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TEN RULES ON HOW TO INVEST IN THE EQUITY MARKETS.
BENEFITS OF REGULAR INVESTING.
HOW TO READ A MUTUAL FUND OFFER DOCUMENT ?
SETTING REALISTIC GOALS.
UNDERSTANDING THE RISK & REWARD RELATIONSHIP.
WHAT TO LOOK FOR IN A BOND FUND ?
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What is a Mutual Fund?
Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.
Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money invested by them. Investors of mutual funds are known as unitholders. The profits or losses are shared by the investors in proportion to their investments. The mutual funds normally come out with a number of schemes with different investment objectives which are launched from time to time. A mutual fund is required to be registered with Securities and Exchange Board of India (SEBI) which regulates securities markets before it can collect funds from the public.
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What is the history of Mutual Funds in India and role of SEBI in mutual funds industry?
Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s, Government allowed public sector banks and institutions to set up mutual funds. In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives of SEBI are – to protect the interest of investors in securities and to promote the development of and to regulate the securities market.
As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds to protect the interest of the investors. SEBI notified regulations for the mutual funds in 1993. Thereafter, mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and have been amended thereafter from time to time. SEBI has also issued guidelines to the mutual funds from time to time to protect the interests of investors. All mutual funds whether promoted by public sector or private sector entities including those promoted by foreign entities are governed by the same set of Regulations. There is no distinction in regulatory requirements for these mutual funds and all are subject to monitoring and inspections by SEBI. The risks associated with the schemes launched by the mutual funds sponsored by these entities are of similar type. It may be mentioned here that Unit Trust of India (UTI) is not registered with SEBI as a mutual fund (as on January 15, 2002).
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How is a mutual fund set up?
A mutual fund is set up in the form of a trust, which has sponsor, trustees, asset management company (AMC) and custodian. The trust is established by a sponsor or more than one sponsor who is like promoter of a company. The trustees of the mutual fund hold its property for the benefit of the unitholders. Asset Management Company (AMC) approved by SEBI manages the funds by making investments in various types of securities. Custodian, who is registered with SEBI, holds the securities of various schemes of the fund in its custody. The trustees are vested with the general power of superintendence and direction over AMC. They monitor the performance and compliance of SEBI Regulations by the mutual fund.
SEBI Regulations require that at least two thirds of the directors of trustee company or board of trustees must be independent i.e. they should not be associated with the sponsors. Also, 50% of the directors of AMC must be independent. All mutual funds are required to be registered with SEBI before they launch any scheme. However, Unit Trust of India (UTI) is not registered with SEBI (as on January 15, 2002).
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What is Net Asset Value (NAV) of a scheme?
The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV).
Mutual funds invest the money collected from the investors in securities markets. In simple words, Net Asset Value is the market value of the securities held by the scheme. Since market value of securities changes every day, NAV of a scheme also varies on day to day basis. The NAV per unit is the market value of securities of a scheme divided by the total number of units of the scheme on any particular date.
For example, if the market value of securities of a mutual fund scheme is Rs 200 lakhs and the mutual fund has issued 10 lakhs units of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.20. NAV is required to be disclosed by the mutual funds on a regular basis - daily or weekly - depending on the type of scheme.
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What are the different types of mutual fund schemes?
Schemes according to Maturity Period:
A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period.
Open-ended Fund/ Scheme
An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.
Close-ended Fund/ Scheme
A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally on weekly basis.
Schemes according to Investment Objective:
A scheme can also be classified as growth scheme, income scheme, or balanced scheme considering its investment objective. Such schemes may be open-ended or close-ended schemes as described earlier. Such schemes may be classified mainly as follows:
Growth / Equity Oriented Scheme
The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time.
Income / Debt Oriented Scheme
The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.
Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.
Money Market or Liquid Fund
These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and interbank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.
Gilt Fund
These funds invest exclusively in government securities. Government securities have no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes.
Index Funds
Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as “tracking error” in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.
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What are sector specific funds/schemes?
These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc.
The returns in these funds are dependent on the performance of the respective sectors/industries. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time. They may also seek advice of an expert.
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What are Tax Saving Schemes?
These schemes offer tax rebates to the investors under specific provisions of the Income Tax Act, 1961 as the Government offers tax incentives for investment in specified avenues. e.g. Equity Linked Savings Schemes (ELSS).
Pension schemes launched by the mutual funds also offer tax benefits. These schemes are growth oriented and invest pre-dominantly in equities. Their growth opportunities and risks associated are like any equity-oriented scheme.
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What is a Load or no-load Fund?
A Load Fund is one that charges a percentage of NAV for entry or exit. That is, each time one buys or sells units in the fund, a charge will be payable.
This charge is used by the mutual fund for marketing and distribution expenses. Suppose the NAV per unit is Rs.10. If the entry as well as exit load charged is 1%, then the investors who buy would be required to pay Rs.10.10 and those who offer their units for repurchase to the mutual fund will get only Rs.9.90 per unit.
