Sunday , 25 June 2017

Basics of Mutual Funds

Money is merely a piece of paper until you realise the importance of saving and making it grow spirally. There is plethora of investment avenues available at present, but what suits your objective is the one you should opt for. On a broader picture, a common man can think of two options, either invest in shares offering glamorous returns with an associated unknown risk or invest in the regular income debt options offering lesser but safer returns.

Now the question arises: Is there a way in middle so that you get good returns like equity and safety of investment like fixed income options. Yes, a Mutual fund is what you should look for.

Why Mutual funds?

What if you are a novice in the world of stock markets but still want to invest? What if you don’t have enough risk appetite for the investments you want to make? What if you don’t have time and skill to manage your portfolio and want some professionally qualified people to invest on your behalf?

What are Mutual funds?

As implicit by name, mutual fund is a fund mutually held by the investors who are the beneficiaries of the fund. It is a type of Investment Company which collects money from so many investors in common pool and then invests this capital raised in variety of options like bonds, equity, gold, real estate etc. At the core of it are professionally qualified people called fund managers analysing the markets conditions and making investment decisions with an objective of maximization of profit. Substantially all the earnings of a MF are passed on to the investors in proportion to their investments. In lieu of the services offered, the mutual fund also charges some fees from the investors. The diagram below clearly indicates that investors invest in mutual fund that further makes investment in various options.

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Having been through basics, one can infer that investing in mutual funds is an easy way of playing safe in equity especially you being unaware of tactics of stock markets because it provides professional expertise of fund managers who make investment decisions based on constant study and market research. Besides this, it offers benefits like diversification of portfolio. Since mutual fund is a collective investment vehicle, they have an option to invest in different sectors of market like retail, real estate in addition to options like debt and commodities market. This reduces the risks to which an individual investor would have been exposed if a particular sector is in period of downfall. The simplicity of investment and various benefits offered have made them so popular that can be seen from their growth in past. They came into picture in 1963 with 67bn assets under management (AUM) compared to current figures of 4609.49bn with total of 35 mutual funds available at present and still expected to grow in years to come

KEY ENTITIES INVOLVED

Introduction:

Consider yourself a mutual fund company in which millions of investors have invested their trust, not just money with a hope of getting good returns on their investment. The criticality lies in the soundness of fund’s management responsible for meeting the expectations of the investors as well as fund’s financial goal. There are multiple key players at the background working together to achieve this common goal. These players and their role is what we will be scanning through here.

Sponsor:

A sponsor is an entity responsible for laying the foundation stone of a fund. In real sense, it puts in the seed money in fund’s set up. Any registered company, a scheduled bank or financial institution can act as sponsor. As per SEBI norms it must possess a prerequisite and good financial record in past. AMC and custodian are appointed by sponsor but once AMC is constituted, sponsor is just the stakeholder of fund and is not liable for making up any operational losses of the fund.

Board of trustees:

Mutual funds in India are constituted as trusts and have a board of trustees to run the fund. AMC is a third party appointed by trustees for managing the money but the real power lies with the trust that is accountable for investor’s money held in the fund. They can even sack the AMC if it is found doing unethical practices or underperforming.

Custodian:

It is an independent entity appointed for holding and safekeeping of the fund’s assets. Bigger fish, bigger will be the pond. As the portfolio of securities for a mutual fund is so big it need a third party for receipt, delivery of securities and keeping an account of the same. Most of the funds use banks as their custodians but one bank can act ascustodian of multiple funds. On a broader side when instead of common public, bigger players like FIIs are the investors; the concept of domestic and global custodian comes into picture.

AMC: 

Asset Management Company can be considered as the heart of any fund. It manages the investments you have made. At the core are fund managers or portfolio managers taking investment decisions on your behalf. They have access to critical market data that helps them analyze the market conditions and explore investing opportunity to meet their financial objectives. In addition, it is responsible for maintaining a record of pricing and accounting data. It also calculates NAV of the fund that is mandated by SEBI to be disclosed publicly on daily basis. The fund charges investors a fee called management fees for the services offered by AMC.

The ultimate aim any fund is benefit of investors and SEBI is keeping an eye on above entities to ensure compliance of rules and regulations set for the investor’s benefit. The fund regulations in India are considered the best in the world and one major strength lies in well coordinated structure with defined roles of sponsor, trustee, AMC that tend to protect investor’s from risk of default.

