Without knowing companies you cannot make the most of this opportunity to pick up quality stocks. Here’s where you should go for information you can trust.
There are many lessons to learn from the 2008 market crash. One of the most important is: understand a company before investing in it. If you do, the market is offering a good chance to pick quality stocks at reasonable prices. The problem is that without sound information, any investment decision would be based on weak reasoning and is unlikely to support your overall portfolio performance. But how do you know that the information you have is accurate? For that, you need to do your research well and look at the right place for the right information. Here are seven parameters you should look at and the places you can find information on them.
Market Capitalisation
What is it?
Market capitalisation (cap) is calculated by multiplying a company’s outstanding shares (paid-up equity capital divided by the face value) with the current market price (CMP). This indicates the worth of the company in terms of its shares. To calculate the market cap of, say, GlaxoSmithKline (GSK) Consumer Health-care, multiply the CMP—Rs 815 as on 13 May—with the 4.20 crore outstanding shares, which comes to Rs 3423 crore.
Where to look
- The financial results section or the company related page on stock exchange websites (www.nseindia.com or www.bseindia.com) give details of outstanding shares
- The quotes page on these sites give CMP
- Financial dailies publish market cap data of select companies
Trading Volumes
What is it?
It is the total number of stocks of a company traded at an exchange. It is a measure of the liquidity and also shows the level of market participation in the stock. This figure is especially important in the case of low-volume stocks (below 2,000 shares). During tough market conditions, liquidating low-volume stocks becomes difficult. The 2-week average quantity of Dabur India shares is around 2.2 lakh, which is a comfortable number. On the other hand, the number for MMTC is only 500-600 shares for the same period.
Where to look
- Stock exchange sites
- Financial dailies
Historical Price Data
What is it?
This information helps understand how a stock’s price has behaved over a period of time. Information on whether a stock is at a new peak or a new low helps evaluate the quality of the stock. For instance, if a stock has breached its yearly low, you should get into the reason behind it.
Where to look
- The quotes page or the stock reach page on the NSE and BSE sites share the yearly high and low data
- Use the ‘charting function’ of exchange sites for graphical representation. This will help you find whether the stock is trading at a new low or a new high. The co-movement option helps compare the performance of the stock with the index
- On www.nseindia.com, go to the equity, market information, historical data section. Click on the security-wise data section, get the security symbol and choose the dates for which you want information. On www.bseindia.com, go to the archives section
Company Developments
What is it?
Developments in a company such as a new product, capacity expansion or a new clientele can affect the stock’s performance. Find out what impact these developments can have on the stock. Also, find out about the company’s competitors, government regulations related to it, and their impact on its operations.
Where to look
- Financial dailies
- Corporate announcements on exchange sites have information about developments in a company
- Analyst meets or conference call updates on company sites throw light on the company’s future plans
- To understand the operations of a company, read its latest annual report. The director’s report and management discussion and analysis will give you a detailed perspective on the company’s current performance and outlook
- Follow the notes published at the end of the statutory advertisements that companies release to gather information on disclosures
- Investors can also become a member of online investment clubs. You will derive a lot of information which can, subsequently, be validated from a reliable source
Financial Data
What is it?
Before buying a stock, it is important to know about the company’s financial performance. Growth in sales and profit over the last four to five quarters will help you understand its performance in the light of the recent market scenario. Its growth rate in the last 4-5 years will give an insight into the pace of growth in the past. Look at the operating margin growth as well, especially so in the current tough operating environment.
Remember to look at the consolidated, and not the standalone performance. Consolidated performance includes the results of all subsidiaries, joint ventures and investments in associate companies. Its importance is evident from the impact it has on the performance of some companies.
Where to look
- Company website. Results and annual reports need to be read carefully. For example, in case of Dabur India, go to www.dabur.com, click on investor relations and get into financial presentations. You will get quarterly results, annual report, investor communications and analyst conference call transcripts there
- The financial results section on stock exchange websites
Balancesheet
What is it?
Many companies, especially those from the pharmaceutical and IT sectors, are under stress due to high debt and losses on foreign currency borrowings. Many investors ignored the foreign currency convertible bond (FCCB) details before the 2008 stockmarket crash.
FCCB is a type of convertible bond issued in a currency different from the issuer’s domestic currency. The mix of debt and equity instruments it has gives the bondholder an option to convert the bond into a stock.
Due to the sharp stockmarket dip, the companies are unable to offer the bondholders the option of converting the bonds into equity at a premium. Instead, bondholders had to exercise the debt option. Companies would now have to decide on how to service their FCCBs.
The balancesheet will also help you understand the financial leveraging capacity of the company. Calculate the debt-equity ratio to get this. It is arrived at by dividing the total liabilities by the stockholders’ equity.
Take the case of Aurobindo Pharma. It has outstanding FCCB of $260 million. A part of it will come up for redemption in the beginning of 2010. This stock got butchered when the FCCB issue became a major concern and is currently trading at more than 80 per cent discount to its FCCB conversion price.
Recent updates on the NSE website suggest that the company has plans to buy back its outstanding FCCBs in small lots. The company’s debt-equity ratio is 1.5. This should be considered before investing because high debt-equity (normally above one) suggests that the company has been aggressive in financing its growth through debt. If the company’s operation is under stress due to the economic environment and its balancesheet is debt-burdened, then it would be better to stay away from its stock.
Where to look
- Annual report and news releases on the company website
- Corporate announcements available on stock exchange sites
Basic Calculations
Deduct any preferred stock dividends from the net profit after tax and divide the balance by the number of outstanding shares. This will give you the earnings per share (EPS) of a company.
To assess a stock, calculate the trailing 12 months’ EPS (for the last four quarters). Then, calculate the price earning ratio (PE)—CMP divided by EPS.
For example, GSK Consumer’s EPS grew steadily from Rs 30 in December 2006 to Rs 51.30 in March 2009. The company follows the calendar year
and this data can be sourced from the exchange sites and also the company’s website, www.gsk-ch.in. The latest EPS and CMP (Rs 815) translate into a PE ratio of 15.9.
To evaluate whether a PE is high or low, compare it with the industry PE and index PE. This data is also available on exchange sites. Go to the industry index information to get the PE details of a particular industry. The BSE FMCG Index’s PE, for instance, as on 13 May is 23.54 while GSK Consumer’s PE is 15.9. This suggests a comparatively low PE for the company.
Where to look
- Profit & loss account on exchange sites or company website
- Quarterly or annual results published by the company also carry EPS information;
Source: money.outlook.com
Sunday, May 24, 2009
Get The Best Of Both Worlds
Hybrid accounts offer liquidity, high returns and capital protection. In these troubled times, they are a flexible in-out instrument for your funds
How To Get More
Maintain the minimum balance in respective accounts while opting for sweep-in or auto sweep facilities. This way you will not have to pay any service charges for them
In an auto sweep facility, keep a reasonable threshold limit. This will prevent frequent breaking of fds and you will get a higher rate of return from them
In a sweep-in facility, try not to link an FD that’s nearing maturity
***
While the equity markets are passing though a volatile period, banks look attractive as places to park surplus funds
"Smart use of facilities offered by hybrid accounts can make them flexible instruments for meeting longer-term as well as immediate needs"
Savings acc-ounts offer unparalleled liquidity, but returns of just 3.5 per cent a year. Fixed deposits (FDs) give higher returns and capital security, but are not as liquid as savings accounts. And, any premature withdrawal means losing out on interest. So what do you do?
Enter hybrid accounts. They offer liquidity, high returns and capital protection. Most banks offer them under different names (see Revolving Doors).
The use
Says Pune-based certified financial planner Veer Sardesai: "Hybrid accounts have been around for a while. They have gained prominence now because many banks have started offering such facilities."
Hybrid accounts can be used for long-term as well as immediate needs. For long-term goals, such as a child’s education or buying a house, you should move away from riskier asset classes 2-3 years before you need the money. If you know exactly when that need would be, it is better to invest in a bank FD of the same duration. But this rarely happens. In reality, one never knows when money would be required. Usually, if there is an unplanned money requirement, an FD is broken, especially if there is no other source.
Such a situation can be avoided with hybrid accounts with sweep-in or auto sweep facilities. These facilities can also be used to create an emergency fund. "We frequently advise people that everyone must keep aside 6-8 months’ living expenses as an emergency fund," says Sardesai. With a sweep-in facility, excess funds above a threshold limit in a savings account can be automatically transferred into an FD and earn a higher interest rate.
Mother of invention
Earlier, a person had a savings account for liquid money and FDs for investment. In such a situation, every time he had to issue a cheque in excess of the balance in the savings account, he had to visit the bank branch to give instructions to break his FD. Says Seshan Ramakrishnan, head, liabilities products, HDFC Bank: "This was an inconvenience that customers could do without. At the same time, the bank had to manually process all such requests within the agreed turnaround time."
Thus, a hybrid product was created that helped the customer earn higher interest and issue cheques of amounts more than in the account without any manual intervention from the bank.
The working
These accounts work in two broad ways. One is the sweep-in facility, where a savings or current account is linked with multiple FDs in the same bank. HDFC Bank’s facility is a typical example. You would need a savings or current account and FDs that are to be linked, in the same bank. Any deficit in your savings or current account will be met by a withdrawal of an exact value from your FD. Since deposits are broken down in units of Re 1, you will lose interest only on the actual amount withdrawn from the FD.
The second way is the auto sweep facility. ICICI Bank’s Auto Invest Account facility is an example. All you need to do is mention a threshold limit. Any amount above the limit will be converted into an FD in multiples of Rs 5,000. The linked FDs are by default of one-year period or you can go for a period of your choice. Interest rates are as revised by the bank from time to time. Maturing deposits are renewed for a year or for a period of your choice at the interest rate prevailing on the date of renewal.
Your choice. "Each individual needs to choose a hybrid product depending upon his need and cash flows," says Ramakrishnan. For example, try not to use the sweep-in facility for an FD that is nearing maturity since the loss of interest on breaking it would be higher.
In the auto sweep facility, if more than one FD is linked, the last deposit made under the scheme will be used first to meet the shortfall. If this isn’t adequate, then the deposit made prior to the last deposit will be used, and so on.
Costs. These facilities do not cost extra under certain conditions. For example, to availyourself of HDFC Bank’s sweep-in facility without charges, you will have to maintain Rs 50,000 or more in your FD. If the level goes below Rs 50,000, service charges applicable on a savings or current account are levied. ICICI Bank’s auto sweep facility requires you to maintain Rs 10,000 in the linked savings bank account. With Bank of Rajasthan’s Flexi Fixed Deposits, you will need to maintain a minimum of Rs 10,000 in the FD, failing which you would need to pay Rs 100per quarter.