The investors should take the loads into consideration while making investment as these affect their yields/returns. However, the investors should also consider the performance track record and service standards of the mutual fund which are more important. Efficient funds may give higher returns in spite of loads. A no-load fund is one that does not charge for entry or exit. It means the investors can enter the fund/scheme at NAV and no additional charges are payable on purchase or sale of units.
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Can a mutual fund impose fresh load or increase the load beyond the level mentioned in the offer documents?
Mutual funds cannot increase the load beyond the level mentioned in the offer document. Any change in the load will be applicable only to prospective investments and not to the original investments. In case of imposition of fresh loads or increase in existing loads, the mutual funds are required to amend their offer documents so that the new investors are aware of loads at the time of investments.
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What is a sales or repurchase/redemption price?
The price or NAV a unitholder is charged while investing in an open-ended scheme is called sales price. It may include sales load, if applicable. Repurchase or redemption price is the price or NAV at which an open-ended scheme purchases or redeems its units from the unitholders. It may include exit load, if applicable.
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What is an assured return scheme?
Assured return schemes are those schemes that assure a specific return to the unitholders irrespective of performance of the scheme. A scheme cannot promise returns unless such returns are fully guaranteed by the sponsor or AMC and this is required to be disclosed in the offer document. Investors should carefully read the offer document whether return is assured for the entire period of the scheme or only for a certain period. Some schemes assure returns one year at a time and they review and change it at the beginning of the next year. 7
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Can a mutual fund change the asset allocation while deploying funds of investors?
Considering the market trends, any prudent fund managers can change the asset allocation i.e. he can invest higher or lower percentage of the fund in equity or debt instruments compared to what is disclosed in the offer document.
It can be done on a short term basis on defensive considerations i.e. to protect the NAV. Hence the fund managers are allowed certain flexibility in altering the asset allocation considering the interest of the investors.
In case the mutual fund wants to change the asset allocation on a permanent basis, they are required to inform the unitholders and giving them option to exit the scheme at prevailing NAV without any load.
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How to invest in a scheme of a mutual fund?
Mutual funds normally come out with an advertisement in newspapers publishing the date of launch of the new schemes. Investors can also contact the agents and distributors of mutual funds who are spread all over the country for necessary information and application forms.
Forms can be deposited with mutual funds through the agents and distributors who provide such services. Now a days, the post offices and banks also distribute the units of mutual funds. However, the investors may please note that the mutual funds schemes being marketed by banks and post offices should not be taken as their own schemes and no assurance of returns is given by them.
The only role of banks and post offices is to help in distribution of mutual funds schemes to the investors. Investors should not be carried away by commission/gifts given by agents/distributors for investing in a particular scheme. On the other hand they must consider the track record of the mutual fund and should take objective decisions.
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Can non-resident Indians (NRIs) invest in mutual funds?
Yes, non-resident Indians can also invest in mutual funds. Necessary details in this respect are given in the offer documents of the schemes.
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How much should one invest in debt or equity oriented schemes?
An investor should take into account his risk taking capacity, age factor, financial position, etc. As already mentioned, the schemes 8 invest in different type of securities as disclosed in the offer documents and offer different returns and risks. Investors may also consult financial experts before taking decisions. Agents and distributors may also help in this regard.
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How to fill up the application form of a mutual fund scheme?
An investor must mention clearly his name, address, number of units applied for and such other information as required in the application form.
He must give his bank account number so as to avoid any fraudulent encashment of any cheque/draft issued by the mutual fund at a later date for the purpose of dividend or repurchase.
Any changes in the address, bank account number, etc at a later date should be informed to the mutual fund immediately.
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What should an investor look into an offer document?
An abridged offer document, which contains very useful information, is required to be given to the prospective investor by the mutual fund.
The application form for subscription to a scheme is an integral part of the offer document. SEBI has prescribed minimum disclosures in the offer document.
An investor, before investing in a scheme, should carefully read the offer document.Due care must be given to portions relating to main features of the scheme, risk factors, initial issue expenses and recurring expenses to be charged to the scheme, entry or exit loads, sponsor's track record, educational qualification and work experience of key personnel including fund managers, performance of other schemes launched by the mutual fund in the past, pending litigations and penalties imposed, etc.
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When will the investor get certificate or statement of account after investing in a mutual fund?
Mutual funds are required to despatch certificates or statements of accounts within six weeks from the date of closure of the initial subscription of the scheme. In case of close-ended schemes, the investors would get either a demat account statement or unit certificates as these are traded in the stock exchanges. In case of open-ended schemes, a statement of account is issued by the mutual fund within 30 days from the date of closure of initial public offer of the scheme. The procedure of repurchase is mentioned in the offer document.
