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…

Part 9: More on Mutual Funds

You have an option to invest in either of two equity mutual funds.  Both are diversified equity funds, with broadly similar portfolios.  Let’s say Fund A has an AUM of Rs.100 crores and its NAV is Rs.20.  Fund B has a corpus of Rs.500 crores and its NAV is Rs.200. If you invest Rupees one lakh you can buy 5000 units of Fund A, or 500 units of Fund B. Which fund would you invest in? 

Actually, it makes no difference. Since their portfolios are broadly similar, your money would grow/shrink (depending on the market) in the same proportion once you are invested.  Think about it.

Why then the ads that we see saying “Your only chance to invest at Rs.10! Subscribe to the IPO now!”  It doesn’t make sense!  Another gimmick is to advertise “dividends” from a fund.  For a moment ignoring taxation aspects, what difference would that make? Would not the dividends come from your own corpus?

Continuing with our discussion on the different types of mutual funds, let’s talk about debt funds.  These are also known as “income” funds.  Money market or liquid funds are for investing short term surpluses.  These funds invest in overnight call money markets (banks and institutions lending to each other for a day or very short periods) or in very short duration securities maturing in less than 90 days.  Short term bond funds invest in short term bonds primarily with a duration of between 90 and 365 days.  Gilt funds invest in Gilts which are Government Securities, of varying durations, which could extend to a few years.

There are funds which could invest in a mix of securities including Gilts, Certificates of Deposits, call money markets, etc.  Certificates of Deposit are basically tradable debt of banks or companies which may differ in their maturities.  In all these cases the investments carry a credit risk / counter-party risk viz., the risk that the borrower would default.  The funds aim to minimize this risk through proper selection of the securities they buy. Bear in mind that to earn higher interest, the fund manager may invest in slightly lower rated securities as well. As we saw already, risk and return are inversely correlated. The risk is also minimized through diversification, i.e., putting the eggs in more than one basket.

There is another risk that we saw, which is the interest rate risk.  We saw how as interest rates go up, bond prices could go down, and vice versa.  This is especially true of longer duration securities, since the time period involved is larger.  Gilt funds, especially, always carry an interest rate risk.  If your money is invested in a long-duration gilt funds, and the interest rates in the economy go up, your NAV could see a drop.

I reproduce here the section from Part 4 that spoke about interest rate risk. “There is another kind of risk called ‘interest rate risk’.  Let’s assume you lend someone one lakh rupees and he gives you a ten-year ten-percent bond (that means he will pay you ten thousand rupees a year for the next ten years and then repay your principal – if he is still alive).  If you sell this bond to your friend after two years you expect him to give you one lakh rupees for it.  He will, provided the interest rates in the market are ruling at 10% then.  What if the new ten-year bonds in the market yield an interest of 12.5%, i.e., give an interest of rupees twelve thousand five hundred every year on one lakh of investment? He would then obviously pay you Rupees Eighty thousand for your bond – such that the rupees ten thousand interest on it works out to a yield of 12.5%.  Thus, if interest rates go up, prices of existing bonds in the market go down; if interest rates go down, bond prices go up.” 

Your best bet would be to invest in a large “income” fund which invests in a mix of all the above.  It would be the fund manager’s call to manage the maturity profile and mix of his investments in order to optimize both the above risks.  If, however, you have very short term funds which you may need soon and at short notice, you could look at investing in money market / liquid funds.  These funds are supposed to be without any (or very little) credit risk since their lending is only to large and reputed institutions, and that too, for a few days at a time.

So far we have looked at funds that are “open ended” i.e., you can buy units or redeem units of the fund at any time based on the prevailing NAV.  What if the same fund were to collect money which would be “locked in” for a specified number of years?  The fund in this case would not allow you to buy fresh units or redeem them except during some pre-defined windows.  This would give the fund manager more scope to invest for the long term without worrying about fluctuating inflows and outflows.  Such a fund is called a “closed ended” fund. However, in such a fund how would you invest or divest in case you need to?  This is done through listing.  The fund is listed on a Stock Exchange and unitholders can buy or sell the units among themselves, just like they would buy or sell shares.  The price at any point in time is expected to be very close to the underlying NAV of the units; however, in actual practice this may not happen. Several times, the prices are much below, or even slightly above the NAV’s.  Since they are traded on the Exchange, they are also called Exchange Traded Funds.

However, the term Exchange Traded Funds is generally used to denote a specific type of fund that trades on the Exchange. We shall see more about that in the next issue.

And we of course have Fund of Funds.  This would be a fund that invests in other funds.  There could of course be some additional charges involved! In return, you get the benefit of additional diversification.

That covers quite a bit of ground on Mutual Funds.  I’ll stop here – bye till next time!