Getting the most. Use these tricks to get the most out of these facilities.
With an auto sweep facility, make sure you keep a reasonable threshold limit in the savings account so that your FDs are not broken regularly and you continue to earn higher returns on them.
Also, as Sardesai points out, "it becomes a bit difficult for a lay person to understand the bank statement if there are excessive transactions between the multiple accounts". Another thing to remember is that interest earned on these accounts is fully taxable in your hands. So, plan in such a way that the FDs earn more interest than the savings bank account.
Other options
In an emergency, you can take an overdraft against your FD. However, make sure the overdraft is not more expensive than breaking the FD. Also, getting the overdraft takes more time due to the increased paperwork involved. Look for banks that provide an instant overdraft facility against the FD.
People with higher risk appetites can move towards liquid mutual funds for shoring up emergency fund requirements.
Source:money.outlook.com
How To Get More
Maintain the minimum balance in respective accounts while opting for sweep-in or auto sweep facilities. This way you will not have to pay any service charges for them
In an auto sweep facility, keep a reasonable threshold limit. This will prevent frequent breaking of fds and you will get a higher rate of return from them
In a sweep-in facility, try not to link an FD that’s nearing maturity
***
While the equity markets are passing though a volatile period, banks look attractive as places to park surplus funds
"Smart use of facilities offered by hybrid accounts can make them flexible instruments for meeting longer-term as well as immediate needs"
Savings acc-ounts offer unparalleled liquidity, but returns of just 3.5 per cent a year. Fixed deposits (FDs) give higher returns and capital security, but are not as liquid as savings accounts. And, any premature withdrawal means losing out on interest. So what do you do?
Enter hybrid accounts. They offer liquidity, high returns and capital protection. Most banks offer them under different names (see Revolving Doors).
The use
Says Pune-based certified financial planner Veer Sardesai: "Hybrid accounts have been around for a while. They have gained prominence now because many banks have started offering such facilities."
Hybrid accounts can be used for long-term as well as immediate needs. For long-term goals, such as a child’s education or buying a house, you should move away from riskier asset classes 2-3 years before you need the money. If you know exactly when that need would be, it is better to invest in a bank FD of the same duration. But this rarely happens. In reality, one never knows when money would be required. Usually, if there is an unplanned money requirement, an FD is broken, especially if there is no other source.
Such a situation can be avoided with hybrid accounts with sweep-in or auto sweep facilities. These facilities can also be used to create an emergency fund. "We frequently advise people that everyone must keep aside 6-8 months’ living expenses as an emergency fund," says Sardesai. With a sweep-in facility, excess funds above a threshold limit in a savings account can be automatically transferred into an FD and earn a higher interest rate.
Mother of invention
Earlier, a person had a savings account for liquid money and FDs for investment. In such a situation, every time he had to issue a cheque in excess of the balance in the savings account, he had to visit the bank branch to give instructions to break his FD. Says Seshan Ramakrishnan, head, liabilities products, HDFC Bank: "This was an inconvenience that customers could do without. At the same time, the bank had to manually process all such requests within the agreed turnaround time."
Thus, a hybrid product was created that helped the customer earn higher interest and issue cheques of amounts more than in the account without any manual intervention from the bank.
The working
These accounts work in two broad ways. One is the sweep-in facility, where a savings or current account is linked with multiple FDs in the same bank. HDFC Bank’s facility is a typical example. You would need a savings or current account and FDs that are to be linked, in the same bank. Any deficit in your savings or current account will be met by a withdrawal of an exact value from your FD. Since deposits are broken down in units of Re 1, you will lose interest only on the actual amount withdrawn from the FD.
The second way is the auto sweep facility. ICICI Bank’s Auto Invest Account facility is an example. All you need to do is mention a threshold limit. Any amount above the limit will be converted into an FD in multiples of Rs 5,000. The linked FDs are by default of one-year period or you can go for a period of your choice. Interest rates are as revised by the bank from time to time. Maturing deposits are renewed for a year or for a period of your choice at the interest rate prevailing on the date of renewal.
Your choice. "Each individual needs to choose a hybrid product depending upon his need and cash flows," says Ramakrishnan. For example, try not to use the sweep-in facility for an FD that is nearing maturity since the loss of interest on breaking it would be higher.
In the auto sweep facility, if more than one FD is linked, the last deposit made under the scheme will be used first to meet the shortfall. If this isn’t adequate, then the deposit made prior to the last deposit will be used, and so on.
Costs. These facilities do not cost extra under certain conditions. For example, to availyourself of HDFC Bank’s sweep-in facility without charges, you will have to maintain Rs 50,000 or more in your FD. If the level goes below Rs 50,000, service charges applicable on a savings or current account are levied. ICICI Bank’s auto sweep facility requires you to maintain Rs 10,000 in the linked savings bank account. With Bank of Rajasthan’s Flexi Fixed Deposits, you will need to maintain a minimum of Rs 10,000 in the FD, failing which you would need to pay Rs 100per quarter.
Getting the most. Use these tricks to get the most out of these facilities.
With an auto sweep facility, make sure you keep a reasonable threshold limit in the savings account so that your FDs are not broken regularly and you continue to earn higher returns on them.
Also, as Sardesai points out, "it becomes a bit difficult for a lay person to understand the bank statement if there are excessive transactions between the multiple accounts". Another thing to remember is that interest earned on these accounts is fully taxable in your hands. So, plan in such a way that the FDs earn more interest than the savings bank account.
Other options
In an emergency, you can take an overdraft against your FD. However, make sure the overdraft is not more expensive than breaking the FD. Also, getting the overdraft takes more time due to the increased paperwork involved. Look for banks that provide an instant overdraft facility against the FD.
People with higher risk appetites can move towards liquid mutual funds for shoring up emergency fund requirements.
Source:money.outlook.com
Saturday, May 23, 2009
Make The New Pension System Work For You
NPS scores over several other retirement products in many ways, check out how and why
After much delay and several near misses, we finally have a pension plan; a social security scheme for 89 per cent of India’s workforce that doesn’t have a formal retirement solution. The New Pension System (NPS), as it is now referred to, was fittingly launched on Labour Day, 1 May. Though there are some concerns, such as its taxability, NPS is superbly designed to help you save for your retirement. We feel it merits a place in your portfolio. The only question that remains is: just when should you sign up for NPS?
ABOUT NPS
It is a pure defined-contribution product. You can choose the fund option as well as the fund manager. You get a retirement corpus when you turn 60. Of this, you get 60 per cent in your hands, while the remaining goes into buying you an annuity plan (to ensure pension money) from an insurer. The system discourages early withdrawal by giving just 20 per cent in your hands and annuitising 80 per cent of the corpus.
Structure
NPS begins with a mandatory Tier I account and an annual contribution of at least Rs 6,000. A Tier II account, which would offer a withdrawal facility, is expected to be launched in another six months. You can invest in NPS in two ways.
Active choice. You can allocate your funds across three fund options: equity (E), in which a maximum of 50 per cent of the portfolio is allowed; fixed income instruments other than government securities (C); and government securities (G).
Auto choice. Under this, your funds automatically begin with a maximum equity exposure of 50 per cent till the age of 35 years, which tapers off to 10 per cent by age 55. This gives stability to your investment as you near the maturity line.
You can choose from the six designated pension fund managers (see 10 Common Questions Answered). Says Kartik Varma, financial planner and co-founder, iTrust Financial Advisors: “With time, fund performance could be a yardstick, but it is unlikely that fund performance would vary hugely since the funds would be invested in similar products.”
MechanismWhat makes NPS an excellent pension vehicle is its low cost and the ease with which an individual can invest for retirement. It hinges on a Central Recordkeeping Agency (CRA), which captures your data when you open your Tier I account and issues you a Permanent Retirement Account Number (PRAN). This number remains the same even if you change jobs or location. You would also be given Internet passwords for online transactions
NPS is the cheapest among retirement products, after the Public Provident Fund (PPF) and the Employees’ Provident Fund (EPF), both of which are charge-free. NPS has two sets of charges—flat and variable.
You would need to pay about Rs 470 as flat charges every year, but this is expected to come down as volumes go up. The variable charges are custodian charge of 0.0075-0.05 per cent of the fund value per annum and fund management charge of 0.0009 per cent of the fund value per annum. These are the lowest in the industry.
Challenges
Tax treatment. Though NPS scores in terms of cost and ease of handling, it loses out in terms of taxability. At present, the contributions get tax benefit under Section 80C. However, at the time of withdrawal, the lumpsum would be taxable as per your tax slab. Says Tarun Chugh, director, ICICI Prudential Pensions: “The currency of NPS is its low-cost structure. But what will pull the masses to this scheme is tax benefit. NPS needs a tax treatment similar to that enjoyed by EPF and PPF.”
Both EPF and PPF enjoy the EEE tax benefit, under which contribution, accumulation and withdrawal are all tax-free.
Volumes. For NPS to remain low cost, it is imperative for the volume of investment money to go up. Says Manish Sabharwal, chairman and co-founder, Teamlease, a staffing company: “Costs come down with large scales and not with regulatory intervention. At the current fund management cost, the crying need is for the volumes to go up. This can happen by bringing funds from PPF, EPF and other superannuation funds under the Pension Fund Regulatory and Development Authority (PFRDA), the interim regulator for NPS. The distinction of government NPS and non-government NPS needs to go, too.”
Distribution. The Points of Presence (PoP) or distribution agents of NPS will charge up to Rs 20 for every transaction. With four mandatory transactions every year, it comes to Rs 80. Compare this with what an insurer gives to its agents—7.5 per cent of the annual premium. Clearly, the incentive for distribution in case of NPS is much lower. Says Gautam Bharadwaj, director, Invest India Economic Foundation, a think tank involved in financial and pension policy analysis: “Low costs are great for customers, but NPS will struggle with distributor interest since banks and others will prefer to sell you an insurance or mutual fund product that pays much higher commissions. The solution, of course, is to bring down the high cost of buying financial services.”
HOW DOES IT COMPARE...
The numbers show that NPS is right at the bottom of the pyramid despite the low cost, and this is purely because it is taxable on maturity. However, we are confident that eventually NPS would have tax benefits in sync with EPF and PPF. Once that happens, NPS would become an attractive investment vehicle.
...with EPF. Contribution in the EPF enjoys tax benefit under Section 80C. Withdrawals, too, are tax-free. While your money grows at 8.5 per cent per annum, your employer matches your contribution to your fund. However, to rely on your EPF alone may be foolhardy—you may not stick around in a salaried job, you may withdraw your funds periodically, or the rate on the EPF may be reduced. Your EPF corpus may not be sufficient for meeting your retirement needs. NPS is linked to you rather than your employer. So, any change in your job won’t affect your investments. Also, NPS is completely portable and even allows you to invest in equity, which is a must for young investors.
