is arrived at by converting the value of the dollar assets into the local currency, the exchange rate fluctuations play a key role in the fund’s return profile. A weaker rupee relative to the dollar adds to the actual return from the fund, while a stronger rupee can put a dent in the fund performance. This is visible in the return profile of international funds in recent years. 

US focused equity funds have fared well in recent years 3 and 5 year returns are annualised. Source: Value Research. Data as on 10 Sept 2018 Certain US focused equity funds in particular have benefited from the currency movement in the past few years. For instance, the Motilal Oswal Nasdaq 100 ETF has clocked 20.4% annualised returns over the past five years. 

However, the underlying index has actually gained 18.6% in dollar terms during this period. The additional return from the ETF is owing to the 2.4% annualised appreciation in the dollar during this period, excluding the impact of expense ratio and tracking error. Similarly, the DSP US Flexible Equity Fund has clocked 13.25% annualised returns over the past five years, even as the NAV of its underlying fund, BlackRock Global Funds-US Flexible Equity Fund, has gained 12.74%. 

Again, the additional return is owing to the rupee depreciation. An international fund can help investors hedge the currency risk to the domestic portfolio. “Being a developing economy with a higher inflation trajectory, the local currency is likely to continue to depreciate against the dollar over the years. Its impact can be nullified to some extent with an international fund,” says Amol Joshi, Founder, PlanRupee Investment Services. 

Gain from geographical diversification

However, hedging currency exposure cannot be the sole reason to consider an international fund. The biggest benefit of opting to invest in foreign equities is bringing geographical diversification to the portfolio. By investing overseas, you prevent the portfolio from becoming entirely dependent on the performance of the domestic market. 

At times when the domestic economy and markets are going through a tough phase, having exposure to a better performing overseas market can lend stability to the portfolio. “Since the Indian market has very low correlation with some of the overseas markets, having global exposure ensures healthy diversification,” contends Prateek Pant, Co-founder and Head of Products and Solutions, Sanctum Wealth Management whose firm offers a Global Allocator strategy using the PMS platform to enable clients to diversify geographically.

Besides, investing in international funds is no longer tax inefficient compared to investing in domestic equity funds. Earlier, gains from domestic equities attracted no tax if held for a year, even as gains from an international fund were taxed at the marginal rate if sold before three years, after which gains were taxed at 20% with indexation benefits. Now, with domestic equities also facing 10% tax on capital gains after one year, investing in international funds is no longer a tax-negative proposition.

Planning for foreign currency expenses

This avenue is particularly worthwhile for those planning to send their children abroad for higher studies or even considering a foreign vacation at some point in the future. Given that the effective cost of foreign education or a trip is likely to go up as the rupee weakens, investment in an international fund can help partially offset the impact of any adverse exchange rate movements. 

In fact, some experts insist that planning for a goal such as foreign education or vacation should involve investment in an appropriate international fund. Joshi says, “Putting some money in an international fund makes sense for anyone with certainty of future expense in dollar terms.” Out of every Rs 100 allocation towards any financial goal involving foreign currency exposure, Joshi suggests putting Rs 25-30 in an international fund while the rest can remain invested in domestic assets. 

Maintain simplicity and discipline

The choice of international fund, however, is critical given the plethora of themes on offer in this category. Planners recommend a simple US dedicated equity fund for the required international exposure, given the stability of the US market. Other more exotic offerings—targeting other geographies or specific investment themes—may do more harm than good to your portfolio. Pant insists that investing in a global fund should not be a one-time exercise. “Investors should follow the same investing discipline with their international allocation as their regular domestic investments,” he says. 

                                                                                                                                             

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PFRDA caps equity mutual fund investment at 5% of total corpus

Chennai: The pension fund regulator has put restrictions on the amount of money an asset manager can invest in equity mutual funds, taking cognizance of the fact that some of them had invested huge sums of money in these investment vehicles.

The Pension Fund Regulatory and Development Authority (PFRDA), in a 20 August circular, has capped investment in equity mutual funds at 5% of the total corpus. The rule will also apply to fresh investments. After permitting active management of the equity portfolio in 2015, the regulator also allowed pension fund managers to invest through mutual funds to offer them flexibility. 

“We wanted to provide flexibility and an avenue for the fund managers to park the money while waiting for the right scrips,” said B.S. Bhandari, whole-time member (economics), PFRDA. “However, some fund managers chose mutual funds as their investment strategy and invested huge sums of money. Being fund managers themselves, it’s incorrect to outsource fund management,” he added. Mint had flagged this issue last year.

Of the eight pension fund managers that NPS (National Pension System) has, this move will primarily impact Kotak Mahindra Pension Fund Ltd (KMPFL) because it had invested its entire equity portfolio through mutual funds. According to the company, it has about ₹ 225 crore of assets under management under the equity portfolio.

“We have diluted about 50% of our mutual fund holding, but some mutual funds have an exit load, so we will wait for the exit load period to get over before redeeming the rest in the interest of the investors,” said Sandeep Shrikhande, chief executive officer, Kotak Pension Fund.

The fund manager is now moving to invest directly in equities. While this strategy tantamounts to outsourcing fund management, it also means that investors pay extra costs of the mutual funds.

