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Decision to invest in a fund should depend on its performance rather than

Tax Incidence
What will be the tax incidence if I redeem my units in less than a year? Also tell me what happens if I have an SIP for tenure of three years and I redeem the units at the end of three years? Also let me know about the tax exemptions if an investment is made in the ELSS.
- Rohit Verma

All gains on redemptions made after one year are exempt from capital gains tax since there is no tax on long-term capital gains tax on equity funds. However, if you redeem units within one year from the date of allotment, then the profits you book will be subject to a short-term capital gains tax of 10 per cent. The same is true for investments through the SIP route. The tax will be calculated individually for each installment according to the period of holding. Suppose you start a monthly SIP from January 1, 2006, with each installment falling due on the first of every month. Now, your first installment will complete one year on December 31, 2006, after which any gains made upon the sale of these units will be exempt from tax. Likewise, in each successive month after December 31, 2006, your subsequent installments will complete one year periodically. So if you want to redeem units at the end of three years, then investments made in the first two years will be exempt from tax while the installments made in the last year will be subject to a short-term capital gains tax of 10 per cent. As far as the tax benefits under ELSS are concerned they are exempt from tax under section 80C, subject to an overall investment limit of Rs 1 lakh.

NFOs Cheaper ?
Why should one not invest in NFOs? The funds which your website recommends were also NFOs some years back. Aren't they cheaper when one invests in them at the face value with a long-term view?
- SC Jain

Buying units of an NFO (new fund offer) is not cheap as you are made to believe by the colourful advertisements of the fund houses. It makes no difference whether the net asset value (NAV) of a fund is high or low. The lure of getting units cheap at par for Rs 10 per unit has been one of the reason for the huge success of the NFOs. A mutual fund always sells at par, be it a new or an old fund, even with an NAV of Rs 100.

If you invest in two funds with different NAVs, your returns from the two can be same or even higher. Your decision to invest in funds should depend on the consistency of the fund house in generating returns rather the price of NAVs. We at Value Research do not recommend new funds. The funds that are new may top the recommended funds' lists some time in future, if they perform well. Same has been the case with funds that are currently investment worthy. It is only by consistently performing well, in line with their objective, that these funds have earned the reputation of being the star performers. One may argue that past performance is no guarantee of future returns but at least you know where your money has been invested and that if the fund manager has the ability to manage the fund well in turbulent times. This advantage is not available in a new fund.

Over Diversification
I want to know if there is a need to churn my portfolio. I have invested Rs 50,000 each in Tata Equity Opportunities Fund, Tata Equity P/E Fund, Tata Infrastructure Fund, Tata Service Industries Fund, Chola Multi Cap, Sundaram Select Midcap, DSPML TIGER Fund, HDFC Premier Multicap, ING Vysya Mid Cap, UTI Dividend Yield Fund, Reliance Equity Opportunities Fund, Reliance NRI Equity Fund, Sundaram SMILE and UTI Master Value etc. I also have a reasonable amount invested in UTI Retirement Benefit Plan. I don't want to invest in new fund offers.
- Shivam Diwan

Your portfolio suffers from problem of plenty. A portfolio with a long list of funds is not necessarily a good one. The fact that it is quite difficult to keep track of every fund in a big portfolio is self-evident from the fact that you have used the word 'etc.' after naming 14 of them! It seems that you have been investing in each and every fund that comes your way, or rather, every fund which your distributor comes selling to you.

The purpose of investing in more than one fund is to build a well-diversified portfolio, spread over various asset classes including stocks, bonds and money market instruments. Further, you can choose funds on the basis of stocks they invest in, like large-cap, mid-cap, small-caps or a combination of all three. On the debt side, you should look for credit quality and maturity of papers.

There is no rule as to how much funds should there be in a portfolio but a good portfolio can be built with around 8-10 funds, depending on the amount to be invested and the need for diversification. In your case, of the 14 funds you have mentioned, as many as 13 are the equity funds, which are much more than required. Remember convenience is one of the advantages of mutual funds. By mindlessly buying so many funds you have missed out on this benefit.

Another worrisome factor about your portfolio is that most of your funds are quite young. Only four of the funds that you have mentioned- Tata Equity Opportunities, Sundaram Select Midcap, UTI Master Value and UTI RBP have a track record of more than three years. Ideally, while selecting a fund, one should look at the past history of the fund to see how they have performed over long term and across market cycles. The new funds in your portfolio are yet to prove their worth.

The following are five broad parameters which should be considered before investing in a fund: What are the mutual fund's returns over various time periods?

How much risk does it take?

Who manages it?

What does it invest in?

How much does it cost?

Your portfolio is quite diversified but you can achieve the same level of diversification with lesser number of funds. Also keep in mind your tax implications and exit loads while exiting the funds. Some of your investments might be less than one-year old. If you exit from a fund in less than a year, then you will be subject to capital gains tax.

Technical Terms
What should we decipher from a fund's Sharpe Ratio and Beta?
- Mehreen Noorani

Sharpe Ratio: The Sharpe ratio is a single number which represents both the risk, and return inherent in a fund. As is widely accepted, high returns are generally associated with a high degree of volatility. The Sharpe ratio represents the trade off between risk and returns. At the same time, it also factors in the desire to generate returns, which are higher than risk-free returns.

Mathematically, the Sharpe ratio is the returns generated over the risk-free rate, per unit of risk. Risk in this case is taken to be the fund's standard deviation. A higher Sharpe ratio is therefore better as it represents a higher return generated per unit of risk.