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How long will it take for transfer of units after purchase from stock markets in case of close-ended schemes?
According to SEBI Regulations, transfer of units is required to be done within thirty days from the date of lodgment of certificates with the mutual fund.
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As a unitholder, how much time will it take to receive dividends/repurchase proceeds?
A mutual fund is required to despatch to the unitholders the dividend warrants within 30 days of the declaration of the dividend and the redemption or repurchase proceeds within 10 working days from the date of redemption or repurchase request made by the unitholder.
In case of failures to despatch the redemption/repurchase proceeds within the stipulated time period, Asset Management Company is liable to pay interest as specified by SEBI from time to time (15% at present).
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Can a mutual fund change the nature of the scheme from the one specified in the offer document?
Yes. However, no change in the nature or terms of the scheme, known as fundamental attributes of the scheme e.g.structure, investment pattern, etc. can be carried out unless a written communication is sent to each unitholder and an advertisement is given in one English daily having nationwide circulation and in a newspaper published in the language of the region where the head office of the mutual fund is situated. The unitholders have the right to exit the scheme at the prevailing NAV without any exit load if they do not want to continue with the scheme. The mutual funds are also required to follow similar procedure while converting the scheme form close-ended to open-ended scheme and in case of change in sponsor.
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How will an investor come to know about the changes, if any, which may occur in the mutual fund?
There may be changes from time to time in a mutual fund. The mutual funds are required to inform any material changes to their unitholders. Apart from it, many mutual funds send quarterly newsletters to their investors. At present, offer documents are required to be revised and updated at least once in two years. In the meantime, new investors are informed about the material changes by way of addendum to the offer document till the time offer document is revised and reprinted.
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How to know the performance of a mutual fund scheme?
The performance of a scheme is reflected in its net asset value (NAV) which is disclosed on daily basis in case of open-ended schemes and on weekly basis in case of close-ended schemes. The NAVs of mutual funds are required to be published in newspapers. The NAVs are also available on the web sites of mutual funds as well as on our website http://www.bluechipindia.co.in/ . You can also get the retruns/yields over a period of time as per your requirements. The Fund Factsheet is also available which will you can study and compare with other funds in the same category On the basis of performance of the mutual funds, the investors should decide when to enter or exit from a mutual fund scheme.
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How to know where the mutual fund scheme has invested money mobilised from the investors?
The Portfolio of All schemes are available on this website. The scheme portfolio shows investment made in each security i.e. equity, debentures, money market instruments, government securities, etc. and their quantity, market value and % to NAV.
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Is there any difference between investing in a mutual fund and in an initial public offering (IPO) of a company?
Yes, there is a difference. IPOs of companies may open at lower or higher price than the issue price depending on market sentiment and perception of investors. However, in the case of mutual funds, the par value of the units may not rise or fall immediately after allotment. A mutual fund scheme takes some time to make investment in securities. NAV of the scheme depends on the value of securities in which the funds have been deployed.
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If schemes in the same category of different mutual funds are available, should one choose a scheme with lower NAV?
Some of the investors have the tendency to prefer a scheme that is available at lower NAV compared to the one available at higher NAV. Sometimes, they prefer a new scheme which is issuing units at Rs. 10 whereas the existing schemes in the same category are available at much higher NAVs.
Investors may please note that in case of mutual funds schemes, lower or higher NAVs of similar type schemes of different mutual funds have no relevance. On the other hand, investors should choose a scheme based on its merit considering performance track record of the mutual fund, service standards, professional management, etc. This is explained in an example given below.
Suppose scheme A is available at a NAV of Rs.15 and another scheme B at Rs.90. Both schemes are diversified equity oriented schemes. Investor has put Rs. 9,000 in each of the two schemes. He would get 600 units (9000/15) in scheme A and 100 units (9000/90) in scheme B. Assuming that the markets go up by 10 per cent and both the schemes perform equally good and it is reflected in their NAVs. NAV of scheme A would go up to Rs. 16.50 and that of scheme B to Rs. 99. Thus, the market value of investments would be Rs. 9,900 (600* 16.50) in scheme A and it would be the same amount of Rs. 9900 in scheme B (100*99). The investor would get the same return of 10% on his investment in each of the schemes. Thus, lower or higher NAV of the schemes and allotment of higher or lower number of units within the amount an investor is willing to invest, should not be the factors for making investment decision. Likewise, if a new equity oriented scheme is being offered at Rs.10 and an existing scheme is available for Rs. 90, should not be a factor for decision making by the investor. Similar is the case with income or debt-oriented schemes. On the other hand, it is likely that the better managed scheme with higher NAV may give higher returns compared to a scheme which is available at lower NAV but is not managed efficiently. Similar is the case of fall in NAVs.