“Our focus has been to give superlative returns to the investors, and since asset management companies have the required skill set and capabilities we chose mutual-funds investments. Despite the costs, we were able to beat returns of other fund managers,” added Shrikhande.

LIC Pension Fund Ltd had also invested a portion of its equity funds through mutual funds.

LIC Pension Fund didn’t respond to a query seeking comment.

According to the annual report for FY18 of LIC Pension Fund, it had about 11% of its equity corpus invested in mutual funds for the private sector and about 13% for the government sector.

As on 31 August, the fund manager had assets under management of around ₹455.79 crore in the equity portfolio of the private sector NPS. Its exposure to mutual funds has come down to less than 4%, according to portfolio disclosure of 31 August.

According to a chief investment officer of a pension fund company who didn’t want to be named, this circular will also impact some state-run pension fund managers as they had invested in Bharat 22 exchange-traded fund (ETF).

                                                                                                                         -Livemint

What is 'investor inertia' and how it can waste your wealth

There is an explanation as to why we treat our assets carelessly. Many of us have pending tasks stashed at the back of our minds that we hope to complete some day. The pending nomination in the demat account; the incomplete change of address request; the matured deposits that are hopefully renewing; and the will we never made. We believe everything will somehow fall into place and be alright. 

Aretha Franklin, regarded the queen of soul, died at 76 after a long struggle with pancreatic cancer. She left no will behind for her estate estimated at $ 80million. Her lawyers advised her to set up a trust or create a will, several times but to no avail. They say she did not refuse to write a will, only she did not come around to doing it in her lifetime. What should have been an easy transfer of wealth, will now be a prolonged court affair played out in public. 

Investor inertia, or the condition where investors are comfortable doing nothing is a well-documented phenomenon. Investors worry about making the wrong decision. Faced with too many choices, they do not know what to do. They dislike tasks that entail making multiple decisions. Paperwork is something they hesitate to take on as it involves time, too many details, and the need to deal with multiple agencies. Denial is preferred instead. 

Investors who leave money lying in the bank are not uninformed. Research shows senior executives, CXOs and investment managers who manage a large amount of public wealth, are also victims of inertia when it comes to their own wealth. Either they do not come around to deciding, or they worry so much about making the right choices, that they do not make one at all. 

The consequences of this inaction are well known. Wealth is created when its current use is sacrificed for a future benefit. Not taking care of it undermines the sacrifice, while defeating the purpose for which it was accumulated. What can be done about this? 

First, keep all transactions clean and simple. Many investors struggling with multiple demat accounts and signatures that do not match are the ones who made investment decisions in haste, listening to the wrong advice. There was a time when someone with the name, say, Ram Kumar Shinde, would make multiple applications to an IPO with these variations in name and signature: R.K. Shinde, Ram K. Shinde, R. Kumar Shinde, and so on. This was to somehow get an allotment. Now Mr Shinde does not remember how he signed the forms. 

Multiple bank accounts were opened at a time when banks did not have the technology to link them. Post offices were used to stash cash, without anyone finding out. Studies show the post office schemes were used to systematically whitewash black money, even as we thought these were schemes for the poor. Every time a politician died unexpectedly, a few hundred followers turned rich overnight, encashing the benami wealth kept in their names. There is no need to feel smart about the disease popularly called jugaad. With PAN, Aadhaar and other identifications now available, many loopholes are being plugged. Keeping it simple is not naiveté. 

Second, do not overdo the diversification idea. There is no need to have a 100 plus items in your list of wealth, especially if you are not wealthy enough to have your own private office to manage it. Studies of portfolios of high net worth individuals show a long list of stocks, funds, bonds and other investments made in small amounts, over time. This many not be efficient. 

When we are unsure about an investment opportunity, we tell ourselves that a small amount won’t matter. So a new product is launched, and we put in a small amount. Then it fails to perform. We believe it will bounce back, and the small stake allows us to ignore it. We then move on to something else, allowing the earlier investment to continue to bleed. Our inability to sell loss-making investments is also well documented. 

There is no need to have a long list of investments to be successful. It is counterproductive. Your best investments won’t matter much if they aren’t sizeable, and your bad investments will keep dragging your portfolio down. If you have to scroll down an excel sheet to view your investments, you have too many. Twenty to 30 products should serve the purpose for most investors. Keep those numbers in control and sell off what is not working. 

Third, take help for tasks you do not like to do. Many advisers say it is common for investors to have their wealth managed by multiple agencies—banks, brokers, a few distributors, hopefully an adviser, and some by themselves. This means only the investor knows where the assets are, and fails to trust anyone with the entire list. It is today possible to get a consolidated statement of all your listed assets —stocks, bonds, mutual funds—as a common account statement generated by NSDL. 

Hand over this statement to your financial adviser and for a fee you can negotiate, get it all cleaned up. They are familiar with the process, and will help you manage the paperwork if you let them manage your assets. Do not assume that being secretive about your assets is helpful; it can harm your wealth if you do not manage the multiple portfolios that you zealously created. 

Fourth, write a will. It is not as tough as it is made out to be. You do not have to identify each item of your wealth and list it. You will should primarily indicate who will get what (beneficiaries) and who should ensure that the distribution is made according to your will (executor). The executor will take up the tasks of probating your will, making the lists, completing the paperwork, and ensuring that everything is settled as indicated. Two witnesses are adequate to validate the will. After your time, your will prevails and ensures that your wealth is not left to waste. 

