Wednesday, January 6, 2010

Part 10: Talking about Funds...

Any closed-ended Fund that trades on a stock exchange can be called an Exchange Traded Fund (ETF). However, ETF’s are more generally used to refer to closed-ended funds that track an underlying index or asset.  For example, a Nifty ETF would invest in Nifty stocks in the same proportion as the Nifty. This ensures that the rise or fall in the NAV is in the same proportion or percentage as the rise or fall in the Nifty.  A fund that follows such a strategy is said to be passively managed i.e., the fund manager does not have to do any work – his job is to buy or sell shares whenever there is an addition/redemption to the fund, or on the rare occasion when the composition of the Nifty changes, to achieve the required proportion once again. As you can see, that’s a job that can be done equally well by a computer.  Which is why the management fees for such an ETF is supposed to be lesser. 

The ETF of course does not track the underlying index (Nifty in this case) exactly. There is always a difference due to annual management fees; also due to the fact that the timing of the fund manager’s buy or sell can never exactly match the Nifty movements. This difference is called Tracking Error.  The annual management fees for an actively managed equity fund are in the range of 2% whereas the management fees for an index fund of this kind is likely to be around 0.4% to 1%.

There are ETF’s for Gold as well. There are about half a dozen Gold ETF’s available in the Indian market. GoldBees, UTI Gold fund and Kotak are some of them.  You buy and sell Gold ETF units just like buying or selling shares.  The corpus of the fund is invested in Gold or Gold-backed securities in such a way that the price goes up or down with the price of Gold. 

You pay brokerage and transaction charges just like you do for a share transaction on buying or selling ETF’s.

While investing in a fund, it is good to follow what is termed as a Systematic Investment Plan (SIP).  You can give post-dated cheques to the Fund of the same amount every month, say, Rs. 1000 per month.  The Fund would then systematically encash the cheque every month on the given date and credit units to you worth that amount at the NAV prevailing on that date.  What are the benefits of such an approach?

To start with, it ensures discipline in investing.  It eliminates the temptation to try to time the market, which is a job best left to experts who think they know what they are doing. It has another advantage that may not be so obvious at first glance.  Let us say you have decided to buy Reliance Shares every month.  For a moment assume you can buy fractional shares as well.  You start an SIP with Rs.5000 a month.  During the first month, Reliance is quoting at Rs.1000.  You buy five shares.  Next month the price is at 1200. You invest the same 5000, hence you buy 4.17 Reliance shares.  The month after that it quotes at Rs.900, hence you buy 5.55 shares.  In the fourth month, the price drops to 400 and you are able to buy 12.5 shares.  In the fifth month it bounces up to Rs.2500, hence you buy only two shares.

What have you done in the process of investing in the above fashion?  If you notice you bought more shares when the price was low, and you bought less shares when the price was high.  What a brilliant strategy!  Executed with a methodical precision, without the burden of having to think!  This strategy is called dollar (or rupee) cost averaging, and it is an automatic benefit of investing using the SIP method.  For those who are retired, and want to draw down, the same concept can be applied to a Systematic Withdrawal Plan (SWP) as well!

When it comes to Equity Investments, if you feel you will be able to able to do a better job than a fund manager, then by all means invest on your own.  However, please do not venture into Equity investing without adequate preparation. You need to read up on the stock markets and do research on companies.  You need to keep track of what’s happening in the economy and to the world in general.  You need to be able to quantify the millions of inputs that you receive into a monetary value, and you must be able to ignore useless noise in the form of irrelevant data which is thrown at you from all directions. You must be prepared to stick to your convictions to get the returns you envisaged, and you must also be able to exit without emotion, taking a loss if required.  You must be a combination of fortune teller and financial expert.  You must have a finely-honed sixth sense which guides you on what to buy and when, and more important, when to sell.  In short, you must be Superman.  Or Warren Buffet.  And you need to have a spouse who doesn’t insist on making joint investment decisions. 

If that seems like a pretty daunting list of requirements, please don’t feel discouraged.  We did say learning to invest is easy; but we did not mean investing on your own in the Equity Markets!  In this series we will assume that you will stick to mutual funds when it comes to equity investing.  Long experience over various equity markets have proven that fund managers don’t necessarily perform much better than the index; but your average John Doe who invests in the equity market does not do much better either. You might as well leave it to a Fund Manager and pay him to worry about it!

On the other hand, Warren Buffet or Rakesh Jhunjhunwala would never be where they are today if they had invested through funds.  Think about it…