...with PPF. PPF is also an excellent long-term vehicle to plan for retirement. It is government-backed and gives a guaranteed tax-free return of 8 per cent per annum. Says Maneesh Kumar, head (wealth management solutions), ASK Wealth Advisors: “For young individuals, NPS could be the best alternative after EPF and PPF. NPS lets you invest up to 50 per cent in equities, which outperform bonds over the long term.”
...with a mutual fund (MF). Here the comparison is at two levels: costs and fund management. On costs, NPS beats MFs, including the cheaper index funds, hands down. However, for those who wish to kick start their retirement portfolio with equity investment, index funds are a good bet. They are cheap, are not saddled with a fund manager and their maturity amount is tax-free. NPS is still awaiting that tax edge. On fund management, Pune-based financial planner Veer Sardesai says: “The best feature of NPS is that the equity component will be invested in index funds. This eliminates the uncertainty of who the fund manager will be, how long will he be there, will he really be able to outperform the benchmark indices. Being a pension product, consistency of management over the long term is very important.”
...with pension plans offered by insurers. These plans most closely resemble NPS’ structure. They have withdrawal penalties and ensure you get pension as they mandate annuitising 66.6 per cent of the fund value at the time of maturity. Also, they are much cheaper than unit-linked pension plans. Despite the low charge structure in pension plans, NPS scores on cost.
HOW DOES IT FIT
NPS is definitely the need of the hour and it scores over other products either in cost or in flexibility. But it needs the tax edge to make it comparable. There is merit in waiting. But if you wish to invest in NPS early, we would advise you keep it your third or fourth priority, after you have exhausted EPF and PPF limits.
You could adopt the age-old strategy. Invest more in equity in the beginning and temper down the exposure as you reach maturity. Adds Hrishi Parendekar, CEO, Karvy Wealth Management: “For a person under 35 years of age who has 20 years to go before retirement, equities would be a far superior product in terms of returns.”
Financial planners advise caution because of the tax treatment, while experts are skeptical of the sustainability of low costs. The stepping stone to dealing with this would be the EEE regime that the PFRDA is most certain to get. Once the tax benefits come through, volumes would certainly increase. Watch this space as the product evolves. It is very likely that this is where you would be parking a big chunk of your retirement funds.
Source: money.outlook.com
After much delay and several near misses, we finally have a pension plan; a social security scheme for 89 per cent of India’s workforce that doesn’t have a formal retirement solution. The New Pension System (NPS), as it is now referred to, was fittingly launched on Labour Day, 1 May. Though there are some concerns, such as its taxability, NPS is superbly designed to help you save for your retirement. We feel it merits a place in your portfolio. The only question that remains is: just when should you sign up for NPS?
ABOUT NPS
It is a pure defined-contribution product. You can choose the fund option as well as the fund manager. You get a retirement corpus when you turn 60. Of this, you get 60 per cent in your hands, while the remaining goes into buying you an annuity plan (to ensure pension money) from an insurer. The system discourages early withdrawal by giving just 20 per cent in your hands and annuitising 80 per cent of the corpus.
Structure
NPS begins with a mandatory Tier I account and an annual contribution of at least Rs 6,000. A Tier II account, which would offer a withdrawal facility, is expected to be launched in another six months. You can invest in NPS in two ways.
Active choice. You can allocate your funds across three fund options: equity (E), in which a maximum of 50 per cent of the portfolio is allowed; fixed income instruments other than government securities (C); and government securities (G).
Auto choice. Under this, your funds automatically begin with a maximum equity exposure of 50 per cent till the age of 35 years, which tapers off to 10 per cent by age 55. This gives stability to your investment as you near the maturity line.
You can choose from the six designated pension fund managers (see 10 Common Questions Answered). Says Kartik Varma, financial planner and co-founder, iTrust Financial Advisors: “With time, fund performance could be a yardstick, but it is unlikely that fund performance would vary hugely since the funds would be invested in similar products.”
MechanismWhat makes NPS an excellent pension vehicle is its low cost and the ease with which an individual can invest for retirement. It hinges on a Central Recordkeeping Agency (CRA), which captures your data when you open your Tier I account and issues you a Permanent Retirement Account Number (PRAN). This number remains the same even if you change jobs or location. You would also be given Internet passwords for online transactions
NPS is the cheapest among retirement products, after the Public Provident Fund (PPF) and the Employees’ Provident Fund (EPF), both of which are charge-free. NPS has two sets of charges—flat and variable.
You would need to pay about Rs 470 as flat charges every year, but this is expected to come down as volumes go up. The variable charges are custodian charge of 0.0075-0.05 per cent of the fund value per annum and fund management charge of 0.0009 per cent of the fund value per annum. These are the lowest in the industry.
Challenges
Tax treatment. Though NPS scores in terms of cost and ease of handling, it loses out in terms of taxability. At present, the contributions get tax benefit under Section 80C. However, at the time of withdrawal, the lumpsum would be taxable as per your tax slab. Says Tarun Chugh, director, ICICI Prudential Pensions: “The currency of NPS is its low-cost structure. But what will pull the masses to this scheme is tax benefit. NPS needs a tax treatment similar to that enjoyed by EPF and PPF.”
Both EPF and PPF enjoy the EEE tax benefit, under which contribution, accumulation and withdrawal are all tax-free.
Volumes. For NPS to remain low cost, it is imperative for the volume of investment money to go up. Says Manish Sabharwal, chairman and co-founder, Teamlease, a staffing company: “Costs come down with large scales and not with regulatory intervention. At the current fund management cost, the crying need is for the volumes to go up. This can happen by bringing funds from PPF, EPF and other superannuation funds under the Pension Fund Regulatory and Development Authority (PFRDA), the interim regulator for NPS. The distinction of government NPS and non-government NPS needs to go, too.”
Distribution. The Points of Presence (PoP) or distribution agents of NPS will charge up to Rs 20 for every transaction. With four mandatory transactions every year, it comes to Rs 80. Compare this with what an insurer gives to its agents—7.5 per cent of the annual premium. Clearly, the incentive for distribution in case of NPS is much lower. Says Gautam Bharadwaj, director, Invest India Economic Foundation, a think tank involved in financial and pension policy analysis: “Low costs are great for customers, but NPS will struggle with distributor interest since banks and others will prefer to sell you an insurance or mutual fund product that pays much higher commissions. The solution, of course, is to bring down the high cost of buying financial services.”
HOW DOES IT COMPARE...
The numbers show that NPS is right at the bottom of the pyramid despite the low cost, and this is purely because it is taxable on maturity. However, we are confident that eventually NPS would have tax benefits in sync with EPF and PPF. Once that happens, NPS would become an attractive investment vehicle.
...with EPF. Contribution in the EPF enjoys tax benefit under Section 80C. Withdrawals, too, are tax-free. While your money grows at 8.5 per cent per annum, your employer matches your contribution to your fund. However, to rely on your EPF alone may be foolhardy—you may not stick around in a salaried job, you may withdraw your funds periodically, or the rate on the EPF may be reduced. Your EPF corpus may not be sufficient for meeting your retirement needs. NPS is linked to you rather than your employer. So, any change in your job won’t affect your investments. Also, NPS is completely portable and even allows you to invest in equity, which is a must for young investors.
...with PPF. PPF is also an excellent long-term vehicle to plan for retirement. It is government-backed and gives a guaranteed tax-free return of 8 per cent per annum. Says Maneesh Kumar, head (wealth management solutions), ASK Wealth Advisors: “For young individuals, NPS could be the best alternative after EPF and PPF. NPS lets you invest up to 50 per cent in equities, which outperform bonds over the long term.”
...with a mutual fund (MF). Here the comparison is at two levels: costs and fund management. On costs, NPS beats MFs, including the cheaper index funds, hands down. However, for those who wish to kick start their retirement portfolio with equity investment, index funds are a good bet. They are cheap, are not saddled with a fund manager and their maturity amount is tax-free. NPS is still awaiting that tax edge. On fund management, Pune-based financial planner Veer Sardesai says: “The best feature of NPS is that the equity component will be invested in index funds. This eliminates the uncertainty of who the fund manager will be, how long will he be there, will he really be able to outperform the benchmark indices. Being a pension product, consistency of management over the long term is very important.”
...with pension plans offered by insurers. These plans most closely resemble NPS’ structure. They have withdrawal penalties and ensure you get pension as they mandate annuitising 66.6 per cent of the fund value at the time of maturity. Also, they are much cheaper than unit-linked pension plans. Despite the low charge structure in pension plans, NPS scores on cost.
HOW DOES IT FIT
NPS is definitely the need of the hour and it scores over other products either in cost or in flexibility. But it needs the tax edge to make it comparable. There is merit in waiting. But if you wish to invest in NPS early, we would advise you keep it your third or fourth priority, after you have exhausted EPF and PPF limits.
You could adopt the age-old strategy. Invest more in equity in the beginning and temper down the exposure as you reach maturity. Adds Hrishi Parendekar, CEO, Karvy Wealth Management: “For a person under 35 years of age who has 20 years to go before retirement, equities would be a far superior product in terms of returns.”
Financial planners advise caution because of the tax treatment, while experts are skeptical of the sustainability of low costs. The stepping stone to dealing with this would be the EEE regime that the PFRDA is most certain to get. Once the tax benefits come through, volumes would certainly increase. Watch this space as the product evolves. It is very likely that this is where you would be parking a big chunk of your retirement funds.
Source: money.outlook.com
Get the most out of fixed deposits
High volatility in stock markets combined with the easing inflation has again made fixed deposits an attractive avenue for investors, particularly those seeking assured returns. For, FD schemes of banks not only give assured returns but risk-free returns as well, and all one has to do is park one’s money in such a scheme and forget about it till maturity.
The best part of FD schemes are that they are one of the safe investment avenues and there is very little chance of losing you money as banks are closely regulated and monitored by the Reserve Bank of India. In the current turbulent times, investors are increasingly banking on such age-old investment tools.
Another advantage of FD schemes are that they can get you loans of up to 75-90% of the amount deposited with the bank.
Here are some tips to get the most out of FD schemes:
Do your research well
Take a look at the interest rates offered by different banks before going in for a scheme. You also need to decide the tenure of your deposit. The interest rates offered by different banks could vary. Also, the interest rates for different tenures are different.
Interests offered by banks are either calculated quarterly, half-yearly, yearly or at maturity. So, calculate which bank is going to get you the highest interest.
Suppose there are two banks -- 'A' & 'B'. Bank 'A' gives an interest rate of 10% p.a on a fixed deposit of five years and the interest is calculated on a quarterly basis.