Efficiently managed scheme at higher NAV may not fall as much as inefficiently managed scheme with lower NAV. Therefore, the investor should give more weightage to the professional management of a scheme instead of lower NAV of any scheme. He may get much higher number of units at lower NAV, but the scheme may not give higher returns if it is not managed efficiently.
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How to choose a scheme for investment from a number of schemes available?
As already mentioned, the investors must read the offer document of the mutual fund scheme very carefully. They may also look into the past track record of performance of the scheme or other schemes of the same mutual fund. They may also compare the performance with other schemes having similar
objectives. Though past performance of a scheme is not an indicator of its future performance and good performance in the past may or may not be sustained in the future, this is one of the important factors for making investment decision. In case of debt oriented schemes, apart from looking into past returns, the investors should also see the quality of debt instruments which is reflected in their rating. A scheme with lower rate of return but having investments in better rated instruments may be safer. Similarly, in equities schemes also, investors may look for quality of portfolio. They may also seek advice of experts.
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Are the companies having names like mutual benefit the same as mutual funds schemes?
Investors should not assume some companies having the name “mutual benefit” as mutual funds. These companies do not come under the purview of SEBI. On the other hand, mutual funds can mobilise funds from the investors by launching schemes only after getting registered with SEBI as mutual funds.
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Is the higher net worth of the sponsor a guarantee for better returns?
In the offer document of any mutual fund scheme, financial performance including the net worth of the sponsor for a period of three years is required to be given. The only purpose is that the investors should know the track record of the company which has sponsored the mutual fund. However, higher net worth of the sponsor does not mean that the scheme would give better returns or the sponsor would compensate in case the NAV falls.
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If mutual fund scheme is wound up, what happens to money invested?
In case of winding up of a scheme, the mutual funds pay a sum based on prevailing NAV after adjustment of expenses. Unitholders are entitled to receive a report on winding up from the mutual funds which gives all necessary details.
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How can the investors redress their complaints?
Investors would find the name of contact person in the offer document of the mutual fund scheme whom they may approach in case of any query, complaints or grievances.
Trustees of a mutual fund monitor the activities of the mutual fund. The names of the directors of asset management company and trustees are also given in the offer documents. Investors can also approach SEBI for redressal of their complaints. On receipt of complaints, SEBI takes up the matter with the concerned mutual fund and follows up with them till the matter is resolved. Investors may send their complaints to:
Securities and Exchange Board of India
Mutual Funds Department
Mittal Court ‘B' wing, First Floor,
224, Nariman Point,
Mumbai – 400 021.Phone: 2850451-56, 2880962-70
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TEN Rules on How to Invest in the Equity Markets
Equity market investments typically yield high returns, particularly if invested over longer periods of time, although such investments are characterized by a high degree of price volatility in the short term. The volatility in our markets, reflects significant shifts in the nature of the Indian economy, with the services sector gaining increasing importance. This fundamental change in the economy has resulted in a dramatic change in the nature of our stock markets with the services sector, including technology, assuming increasing importance. Investment in equities has dismayed many in the short term, but if executed as per the investment rules outlined below, may help in better choices.
Rule no. 1 : Identify objective
Identify your objective, given your needs, life stage and resources. If you want to increase the value of your investment in order to have a larger sum to spend at a later date, your main priority will be capital growth.
Rule no 2 : Identify your risk tolerance and then invest appropriately
Young people at the start of their working lives will have a greater appetite for taking financial risk as compared to people at the end of their career who are looking forward to stable income and preservation of capital. These two extremes will exemplify the ability to take equity exposure. The young person is likely to be invested largely in equities for he can afford to take short term capital loss in anticipation of higher rates of return from equities. The elderly will be unable to take the risk of capital loss even in the short term as their ability to make back any losses will be limited by time and ability to earn.
Rule no 3 : Categorize your stock : Cyclical, Growth or Defensive
Investing in cyclical stocks, such as those in the cement or steel sector, requires an understanding of the economic scenario. An active involvement in the investment is required in order to reap the maximum benefits of swings in economic cycles over time. The stock prices are likely to move through extreme highs and lows, and the ability to time entry and exit will be necessary. Growth investing refers to stocks in sectors where the future direction is clear for the medium term - such as technology. However even here, timing is key, for the stock may do nothing for a long time as momentum builds up and then move sharply thereafter. Defensive investing is that which is done from a longterm viewpoint, where a stock is held on the premise that it will grow consistently and on a sustainable basis over time, such as those in the fast moving consumer goods sector. While the appreciation may, at times, not be as dramatic as cyclical or growth stocks, stocks that constitute defensive investments grow steadily over
longer time periods.
Rule no 4 : Check out the technical position
Can you actually sell your investment when you want to? The liquidity of a stock is very important in taking an investment decision, for if there is very little free stock available in the market, buying and selling may well impact the stock price in an adverse manner. It is interesting to see what the price volume relationship is for a stock. So if a stock price is moving up or down on high trading volume, it is more likely that there is real interest in that price movement than if there is very
little volume supporting the price move.
