Ask Value Research Long-term orientation in an equity fund can help beat inflation and enhance your returns
Ask Value Research

Ask Value Research

Long-term orientation in an equity fund can help beat inflation and enhance your returns

Suffering Losses
I retired recently. I being a risk-averse investor, all my investments were in Relief Bonds, PPF and other 100 per cent secured instruments, till recently. A few months back, I made an entry into equity-oriented mutual funds, using the maturity proceeds of Relief Bonds. I had earlier invested in equity funds in the beginning of 2000 but made a quiet exit after suffering heavy losses. Again this time, my equity investments are down with losses. I don't want a repeat of 2000. Please tell me what should I do? I have other savings and these investments form 10 per cent of my total investments.
- Ritu Srivastava

There is only one word of advice for you, 'patience'. It is disappointing to lose soon after you invested and your anxiety is understandable. But a steep fall in the value of an equity fund in little time is not unusual. So don't let this anxiety prompt you to act in haste, as it often leads investors to buy high and sell low.

Your decision to allocate 10 per cent of investment into equities was not a bad one, particularly in the present scenario, when the fixed income funds look distressed. And with a long-term orientation, equity can help you beat inflation and enhance your total return. With exposure just being 10 per cent of your total investments, you are better placed to ride the equity downturn. In all probability, a few years from now you can laugh at your present notional loss. But you will have to be patient enough to see the volatility off.

But take care to keep your mid- and small-cap exposure in check. If you have a chunk of your equity investments in mid-cap oriented funds. We would recommend you to switch to large-cap funds, as large cap stocks tend to be more stable than mid- and small-caps and enjoy superior liquidity. After the May collapse, large-caps stocks have almost completely recovered, while the smaller stocks are still lagging. As a thumb rule, we suggest at least 70 per cent allocation to large cap stocks for your equity investments.

Equity, as an asset class, can be quite volatile at times but it also has the potential to generate maximum returns over long-term. But you will have to tide through the lean phase of the markets to make any meaningful returns.

Why Index Funds?
I have 10 years remaining in service. My question is, are index funds a good investment for a person like me? If yes, what should be the selection criteria?
- Ranbeer Singh Lodha

The brief answer to your question is that they are definitely worth considering. There's no reason why index funds can't be a good investment option for a person like you. But the first decision you need to take is how much of your total investments do you want to put in equities. Once you determine the equity allocation for yourself, index funds can be a suitable vehicle. Compared with actively managed funds, index funds are relatively low risk-return equity instruments.

However, don't lose sight of the fact that index funds are equity investments and would have the same characteristics as that of the equity asset class. And therefore, they have the potential to generate superior returns in comparison to other asset classes.

By definition, index funds track a particular market index by purchasing all the stocks of that index in same proportions as they are in present in the index. This ensures a performance identical to that of the index they track.

You can derive two advantages out of investing in index funds. Firstly, most of the index funds either track the Nifty or the Sensex. And both these indices consist of shares of the largest companies and are also the most liquid. In short, a portfolio of bluechips. Therefore, they are suitable for conservative equity investors. Secondly, they are very economical as their expenses are quite low in comparison to the actively managed equity funds. In fact, expenses are one of the things to look out for while choosing an index fund. Since, the index fund manager doesn't have to spend time and money on research and in monitoring stocks, costs should be low.

Another important decision-making criterion is the fund's tracking error. Tracking error measures how much an index fund's returns deviate from the benchmark index's return over any given period of time. The lower the tracking error, the better the fund is at keeping pace with its index. A poorly run index fund will generally have a large tracking error.

Do remember that index funds' advantages do not mean that this is the only kind of fund you should invest in. Well-run actively managed equity funds can give your returns a boost. Historic performance records show that actively managed funds have outperformed the indices by far in India. But while choosing an actively-managed fund, go for the ones which invest primarily in large-cap stocks, rather than the riskier mid-caps. This will provide with the benefits of active management while maintaining the focus upon the blue-chip stocks.

Risk Tolerence
On my retirement recently, I purchased a couple of balanced funds, thinking them to be safer investments. But now, the NAVs of my funds have come down. I want to know whether it's proper to switch over to monthly income plans.
- P.K. Verma

Balanced funds are not risk proof. We would like to point out that while balanced funds are safer in the sense that they offer lower risks and lower rewards, when compared to pure equity funds, they cannot be considered safe in an absolute sense. They usually allocate their corpus between stocks and bonds in the ratio of 60:40. The result of this is that they fall less than a pure equity fund when the stock market falls but also gain less when the market rises. There is no other 'safety' that these funds have. If the equity markets decline sharply, these funds also incur losses. You need to re-assess your risk tolerance level. Perhaps you have taken more risk through these investments than what you can bear. You should re-examine the financial goals you expect to achieve from these investments. If the goal is long term growth of capital at lower levels of risk then these instruments will serve the purpose. If not then you will have to consider an exit.

Monthly income plans (MIPs) are relatively safer than balanced funds, but have a lower return potential. They invest primarily in bonds with a small (10-15 per cent) exposure to stocks. Though the name implies a payment of a monthly return, these are also not guaranteed products. There is no assurance that the fund will deliver a payout each and every month. And even these funds are prone to capital loss, though the extent of losses is likely to be less than balanced funds.

Thus MIPs are a low-risk low-return product as compared to balanced funds. However, before you act in haste and then repent, why not sit down and assess your investments vis-à-vis your financial goals. This is the most important step and only with this, will you be able to take the right decision.