Bank 'B' gives the same interest rate for the same period, but the interest is calculated on a yearly basis. In this case, Bank 'A' will get you more interest than Bank 'B'. The more frequently interests are calculated, the more interest you will get.
Split your FD investments
TDS (tax deductable as source) at 10% is applicable on fixed deposits if the interest earned exceeds Rs 10,000 in a financial year. The tax liability of TDS is determined at the branch level.
To avoid TDS, you can split your fixed deposits, that is, open fixed deposits in different branches of the bank, so that the interest earned does not exceed Rs 10,000 in a particular branch. You could also open fixed deposits in different banks to avoid TDS.
Splitting you fixed deposits has another benefit as well. If you are in need of urgent cash and need to withdraw money, you won't have to break all your fixed deposits.
You could get the money by breaking either one or two FD accounts while the remaining accounts would continue to earn you the predetermined interest.
Re-investing the interest earned
You have the option of either withdrawing the interest earned or reinvesting the same. If you opt for the withdrawal option, the interest earned will be credited to the savings account specified by you on a regular basis.
The interest you earn every year will be higher compared to the previous year if you keep reinvesting the interest. On the other hand, if you withdraw the interest, you will earn the same interest every year until maturity.
Let’s assume that you are planning to invest Rs 50,000 in a FD scheme for 5 years at the rate of 9.5% p.a. and the interest is calculated on a quarterly basis. If you reinvest the interest, your total interest earned will amount to Rs 29,955.49 in 5 years.
If you withdraw the interest, your total interest earned will amount to Rs 24,609.55. That is a difference of Rs 5,345.94. The greater the fixed deposit, the greater the difference will be.
Tax-saver FDs for better returns
Tax saver fixed deposits give you dual benefits. Apart from giving you an assured return, they are also eligible for exemption under Section 80C of the Income Tax Act 1961. However, TDS is applicable.
These fixed deposits have a lock-in period of five years and premature withdrawal is not allowed. You can’t use this deposit as a means to secure loan from the bank and the maximum amount you can invest in this instrument is Rs 1 lakh.
HDFC Bank at present offers 9.50% interest (calculated quarterly) on tax-saving FDs as well as on regular FDs for 5 years. ICICI Bank, on the other hand, gives 8.5% interest (calculated quarterly) on tax-saving FDs and 9.5% (calculated quarterly) interest on regular FDs for 5 years.
If you fall in the higher tax-slab, investing in tax-saver FDs will fetch you more return than a regular FD as tax-saving FDs are exempted under Section 80C.
Source:Economictimes.com
The best part of FD schemes are that they are one of the safe investment avenues and there is very little chance of losing you money as banks are closely regulated and monitored by the Reserve Bank of India. In the current turbulent times, investors are increasingly banking on such age-old investment tools.
Another advantage of FD schemes are that they can get you loans of up to 75-90% of the amount deposited with the bank.
Here are some tips to get the most out of FD schemes:
Do your research well
Take a look at the interest rates offered by different banks before going in for a scheme. You also need to decide the tenure of your deposit. The interest rates offered by different banks could vary. Also, the interest rates for different tenures are different.
Interests offered by banks are either calculated quarterly, half-yearly, yearly or at maturity. So, calculate which bank is going to get you the highest interest.
Suppose there are two banks -- 'A' & 'B'. Bank 'A' gives an interest rate of 10% p.a on a fixed deposit of five years and the interest is calculated on a quarterly basis.
Bank 'B' gives the same interest rate for the same period, but the interest is calculated on a yearly basis. In this case, Bank 'A' will get you more interest than Bank 'B'. The more frequently interests are calculated, the more interest you will get.
Split your FD investments
TDS (tax deductable as source) at 10% is applicable on fixed deposits if the interest earned exceeds Rs 10,000 in a financial year. The tax liability of TDS is determined at the branch level.
To avoid TDS, you can split your fixed deposits, that is, open fixed deposits in different branches of the bank, so that the interest earned does not exceed Rs 10,000 in a particular branch. You could also open fixed deposits in different banks to avoid TDS.
Splitting you fixed deposits has another benefit as well. If you are in need of urgent cash and need to withdraw money, you won't have to break all your fixed deposits.
You could get the money by breaking either one or two FD accounts while the remaining accounts would continue to earn you the predetermined interest.
Re-investing the interest earned
You have the option of either withdrawing the interest earned or reinvesting the same. If you opt for the withdrawal option, the interest earned will be credited to the savings account specified by you on a regular basis.
The interest you earn every year will be higher compared to the previous year if you keep reinvesting the interest. On the other hand, if you withdraw the interest, you will earn the same interest every year until maturity.
Let’s assume that you are planning to invest Rs 50,000 in a FD scheme for 5 years at the rate of 9.5% p.a. and the interest is calculated on a quarterly basis. If you reinvest the interest, your total interest earned will amount to Rs 29,955.49 in 5 years.
If you withdraw the interest, your total interest earned will amount to Rs 24,609.55. That is a difference of Rs 5,345.94. The greater the fixed deposit, the greater the difference will be.
Tax-saver FDs for better returns
Tax saver fixed deposits give you dual benefits. Apart from giving you an assured return, they are also eligible for exemption under Section 80C of the Income Tax Act 1961. However, TDS is applicable.
These fixed deposits have a lock-in period of five years and premature withdrawal is not allowed. You can’t use this deposit as a means to secure loan from the bank and the maximum amount you can invest in this instrument is Rs 1 lakh.
HDFC Bank at present offers 9.50% interest (calculated quarterly) on tax-saving FDs as well as on regular FDs for 5 years. ICICI Bank, on the other hand, gives 8.5% interest (calculated quarterly) on tax-saving FDs and 9.5% (calculated quarterly) interest on regular FDs for 5 years.
If you fall in the higher tax-slab, investing in tax-saver FDs will fetch you more return than a regular FD as tax-saving FDs are exempted under Section 80C.
Source:Economictimes.com
Wednesday, May 13, 2009
Government Backed Investment Options
Government backed options give the highest security. A new gameplan with old warhorses
3 Get-More Tricks
Besides secure returns, the safest investment options can be cleverly tailored to suit various requirements. Here are strategies that have been used for ages and can work wonders in these harsh times
Reinvest Monthly Income Scheme (MIS) Interest
Take a 6-year, 8 per cent per annum Mis. reinvest the monthly interest in a savings account (3.5 per cent interest per annum), which will give you an annualised return of 7.53 per cent after six years. reinvesting in a recurring deposit (7.5 per cent per annum) will give you an annualised return of 7.76 per cent.
Ladder National Savings Certificates (NSCS)
NSC is a 6-year instrument. assume that you buy nscs worth 24,000 in one financial year. instead, buy worth 2,000 every month till your retirement. renew every investment after six years and continue doing so until your retirement. finally, the matured will give regular income, which can be used as pension.
Use your Public Provident Fund (PPF)
PPf is a 15-year account in which you can put up to 70,000 every year. After the fifth year, make partial withdrawals for tax-free funds and contribute 70,000 as before from current income to get tax benefits.
***
It might seem ridiculous to talk about safe investments and sound returns at a time when the equity markets are down 34 per cent since last year and a tumbling real estate market is giving most of us sleepless nights. One thing that the glum developments of the last 18 months has taught us is that when things go wrong, it’s time to go back to the basics. When everything around us is crashing, the only comfort is in the simple and staid; like listening to an old song, or eating your mother’s cooking.
For our money lives, this new reality of volatile markets indicates the need to go back to old options and invest in products that our parents relied on, the ones we turned our noses up at as too cumbersome, or even too boring. These options, debt products with fixed returns mostly sold through post offices, are the safest possible as the government guarantees them. Although, theoretically, it is possible that the government defaults, in reality, it has never happened in India and is unlikely to happen in the future. Also, thanks to the lack of interest rate reforms, the returns on these products are higher than market determined rates. They also give tax benefits.
However, we are not suggesting that you move all your money into these products. If you are to meet your financial goals, you will need to have a decent mix of high-risk, high-growth options and assured return instruments. If you want to set aside Rs 5 lakh at today’s cost for your child’s higher education 15 years later, you will need Rs 10 lakh then after accounting for an inflation of 5 per cent per annum. If you invest only in debt products, you will have to save Rs 36,000 a year at 8 per cent interest per annum to build up that corpus in 15 years. Using equities over the same period and assuming 12 per cent annualised returns, the savings required would be a more modest Rs 24,000 a year.
So, what role can these embodiments of certainty and security play in your portfolio in a loss-ravaged year? While investing in these products will not be your short cut to wealth, it will certainly ensure that your downside is protected and your accounts are still in the green even as the world around you turns red.
THE RIGHT ONE FOR YOU
Assured return instruments have non-flexible features such as tenure, interest payment amounts and dates, taxability and liquidity. The basket of products with fixed and assured returns largely has nine instruments. Except bank fixed deposits (FDs), all these products are fully government-backed. We have classified them as tax-savers, regular income providers and others.
Bank Deposits
The eight post office products described in the article carry a sovereign guarantee. Bank fixed deposits (FDs), too, offer fixed and assured returns, but they are not backed by any government guarantee beyond Rs 1 lakh (principal and interest together) per bank per person. This leaves any amount over this susceptible to risk in case of a bank default. It is better to spread your fixed deposits over banks rather than invest a big sum in a single bank. FDs’ tenure varies from one month to 10 years. The interest income can be had monthly, quarterly, half-yearly or even yearly and is fully taxable. Among the banks offering high interest rates currently, over a 1-year period, Development Credit Bank’s rate is 9.25 per cent per annum and Tamil Nadu Mercantile Bank is paying 9.25 per cent for a 5-year tenure. Many banks offer senior citizens 0.5 percentage points more.
Investment in 5-year notified tax-saving bank FDs helps secure a regular income and save tax under Section 80C. The interest (fully taxable) on such deposits may be a shade lower than on non-tax deposits of the same duration. ICICI Bank and State Bank of India currently offer 8.25 per cent per annum. For senior citizens with annual incomes less than Rs 2.25 lakh, this is a decent option.
The Tax-savers
Public Provident Fund (PPF). Not only does PPF give tax exemption on deposits, but also gives you tax-free returns. Says Manish Jain, founder, Knowledgepartners.in, a financial planning portal: "For younger investors, especially those in the highest tax bracket, PPF is the best option. Being a 15-year product, it helps in achieving long-term goals."
Myth
Post office investments are absolutely safe
Reality Post office instruments are backed by the government. This makes them highly secure, but not infallible. Although it has never happened in India, governments of other countries have defaulted in the past
New investors. You can open a PPF account either in your or your child’s name. Combined contributions may vary between Rs 500 and Rs 70,000 each year. A separate minor account helps save funds earmarked for your child’s needs.