There are millions left unclaimed by investors over years. This money is transferred to the investor education and protection fund, to hopefully educate others about how to not let their wealth go waste. Guard yours. 

                                            

                                                                                                                                                               -etwealth

How long is long-term when investing in equity?

In personal finance, there are many terms that mean nothing at all, some that could mean anything, and a few that mean different things to different people. 

One such term is ‘long term’. How long is long-term? Everyone’s answer is different, perhaps legitimately so. Even so, there must be a period when the benefits of a long-term investing strategy become obvious to all. 

Some years ago, Fidelity Investments conducted a study in the US to find out more about this and discovered something rather odd: being dead could be a good investing strategy. They discovered that the highest returns were earned by investors who had just ignored their investments for years and decades. What’s more, it also turned out that many of these investors had actually died at some point. So the conclusion was that when it comes to managing your investments, the best strategy could be to do what a dead person would do—nothing. 

While Fidelity actually studied a large number of investors, we all know many anecdotes like this. Some time last year, someone called into a stock market channel with a story of this category. This person—who seemed to know almost nothing about equity investing—said that about 25 years ago, a relative had bought 20,000 shares of MRF. He wanted to know whether those shares would have a good value today. It turned out that if this number was correct, then the shares would be worth around Rs 130 crore. Even if the number of shares was exaggerated, an investment in this company would have multiplied by about 200 times over the period mentioned. 

From the punters who think that three four months is long-term, all the way to examples like above, there’s a huge range of answers to the question, ‘how long is long term?’ As it happens, there’s one official answer from the revenue department of the Government of India. For the purpose of calculating your taxes, investments in listed stocks and equity mutual funds are considered long-term if the holding period is one year. For other investments, the limit is three years. 

However, from an investment perspective, this makes no sense. One year is too short a period for equity investing. For the right answer, let’s get back to the basics and ask the fundamental question: Why should equity investing be done only for the long-term? The answer, of course, is, to deal with volatility. Over a period like five or six years, the returns are often great, but the variability is high. In any given short period, you could face poor returns, or even losses 

There’s another way to look at it. The equity markets move in cycles, and often, it takes five to seven years to go through a full cycle of a sharp rise, decline and stagnation and back. To get the right level of returns, we need to invest through the whole cycle. That won’t happen in a year or even two years. 

There’s yet another way of looking at it, which was the subject of a unique study that Value Research conducted a couple of years ago. We found that on an average, if you invest through an SIP (Systematic Investment Plan) over four years, then your risk of a loss is negligible. 

For a typical fund with a multi-decade history, over all possible one year periods, the maximum returns are 160% and the minimum -57%. Over two years, this becomes 82% and -34%. Over three, 63% and -18%. Over five, 54% and 4%, meaning never any loss. Over 10 years, the maximum is 30% and the minimum 13%. These are all annualised figures. 

The trade-off is crystal clear—the shorter the period, the higher the potential gain but the worse the possible risk. This evidence squarely puts long-term at five years and above. Long-term is not a vague rhetorical term that can be defined just as someone wishes. Five years and more is long term, and that’s the only correct answer. 

                                                                                                 

                                                                                                                                                                 -etwealth

Are Equity Savings Mutual Funds suitable alternative for Fixed Deposits

Mutual funds have been growing in popularity among retail investors in India over the last few years. 2017 was one of the best years for the mutual fund industry with record inflows. Media observers and experts attribute this growth to increased awareness and maturity of the retail investors. Despite the phenomenal growth in mutual fund AUM, penetration of mutual funds in our country is still very low. The share of mutual funds in financial savings is below 3% (October 2017), whereas insurance is about 25% of savings. The maximum share of financial savings, around 40% (October 2017), is in cash and deposits.

The above figures show that risk aversion is still the pre-dominant sentiment among large sections of investor population in our country; Bank Fixed Deposits and Government Small Savings Schemes are still automatic investment choices for most investors. In fact, many investors, who have been investing in mutual funds for several years, still have most of their savings in Fixed Deposits. With FD and small savings interest rates falling over the last 2 years or so, many financial advisors are advising their clients to replace their FDs with investment in Equity Savings Mutual Funds. In this blog post, we will discuss about Equity Savings Fund and their suitability for different investment needs.

Why did Equity Savings Funds come into being?

Equity Savings Fund is a relatively new category of mutual fund schemes. Equity Savings Funds were launched in late 2014 and 2015, primarily in response to the change in debt fund taxation introduced by in NDA Government’s 2014 Budget. Prior to 2014, capital gains in debt mutual funds held for more than 1 year were taxed at 10% without indexation or 20% with indexation. Debt fund capital gains taxation gave debt funds, especially low risk products like Fixed Maturity Plans, a significant tax advantage of bank FDs, especially for investors in the higher tax brackets because FD interest is taxed as per the income tax rate of the investor; indexation, on the other hand in an inflationary environment, reduced the tax outgo of debt fund investors considerably.

In the 2014 Budget, the Finance Minister, Mr. Arun Jaitley, changed the holding period for long capital gains tax for debt funds from 1 year to 3 years. Long term capital gains (investment held for more than 3 years) was to be taxed at 20% with indexation and short term capital gains (investment held for less than 3 years) was to be taxed as per the income tax rate of the investor. With this change in taxation, over a 3 year plus investment tenure debt mutual funds still enjoyed a tax advantage over FDs, but there was no tax advantage for shorter tenures. The industry response to this tax change was to come up with a tax friendly product, which retained some of the riskcharacteristics of debt funds. This product was Equity Savings Fund.