Rule no 5 : Know what the company does
The fate of each stock is tied inextricably to the fortune of the underlying business, and the market's perception of the future prospects for that business. The industry's future potential in terms of projected demand-supply is key as is the company's competitive position in the
industry. The business model of the company should be considered, as well as possible future changes, and the ability of the company to sustain growth and momentum well into the future.
Rule no 6 : Know who runs the company
The capability and integrity of management is even more important in determining the future viability of your investment. A strong, credible, experienced and shareholder responsive management team is critical for operating and growing a successful company. In the
newer areas of our economy, management vision is also of significant importance.
Rule no 7 : Know the company's performance
The price earnings (P/E) ratio is the often quoted measure of a company's value. This ratio divides the stock price by the year's earnings, and is useful in arriving at comparative valuation. But the tool that is quite prevalent in professional evaluations is the return on equity (ROE), which is the year's earnings divided by the net worth of the company. This when compared
to the cost of capital for the company allows the investor to gauge the company's wealth creating ability. Apart from the ratios the investor must also focus on the sustainability of earnings growth.
Rule no 8 : Know the company's valuation
Two stocks may have the same EPS but different P/E's. This is because ROE may be different and its sustainability may be different. Broadly speaking, the higher the sustainable ROE, the higher the P/E rating. A high P/E does not therefore necessarily imply an overvalued stock. Stocks with high sustainable ROE's are likely to trade at high P/E multiples.
Rule no 9 : Know the price target
Having selected stocks and built a portfolio, it is now imperative to track these investments closely. One method of doing so is to set expectations, by identifying a target price, and to re-evaluate the stock when this target is reached. Here, it is important to consider opportunity costs. If there is a loss on a stock, should one realize that loss and invest in another stock, which
has a greater potential, or should one wait for the loss to turn into a profit. By not selling out of low return stocks to get into higher return stocks, investors miss out on opportunities.
Rule no 10 : Do you want a professional manager?
Many investors mistakenly assume that they can purchase one or two stocks and they will do well. In the absence of good luck, this can be a dangerous strategy since there is always a risk of a stock declining in value or the business facing company specific problems. The more diversified the portfolio, lower is the risk of one poorly performing stock affecting overall performance of the portfolio. However, a good way of diversifying the portfolio is to invest through mutual funds where the professional fund manager and the rigorous investment process is likely to limit risk while maximizing profit, depending on the risk profile of the fund invested in.
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Benefits of Regular Investing
In plain English, Rupee Cost Averaging means investing regularly, regardless of what the market is doing. It's a way of making the value of your investment grow at the same time as removing the difficulty of “timing the market”. In the long run, investing on a regular basis also helps to reduce
your overall risk.
It's hard to time markets
Make no mistake, it's hard to time when to enter and exit markets. Financial markets are made up of a host of different investors. There are large institutions, such as fund managers, as well as
companies, brokers and individual investors. Over the long-term, markets can do well but in the shortterm, prices fluctuate on the basis of fundamental news, market sentiment, expectations, rumour and competitor activity. Sometimes the ‘herd' mentality can set in. When the news about a particular stock is good, investors buy in. Even though the price keeps rising, buyers keep buying, as nobody is sure when the price has peaked. Similarly, when prices are falling, nervous
investors sell in an attempt to cut their losses. There are statistical measures and yardsticks, such
as price-earning ratios, which help determine the true value of a stock or bond, but as the boom and bust in Internet stocks has proven, rational measures are often ignored and sentiment can take over. Deciding when to invest in this environment can be a stressful task. If the market is doing well you may fear that you're buying when prices are too high. By contrast, when the market is falling, there is a reluctance to invest due to fears that it may fall further.
So what should an investor do to avoid having to make these timing decisions?
Why investing regularly, works ?
Investing on a regular basis removes the stress of “timing the market” because you are employing the concept of “Rupee Cost Averaging”. If you are an investor in mutual funds it means that you buy more units when the purchase price is low and fewer units when the purchase price is high. The trick to all this is to remember that it's not the price you pay for each unit that matters. It's the average price per unit over time that determines your overall return.
Illustration on Rupee cost averaging
Lets look at an example to make all this a bit clearer. Ajay has been investing Rs 5,000 per month in a particular scheme since October 1999. The table below shows the purchase price Ajay paid for the units each month as well as the number of units Ajay purchased.
A brief glance at the table reveals the benefits of Rupee Cost Averaging. When the purchase price was high (eg. Rs 10 in Oct 1999), Ajay bought fewer units (500) and when the purchase price was low (eg. Rs 6 in Apr 2000), he bought significantly more (833).
The benefits of this strategy are twofold:
• The average price Ajay paid for the units was Rs 7.52* (the total cost of the units – ie.