Systematic Investment Plan is a feature specifically designed for those who are interested in investing periodically rather than making a lump sump investment. It is just like a recurring deposit with the post office or bank where you put in a small amount every month. The difference here is that the amount is invested in a mutual fund. (Read more about SIP)

 SIP is provided by Mutual Funds to ensure that the investment goal is reached, and thus to compensate for a potential deficit if the systematic investment plan is interrupted due to premature death. It is a service option that allows investors to buy mutual fund shares on a regular schedule, usually through bank account deductions. Th nomenclature of this mode of investment can be different with some mutual fund houses; for example Reliance Mutual Fund calls it Recurring Investment Plan

Please be clear that a systematic investment plan is not a tool that helps improve your investment returns.

The primary objective of a SIP is to enable investors to clearly define an investment goal, and then to help them reach it through systematic investment in select equity-oriented mutual fund schemes that have a track record of consistent good performance. Most of the mutual funds offer this facility. The real value lies in the portfolio of the fund. Almost all schemes have the facility of steady investment plan.

Systematic investment adds value through rupee cost averaging and the power of compounding. The NAVs (net asset value) of these funds can vary widely, but, through rupee cost averaging, an SIP can make this volatility work for you. Many investors tend to think that monthly income plan and systematic investment plan are one and the same. The minimum monthly investment for a systematic investment plan is Rs 1,000. If you are in the 30-40 year age group, you should probably keep to an allocation of 30-40 per cent to equity investments. It is managed by a team of investment professionals and other service providers with advantages of professionals management, portfolio diversification, reducing risk, reduction of trading cost, convince and flexibility liquidity, access to information.

In simple words Systematic investment plan, is a simple, time-honored strategy designed to help investors accumulate wealth in a systematic manner over the long-term. Systematic Investment Plan is the most effective way of investing in market especially in a volatile market. SIP is a way to invest in a regular and disciplined manner while taking care of volatility. It is yet another investment technique which helps in mitigation of risk in terms of the entry point in an equity fund.

For individuals or families just getting started, based upon the above mentioned investment analysis, proper investment allocation is determined and asystematic investment plan is established through one of the many mutual fund families offered by various Mutual Funds in India – Principal Income Fund, Monthly Income Plan, Child Benefit Fund , Balanced Fund, Index Fund, Growth Fund, Equity Fund and Tax Savings Fund.

The best way to enter a mutual fund is through a Systematic Investment Plan. But to get the benefit of an SIP, think of minimum three-year time frame when you won’t touch your money. Small but regular investments go a long way in creating wealth over time

Things you should not expect from MFs

The role of a financial or investment advisor is to manage expectations of the client more than to manage the money. Time and again, clients get dissatisfied with their advisors because they started with wrong expectations. The expectations are either set very high or they are not clearly defined at all.

Never try to predict the future performance based on its past

Extrapolation of past performance is an objective process of setting expectations, but could be a landmine if not understood properly. This is one of the most popular methods of setting expectations in many client-advisor dialogues. Often, they will look at past performance of a fund or an asset category (an investment option, in short) – either only the returns or a combination of returns and risk – to put an estimate to the future performance of the scheme.

It is fair if one concludes that there is a possibility to beat inflation through investment in equity, looking at long-term performance of equity as an asset class. But if someone concludes that since equity has delivered 15% p.a. for the past 20 years, it will continue to do so every single year, one is only daydreaming. Similar things can be said about individual schemes. It actually becomes more difficult to arrive at a conclusion regarding individual schemes than an asset category.

A lot of the investment advisors and investors, in 1999-2000, thought it was prudent to assume the growth rate of infotech companies in the range of around 50% to 75% p.a. for the foreseeable future, since the past growth of these set of companies was in excess of 100% p.a. The stocks got priced with the assumption of such high growth rates. They were in for a rude shock.

If you assume the company to grow its profits at a high rate for the next 5 years, with the present EPS being Rs. 50, the present value of the future profits at a discounting rate of 8% would be Rs. 2138 for 100% p.a. growth, Rs. 1276 for 75% p.a. growth, Rs. 920 for 70% p.a. growth and Rs. 735 for 50% p.a. growth. Look at the crash in valuations for a small drop in growth rate from 75% p.a. to 70% p.a. The prices also trace this path generally. Between 2000 and now, many infotech companies have experienced handsome growth rates, but the share prices have seen a fall. This can only be explained if we look at the expectations at the beginning of the period under consideration. The growth in the profits, although being spectacular by any standards and much more than most sectors in the economy, has been lower than the expectations of the investors.