Part 8: A primer on mutual funds

We have seen how to keep money aside, without which there can be no investments.  We also looked at how investments are evaluated viz., on the parameters of Risk, Return and Liquidity.  The Return of course has to be above the inflation rate, otherwise our money slowly becomes worthless.  Now comes the next question: what are the possible investment options?

I have heard many people say “Equity Shares, Fixed Deposits, and Mutual Funds”!  It’s like saying I like to drink milk, colas and the bottle!  Mutual Funds are not an asset class; they are just the vehicles to invest in some asset classes.  You can have Mutual Funds that invest in Equity, Funds that invest in Debt, in Gold, in Real Estate, and Funds that invest in other Funds!  This is a good time for us to understand what  Mutual Funds are – we need to know that if we want to invest in today’s times.  Not also forgetting the fact that we owe our living to the Fund business!

A group of people get together to give their money to a professional to manage.  Who then invests it in certain investments as per the mandate given to her.  Thus she could invest the money in Equity, Bonds, Art, Silver or even Antique Motor Cars (if you know of any Fund that does this, let me know).  Let’s say each of them invests a lakh of rupees.  The fund manager takes away 3% (say) on entry towards marketing and other expenses and invests 97,000 into the fund – and there are 100 people who have thus invested. She thus starts with a corpus (Assets under Management in Fund parlance) of Rs.97 lakhs.

She invests it, say, in rare stamps since it happens to be a philatelic fund.  At the end of two months, she has bought stamps worth Rs.57 lakhs and has cash worth 40 lakhs still left over, which she has parked in very short-term instruments – these instruments are currently yielding 4% p.a.  Now, ten more people, friends of those who have invested, want to join – will they each pay one lakh?  The premise is that once they are in, they are on par with the existing people, who are known as Unitholders (Shareholders in the U.S.).

That’s of course not fair.  The Fund Manager will carry out a valuation of the Fund’s assets on that day and decide what each of the current units is worth. Let’s say the market value of the stamps has gone up to Rs.65 lakhs; and the total cash lying with the Fund is Rs.43 lakhs.  That’s Rupees one lakh eight thousand per Unit Holder.  This number, 108,000 is called the Net Asset Value (NAV) of the Fund on that particular day.  The ten new people are invited to join the fund at Rs.108,000 plus an entry load of 3% - hence, they each pay Rs.111,240.  What if one of the existing unitholders wants to leave on that day?  He of course cashes out at Rs.108,000 less exit load if any.

That broadly is how a fund works. 

Let’s look at some common kinds of funds.  Equity Funds invest in Equity i.e., Equity Shares of companies.  Debt Funds invest in a mix of debt instruments, i.e. instruments that yield a fixed interest rate.  Within these, of course, you have several flavors.

A Diversified Equity Fund invests in whichever equities the fund manager feels like investing in.  An index fund invests in shares that constitute the index (the Sensex or the Nifty) in the same proportion; hence its performance will reflect the index within a small range of variation that is called a tracking error.  A Sector Fund invests in shares of companies in a particular sector, say, Infrastructure, IT, or Power.  A large-cap fund invests in companies with large market capitalizations; as opposed to mid-cap and small-cap funds. Some fund houses have come out with “multi-cap” funds which essentially means nothing - the fund manager invests in whichever equities he feels like.  Usually, all funds have a minimum market-cap below which they will not invest – this is due to the fact that a large pot of money always has to look at investments that are highly liquid, i.e., can be sold easily when the time comes.

There are funds which believe in “value-investing” which follow a “bottom-up” stock picking approach. These are funds that research individual companies and believe in the philosophy that a share should be bought when its market value drops far below the intrinsic value. The art lies in, of course, how the intrinsic value is computed.  Your number will always be different from mine!  There are funds which believe in “momentum” investing which try to time the market – they will buy any share that they think will go up in the short to medium term and sell or short what they think will go down in price.  Most individual investors like to believe that they follow the value investing approach; while, in reality they are momentum investors buying when prices are going up and selling when prices are going down. Which doesn’t necessarily mean that they make money.

Talking of making money in Equities, I am told the formula is very simple.  Buy Low and Sell High!  If you know how to do that consistently, go join Warren Buffett or Rakesh Jhunjhunwala.  You don’t need to read any articles on investments, least of all mine!

The Fund Manager is employed by a Fund House or Asset Management Company (AMC) to manage a particular fund under its umbrella of funds.  Some of the big AMC’s which manage several funds are Franklin Templeton,  Prudential, Fidelity, Vanguard, Reliance, etc.