Rs 65,000 divided by the total number of units purchased - ie. 8,648). This is less than the
average market price over the period (Rs 7.77*) even though Ajay was not even trying to “time
the market”.
• In Oct. 2000, the value of Ajay's investment is approximately 33% higher than what it
originally cost him (Original cost : Rs 65,000 Current value : Rs 10 x 8,648 units = Rs 86,480 ),
even though the purchase price in Oct. 2000 was the same as it was in Oct. 1999 (ie. Rs 10).
By investing regularly, Ajay bought units as the price was falling and was able to benefit from price appreciation as the market recovered. So Ajay has avoided the stress of timing the market but has still done very well on his investment. The key – Rupee Cost Averaging which, in simple
terms, just means investing regularly.
*Approximate value rounded upto two decimal places
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How To Read A Mutual Fund Offer Document
Many people today find that they are deluged with information about investing. News programs provide updates on the stock market several times a day. Through the Internet, individuals can check on the performance of their investments at the click of a mouse. But one of the key sources of investment information, and one that some investors may be tempted to overlook, is the Mutual Fund Offer Document.
A mutual fund offer document is a legal document that must adhere to standards set forth by the
Securities Exchange Board Of India (SEBI), the regulatory agency that oversees the Indian Mutual Fund industry. The information contained in the prospectus is intended to help you understand what types of securities a fund invests in and the investment philosophy that the Investment Manager uses in selecting individual securities for the fund. The offer document will also provide information on the fund's income and expenses, a review of historical performance, and information about your ability to purchase or redeem your units. In addition, the offer document will also outline any loads/sales charges that may apply to your investment transactions. By law, mutual fund companies are required to provide you with an offer document before you make an initial investment. Before investing, take the time to read this important document.
Questions to ask before investing
A mutual fund offer document can help you answer the following questions:
• In what does this scheme invest ?
• Is the scheme seeking income or capital growth ?
• What has been the rate of return ?
• What are the options available in the scheme (Growth / Dividend) ?
• Is the scheme an open ended / close ended scheme and if there is a lock-in period applicable ?
Key Elements of a Mutual Fund Offer Document
The information contained in a mutual fund offer document is presented in several sections. As you read through these sections, you'll want to evaluate how well the fund matches your investment objectives. Here's a look at key elements that are contained in an Offer Document.
• Date of issue — A prospectus must be updated at least once in two years.
• Minimum investment — Mutual funds differ both in the minimum initial investment required
and the minimum for subsequent investments.
• Investment objective — This section states the investment goal of the fund, from income to
long-term capital appreciation, and may state the types of investments that the scheme invests in,
such as government bonds or common stocks. Be sure the scheme's objective matches your
investment goal.
• Investment policies — An offer document will outline the general strategies the Investment
Manager will use in selecting individual securities. This section may provide further information about the securities in which the scheme invests, such as ratings of bonds or the types of companies considered appropriate for a fund.
• Risk factors — Every investment involves some level of risk. The scheme offer document will
describe the risks associated with investments in the scheme.
• Fees and expenses — Sales and management fees associated with a mutual fund must be clearly listed.
• Tax information — An Offer Document will include information on the tax treatment of
dividend and capital gains, including information on deduction of tax at source
• Investor services — Unitholders may have access to certain services, such as automatic
reinvestment of dividends, systematic investment plan (SIP), systematic withdrawal plans (SWP)
and systematic investment plan for corporate employees. This section of the prospectus, usually
near the back of the publication, will describe these services and how you can take advantage of
them. A prospectus generally ranges from 20 to 30 pages and includes a table of contents. The scheme offer document may be amended from time to time and attaching an addendum which highlights the changes e.g. change in load structure, introducing of a new facility etc. usually reflects this. It is therefore important for investors to read the offer document in detail to be able to understand the features of the scheme and get the best out of the services offered by the Investment Manager.
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Setting Realistic Goals
Much has been said about the importance of planning your financial future. But after you have sought advice, planned, and invested your assets, there are further crucial aspects that will determine the achievement of your goals. Your expectations from your investments are a crucial factor that will determine your ongoing level of comfort with, and therefore your adherence to, your plan. The key is to set realistic expectations about market performance and the returns on your investments, towards which we offer you the following advice.