Balancing risk and return

Equity Savings Funds are hybrid mutual fund schemes, which invest in both debt and equity securities. The main purpose of any hybrid fund is to balance the risk return characteristics of different asset classes. Risk and return are directly correlated; higher the risk, higher the return and vice versa. Equity is a risky asset class, but gives higher returns in the long term. Some investors are comfortable with the risk, while others may not be comfortable. Debt is a low risk asset class, but gives lower returns than equity. Some investors may prefer low risk, but also seek higher returns. Hybrid funds combine equity and debt assets to produce an asset type whose risk is lower than equity, but which can beat fixed income returns. There are different types of hybrid funds with different debt and equity allocations. Balanced Funds, for example, have 65% asset allocation in equity and the remaining in debt securities. You may like to read Balanced Fund Demystified

Monthly Income Plans have 5% to 25% asset allocation in equity and 75% to 95% in debt. The risk characteristics of hybrid mutual funds depend on the asset allocation. SEBI has devised a “Riskometer”which can give investors a sense of the risk in each scheme – we encourage investors to refer to the scheme “Riskometer” before investing.

Equity Savings Fund

Equity Savings Mutual Funds invest in debt and equity securities. The gross equity exposure of these funds is at least 65%. This ensures that, these funds enjoy equity taxation – equity is much more tax friendly than debt (we will discuss in more details later). Debt exposure will not exceed 35%. But how is this different from Balanced Funds; after all, Balanced Funds have existed in India for more than 20 years. Remember, the idea was to have a product, which is a somewhat similar to a debt fund and tax friendly at the same time. In other words, the risk profile of Equity Savings Funds has to be lower than that of Balanced Funds, while maintaining the 65% equity allocation to enjoy equity taxation. This was accomplished through hedging.

What is hedging?

Hedging is a strategy for reducing the price risk of a security. It is achieved through derivatives. Let us understand this with the help of an example. Suppose you buy 1000 shares of a company at Rs 100 each. If the share price rises to Rs 110, you will make a profit of Rs 10,000; if the share price falls to Rs 90, you will make a loss of Rs 10,000. Now you want to hedge your risk by 50%. You sell 500 futures of the company in the derivatives (F&O) market. Futures price moves closely with the share price and converges on expiry of the futures contract every month. If futures price increases by Rs 10, you will make a loss of Rs 5,000 in futures, but you made Rs 10,000 profit in the stock and so your overall profit will be Rs 5,000. If futures price falls by Rs 10, you will make a profit of Rs 5,000 in futures and this will offset the Rs 10,000 loss you made in the stock and your loss is limited to just Rs 5,000.

In this example, our hedge ratio was 50%, but if you want you can hedge 100%. If you hedged 100%, there would be no profit or loss. Equity Savings Funds also hedge a certain portion (usually 50 to 60%) of their gross equity exposure, to reduce the risk for the investor. Thus Equity Savings Funds are able to enjoy equity taxation, but the equity risk is reduced by around 50% due to hedging. The un-hedged equity allocation, also known as the active equity allocation, is exposed to risk but also gets returns for investors over a sufficiently long investment horizon.

Hedging reduces risk and also can yield returns

In a perfect market, hedging reduces the risk exactly in proportion of the hedge ratio. However, the market is not perfect. There are inefficiencies in the market which can allow investors to make risk free profits. Futures usually trade at premium or sometimes at a discount to the spot price (price of the share in cash market). Suppose in the above example, the futures price was Rs 101 when the share price was Rs 100; you sold 500 futures. On expiry of the futures contract, the futures price will converge with the stock price. So if the share price rises to Rs 110 by expiry, you will make a profit of Rs 10,000 in the stock and a loss of Rs 4,500 in the futures. So your net profit will be Rs 5,500 (in the earlier example, the profit was Rs 5,000).

Similarly, if the share price falls to Rs 90 by expiry, you will make a loss of Rs 10,000 in the stock and the profit of Rs 5,500 in futures. So your net loss will be Rs 4,500 (in the earlier example, your loss was Rs 5,000). So in this example, irrespective of whether the price went up or down, you made an extra Rs 500 in your combined position. This profit is known as Arbitrage.

Please note we have ignored transaction costs like brokerage, Securities Transaction Tax etc. in the Arbitrage example. Transaction costs reduce Arbitrage profits, but equity savings fund managers have the ability to identify arbitrage opportunities, which can yield reasonable returns even after factoring transaction costs. Liquidity is another important consideration for fund managers in Arbitrage and fund managers try to ensure high liquidity in the hedged portion of Equity Savings Fund’s portfolios. Historically, arbitrage opportunities yielded 6 – 8% average annualized returns, similar to what money market mutual funds like liquid funds yield. Arbitrage profits on the hedged positions enable Equity Savings Mutual Funds to generate additional returns to investors without any risk– Arbitrage, by definition, is risk free profits. The hedged equity portion of Equity Savings Mutual Funds is usually around one third of the total portfolio; however, it can vary within 30 – 40% range at the fund manager’s discretion.