Wrong Perception
How much is it worthwhile to invest in the bonus plan of a mutual fund, which is about to declare a bonus? Many mutual funds offer bonus plan along with growth and dividend plans. What can be the impact of the bonus issue on my investments?
- Shamim Ahmed

There is a popular perception that in a bonus issue, a mutual fund issues additional units to investors without asking them to pay for it. However, a bonus issue is just a way of distributing profits earned by the fund. If you enter a fund just with the aim of receiving the bonus you will not obtain any financial gain.

A bonus is just an accounting device-on the day a bonus is declared, the NAV will fall in proportion to the bonus declared. Suppose you invest Rs 1 lakh in a fund, which has an NAV of Rs 20. So you have 5,000 units in your account in the beginning.

Assuming that the fund declares a bonus of 1:1 (one unit for every one unit you hold) you will receive 5,000 units more taking the total number of units you hold to 10,000. However, the NAV of units will also fall in the same proportion. So post bonus the NAV of the units will be Rs 10. As a result the total value of your investments will be unchanged.

The point here is that dividends, bonuses and other such rewards are given out of accumulated profits. If you have not been with the fund for long and your money has not generated sufficient return, you don't get the share in profits. A similar situation arises when one tries to enter a fund just to get dividends.

Effectively, dividends come out of the capital invested giving no profits to the investor in such cases. Dividends and bonuses apart, we believe that the best investment decisions are made when financial goals are kept in mind.

Debt/Income Funds Worthy?
Why the returns of debt/income mutual fund keep changing from time to time even when they invest in fixed income instruments? Are they investment worthy?
- Joymitra Chatterjee

You have raised a good point here. Debt mutual funds do invest in fixed income instruments like government securities, corporate bonds and commercial papers issued by corporate entities, which have a fixed interest rate (coupon) attached to it. Ideally, an investment in a fixed interest instrument should fetch you the guaranteed return on maturity assuming other things remain constant. However, this is not the case. Usually, neither mutual funds hold these securities till maturity nor interest rates remain constant over a period of time.

That apart, these fixed interest instruments are also traded in the market. Therefore, their prices change on a regular basis, which make mutual funds susceptible to market risks. Any unfavourable development in the market may affect the fund's net asset value (NAV). Moreover, changes in interest rates also affect the scheme's NAV. When interest rates fall, existing securities with higher coupons become more attractive. Hence, high demand for these securities pushes their prices up. And inversely, prices of these securities fall if interest rates move up. Prices of long-term securities generally fluctuate more in response to interest rate changes than those of short-term securities. Thus, funds with larger quantities of long-term paper are more prone to NAV fluctuations when interest rates change.

Let's understand this with an example. Suppose a mutual fund buys a bond for Rs 100 with a coupon rate of 10 per cent. Thus, the fund should get Rs 110 at the end of the year. However, if RBI cuts interest rates, this bond can be more attractive due to the higher coupon it offers now and its price will increase to Rs 111.11. Therefore, the NAV will increase. Thus, the fund's return will subsequently increase.

Conversely, the return will fall if RBI hikes interest rate. Government securities are actively traded in the market and are more susceptible to interest rate changes. Therefore, gilt funds are more volatile than income funds. The NAV of a fund may also be affected if a bond issuing company fails to honour its obligation to pay principal, interest or both. Though government securities, being sovereign obligations, are free of this risk, corporate bonds are not. Thus, if a corporate bond holding of the fund defaults, then it will have its bearing on the fund's return and its NAV will fall. Different types of debt funds will have varying degrees of fluctuation in returns. These fluctuations will be minimal in ultra short-term funds and will increase as the duration of the fund's holding increases.

Thus, the returns of fixed income instruments may fluctuate due to the presence of three types of risk-market risk, interest rate risk and credit risk.

Right Investment Age
What is the right age to invest in mutual fund? I am 19 years old and planning to invest in a mutual fund? What is the right time to invest? Should I invest in a debt fund or an equity fund?
- Suresh Topne

There is no right age of investing in a mutual fund. The sooner you start the better it is. It is good that you have decided to start investing at a young age. To begin with, investment in mutual funds is a step in the right direction. However, if you are thinking of bottom-fishing, then you are on the wrong track. You can know that the market has reached a bottom only after it has happened and, by then it's too late. It is virtually impossible to buy at the bottom and sell at the peak.

So, instead of waiting for the right opportunity, invest regularly in mutual funds, ignoring the ups and downs of stock markets. This is the only way you can reduce the risk of investing as no one can forecast accurately which way markets are headed. Also, it is important that you invest in funds with the intent of staying put for a long time. Stock market can go though the ups and downs over short periods of time, but over the long-term they are quite likely to reward you well.

As for an appropriate fund, much would depend upon your time horizon, risk appetite and return expectation. If you have time by your side and do not mind taking a few risks (which probably would be the case with you considering your young age), a well-diversified equity fund could be a good option. With almost no liability to speak of, you can afford to take risks and bear some volatility, which is an inherent characteristic of equity investing. If you are looking at a relatively less volatile equity offering, then an index fund is what you need to look at.

On the other hand, risk-averse youngsters can tap bond funds as they are safe investments. Bond funds neither fetch you high returns nor do they give you sleepless nights. Since these schemes invest in fixed income securities, they are less volatile than equity funds. In case you have a short investment horizon, a cash fund or a short-term debt fund could meet your requirement.

In a nutshell, stop worrying about market timing and start investing with a goal in mind. Since you are young and not an investment expert, the best strategy for you will be to buy and hold. Through this, you can take advantage of the power of compounding, and the ability of your invested money to make money. Always remember the best time to buy is 'now'. But remember to invest in equity funds through an SIP, rather than investing a lump sum amount.

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