Stock market movements The stock market tends to move up and down sharply, and exhibits a fair degree of volatility - sometimes in the course of a
single day. At times, certain segments of the markets may perform exceedingly well while others may not. Although such an unstable market environment, and the
possibility of higher than expected returns, may tempt you to assume risk beyond your tolerance, remember not to base your decisions on data about short-term
performance. Timing the market
It may also be tempting to avoid market declines by trying to “time the market,” that is, moving your money out of stocks when you think their prices have peaked and may fall. This is generally a losing strategy, as your returns will be greatly reduced if you are not invested when the market goes up. History shows that buying and selling in an attempt to “time” the market typically produces much poorer results than simply staying in the market. For example, although the compounded annualized return in the stock market since 1985 has been roughly 16%, many individual years in this period have seen losses. For example, in the twelve months
ended December 31, 2000, the stock market lost nearly 21%. Such short-term deviations from longterm averages present the real risk of “mis-timing”. Always set your expectations based on a study of historic average returns of the market. If you set your expectations too high, your investment plan will not allow you to achieve your financial goals, as you will be unprepared for the downside. The majority of the most dramatic market gains - as well as losses - occur over brief time periods that are impossible to predict. Even in a developed market such as the USA, an investor who stayed in the stock market during the entire 30-year period from 1963 through 1993 would have had an average annual return of nearly 12%. But, in an effort to time the market, if the investor missed the 90 days where the market gains were the highest in the period, the average return would have fallen to roughly 3% per year. But it is impossible to predict the 90 best days during a 30-year period. The short-term ups and downs of the market will be less worrisome if you keep in mind that you are investing to meet long-term goals.
Past performance
Investment advisors provide data about past performance so that you understand how an investment has behaved in different market conditions. Research about past performance
should focus on how an investment compares to other investments with the same objective and to other relevant performance measures. Such research does not provide a tool to predict
future results. Although history suggests that, over time, gains in the stock market exceed losses, you must be aware that there is no guarantee that this will continue in the future. Understand all the risks involved in making an investment, and evaluate them carefully, even if they appear improbable.
Goals versus risk tolerance
There is a wealth of information available on different investment avenues, but not viewing it in the right context is a potential risk in investing. It is important to remember that in addition to market-related factors, several aspects of your own investment behavior, including your expectations, goals, risk tolerance, and adherence to your plans and objectives, will determine the results that your financial plan will achieve. Setting realistic longterm expectations for the performance of your investments is key to establishing and adhering to a successful investment plan.
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Understanding the Risk & Reward Relationship
Most investments usually involve some element of risk. It's the uncertainty around the potential
performance of your investment that can sometimes cause concern. The important thing to remember is that risk can be managed, and sometimes even minimised. The aim of most investors is to invest in assets that will generally provide the best returns for their money within the level of risk they are comfortable with. To enjoy higher returns, you may need to invest in assets where there is greater short-term risk. So when it comes to your investments, rather than
shy away from risk, consider it as just another factor that needs to be carefully managed.
What is risk?
Most investors think of risk as the “chance of loss” or to quantify it, how much you could potentially lose for the potential gain. The basic rule of thumb in investing is the higher
the risk, the higher the potential return; the lower the risk, generally the lower the return.
There are also other risks associated with investing. These include risks such as investments that don't keep pace with inflation, or investments that experience unacceptable levels of volatility
(fluctuations in value).
Managing risk
There are a number of steps you can take to better understand and manage the risks associated with investing:
Clarify your “risk profile”
It's important to understand how much risk you are willing to take with your investments. Are you happy with low growth investments that provide returns marginally above inflation for very low risk, or are you prepared to take more risk with your investments for potentially significantly higher returns? All of us have a different appetite for risk, so you need to know what level you are comfortable with before making your decision.
Set your investment objectives
Secondly, work out how much of a return will make you happy and meet your needs. What are your future goals and what kind of investments can help you achieve these goals? For example, are you saving for your retirement or a round the world holiday?
Know your timeframe
The amount of time you have available to invest is also critical in determining which investments may suit your needs and in managing investment risks. The longer you have to invest, generally the more risks you can take with your investments, as there is more time for you to ride out the peaks and troughs of investment performance. Alternatively, investors nearing retirement may wish to invest in low risk investments where the likelihood off fluctuation in investment performance is significantly reduced.
Diversify your investments
Diversifying your investments across a range of assets and asset classes can also be an effective strategy in helping to reduce investment risk. By spreading your investments around, you aren't as affected by (or “exposed to”) the movements of just one market, some of which may rise, while others may fall.
What should I invest in?
Asset classes have a long history and have been the focus of much analysis. Although it is difficult to pick exactly how well one particular asset is going to perform, as a general rule of thumb, the lower the risk, the lower the return and the higher the risk, the higher the potential return. When choosing what asset class to invest in, the three major classes of financial assets in order of their volatility from lowest to highest are as follows:
• Cash / Certificate of Deposit
• Bonds
• Equity shares
Choosing which asset class to invest your money will depend on many factors including your risk
profile, the amount of time you have to invest and your overall investment objectives.
Mutual funds
Mutual funds are designed to give investors access to a range of investments they would find difficult to access on their own. There are many mutual funds available and they usually provide a
diversified approach to investing, ensuring an appropriate balance of investments and asset classes to minimise risk. Different mutual fund schemes have different levels of risk, depending on the way they are weighted across the various assets. For example:
• Fixed Income schemes are heavily weighted in fixed interest and cash investments. These are
generally low risk in nature and provide lower returns.