However, while looking at Sharpe ratio, please keep in mind that it being only a ratio, is a pure number. In isolation it has no meaning. It can only be used as a comparative tool. Thus the Sharpe ratio should be used to compare the performance of a number of funds. Alternatively, one can compare the Sharpe ratio of a fund with that of its benchmark index. If the only information available is that the Sharpe ratio of a fund is 1.2, no meaningful inference can be drawn as nothing is known about the peer group performance. Secondly, it may be misleading at times. For example, a low standard deviation can unduly influence results. A fund with low returns but with a relatively mild standard deviation can end up with a high Sharpe ratio. Such a fund will have a very tranquil portfolio and not generate high returns.

Beta: Beta is a statistical tool, which gives you an idea of how a fund will move in relation to the market. In other words, it is a statistical measure that shows how volatile a fund is to market moves. If the Sensex moves by 25 per cent, a fund's beta number will tell you whether the fund's returns will be more than this or less. The beta value for an index itself is taken as one. Equity funds can have beta values, which can be above one, less than one or equal to one. By multiplying the beta value of a fund with the expected percentage movement of an index, the expected movement in the fund can be determined.

Thus if a fund has a beta of 1.2 and the market is expected to move up by ten per cent, the fund should move by 12 per cent (obtained as 1.2 multiplied by 10). Similarly if the market loses ten per cent, the fund should lose 12 per cent. This shows that a fund with a beta of more than one will rise more than the market and also fall more than the market.

But please note that beta depends on the index used to calculate it. It can happen that the index bears no correlation with the movements in the fund. For example, if beta is calculated for a large-cap fund against a mid-cap index, the resulting value will have no meaning. This is because the fund will not move in tandem with the index. Due to this reason, it is essential to take a look at a statistical value called R-squared along with beta. The R-squared value shows how reliable the beta number is. It varies between zero and one. An R-squared value of one indicates perfect correlation with the index. Thus, an index fund investing in the Sensex should have an R-squared value of one when compared to the Sensex. For diversified equity funds, an R-squared value greater than 0.8 is generally accepted to mean that the underlying beta value is reliable and can be used for the fund.

ULIPS vs Mutual Funds
Is it advisable to invest in unit linked insurance plans (ULIPS)? How do they compare with mutual funds? What are the tax exemptions available?
- Col (retd) BS Sanyal

Both these instruments are designed to serve different purposes and are not comparable. A unit-linked plan from an insurance company is an insurance policy designed to pay a lump sum on maturity or on death, whichever is earlier. Premium paid under these plans is eligible for tax deduction under Section 80C of the Income Tax Act. On the other hand, mutual funds are investment avenues to participate in the growth of financial markets and do not provide any tax deduction (except ELSS and pension funds).

For a unit-linked insurance plan, providing life cover is the most important function; returns are just an added benefit, which gets magnified, given the tax rebates. Though unit-linked plans offer transparency in returns in terms of net asset value and flexibility in investment options in debt, equity or a mix of both, these advantages are secondary. For a mutual fund the main objective is to provide returns.

Moreover, unit-linked plans are not as liquid as mutual funds. There is a lock-in of three years. Even if one redeems after three years, he or she would be at a loss because of higher initial administrative charges. For example, the upfront charges for the first two premium amounts are as high as 20-27 per cent. Then there can be other charges like an annual management fee of 0.8-1.25 per cent and a flat fee of Rs 15-20 per month. Finally, there is a deduction for risk cover. This goes towards contribution to the sum assured or the life insurance cover, which is based on mortality rates as calculated by actuaries. Though mutual funds too have entry and exit loads (usually 2.25 per cent) and expenses (maximum 2.5 per cent), these costs are much lower than unit-linked plans.

From your perspective, consider unit-linked plans only if you want insurance cover and not as an investment avenue. If you want an exposure to the stock or bond market, mutual funds are better investment avenues. Don't go by the performance of these unit-linked products. Both unit-linked plans and mutual funds invest in the same financial markets. If the equity market is doing well, both equity-linked insurance plans and equity mutual funds will do well. But as an investment tool, you would be better off investing in mutual funds rather than unit-linked plans due to high fees charged by the insurance companies for this particular product. By design, unit-linked plans and mutual funds are not comparable and are meant to suit different objectives.

Price Differential
I want to start investing in mutual funds. But before that I want to know why is it that the buy and sell price is different for some mutual funds and the same for others?
- Prashant Bhaskar

Basically, buy price is the price at which you enter a fund and sell price is the price at which you exit a fund. What makes the two different is the entry and exit load charged by a mutual fund scheme. However, in a no-load fund, the buy and the sell price is same-i.e., equivalent to its net asset value (NAV).

Let's explain this with the help of an example. Suppose you want to invest Rs 5,000 in a fund, whose NAV is Rs 12 and charges an entry load of two per cent. This mean that the price at which you would purchase units from the fund would be two per cent higher than the NAV. Two per cent of Rs 12 is Rs 0.24. So, your purchase price will be the NAV plus this sum, i.e., Rs 12.24. So in the case where entry load is levied, the purchase price becomes higher than the NAV. Generally, most of the equity funds charge an entry load these days.

Another way of looking at this is that two per cent of your investment would be deducted towards meeting the load. Two per cent of Rs 5,000 is Rs 100. This means that of the Rs 5,000 investment amount, only Rs 4,900 would go to the fund, with Rs 100 going towards meeting the load. Similarly, when you exit a fund whose current NAV is Rs 12 and it levies an exit load of two per cent, the sell price would work out to Rs 11.76. Here the load, Rs 0.24 (two per cent of NAV, Rs 12) is deducted from the NAV. As a result of this, selling price in case of an exit load is always lower than NAV.

Therefore, the buy and sell price just reflects the price at which a fund is available for purchase or redemption, respectively. The higher the entry load, the higher is the buy price, whereas the higher the exit load the lower is the value you would receive on redemption of your investment.

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