Active Equity Exposure

The un-hedged equity exposure of Equity Savings Funds, also known as an active equity exposure or net equity exposure, is subject to stock market risks generates capital appreciation for the investors. The active equity exposure is in a diversified portfolio of stocks across different sectors and market cap segments. Some equity savings funds employ a predominantly large cap strategy, which limits risk, while others employ a multi-cap strategy, which increases risks but generates higher returns. Investors can chose a large cap oriented or multi-cap oriented Equity Savings Fund based on their risk preferences. The active equity exposure of Equity Savings Funds can help investors and inflation over a sufficiently long investment horizon. If you are looking to get higher than FD interest rates, then the active equity exposure will help you get the additional returns. The un-hedged equity portion is usually around one third of an Equity Savings Fund portfolio.

Fixed Income Exposure

As discussed earlier, the debt or fixed income exposure is below 35%, so that Equity Savings Funds enjoy equity taxation. The fixed income or debt portion of the portfolio has much lower risks than the active equity portion of the portfolio, but slightly higher risk than the hedged equity portion. This is because the debt portion is exposed to interest rate and credit risk. The degree of interest rate and credit risk varies from one Equity Savings Fund to another. In most cases these risks are moderate, but in Advisorkhoj, we ask investors to do their own homework before investing.

Investors should look at the modified duration and the credit rating profile of the debt portion of Equity Savings Mutual Funds. If the modified duration of Equity Savings Mutual Fund is low (2 – 3 years or less) then the interest rate sensitivity is limited. Since, risk moderation is an important investment objective for investing in Equity Savings Mutual Funds, an accrual based fixed income strategy is best suited for investor needs and for this fund managers should invest in low duration bonds. But some fund managers may want to take duration calls to benefit from interest rate changes which increase the risk. Investors should therefore, look at the modified duration to decide, whether they are comfortable with the interest rate risk of the fund.

We in Advisorkhoj, urge investors to invest in high credit quality funds because credit risk can yield higher returns, it is unpredictable. Therefore, in our view, you should invest in funds which have a high percentage, 85% or higher, in Sovereign / AAA / AA rated bonds or NCDs or commercial papers. You can find the modified duration and credit profile of a fund in the monthly factsheet available on the AMC websites.

Overall risk profile of Equity Savings Funds

We have seen that, Equity Savings Mutual Funds usually invest a third in debt securities for income, third in hedged equity earning arbitrage profits and a third in un-hedged / active equity for capital appreciation. Approximate, two thirds of the portfolio of an Equity Savings Fund is therefore, low to moderately low risk - only one third has high risk. The risk profile of these funds is therefore similar, though slightly higher than, aggressive debt oriented hybrid funds (e.g. Monthly Income Plans).

However, in quite a few mutual fund research websites, these funds are clubbed together in the same category as aggressive hybrid funds like balanced funds due to their gross equity exposure. This categorization leads to wrong comparisons. Equity Savings Funds simply, cannot be compared with Balanced Funds – if at all, they are more similar to aggressive Monthly Income Plans (MIP). Therefore, in Advisorkhoj research, we have a separate category for Equity Savings Mutual Funds.

Are Equity Savings Funds good alternatives for FDs

This was the topic of our blog, but we are addressing it towards the fag end of our post. The reason is that, investors should understand the risk characteristics of a financial product before making investment decisions. By now, it should be clear to you that Equity Savings Funds cannot be compared to Fixed Deposits because around a third of the scheme portfolio is subject to equity market risk. In fact, no mutual fund product can be compared to Fixed Deposit because mutual funds are subject to market risks (debt or equity markets), whereas Fixed Deposits are risk free.

However, let us discuss this point from the perspective of investment need, rather than the risk characteristics. Why do you invest in Fixed Deposit? If you need an assured amount, principal + interest, at the end of the investment term for a specific financial goal, then there is no alternative to FDs. But very often, we invest in FDs because we have surplus funds and we do not want to take risks. The problem with that approach is that, FD returns on a post-tax inflation adjusted basis is often negative, in other words, we are not creating wealth but diminishing it, in terms of purchasing power.

Consider an FD which pays 6.25% interest rate to an investor in the 30% tax bracket. The post-tax return to the investor is 4.35% (after tax including 4% Cess); the inflation rate currently is over 5%. Clearly, the real return (inflation adjusted return) is negative. To beat inflation, you need the higher asset yields of equity. At the same time, you may not have the risk appetite associated with equity investments. This is where Equity Savings Funds can offer investment solutions. On an average, over time, Equity Savings Mutual Funds can give inflation beating returns to investors, while limiting downside risks.

Consider this scenario, where an Equity Savings Fund has one third is fixed income yielding 7 - 8% returns, one third in hedged equity / arbitrage yielding 6 – 7% returns and one third in active equity. Even if the market falls 13 to 15% (assuming the equity portion of the fund falls in line with market), the fund will not give negative returns. One the other hand, if market rises 15 to 20%, the fund will give double digit returns (assuming that the equity portion of the fund rises in line with market). Purely from a risk return trade-off perspective, therefore, Equity Savings Mutual Funds are good investment options for investors with moderately low to moderate risk capacities.