It might be a better idea to understand the basic characteristics of the asset class to set the expectations rather than the price movements in the recent past. Just looking at the price movements, one is likely to set wrong expectations and erect the building of long term relationship on a weak foundation.

In lighter vein, if extrapolation was the way to predict future, an 80 year old would live for another 80 years, whereas a 20 year old has another 20 years to live. Truth is far from this.

Even Fund Managers cannot predict market direction

A classic example of wrong expectations is what one expects from a mutual fund manager. The debate resurfaces every time the market experiences one of its regular crashes. Many investors expect the equity fund manager to exit the stock market just before the downturn starts. Now, if one looks at the objective of an equity fund, it is supposed to be invested in stocks at all times. It is this objective, for which the investor should have invested the money with the respective fund. The very objective of having a fund’s objective is to help the investor arrive at an informed decision regarding what the fund manager intends doing. If the fund manager exits stocks, even while taking a call on the market direction, it is a deviation from the fund’s objective. Taking a call on the direction of the market, on the other hand, is extremely difficult – well, almost impossible.

To quote John Bogle, the founder of Vanguard, “I don’t know anyone who’s ever got market timing right. In fact, I don’t know anyone who knows anyone who’s ever got it right.”

Or as mentioned by the legendary investor Benjamin Graham, “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

What should an investor, then, expect from a mutual fund manager? Well, the fund manager is required to invest the investors’ money in line with the fund’s objective. The selection of stocks is crucial. If the fund manager has done his / her job well, every single time when the market recovers from a crash, the fund’s portfolio should start to recover faster than an average individual investor. A crash in the prices of stocks is often a function of the shift in preference away from stock market or the drying up of liquidity from the markets. In such a scenario, the exiting investor does not look at the quality of the stocks, which causes even the best of the stocks also to lose. However, it is the good quality stocks that recover the first. In the current meltdown also, the investor needs to check if the fund’s portfolio consists of good quality stocks and leave the rest to the market.

Do not start your investment journey without setting any goal

If the above discussion was regarding setting up wrong expectations, there are certain investors and advisors, who started without setting any goals at all.

“Would you tell me, please, which way I ought to go from here?” 

“That depends a good deal on where you want to get to,” said the Cat.” 

- Lewis Carroll, Alice’s Adventures in Wonderland

There was an investor, whose portfolio was appreciating every day, used to tell his friends: “I just don’t want to go through the details of various investment options – it’s too much for me. I just ask my investment advisor where to sign – no questions asked. I will check only after two-three years what happened to my investments. I am interested only in the bottom-line – the returns – not the mundane details. And I have done very well so far.”

These discussions happened in early April-2006, with the Sensex soaring sky-high. So, the investor was right to be happy about the performance of his investments. But what can one understand from the said investor’s approach to his investments. How can someone be so grossly lackadaisical about one’s investments, which is such a serious business? Let us visualize what would happen when the same investor were to travel to some place around 12 hours from here. Will he go to the railway station and ask the ticket clerk to give him whichever was the best train according to the ticket clerk and only check where he has reached after 12 hours – the stipulated time of travel? Will he get on board the train just because someone recommended or check where the train was going?

He has to be simply lucky in order to reach his destination. The investor in the above example also was simply lucky till the time of those discussions, but such a hands-off approach is hazardous to anyone’s financial health.

Choosing a Fund? Don’t just go by returns!

We live in a world ruled by Stars and Ratings. What has this got to do with the world of investments you may wonder?

A lot because when it comes to investments most of us tend to give a lot of weight to the winners of last year. We want the highest rated Fund or Best Performing Stock. The Financial Services industry along with its aggressive marketing entices people to chase performance by touting 5 star mutual funds or Emerald stocks. Magazines and Television channels are not far behind in getting experts to tell you how you should identify these gems. And for some people it’s so easy just pick last years best performing funds or stocks.

Fidelity Magellan was one of the best performing funds in the US and Peter Lynch was regarded as one of the best fund managers in US history. Under Lynch’s management, the fund had a stellar performance and guess what. It had billions of dollars pouring in and as its popularity grew, its performance diminished. But Mr. Lynch retired at his peak when he was doing well and got himself a coveted position of being one of the best fund managers.