Existing investors. Use the partial withdrawal facility (available after five years) only if needed. You can choose to close the account on maturity or continue in blocks of five years indefinitely, with or without making fresh deposits.
Taxpayers. Tax exemption is available on contribution and returns. A PPF’s effective return currently works out to above 11.57 per cent for someone paying 30.9 per cent tax. Depending on your risk profile, PPF can be used judiciously with equity-linked savings schemes (ELSS) to bolster returns over the long term.
Retired. If you are retired and pay no or very low taxes, you could close your PPF account and move to products with higher yields, such as a bank FD, if available. Retired taxpayers may continue with or without fresh deposits.
National Savings Certificates (NSCs). If you want to save tax and are not looking at a regular income, NSC can be a good option. It is suitable for investors of any age as long as they don’t mind the long tenure. Taxpayers below 60 years of age can buy an NSC every month and build up a self-made pension plan.
The Regular Income Providers
Senior Citizens Savings Scheme (SCSS). This can be availed from a post office or a bank by anyone over the age of 60 years. Early retirees can invest in SCSS, provided they do so within three months of receiving retirement funds. It offers the highest post-tax returns among taxable products. The upper investment limit is Rs 15 lakh and the interest is payable quarterly.
Post Office Monthly Income Scheme (POMIS). If you want a regular monthly flow of income, POMIS is ideal. You should go for it, especially if the amount is more than Rs 1 lakh as bank deposits per bank are insured only up to Rs 1 lakh (see Bank Deposits). In POMIS, one may deposit a maximum of Rs 9 lakh under a joint account. If you exit before the term ends, you will have to forego 5 per cent bonus.
Myth
Bank fixed deposits are absolutely safe
Reality The Deposit Insurance and Credit Guarantee Corporation insures bank deposits up to Rs 1 lakh per bank per person. This includes the principal and the interest in all branches
8 per cent Taxable Savings Bonds. The alternative to POMIS is the 8 per cent Taxable Savings Bonds issued by the Government of India. These pay half-yearly interest and also have a cumulative option. They have no upper limit of investment.
Retired. If you are retired and are looking for an enhanced regular income, start with SCSS. Then move on to POMIS. Over and above this, invest the remaining retirement corpus in 8 per cent Taxable Savings Bonds.
Myth
Returns from Public Provident Fund (PPF) are fixed
Reality Every year in April, the government fixes the returns from post office products, including PPF. Any change in the interest rate will be applicable on PPF balances made after the announcement
Others
Kisan Vikas Patra (KVP). If you are not looking at a regular income, you could consider the post office KVP, which yields an annualised return of 8.41 per cent, the highest in this group. But, if you are in the 30.9 per cent tax bracket, your post-tax annualised return will be 5.81 per cent as interest is fully taxable. KVPs are ideally suited to supplement funds to meet long-term expenses such as children’s higher education.
Time deposit. Time deposits may be opened in a post office for 1-, 2-, 3- or 5-year periods. The interest is payable yearly and is fully taxable. You can claim a tax benefit under Section 80C on the amount invested in a 5-year deposit only. This is not a very attractive option since bank notified FDs that come with Section 80C breaks give higher rates.
Recurring deposits (RDs).
RDs in post offices provide an interest rate of 7.5 per cent per annum. These come for a period of five years, which can be extended. Investing Rs 1,000 a month into this scheme would yield Rs 72,890 on maturity. Avoid them as banks provide a better deal.
Myth
Assured return instruments give double tax benefit
Reality Apart from PPF, in which the contribution, returns and the final amount are all tax-free, all other post office products are variously taxed
THE ROADBLOCKS
The products mentioned above are simple and secure. But there’s a hitch. In order to deposit funds, redeem investments, withdraw interest, or even to update your passbook, you need to visit a post office. The notable exceptions are: PPF accounts in State Bank of India and bank RDs, both of which can be operated online, and interest payments from the 8 per cent Taxable Savings Bonds that can be routed electronically through banks. For people who are used to the air-conditioned confines of an advisor’s office, or the three clicks and invest mode of electronic transacting, this can be an unpleasant and frustrating experience. Also, since you will be tied to one particular post office, staying on top of these investments while changing residences or cities can turn out to be a nightmare.
Invest in these only if you either have a trusted and active agent or a friend who will do the running around for you, or if you have the time and patience to do it yourself.
DEBT IN YOUR PORTFOLIO
These income-generating products are ideal for people who are close to achieving their goals. "For them, it makes sense to switch to such products (from equity) to preserve capital and reduce their risk weightage," says Jain.
The biggest drawback of these products with fixed returns is that they are not the best hedge against inflation. Says Kartik Varma, co-founder, iTrust Financial Advisors, a Delhi-based financial advisory company, "Debt products may be good at times of low inflation and for those who, as far as risk-taking is concerned, do not have age on their side."
But interest rates and inflation cannot be predicted easily. We suggest a balanced approach while investing across debt and equity assets. You need to devise your portfolio based on your age, income and financial liabilities, and consider both short- and long-term needs.
REAL RETURNS MATTER
For most investors, the return from these products is only nominal. The interest income is added to your income and taxed as per your slab. So, if you are paying tax at 30.9 per cent, an 8 per cent bank FD would give you a post-tax return of 5.28 per cent (see The Cuts).
Myth
Life insurance endowment plans give assured returns
Reality Returns in the form of bonus are not assured and depend on the insurer’s profitability. However, once attached to a policy, they become assured
Building up a debt portfolio with fixed and assured return plans should be a carefully crafted process. A proper mix of products with varying maturities will help in maintaining liquidity and give higher returns. As with all things in life, even in your portfolio, balance is the keyword.
The Stabilising Influences
Strategies for effectively using highly secure investments
Public Provident Fund (PPF) If you don’t have one, start a PPF account for yourself, your spouse and kids. Use it as a tax-saving investment, while maintaining your portfolio’s debt-equity balance. If you are close to retirement, maximise your contribution. If you are retired, use tax-free money by way of partial withdrawals.
National Savings Certificate Use it only for saving tax if there is room after EPF and PPF. If you are nearing retirement or retired, create a periodic income flow in the future.
Kisan Vikas Patra Good for parking portions of lumpsums or windfalls such as bonuses, increments and refunds that might be earmarked for a goal, say, a gift on your kid’s 18th birthday.
Senior Citizens Savings Scheme (SCSS) Best for a regular retirement income, thanks to the highest rate of 9 per cent per annum.
Post Office Monthly INCOME Scheme (POMIS) SCSS investment can’t exceed Rs 15 lakh. Invest any amount in excess in POMIS, the next best option after SCSS for secure retirement income.
8 per cent Taxable Savings Bond If more regular income is needed after an SCSS and POMIS combination, opt for half-yearly option of this scheme with no upper investment limit.
5-year Time Deposit (with Section 80C) Avoid this post office offering since banks offer higher interest rates.
Other Time Deposits Avoid post office time deposits. You will get a better interest rate from banks.
Recurring Deposits (RDs) Avoid post office RDs as bank RDs offer better interest rates.
Source:money.outlook.india.com
3 Get-More Tricks
Besides secure returns, the safest investment options can be cleverly tailored to suit various requirements. Here are strategies that have been used for ages and can work wonders in these harsh times
Reinvest Monthly Income Scheme (MIS) Interest
Take a 6-year, 8 per cent per annum Mis. reinvest the monthly interest in a savings account (3.5 per cent interest per annum), which will give you an annualised return of 7.53 per cent after six years. reinvesting in a recurring deposit (7.5 per cent per annum) will give you an annualised return of 7.76 per cent.
Ladder National Savings Certificates (NSCS)
NSC is a 6-year instrument. assume that you buy nscs worth 24,000 in one financial year. instead, buy worth 2,000 every month till your retirement. renew every investment after six years and continue doing so until your retirement. finally, the matured will give regular income, which can be used as pension.
Use your Public Provident Fund (PPF)
PPf is a 15-year account in which you can put up to 70,000 every year. After the fifth year, make partial withdrawals for tax-free funds and contribute 70,000 as before from current income to get tax benefits.
***
It might seem ridiculous to talk about safe investments and sound returns at a time when the equity markets are down 34 per cent since last year and a tumbling real estate market is giving most of us sleepless nights. One thing that the glum developments of the last 18 months has taught us is that when things go wrong, it’s time to go back to the basics. When everything around us is crashing, the only comfort is in the simple and staid; like listening to an old song, or eating your mother’s cooking.
For our money lives, this new reality of volatile markets indicates the need to go back to old options and invest in products that our parents relied on, the ones we turned our noses up at as too cumbersome, or even too boring. These options, debt products with fixed returns mostly sold through post offices, are the safest possible as the government guarantees them. Although, theoretically, it is possible that the government defaults, in reality, it has never happened in India and is unlikely to happen in the future. Also, thanks to the lack of interest rate reforms, the returns on these products are higher than market determined rates. They also give tax benefits.
However, we are not suggesting that you move all your money into these products. If you are to meet your financial goals, you will need to have a decent mix of high-risk, high-growth options and assured return instruments. If you want to set aside Rs 5 lakh at today’s cost for your child’s higher education 15 years later, you will need Rs 10 lakh then after accounting for an inflation of 5 per cent per annum. If you invest only in debt products, you will have to save Rs 36,000 a year at 8 per cent interest per annum to build up that corpus in 15 years. Using equities over the same period and assuming 12 per cent annualised returns, the savings required would be a more modest Rs 24,000 a year.
So, what role can these embodiments of certainty and security play in your portfolio in a loss-ravaged year? While investing in these products will not be your short cut to wealth, it will certainly ensure that your downside is protected and your accounts are still in the green even as the world around you turns red.
THE RIGHT ONE FOR YOU
Assured return instruments have non-flexible features such as tenure, interest payment amounts and dates, taxability and liquidity. The basket of products with fixed and assured returns largely has nine instruments. Except bank fixed deposits (FDs), all these products are fully government-backed. We have classified them as tax-savers, regular income providers and others.
Bank Deposits
The eight post office products described in the article carry a sovereign guarantee. Bank fixed deposits (FDs), too, offer fixed and assured returns, but they are not backed by any government guarantee beyond Rs 1 lakh (principal and interest together) per bank per person. This leaves any amount over this susceptible to risk in case of a bank default. It is better to spread your fixed deposits over banks rather than invest a big sum in a single bank. FDs’ tenure varies from one month to 10 years. The interest income can be had monthly, quarterly, half-yearly or even yearly and is fully taxable. Among the banks offering high interest rates currently, over a 1-year period, Development Credit Bank’s rate is 9.25 per cent per annum and Tamil Nadu Mercantile Bank is paying 9.25 per cent for a 5-year tenure. Many banks offer senior citizens 0.5 percentage points more.