Tax Advantage and Conclusion

In this blog post, we discussed about Equity Savings Mutual Funds, how they work, their risk return characteristics and their investment suitability. These mutual fund schemes are good moderate or moderately low risk investments. The major advantage of these funds is that they enjoy equity taxation. Equity fund taxation has been changed in this year’s budget. Short term capital gains (investments held for less than 1 year) in equity and equity oriented mutual funds are taxed at 15% plus Cess (4%). Long term capital gains (investments held for less than 1 year) from April 1, 2018 onwards will be tax exempt up to Rs 1 lakh; above Rs 1 lakh, long term capital gains (LTCG) will be taxed at 10% plus Cess. Even after the re-introduction of long term capital gains tax for equity, equity savings funds will continue to enjoy significant tax benefits compared to FDs.

                                                                                                                        -Advisorkhoj

How SWP from Balanced Mutual Funds can be useful to get regular return

Balanced Mutual funds have 65 – 75% exposure to equities and 25 – 35% to debt. The debt component of balanced mutual funds makes these funds considerably less volatile than equity mutual funds. At the same time, the equity component enables balanced mutual funds to beat inflation and give good returns over a sufficiently long time horizon. Balanced mutual funds are tax friendly investment options - long term capital gains (for an investment holding period of more than 12 months) in balanced mutual funds are tax free. Dividends paid by balanced mutual funds are also tax free. The chart below shows average annual returns from balanced mutual fund category versus the Nifty index over the last 5 years.You can see that, balanced mutual funds as a category was able to beat Nifty in most years. You can see that, balanced mutual funds gave positive returns even in 2015, when the market gave negative returns. Please note that the green bars represent balanced fund category average returns; top performing balanced mutual funds gave much superior returns. As such, balanced mutual funds are ideal investment option for investors with moderate risk capacities looking for stability.

Over the past several years top performing balanced mutual funds had an excellent dividend pay-out track record. The chart below shows the dividend payout track record of Reliance Regular Savings Fund – Balanced Option for the last 9 (we have selected the scheme for purely illustrative purposes; some of the other top performing balanced funds also have been paying regular monthly dividends over the last year or so).Let us now understand how dividends are paid by mutual funds. Investors should remember that mutual fund dividends are not assured. SEBI regulations require mutual funds to pay dividends from the distributable surplus of a scheme. The distributable surplus of a scheme is calculated using the Net Asset Value (NAV), face value, Dividend Equalization Reserve and Unit Premium Reserve.

Let us understand this with the help of an example. Suppose the NAV of mutual fund scheme, whose face value is Rs 10, goes up to 15. What is the increase in NAV represent? This represents the increase in the price of the securities in the scheme portfolio. But the mutual fund cannot use the entire Rs 5 gain to pay dividends to investors. In March 2010, the market regulator, SEBI asked mutual funds to pay dividends only from realized gains. Gains are realized when mutual funds sell securities. Suppose the scheme books Rs 3 as profits (by selling securities). This goes to the Dividend Equalization Reserve account. Dividends can be paid out of this account. The unrealized gains (Rs 2 in this example) go to the Unit Premium Reserveaccount. Therefore, dividend payout arises only when profits are booked.

Investors should note that, the fund may not pay the entire realized gains (Rs 3 in this example) booked to the Dividend Equalization Reserve as dividends to investors. It may save some for a rainy day – at times, when the fund is not able to book profits, the fund may dip into the Dividend Equalization Reserve to pay dividends to investors from profits booked but not distributed.

You may have seen that, older balanced mutual funds were able to pay dividends to investors even in bear market years because they had sufficient distributable balances in their Dividend Equalization Reserve. However, investors should not take historical monthly dividend track record as an assurance of regular monthly dividend payments in the future, because if a fund runs out of balance in Dividend Equalization Reserveand there are no profit booking opportunities due to market conditions, then the fund will not be able to pay dividends to investors. In summary, historical track record notwithstanding, mutual fund dividends are not assured and investors should not solely rely on dividends for their regular monthly income needs.

Fortunately mutual funds offer a smart solution to investors to meet their regular monthly income needs through SWP or Systematic Withdrawal Plan.

Systematic Withdrawal Plan

In a Systematic Withdrawal Plans (SWP) you can regularly withdraw a fixed amount of money from your investment in a mutual fund scheme. The amount to be withdrawn and the frequency of withdrawal are fixed by the investor. So you can have a monthly, quarterly or annual frequency for any fixed amount that you wish to receive. SWP from a Balanced Mutual Fund is an ideal investment option for investors to get regular fixed monthly income from their investment and at the same time see their investment grow in value over sufficiently long investment tenures.

Investors should note that, SWP generates fixed cash-flows for investors by redeeming a certain number of units at prevailing NAVs. While unit balance goes down every month, the unredeemed units continue to accrue returns for the investor over the SWP tenure. If the withdrawal rate per annum is lower the average long term annualized returns of the fund, then investor can get both regular income as well as capital appreciation.

Let us illustrate this with the help of an example. Suppose you can invest Rs 50 lakhs from which you need an income of Rs 40,000 per month. You can invest Rs 50 lakhs in lump sum in growth option of a balanced mutual fund.

To illustrate this we have given the example of Reliance Regular Savings Fund – Balanced Option. We chose a period of Jan 1, 2006 to Jan 18, 2018 (today) to observe the SWP results. We chose a long period for SWP because income planning is usually done for a long period. Further, over a long historical period, we can observe how the SWP performed in different market conditions (multiple bull and bear market cycles). Please note that for the sake of simplicity we have ignored the effect of exit load and short term capital gains tax.