Lets take the example of one of the best performing funds of 2003, which delivered around 177% in a year. Any guesses. The name was Franklin India Prima Fund. In April 2003 the fund was managing approximately Rs 120 crore and was a small fund. Slowly buoyed by the success of the fund and aggressive marketing of its returns saw the fund garner over Rs 2000 crore by the end of 2005. Was the fund the star performer in 2006? No it was not. The fund ended 2006 with a very dismal performance of around 23% against the mid cap index return of 29%. At the same time the top funds in this category Sundaram BNP Paribas Select Midcap gave returns of 60% and SBI Magnum Global of 57% in the same period. The question is why did a star performer of 1-2 years falter in the next year and does this happen quite often. Let us try to examine a few reasons.

  1. The Star Performing Scheme suddenly attracts a lot of money and is sitting on cash for sometime trying to figure out what to do with it.
  2. Lack of opportunities in the mid cap (mad cap) space for funds collected either makes fund managers look out for large caps or buy more of the same stock.
  3. When a core product does well, Mutual Fund Houses often tout these returns and launch several other schemes, which tend to dilute the focus of the fund manager from the core product to several other offerings.

This fund still has a 5 star rating from one of the prominent mutual fund rating agencies of India. I am not trying to say that one should not look at this fund. Instead from a broader perspective, I would like to highlight that there are other important things that one should look out for when choosing funds for his/her portfolio.

Besides your Financial Goals, Current Situation, Returns Required and Asset Allocation, here are a couple of other filters you need to check out:

1. Look at the risk that a fund comes with and does that match with your risk capacity and risk tolerance

Mid cap funds were down an average 35% in May 2006. Some of the Large Cap Funds were down 28%. Can you take this kind of volatility? It’s sexy to look at exotic numbers on the upside but when the same happens on the downside , you are either out of the stock market  forever or you take a short term equity holiday only to enter again when your friend is making money cocoon .

I have given options below in the ascending order of risk:

  • Liquid Funds
  • Floating Rate Funds, FMPs and Arbitrage Funds
  • Monthly Income Plans of Mutual Funds
  • Hybrid Funds with 30-40% exposure to equity
  • Balanced Funds with 65% exposure to equity
  • Index Funds /Diversified Equity Funds
  • Opportunity / Thematic Funds
  • Sectoral Funds

There are various quantitative parameters to analyze the risk associated with the fund. A few of them are Standard Deviation, Beta and Sharpe Ratio.

Standard deviation tells us how much the return on the fund is deviating from the expected normal returns.

Beta tells us how the fund would respond to swings in the market. If the beta is more than 1, then the funds swings will be greater than the market swings and vice versa.

Sharpe Ratio tells us whether the returns of a portfolio are due to smart investment decisions or due to excess risk. This measurement is very useful because although one mutual fund can give higher returns than its peers, it is only a good investment if the higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better is it’s risk-adjusted performance.

2. Consistency of Performance

How has the fund performed in rising and falling markets? The best funds are the ones that have the potential to rise fast and fall less. It is hard to identify such funds and there might be very few such funds. Look at performance over the last 1, 3, 5 and 7 years to see how the funds have done and especially look closely at the fund’s performance in falling markets.

The point that I am trying to make is there is no way to know in advance who the first or the best will be. So it’s a futile exercise to identify the number 1 and anyone who has this midas touch is fooling both you and himself.

Mutual Funds themselves know that selecting funds on the basis of past returns alone is a lousy concept and hence by law, they are required to give this caveat saying “Past Performance is no indicator of future performance” and yet all the funds tout returns like it’s the only language, which people understand. Well it’s partly true and sad that it’s the returns language that supersedes all discussions about risk and the decision is generally skewed in favor of returns.

Let’s take a look at see one of last year’s best performing fund – Sundaram BNP Paribas Select Midcap Fund. From a small size of Rs. 140 crore in September 2004 it has significantly grown to a size of Rs 2000 crore now having cash levels between 20-28%. Excess cash can eat into the returns and like we mentioned above the focus of the fund manager could be diluted by the launch of several NFO’s under his belt.

Well history repeats itself. We hope the crowd is right this time.

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