Investment in 5-year notified tax-saving bank FDs helps secure a regular income and save tax under Section 80C. The interest (fully taxable) on such deposits may be a shade lower than on non-tax deposits of the same duration. ICICI Bank and State Bank of India currently offer 8.25 per cent per annum. For senior citizens with annual incomes less than Rs 2.25 lakh, this is a decent option.
The Tax-savers
Public Provident Fund (PPF). Not only does PPF give tax exemption on deposits, but also gives you tax-free returns. Says Manish Jain, founder, Knowledgepartners.in, a financial planning portal: "For younger investors, especially those in the highest tax bracket, PPF is the best option. Being a 15-year product, it helps in achieving long-term goals."
Myth
Post office investments are absolutely safe
Reality Post office instruments are backed by the government. This makes them highly secure, but not infallible. Although it has never happened in India, governments of other countries have defaulted in the past
New investors. You can open a PPF account either in your or your child’s name. Combined contributions may vary between Rs 500 and Rs 70,000 each year. A separate minor account helps save funds earmarked for your child’s needs.
Existing investors. Use the partial withdrawal facility (available after five years) only if needed. You can choose to close the account on maturity or continue in blocks of five years indefinitely, with or without making fresh deposits.
Taxpayers. Tax exemption is available on contribution and returns. A PPF’s effective return currently works out to above 11.57 per cent for someone paying 30.9 per cent tax. Depending on your risk profile, PPF can be used judiciously with equity-linked savings schemes (ELSS) to bolster returns over the long term.
Retired. If you are retired and pay no or very low taxes, you could close your PPF account and move to products with higher yields, such as a bank FD, if available. Retired taxpayers may continue with or without fresh deposits.
National Savings Certificates (NSCs). If you want to save tax and are not looking at a regular income, NSC can be a good option. It is suitable for investors of any age as long as they don’t mind the long tenure. Taxpayers below 60 years of age can buy an NSC every month and build up a self-made pension plan.
The Regular Income Providers
Senior Citizens Savings Scheme (SCSS). This can be availed from a post office or a bank by anyone over the age of 60 years. Early retirees can invest in SCSS, provided they do so within three months of receiving retirement funds. It offers the highest post-tax returns among taxable products. The upper investment limit is Rs 15 lakh and the interest is payable quarterly.
Post Office Monthly Income Scheme (POMIS). If you want a regular monthly flow of income, POMIS is ideal. You should go for it, especially if the amount is more than Rs 1 lakh as bank deposits per bank are insured only up to Rs 1 lakh (see Bank Deposits). In POMIS, one may deposit a maximum of Rs 9 lakh under a joint account. If you exit before the term ends, you will have to forego 5 per cent bonus.
Myth
Bank fixed deposits are absolutely safe
Reality The Deposit Insurance and Credit Guarantee Corporation insures bank deposits up to Rs 1 lakh per bank per person. This includes the principal and the interest in all branches
8 per cent Taxable Savings Bonds. The alternative to POMIS is the 8 per cent Taxable Savings Bonds issued by the Government of India. These pay half-yearly interest and also have a cumulative option. They have no upper limit of investment.
Retired. If you are retired and are looking for an enhanced regular income, start with SCSS. Then move on to POMIS. Over and above this, invest the remaining retirement corpus in 8 per cent Taxable Savings Bonds.
Myth
Returns from Public Provident Fund (PPF) are fixed
Reality Every year in April, the government fixes the returns from post office products, including PPF. Any change in the interest rate will be applicable on PPF balances made after the announcement
Others
Kisan Vikas Patra (KVP). If you are not looking at a regular income, you could consider the post office KVP, which yields an annualised return of 8.41 per cent, the highest in this group. But, if you are in the 30.9 per cent tax bracket, your post-tax annualised return will be 5.81 per cent as interest is fully taxable. KVPs are ideally suited to supplement funds to meet long-term expenses such as children’s higher education.
Time deposit. Time deposits may be opened in a post office for 1-, 2-, 3- or 5-year periods. The interest is payable yearly and is fully taxable. You can claim a tax benefit under Section 80C on the amount invested in a 5-year deposit only. This is not a very attractive option since bank notified FDs that come with Section 80C breaks give higher rates.
Recurring deposits (RDs).
RDs in post offices provide an interest rate of 7.5 per cent per annum. These come for a period of five years, which can be extended. Investing Rs 1,000 a month into this scheme would yield Rs 72,890 on maturity. Avoid them as banks provide a better deal.
Myth
Assured return instruments give double tax benefit
Reality Apart from PPF, in which the contribution, returns and the final amount are all tax-free, all other post office products are variously taxed
THE ROADBLOCKS
The products mentioned above are simple and secure. But there’s a hitch. In order to deposit funds, redeem investments, withdraw interest, or even to update your passbook, you need to visit a post office. The notable exceptions are: PPF accounts in State Bank of India and bank RDs, both of which can be operated online, and interest payments from the 8 per cent Taxable Savings Bonds that can be routed electronically through banks. For people who are used to the air-conditioned confines of an advisor’s office, or the three clicks and invest mode of electronic transacting, this can be an unpleasant and frustrating experience. Also, since you will be tied to one particular post office, staying on top of these investments while changing residences or cities can turn out to be a nightmare.
Invest in these only if you either have a trusted and active agent or a friend who will do the running around for you, or if you have the time and patience to do it yourself.
DEBT IN YOUR PORTFOLIO
These income-generating products are ideal for people who are close to achieving their goals. "For them, it makes sense to switch to such products (from equity) to preserve capital and reduce their risk weightage," says Jain.
The biggest drawback of these products with fixed returns is that they are not the best hedge against inflation. Says Kartik Varma, co-founder, iTrust Financial Advisors, a Delhi-based financial advisory company, "Debt products may be good at times of low inflation and for those who, as far as risk-taking is concerned, do not have age on their side."
But interest rates and inflation cannot be predicted easily. We suggest a balanced approach while investing across debt and equity assets. You need to devise your portfolio based on your age, income and financial liabilities, and consider both short- and long-term needs.
REAL RETURNS MATTER
For most investors, the return from these products is only nominal. The interest income is added to your income and taxed as per your slab. So, if you are paying tax at 30.9 per cent, an 8 per cent bank FD would give you a post-tax return of 5.28 per cent (see The Cuts).
Myth
Life insurance endowment plans give assured returns
Reality Returns in the form of bonus are not assured and depend on the insurer’s profitability. However, once attached to a policy, they become assured
Building up a debt portfolio with fixed and assured return plans should be a carefully crafted process. A proper mix of products with varying maturities will help in maintaining liquidity and give higher returns. As with all things in life, even in your portfolio, balance is the keyword.
The Stabilising Influences
Strategies for effectively using highly secure investments
Public Provident Fund (PPF) If you don’t have one, start a PPF account for yourself, your spouse and kids. Use it as a tax-saving investment, while maintaining your portfolio’s debt-equity balance. If you are close to retirement, maximise your contribution. If you are retired, use tax-free money by way of partial withdrawals.
National Savings Certificate Use it only for saving tax if there is room after EPF and PPF. If you are nearing retirement or retired, create a periodic income flow in the future.
Kisan Vikas Patra Good for parking portions of lumpsums or windfalls such as bonuses, increments and refunds that might be earmarked for a goal, say, a gift on your kid’s 18th birthday.
Senior Citizens Savings Scheme (SCSS) Best for a regular retirement income, thanks to the highest rate of 9 per cent per annum.
Post Office Monthly INCOME Scheme (POMIS) SCSS investment can’t exceed Rs 15 lakh. Invest any amount in excess in POMIS, the next best option after SCSS for secure retirement income.
8 per cent Taxable Savings Bond If more regular income is needed after an SCSS and POMIS combination, opt for half-yearly option of this scheme with no upper investment limit.
5-year Time Deposit (with Section 80C) Avoid this post office offering since banks offer higher interest rates.
Other Time Deposits Avoid post office time deposits. You will get a better interest rate from banks.
Recurring Deposits (RDs) Avoid post office RDs as bank RDs offer better interest rates.
Source:money.outlook.india.com
Sunday, May 3, 2009
Decoding NPS( New Pension Scheme)
What is the New Pension System (NPS)?
It is a system where individuals fund, during their work life, their financial security for old age when they no longer work. All those who join up would get a Permanent Retirement Account (PRA), which can be accessed online and through so-called points of presence (PoPs).
A central record keeping agency will maintain all the accounts, just like a depository maintains demat accounts for shares. Six different pension fund managers (PFMs) would share this common CRA infrastructure. The PFMs would invest the savings people put into their PRAs, investing them in three asset classes, equity (E), government securities (G)and debt instruments that entail credit risk (C), including corporate bonds and fixed deposits.
These contributions would grow and accumulate over the years, depending on the efficiency of the fund manager. The NPS in this form has been availed of by civil servants for the past one year. Subscribers can retain their PRAs when they change jobs or residence, and even change their fund managers and the allocation of investments among the different asset classes, although exposure to equity has been capped at 50%.
Where can people sign up for the NPS?
People can subscribe to the scheme from any of 285 PoPs across the country. These are run by 17 banks — SBI and its associates, ICICI, Axis, Kotak Mahindra, Allahabad Bank, Citibank, IDBI, Oriental Bank of Commerce, South Indian Bank, Union Bank of India — and four other financial entities, LIC, IL&FS, UTI Asset Management and Reliance Capital. A subscriber can shift his pension account from one PoP to another. Subscribers can choose from six fund managers — ICICI Prudential, IDFC, Kotak Mahindra, Reliance Capital, SBI and UTI.
Is the scheme open to all?
NPS is available for people aged between 18 years and 55 years.
How often should a subscriber contribute to NPS?
The minimum amount per contribution is Rs 500, to be paid at least four times in a year. The minimum amount to be contributed in a year is Rs 6,000.
How will the subscribers get the money back?
If the subscriber exits the scheme before the age of 60, s/he may keep one fifth of the accumulated saving and invest the rest in annuities offered by insurance companies. An annuity transforms a lump sum spent on buying the annuity into a steady stream of payments for the rest of the annuity holder’s life. Now, how long an annuity buyer would live is something that takes a life insurance company’s expertise to compute and that is how they come into the picture. Insurance companies offer flexible investment and payment options on annuities. A person who exits NPS when his age is between 60 and 70 has to use 40% of the corpus to buy an annuity and can take the rest of the money out in one go or in instalments. If a subscriber dies, the nominee has the option to receive the entire pension wealth as a lump sum.