How do Equity Funds get their revenues?   They charge a fee which is a percentage of the Assets under Management; in other words, a percentage of your NAV every year.  In India it varies within a slab rate mandated by the Securities and Exchange Board of India (SEBI – the regulator), but you can assume that the fund management fee is roughly 2% per annum on Equity Funds.  This is deducted from the returns the Fund makes; hence the NAV that you see is after deducting the fund management fee.  It should be obvious to you that, from the fund house’s perspective, a minimum level of Assets under Management (AUM) is required in order to survive in the long run. Funds that don’t manage to grow to a large enough size usually get absorbed into other funds of the same fund house, or get sold to another AMC.

My word limit for the article has been reached.  My apologies to those who knew all this already – I have to cater to a diverse audience!  And if you have reached this far, then at least I have managed to retain your interest!

More on Funds in the next issue.  See you later!

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313

Part 7: Why do we fall for these?

There are several schemes in this world which are designed to enrich everyone but yourself.  There are some things which are akin to cutting your veins, and keeping you comatose till you bleed to death.  There are certain tools which give you lot of power; but used wrongly, could lead to your destruction. Keeping balances on a credit card and paying interest on them belongs to all the above categories.

You want to pay interest at 3% per month? ... that works out to 42% per annum (it is compounded monthly).  You have to earn 61% interest before tax to be able to pay 42% on the other side.  Or, to put it differently, if you invest a lakh of rupees at 42% per annum for 10 years, what would it end up amounting to?  Work that out yourself – keep a glass of water handy.

If you paid only the “minimum” amount due of 5%, and the rate of interest is 3% (per month of course) – how many years would it take you to clear your dues and what would you have paid out by the end of it?  I don’t want to put down the number here – I find it quite horrific.

Did you go and buy that pair of Levi’s jeans on three installments – No way you say, “I can afford my jeans!”  Ok Ok, what about that TV, or that foreign vacation?  Your spouse was nagging you, so you charged your card.  And donated in blood for the rest of the year!

You are just comforting yourself saying you pay most of your dues on time anyway.  All you do is carry forward a “few” balances “sometimes”.  Here is what happens if you do.  Even if you have one rupee as balance on your card beyond the due date, you are charged interest for all fresh purchases from the date of purchase.  And you thought they were giving you a “free” credit period.  How Naïve.

The credit card company calls you and offers to increase the credit limit on your card and you grab the offer. Why would you want to, considering that you should not be carrying forward balances in the first place?  If your card were to be stolen, and used for a shopping spree, would you not be protected better if you had a lower credit limit?  More importantly, is not a lower credit limit better for your wellbeing?

What about the rush of power and feel-good feeling of euphoria that you get when you make that impulsive purchase and swipe your card for it? The feeling that you’re on top of the world – that you can afford anything?  Research has proved that you tend to over-spend when you use the card – counting out notes and handing them over, on the other hand, has a very sobering influence.

Just to make you feel better – having a card is not a bad thing at all, provided you pay off all your dues before the due date.  Before moving on to something else let us repeat a short prayer: “Oh Lord, this day I resolve to pay all my dues on time; especially credit card dues.  Forgive me for all my sins and keep me away from card balances. Amen!”

“Spend more to save more!”  “The more you shop, the more you save!”  “The more you spend, the more reward points you earn!”  You see such exhortations all the time.  I don’t think I need to spend time on dwelling on the absurdity of it.

“Become a Purple Citizen” – you are eligible to get a membership card to our store and you get the most exclusive privileges when you shop!  Our gatekeeper will salute you twice!  You will get a cola with crushed ice! And if you shop more than x thousand rupees a month, you will be elevated to Silver category.  Which is when you will look at the Gold member and feel envious – because the crushed ice in her cola is made of Evian water.  Gimmicks to get you back to the store and make you shop more.  The reward points usually work out to a discount of 1 to 2%; and stores that offer such schemes are usually more expensive than the market-street ones by at least 20%.

What about the store in Bangalore which has a “half price sale” for a month at a time every six months?  That place is my favorite shop – I land up there whenever there is a sale.  Don’t glare at me – I am human too!

I used to go to the movies often.  Till they razed all the old cinema halls down and built multiplexes. And raised the ticket prices by a few hundred percent. I still go often, but with greater reluctance – that’s because my wife’s party circuit swaps stories about the latest movies they saw; and my son only likes popcorn when he pays 50 rupees a pop.  The mineral water bottles there come in special sizes: that’s because it is illegal to sell above MRP – so they created a special size with a special rate, just for multiplexes! 

The one-rupee tickets offered by the airlines are great.  Except that the taxes are 2500 rupees.  We have got such wonderful bargains whenever we travelled in the last one year.  My travel spend for the family was rupees eighty thousand this year.  We are thrilled since the journeys were worth at least double that.  The year before that, I travelled as often and spent only rupees twelve thousand – we used to travel by train.

Oh, the frailties of human nature!  And who understands these better than salespeople?