You can see that, despite drawing Rs 40,000 every month – Total Rs 480,000 in a year - (around 9.6% of invested amount per annum) to meet income needs, the investment in Reliance Regular savings Fund – Balanced Option grew from Rs 50 lakhs to Rs 1.18 Crores in 12 years.

The results of SWP are best over a long investment horizon and moderate rates of withdrawal. In the chart below you can see that, the residual investment value dipped below the investment amount in 2008, but the investment recovered and continued to grow despite withdrawals. In fact, over the 12 year period the cumulative withdrawals exceeded the one time (lump sum) investment amount (please see the chart below). Despite withdrawing more than what you invested, you were still able to grow your investment 2.4 times in value.

Why are Balanced Mutual Funds suited for SWPs?

During market corrections (bear markets) mutual fund investments decline in value since the net asset values (NAVs) fall. The fall in NAVs is a double whammy in SWP because lower the NAV, higher the number of units which need to be redeemed to meet your SWP cash-flows. SWP through a long bear market can cause substantial unit depletion if the fund is volatile. In balanced funds downside risks are limited by asset allocation. While in bear market, balanced mutual fund’s NAVs may decline, it will not be as sharp as equity mutual funds; as a result, unit depletion in SWP through a bear market will be lower. The investment will therefore, be able to recover faster in value when the correction ends and bull market commences.

Conclusion

In this blog we have seen how SWP from a balanced mutual fund is a smart option to generate both regular monthly income and capital appreciation over long investment tenure. Though in the SWP example, of this post we have ignored the impact of exit load and short term capital gains tax on the SWP, investors should be mindful of the impact of exit load and tax when setting up their SWPs; the SWP withdrawals should begin after the exit load and short term capital gains tax period. If you need regular income from your mutual fund investment, you can consult with your financial advisor, if SWP from a balanced mutual fund is appropriate option for you.

                                                                                                                                          -Advisorkhoj

Credit Risk Fund: Good medium term investment options for higher returns

Till about 2014, debt mutual funds were seen primarily as tax arbitrage opportunities vis a vis bank term deposits (FD). In the first union budget of the present NDA Government, debt mutual fund taxation was changed and debt mutual funds no longer enjoyed tax advantage in the first three years of investment tenor. When the tax changes were announced in 2014, I remember quite a few financial experts saying that these changes will kill retail interest in debt mutual funds. However, based on the investment queries and comments received by us in advisorkhoj.com and other online platforms, interest in debt mutual funds has grown in the past 4 years. Interest in debt mutual funds is a sign of the growing maturity of Indian investors and is result of the efforts put in by the mutual fund industry and the IFA community in educating retail investors about debt mutual funds.

Debt market has been challenging in the past 1 year

The past 1 year has not been kind to debt mutual funds. The 10 year Government Bond yield saw an increase of almost 150 basis points in the last 12 months. Rising yields have a negative impact on bond prices; long duration debt mutual funds, Gilt funds and dynamic bond funds gave poor returns in the past 1 year. Long term debt mutual funds were very popular with investors from 2014 till last year, as interest rates were on a declining trajectory during that period. But funds with long duration (maturity) profiles suffer the most when interest rates rise, because these funds have high sensitivity to interest rate changes; longer the duration of a bond, the more sensitive it is to interest rate changes. Bonds with short or medium duration profiles are much less sensitive to interest rate changes and short duration debt mutual fundsperformed much better in the last 1 year.

Debt mutual fund investment strategies

There two broad fixed income investment strategies in debt mutual funds – duration call and accrual strategy. In duration call, the fund manager invests in certain duration (maturity profiles) based on his / her interest rate outlook. In accrual strategy, the fund managers hold the bonds till maturity and accrue the interest paid by them over the residual maturity term of the bond. Upon maturity bonds pay the face value back to the investor and therefore, bond price changes in the interim, do not affect returns in a hold to maturity (accrual) strategy. Debt mutual funds which employ accrual strategy are more suitable for investors who want to reduce interest rate riskand get stable income.

Accrual Strategy

In accrual strategy, the fund managers invest in short to medium duration bonds, with the aim of holding them till maturity. As discussed earlier short duration bonds are much less sensitive to interest rate changes compared to long duration bonds. Unlike long duration funds, where fund managers invest mostly in Government bonds (G-Secs), in accrual strategy, fund managers invest primarily in corporate bonds or debentures, commercial papers etc.

Corporate bonds or debentures pay higher interest (coupons) than Government bonds – spread between AAA and AA rated debentures and G-Secs of similar residual maturities in the yield curve is currently around 100 to 110 bps. Interest rate riskis not the primary risk factor in accrual strategy but corporate bonds or debentures are subject to credit risk. Fund managers of corporate bond schemes do extensive credit evaluation of debentures to minimize credit risk for investors. Corporate bond yields are at a 2 year high and this a good time for investors to lock in these yields with accrual strategy. Over 2 – 3 years tenors corporate bond funds can give good returns to investors; we recommend 3 years plus tenors for these schemes, because investors can avail long term capital gains taxation benefits for3 years plus investment tenors.