Is the scheme tax free?
Long term savings have three stages: contribution, accumulation and withdrawal. The NPS was devised when the government was planning to move all long term savings to a tax regime called exempt-exempt-taxed (EET), standing for exempt at the time of contribution, exempt during the period when the investment accumulates and taxed at the time of withdrawal. So, NPS comes under the tax regime EET. However, the government could not muster the political courage to change the taxation regime of EET on several saving schemes. So, the pension fund regulator has taken up with the finance ministry the need to remove the asymmetry in tax treatment between the NPS and other schemes such as the PPF. In any case, the amount spent on buying an annuity would be exempt from tax.
What is the default allocation of savings towards different asset classes for those who do not make an active choice?
For a saver not yet 35 years of age, half the investments will go into asset class E, one-fifth into asset class G, and the rest into asset class C. Above the age of 35, the default proportion going to equities would come down and the proportion going to government securities, go up. By the age of 60, these investments will gradually be adjusted so that only one-tenth remains in equities, another one-tenth in corporate bonds and 80% in central and state government bonds.
How does the NPS compare with mutual funds?
Since the NPS is meant for post-retirement financial security, it does not permit flexible withdrawals as are possible in the case of mutual funds. Fund management charges are ridiculously low (0.0009% a year), as compared with mutual funds. The cost of opening and maintaining a permanent retirement account, and the transaction charge on changing address, pension fund manager, etc are around Rs 400 now.
What kind of returns would the NPS generate?
The NPS generated an average return in excess of 14% in the last financial year, the first one in which it operated, handling the corpus of civil service pensions.
Source :www.economictimes.com
It is a system where individuals fund, during their work life, their financial security for old age when they no longer work. All those who join up would get a Permanent Retirement Account (PRA), which can be accessed online and through so-called points of presence (PoPs).
A central record keeping agency will maintain all the accounts, just like a depository maintains demat accounts for shares. Six different pension fund managers (PFMs) would share this common CRA infrastructure. The PFMs would invest the savings people put into their PRAs, investing them in three asset classes, equity (E), government securities (G)and debt instruments that entail credit risk (C), including corporate bonds and fixed deposits.
These contributions would grow and accumulate over the years, depending on the efficiency of the fund manager. The NPS in this form has been availed of by civil servants for the past one year. Subscribers can retain their PRAs when they change jobs or residence, and even change their fund managers and the allocation of investments among the different asset classes, although exposure to equity has been capped at 50%.
Where can people sign up for the NPS?
People can subscribe to the scheme from any of 285 PoPs across the country. These are run by 17 banks — SBI and its associates, ICICI, Axis, Kotak Mahindra, Allahabad Bank, Citibank, IDBI, Oriental Bank of Commerce, South Indian Bank, Union Bank of India — and four other financial entities, LIC, IL&FS, UTI Asset Management and Reliance Capital. A subscriber can shift his pension account from one PoP to another. Subscribers can choose from six fund managers — ICICI Prudential, IDFC, Kotak Mahindra, Reliance Capital, SBI and UTI.
Is the scheme open to all?
NPS is available for people aged between 18 years and 55 years.
How often should a subscriber contribute to NPS?
The minimum amount per contribution is Rs 500, to be paid at least four times in a year. The minimum amount to be contributed in a year is Rs 6,000.
How will the subscribers get the money back?
If the subscriber exits the scheme before the age of 60, s/he may keep one fifth of the accumulated saving and invest the rest in annuities offered by insurance companies. An annuity transforms a lump sum spent on buying the annuity into a steady stream of payments for the rest of the annuity holder’s life. Now, how long an annuity buyer would live is something that takes a life insurance company’s expertise to compute and that is how they come into the picture. Insurance companies offer flexible investment and payment options on annuities. A person who exits NPS when his age is between 60 and 70 has to use 40% of the corpus to buy an annuity and can take the rest of the money out in one go or in instalments. If a subscriber dies, the nominee has the option to receive the entire pension wealth as a lump sum.
Is the scheme tax free?
Long term savings have three stages: contribution, accumulation and withdrawal. The NPS was devised when the government was planning to move all long term savings to a tax regime called exempt-exempt-taxed (EET), standing for exempt at the time of contribution, exempt during the period when the investment accumulates and taxed at the time of withdrawal. So, NPS comes under the tax regime EET. However, the government could not muster the political courage to change the taxation regime of EET on several saving schemes. So, the pension fund regulator has taken up with the finance ministry the need to remove the asymmetry in tax treatment between the NPS and other schemes such as the PPF. In any case, the amount spent on buying an annuity would be exempt from tax.
What is the default allocation of savings towards different asset classes for those who do not make an active choice?
For a saver not yet 35 years of age, half the investments will go into asset class E, one-fifth into asset class G, and the rest into asset class C. Above the age of 35, the default proportion going to equities would come down and the proportion going to government securities, go up. By the age of 60, these investments will gradually be adjusted so that only one-tenth remains in equities, another one-tenth in corporate bonds and 80% in central and state government bonds.
How does the NPS compare with mutual funds?
Since the NPS is meant for post-retirement financial security, it does not permit flexible withdrawals as are possible in the case of mutual funds. Fund management charges are ridiculously low (0.0009% a year), as compared with mutual funds. The cost of opening and maintaining a permanent retirement account, and the transaction charge on changing address, pension fund manager, etc are around Rs 400 now.
What kind of returns would the NPS generate?
The NPS generated an average return in excess of 14% in the last financial year, the first one in which it operated, handling the corpus of civil service pensions.
Source :www.economictimes.com
Saturday, May 2, 2009
Mutual funds primer
Overview
The one investment vehicle that has truly come of age in India in the past decade is mutual funds. Today, the mutual fund industry in the country manages around Rs 329,162 crore (As of Dec, 2006) of assets, a large part of which comes from retail investors. And this amount is invested not just in equities, but also in the entire gamut of debt instruments. Mutual funds have emerged as a proxy for investing in avenues that are out of reach of most retail investors, particularly government securities and money market instruments.
Specialisation is the order of the day, be it with regard to a scheme’s investment objective or its targeted investment universe. Given the plethora of options on hand and the hard-sell adopted by mutual funds vying for a piece of your savings, finding the right scheme can sometimes seem a bit daunting. Mind you, it’s not just about going with the fund that gives you the highest returns. It’s also about managing risk–finding funds that suit your risk appetite and investment needs.
So, how can you, the retail investor, create wealth for yourself by investing through mutual funds? To answer that, we need to get down to brass tacks–what exactly is a mutual fund?
Very simply, a mutual fund is an investment vehicle that pools in the monies of several investors, and collectively invests this amount in either the equity market or the debt market, or both, depending upon the fund’s objective. This means you can access either the equity or the debt market, or both, without investing directly in equity or debt.
Mutual funds: The advantages...
And that, naturally, begs the question: why can’t I invest directly in, say, equity? Why go through a mutual fund at all? Here are some compelling arguments in favour of mutual funds:
Professional management
Take equities. Most of us have neither the skill to find good stocks that suit our risk and returns profile nor the time to track our investments–but still want the returns that can be had from equities. That’s where mutual funds come in.
When you invest in mutual funds, it is your fund manager who will take care of your investments. A fund manager is an investment specialist, who brings to the table an in-depth understanding of the financial markets. By virtue of being in the market, the fund manager is ideally placed to research various investment options, and invest accordingly for you.
Small investments
Today, if you wanted to buy government securities, you would have to invest a minimum amount of Rs 25,000. Much the same is the case if you want to build a decent-sized portfolio of shares of blue-chips. Now, that might be too large an amount for many small investors.
A mutual fund, however, gives you an ownership of the same investment pie– at an outlay of Rs 1,000-5,000. That’s because a mutual fund pools the monies of several investors, and invests the resultant large sum in a number of securities. So, on a small outlay, you get to participate in the investment prospects of a number of securities.
Diversified portfolio
One of the oft-mentioned tenets of portfolio management is: diversify. In other words, don’t put all your eggs in one basket. The rationale for this is that even if one pick in your portfolio turns bad, the others can check the erosion in the portfolio value.
Take a simple–even if extreme– example. Say, you have Rs 10,000 invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of your investment will halve to Rs 5,000. Now, say you had invested the same amount in a mutual fund, which had parked 10 per cent of its corpus in the Reliance stock. Assuming prices of other stocks in its portfolio stay the same, the depreciation in the fund’s portfolio– and hence, your investment–will be 5 per cent. That’s one of the merits of diversification.
Liquidity
You are free to take your money out of open-ended mutual funds whenever you want, no questions asked. Most open-ended funds mail your redemption proceeds, which are linked to the fund’s prevailing NAV (net asset value), within three to five working days of your putting in your request.
Tax breaks
Last but not the least, mutual funds offer significant tax advantages. Dividends distributed by them are tax-free in the hands of the investor.
They also give you the advantages of capital gains taxation. If you hold units beyond one year, you get the benefits of indexation. Simply put, indexation benefits increase your purchase cost by a certain portion, depending upon the yearly cost-inflation index (which is calculated to account for rising inflation), thereby reducing the gap between your actual purchase cost and selling price. This reduces your tax liability.
What’s more, tax-saving schemes and pension schemes give you the added advantage of benefits under Section 88. You can avail of a 20 per cent tax exemption on an investment of up to Rs 10,000 in the scheme in a year.
...And disadvantages
Mutual funds are good investment vehicles to navigate the complex and unpredictable world of investments. However, even mutual funds have some inherent drawbacks. Understand these before you commit your money to a mutual fund.
No assured returns and no protection of capital
If you are planning to go with a mutual fund, this must be your mantra: mutual funds do not offer assured returns and carry risk. For instance, unlike bank deposits, your investment in a mutual fund can fall in value. In addition, mutual funds are not insured or guaranteed by any government body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India).
There are strict norms for any fund that assures returns and it is now compulsory for funds to establish that they have resources to back such assurances. This is because most closed-end funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to investors.
Restrictive gains
Diversification helps, if risk minimisation is your objective. However, the lack of investment focus also means you gain less than if you had invested directly in a single security.
In our earlier example, say, Reliance appreciated 50 per cent. A direct investment in the stock would appreciate by 50 per cent. But your investment in the mutual fund, which had invested 10 per cent of its corpus in Reliance, will see only a 5 per cent appreciation.
Types of mutual funds
Many people tend to wrongly equate mutual fund investing with equity investing. Fact is, equity is just one of the various asset classes mutual funds invest in. They also invest in debt instruments such as bonds, debentures, commercial paper and government securities.
Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the class(es) of securities it can invest in. Based on the asset classes, broadly speaking, the following types of mutual funds currently operate in the country.