I had a couple more interesting things to share – but I’ve got to run.  We’ve just got tickets to the latest blockbuster in town – free!  Westside gifted them to us as reward for our Dussera shopping.  And did I tell you – the doorman there knows us by name!

Bye for now!

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313

Part 6: An immediate action plan for investments

It is one thing to learn all the concepts before getting into the meat of a subject.  It is quite another to wait for an indefinite time period for some practical suggestions on what is to be done in the immediate near term.  Concepts are fine, and we need them to enable us to make our own decisions, but we need to be practical as well!

I just realized that there are quite a few concepts/theories still to be covered.  I also realize that I run the risk of losing the attention of my audience (I am making a big assumption here – that you have been avidly devouring every word written so far)!

So, what are those things that you can do right away in terms of a concrete action plan for your investments?  I am assuming that you already have a Third Bank Account and you have made it investment ready.  I am assuming you know how mutual funds work (at least the basics – we shall go in depth later).  And I am assuming that you do have some money set aside in a form that can be easily liquidated in case you have to make some adjustments to your investment portfolio.

If you strip the subject of all its complications and jargon, it’s not really that difficult. 

Do you have credit card balances?  Are you in the habit of carrying forward the dues and paying interest on them?  In case you did not realize it, the interest rates on cards are in excess of 40% per annum.  Your first priority should be to repay all your card (or cards’) dues.

Do you have an emergency fund to cover for three to six months’ expenses?  If you don’t, your next step would be to build that up.  This money should necessarily be in the bank – either in the savings account, or in easily cancellable fixed deposits.  Whether it is three months’ worth of expenses or six months’, I leave that to you to decide.  It depends on what  your spending patterns are, and what kind of social support systems you have.  You don’t want to be facing a sudden medical or family emergency without some liquid cash in hand.

Do you foresee some expenses hitting you in the near future – within the next couple of years?  It could be for marriage, for a house, for education, etc.  When you are keeping aside money for this, remember not to invest in “long-term” investments like equity shares or real estate.  This money should be preferably kept in Bank FD’s or in debt mutual funds that invest in securities of short-term maturity.  You could target the “liquid funds” or “short term debt funds”. 

Once you have taken care of these, whatever is left (the moment of revelation arrives – do you have anything left at all? J ) is for the long term.  Whatever is for the long term can be invested in avenues that are likely to offer a larger rate of return, though with some amount of risk and unpredictability due to volatility.  You could first keep aside some portion for investing in Debt Mutual Funds.  Your typical “Income Fund” of any fund house should fit the bill perfectly. You could also invest in equity mutual funds; or you could invest in Gold.  If you invest in equity mutual funds, pick out a large “diversified equity fund” of any major fund house. For Gold, you could look at Gold ETF’s which are traded just like shares; that is where you pay the least amount of trading margins / dealer profits. Remember, buying gold ornaments does not count as investment – at least not in my book.  You could look at buying gold biscuits (available in any quantity five grams onwards) – if you do, remember it is better to buy it from a jeweler rather than from a bank – the margins charged by banks are huge and unnecessary.

Depending on how much money you have at your disposal you could keep an eye out for buying that property or piece of land.  If it is your first and primary house which you need to buy –don’t delay – take that big loan and do it right away.  If you are already living in your own house (and probably paying a huge emi on it), and are looking for a second property, right now seems to be a good time.  The real estate markets, after a huge rally, have seen some correction in the last one year.  The market seems to be firming up now –  the potential upside is quite good. You should of course be prepared for the long haul – in real estate, the returns are normally good, but over a time frame extending to a decade or more. When you do buy that property, you are fully entitled to sell off all the other investments you have– keeping some emergency funds as a back-up, of course.

Do you have insurance policies that are running on which you are paying regular premiums?  We shall have a lot of things to say on insurance – but that has to wait for later.  For the time being, continue paying your premiums.  Before investing in any new insurance product however, pause: my advice would be to go in for “pure term insurance” where you pay only for life cover and where there is no savings/investment element involved.  The typical premium you will pay will be about Rs. 300 per lakh of life cover per year, for a thirty-year old. 

If you are keen on knowing more about how to manage your own finances and want to build up that mind-set over a period of time, it is not a bad idea to start reading up on the subject.  I would seriously recommend that you subscribe to “Outlook Money” and “Money Today”.

Do all this and you are all set, at least for a reasonable period of time.  In the meanwhile you can continue to pick up more on the subject so that you get more comfortable analyzing options and preparing to make your own financial decisions.

I know that I have covered a lot of ground above, which assumes a basic understanding of some underlying concepts.  We shall be covering all that one by one in subsequent issues.

Happy Investing!

Dinesh Gopalan
Fidelity India Finance
Bangalore
mobile: 9845257313