Credit Risk Funds

Credit Risk Funds are a variant of corporate bonds where the fund manager aims to capture higher yields by investing in slightly lower credit rated debentures or commercial papers, while maintaining the credit quality of the portfolio by investing in highly rated papers as well in the portfolio. In the last 3 and 5 years, credit risk funds as a category gave 8.1% and 9.1% returns respectively, while in the same periods corporate bond funds, gave 6.8% and 8.1% returns respectively (please see our MF category monitor).

Though fairly intuitive, let us spend some time discussing why credit risk funds give higher returns than the usual corporate bond funds for the benefit of less experienced investors among our reads. The risk versus return relationship is a fundamental premise in finance, irrespective of asset classes. It is very intuitive also – if you are taking more risks, as an investor you will also want higher returns. Midcap stocks are more risky than large cap stocks; that is why midcaps give higher returns than large cap in the long term. Similarly, lower rated debentures are more risky than higher rated debentures. Therefore, issuers of lower rated debentures have to pay higher rate of coupon (higher interest rate), if they want to attract investors.

Different grades of credit risk

Let us first understand what credit risk is. Credit risk refers to risk of non-payment of interest (coupon) or principal (face value) or both by the bond issuer. Rating agencies like CRISIL, ICRA etc., assign credit ratings to different debt papers (debentures, CPs etc.) to indicate their credit risk assessment of the papers. The table below describes the credit rating scale used by CRISIL to rate fixed income securities.

Lower the rating of a bond, higher the bond yield (interest paid by the bond as a percentage of the price). Yields on A rated papers can be 175 to 200 bps higher than that on AA rated papers. Similarly the yield spread between A and AAA rated papers can be 200 to 225 bps. Credit risk funds aim to capture the higher spread producing higher returns for investors while managing risks at the same time. Managing risks require considerable level of fund management experience and expertise in credit assessment. The fund house also should have robust credit risk monitoring mechanisms and processes. When selecting credit risk funds for investments, the track record of the fund manager and the AMC is of great importance.

Impact of rating changes on returns

Changes in financial situation of a company can impacts its credit risk profile and cause the rating agencies to change the credit rating of its debt papers (e.g. debenture, commercial paper etc.). The change can be either positive or negative – upgrade or downgrade. If the rating of a debenture gets upgraded the price of the debenture rises resulting in capital appreciation for the investor; on the other hand if the debenture gets downgraded, the price of the debenture will fall resulting in loss for the investor.

From time to time, reports of rating downgrades get published in media causing fear psychosis among investors. Unfortunately in modern media, negative stories get much more publicity than positive stories. Instances of corporate bond funds or credit risk funds making a loss due to ratings down grade are quite rare. Further, reports of rating upgrades do not receive much attention in the media, even though there are as many instances of rating upgrades as there are of downgrades. As discussed earlier, fund managers do extensive credit risk evaluation before investing in corporate bonds, especially slightly lower rated corporate bonds. Good fund managers aim to invest in papers which can get upgraded resulting in price appreciation. Even if a bond in a credit risk fund portfolio gets downgraded, its negative impact can be cancelled out by another bond getting upgraded.

Objective understanding of risk – how to invest

Investors should have an objective understanding of risks, instead of being led by incorrect perceptions. Firstly, one should not assume that a lower rated paper will invariably default or get downgraded. There is also the probability of the paper getting upgraded. As per a CRISIL report based on 1988 to 2015 data, the average default rate of A rated papers over 3 year tenor is only 4.8% while that of BBB rated paper in 5.7%. The default rate of BB rated paper is higher at 13%. If you want to be conservative, select credit risk funds which have low percentage allocation to BB or lower rated papers. If you want to be even more conservative, select funds which have low allocations to BBB or lower rated papers. However, the more conservative you are, lower will be your returns.

Secondly, just because a bond in the scheme portfolio gets downgraded you should not panic and sell. The downgrade may be due to some temporary factors and the bond may get upgraded in the future. Even if it does not gets upgraded as long as the fund does not default, you will get the yield you want by holding the bond to maturity. You should trust your fund managers to make the right investment decisions.

Thirdly, you should look at concentration risk - percentage of single issuer holding in scheme portfolio. Lower the concentration, lower is the credit risk of the overall scheme portfolio. In most of the cases, where funds faced distress due to rating actions (downgrades), the exposure to a single issuer was high. SEBI has advised firms to lower concentration risk. AMCs usually have internal guidelines on concentration risks. As an investor, you should also do your homework, go through the scheme factsheet and see holding percentages in the scheme portfolio. If the scheme’s exposure to one issuer is less than 8 - 9%, then even in the event of a downgrade, the impact on overall returns will be fairly small.

Conclusion

In this blog post, we discussed about credit risk mutual funds. Historically, the credit risk fund category has been one of the best performing debt mutual fund categories. In our view, AMCs with strong performance track-records have managed credit risk quite well, even in difficult economic environments. In the current environment, when yields are high and widened credit spreads, there is an opportunity to get higher returns by investing in credit risk funds. Over 3 years plus investment tenors these funds are also much more tax efficient than traditional fixed income investment avenues. However, you should understand the risk factors well and select the right funds. Investors should consult with their financial advisors, if credit risk mutual funds are suitable for their investment needs.

                                                                                                                          -Advisorkhoj