• Balanced/growth schemes generally have a heavier weightage in equity than in Fixed Income
instruments and aim to provide higher returns than a Fixed Income schemes.
• High growth schemes will generally have an even higher weighting in equites. They carry the
greatest risk, but over time, may provide the highest returns. There are also mutual fund schemes that comprise a single asset class (eg. Technology funds). As these funds invest in one asset class they can potentially involve a greater level of risk, but may also generate higher returns over the long term.
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What To Look For In A Bond Fund
Performance of the fund is clearly the driving factor for all investors, but it is only one factor in assessing fund choice for an investor, and must be judged against the risks that the fund manager takes in delivering these returns. Such risks are to do with: the credit ratings of the
investments in the portfolio - Credit Risk, the Liquidity Risk of the portfolio with regard to the
ease of sale or purchase of the portfolio investments without impacting price, the Price Risk which can be judged against the maturity profile of the investments and the mix of investments in terms of sectoral allocation and finally Volatility, which is a measure of the consistency of NAV movement in the short and the longer term. Let's look at these in some more detail.
Performance
Performance is a quantitative tool, measuring NAV movements across periods of time, and is easily derivable. This is therefore a measure that most advisers latch onto in terms of recommending funds to investors. Typically performance should be looked at over 3 months, 6 months, 1 year, 3 years and longer duration to determine the consistency of returns and therefore the ability of the fund manager to replicate performance in the future. Performance should be compared on a rolling basis. For funds in existence for less than a year, returns must be compared on an absolute basis. For funds in existence for greater than a year, compounded
annualised return should be used.
Credit risk
Lower the credit, higher the return - but beware: Understanding credit quality is one of the two core tenets of measuring risk of a bond fund portfolio, the other being price risk which will be discussed later. Government securities are regarded as risk free, and form the basis of corporate finance theory in terms of establishing risk-return benchmarks. Securities that are AAA rated, will typically trade at a small spread above government securities, for these are regarded only next to government securities in terms of the safety of the capital and interest cash flows. However, a security rated A will trade much higher. But as the ratings move down the risk of default on interest and even capital become more real, particularly when the economy cycles back
into periodic slowdown. We are sure you wouldn't chase higher returns at the risk of losing capital?
Liquidity
Liquidity flows from credit quality, and is very important: Higher credit quality of the portfolio is
correlated to liquidity of the fund. Why is liquidity so important? For any investor, the ease of
transacting, both at the time of investing and redeeming, is key. If the NAV price moves either for
buying or selling then the return to the investor will suffer. For a bond fund manager, who sees
significant fund flows with investors coming in and out of the fund, the ability to buy or sell portfolio securities at a fair and transparent price is fundamental to maintaining consistency and
sustainability of NAV price performance and safeguarding investor interest.
Price risk
Maturity profile of the portfolio will determine price risk: Interest rates move up and down all the
time, determined by macroeconomic influences as well as structural and technical funds flow reasons. This movement of interest rates has significant impact on the pricing of bonds depending on the maturity of the bond. If a bond is due to be redeemed in the short term - say less than a year, the impact of a rise or fall in interest rates will be much lower than on a bond with 10 years tenure. Similarly a portfolio consisting of bonds with a low average maturity profile will have low impact on price movement in the NAV price as a result of volatile interest rates as compared to a fund with higher average maturity. In order to maximise gains to the fund, the portfolio should take into account possible interest rate movement in the future, although it is difficult to predict interest rate movement. So in a volatile environment, a portfolio is well positioned if it is at the short end of the market. The price risk arises from the ability of the
fund manager to forecast future interest rate movements.
Volatility
Volatility of NAV prices is also regarded as a factor that influences the investor in his choice of funds. We believe that volatility is important in a relative sense against a benchmark, or peer group funds, in the absence of an appropriate benchmark. However, we are also of the view that short term volatility arising out of anomalies in pricing and valuation methodologies adopted by funds, are unimportant in relation to longer term volatility say over 6 months and preferably on a 12 month basis. Investors in bond funds typically don't come for the short term. So the volatility match must be looked at in the context of the investors time horizon, which would typically be 6 months and above.
Valuation & Transparency
In the long run the performance return to trend due to shorter term valuation anomalies, in the
absence of industry guidelines and uniformity, there are shorter term aberrations as different funds follow differing valuation methodologies. SEBI has recently issued guidelines on valuation norms and practices across the industry, which is good news for investors.
Corpus
The size of the fund is also very important. Larger funds have the ability to be more diversified in their investments thereby reducing market risk somewhat. In addition larger funds will also have the first pick of the cherry in terms of investment issues and in the market. For larger investors particularly, size of the fund will offer liquidity, diversification and the probability of higher returns.
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