Equity funds. The highest rung on the mutual fund risk ladder, such funds invest only in stocks. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. There are also ‘specialised’ equity funds, such as index funds and sector funds, which invest only in specific categories of stocks.
Debt funds. Such funds invest only in debt instruments, and are a good option for investors averse to taking on the risk associated with equities. Here too, there are specialised schemes, namely liquid funds and gilt funds. While the former invests predominantly in money market instruments, gilt funds do so in securities issued by the central and state governments.
Balanced funds. Lastly, there are balanced funds, whose investment portfolio includes both debt and equity. As a result, on the risk ladder, they fall somewhere between equity and debt funds. Balanced funds are the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments.
Let’s now take a closer look at the working of each of these three categories of funds, the investment options they offer, and how best you can make money from them.
Equity funds
As explained earlier, such funds invest only in stocks, the riskiest of asset classes. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are:
Index funds
These funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portfolio mirrors the index they track, both in terms of composition and the individual stock weightages. For instance, an index fund that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds don’t need fund managers, as there is no stock selection involved.
Investing through index funds is a passive investment strategy, as a fund’s performance will invariably mimic the index concerned, barring a minor "tracking error". Usually, there’s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. So, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent.
To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualised return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualised return to 16.2 per cent. Obviously, the lower the tracking error, the better the index fund.
Diversified funds
Such funds have the mandate to invest in the entire universe of stocks. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager.
This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager’s picks languish, the returns will be far lower.
The crux of the matter is that your returns from a diversified fund depend a lot on the fund manager’s capabilities to make the right investment decisions. On your part, watch out for the extent of diversification prescribed and practised by your fund manager. Understand that a portfolio concentrated in a few sectors or companies is a high risk, high return proposition. If you don’t want to take on a high degree of risk, stick to funds that are diversified not just in name but also in appearance.
Tax-saving funds
Also known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, you can claim a tax exemption of 20 per cent from your taxable income. You can invest more than Rs 10,000, but you won’t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that you are locked into the scheme for three years.
In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.
Sector funds
The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.
Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.
How to pick an equity fund
Now, that you have an idea of the investment profile and objective behind each type of equity fund, let’s get down to specifics: what you should look for while evaluating an equity fund. First, narrow down your investment universe by deciding which category of equity fund you would like to invest in. That decided, seek the following four attributes from a prospective fund.
Track record. It’s always safer to opt for a fund that’s been around for a while, as you can study its track record. You can see how the fund has performed over the years, which will facilitate historical comparison across its peer set.
Although past trends are no guarantee of future performance, it does give an indication of how well a fund has capitalised on upturns and weathered downturns in the past. The fund’s track record also gives an indication of the volatility in its returns. Avoid funds that show a volatile returns patterns.
Diversified portfolio. Unless you are willing to take on high risk, avoid funds that have a high exposure to a few sectors or a handful of stocks. Such funds will give superior returns when the selected sectors are doing well, but if the market crashes or the sector performs badly, the fall in NAV will be equally sharp. Ideally, a diversified equity fund should have an exposure to at least four sectors and seven to 10 scrips.
Diversified investor base. Just as the fund needs diversified investments, it also needs to have a diversified investor base. This ensures that a few investors do not own a significant part of the fund, as it would belie the very principle of a mutual fund.
Sebi (Securities and Exchange Board of India) regulations stipulate that a fund must publish, in its half-yearly disclosures, details of the number of investors who hold more than 25 per cent of the scheme’s corpus. Avoid such funds, as they could well be catering to the interests of the large investors–at your expense.
Transparency in operations. Before investing in a fund, always go through its offer document and fact sheet. If the fund house doesn’t give out such information regularly, avoid that fund. Funds that do not disclose details on a regular basis to their unitholders are better left alone, as you may not be told what will happen to your money once you invest.
Debt funds
Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.
Income funds
By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.
Gilt funds
They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.
Liquid funds
They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.
The ‘risk’ in debt funds
Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.
Interest rate risk. This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities.
Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper. If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.
Credit risk. This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies.
The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper. The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper.
Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.
Liquidity risk. This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper.
As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.
How to pick a debt fund
It’s evident there is an element of risk associated with debt funds. Hence, some care and thought has to go into picking a debt fund. Here are some factors you ought to look at while scouting for a debt fund.
Investment horizon. The first thing you need to get a fix on is your investment horizon. If you wish to invest in a debt fund for anything up to one year, opt for a liquid fund. Anything above that, you should be looking at a gilt fund or an income fund.
Track record. As with equity funds, a debt fund with a good track record is always preferable. The longer the track record, the better–to be on the safe side, choose funds that have been in the market for at least a year.
Credit quality. One of the most important factors you need to look for in an income fund is the credit rating of the debt instruments in its portfolio.
A credit rating of AAA denotes the highest safety, while a rating of below BBB is classified as non-investment grade. Although rating agencies classify BBB paper as investment grade, you should budget for downgrades, and set the minimum acceptable rating benchmark at AA. In order to ensure the safety of your investment, opt for a fund that has at least 75 per cent of its corpus in AAA-rated paper, and 90 per cent in AA and AAA paper.
Diversification. In order to limit the loss from a possible default, an income fund should be reasonably diversified across companies. Say, a fund manager invests his entire corpus in debt instruments of just one company. If the company goes under, the fund loses everything. Now, had the fund manager diversified and invested 10 per cent of his corpus in 10 companies, with one-tenth in the troubled company, his loss would be lower. Assuming the other companies meet their debt obligations, the fund’s loss would be restricted to 10 per cent.
Diversified investor base. Similar to the pre-condition for equity funds, avoid debt funds where a few large investors account for an abnormally high portion of the corpus.
Balanced funds
As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.
How to pick a balanced fund
The same criterion that applies to selecting an equity fund holds good when choosing a balanced fund. The one additional factor you should check for a balanced fund is the equity and debt split. The offer document will state the ratio of equity and debt investments the fund plans to have. Mostly, this takes on a range, and varies from time to time depending on the fund manager’s perception of the financial markets.
Before investing in an existing balanced fund, go through a few of its past fund fact sheets, and look up the equity-debt split. If you are a conservative investor, opt for a fund where equity investments are capped at 60 per cent of corpus. However, if you are the aggressive sort, you could even go along with a higher equity holding.
The intelligent investor's seven rules
It’s one thing to understand mutual funds and their working; it’s another to ride on this potent investment vehicle to create wealth in tune with your risk profile and investment needs. Here are seven must-dos that go a long way in helping you meet your investment objectives.
Know your risk profile
Can you live with volatility? Or are you a low-risk investor? Would you be satisfied if your fund invests in fixed-income securities, and yields low but sure-shot returns? These are some of the questions you need to ask yourself before investing in a fund.
Your investments should reflect your risk-taking capacity.
Equity funds might lure when the market is rising and your neighbour is making money, but if you are not cut out for the risk that accompanies it, don’t bite the bait. So, check if the fund’s objective matches yours. Invest only after you have found your match. If you are racked by uncertainty, seek expert advice from a qualified financial advisor.
Identify your investment horizon
How long you want to stay invested in a fund is as important as deciding upon your risk profile. A mutual fund is essentially a savings vehicle, not a speculation vehicle–don’t get in with the intention of making overnight gains.
Invest in an equity fund only if you are willing to stay on for at least two years. For income and gilt funds, have a one-year perspective at least. Anything less than one year, the only option among mutual funds is liquid funds.
Read the offer document carefully
This is a must before you commit your money to a fund. The offer document contains essential details pertaining to the fund, including the summary information (type of scheme, name of the asset management company and price of units, among other things), investment objectives and investment procedure, financial information and risk factors.
Go through the fund fact sheet
Fund fact sheets give you valuable information of how the fund has performed in the past. You can check the fund’s portfolio, its diversification levels and its performance in the past. The more fact sheets you examine, the better.
Diversify across fund houses
If you are routing a substantial sum through mutual funds, you should diversify across fund houses. That way, you spread your risk.
Do not chase incentives
Don’t get lured by investment incentives. Some financial intermediaries give upfront incentives, in the form of a percentage of your initial investment, to invest in a particular fund. Don’t buy it. Your focus should be to find a fund that matches your investment needs and risk profile, and is a performer.
Track your investments
Your job doesn’t end at the point of making the investment. It’s important you track your investment on a regular basis, be it in an equity, debt or balanced fund. One easy way to keep track of your fund is to keep track of the Intelligent Investor rankings of mutual funds, which are complied on a quarterly basis (log on to iinvestor.com to see the rankings for the quarter ended June 2001). These rankings allow you to take note of your fund’s performance and risk profile, and compare it across various time periods as well as across its peer set. In addition, you should run some basic checks in the fund fact sheets and the quarterly reports you get from your fund.
Equity funds are subject to market volatility, and the pace of change can be quite brisk. Check your fund’s quarterly reports for changes that could have severe implications on your investment. If you find a high degree of concentration in a few stocks or sectors, it means the fund manager is banking on the performance of these sectors. If they keep up to his expectations, you could end up making hefty returns, but if they don’t, chances are that the NAV will depreciate heavily.
In the case of debt funds, check the portfolio distribution and the fund’s holding in AAA and equivalent papers. If you find your fund is holding a significant quantity (above 10 per cent) in below AA-rated paper, your investment is not safe. Remember, even a single default can drag the NAV of your debt down.
If you come across negative reports of the fund, ask your financial advisor or broker about it, especially if there’s a possibility of your investment depreciating in value. If the threat is real, reduce your exposure to the fund.
Source : money.outlookindia.com
The one investment vehicle that has truly come of age in India in the past decade is mutual funds. Today, the mutual fund industry in the country manages around Rs 329,162 crore (As of Dec, 2006) of assets, a large part of which comes from retail investors. And this amount is invested not just in equities, but also in the entire gamut of debt instruments. Mutual funds have emerged as a proxy for investing in avenues that are out of reach of most retail investors, particularly government securities and money market instruments.
Specialisation is the order of the day, be it with regard to a scheme’s investment objective or its targeted investment universe. Given the plethora of options on hand and the hard-sell adopted by mutual funds vying for a piece of your savings, finding the right scheme can sometimes seem a bit daunting. Mind you, it’s not just about going with the fund that gives you the highest returns. It’s also about managing risk–finding funds that suit your risk appetite and investment needs.
So, how can you, the retail investor, create wealth for yourself by investing through mutual funds? To answer that, we need to get down to brass tacks–what exactly is a mutual fund?
Very simply, a mutual fund is an investment vehicle that pools in the monies of several investors, and collectively invests this amount in either the equity market or the debt market, or both, depending upon the fund’s objective. This means you can access either the equity or the debt market, or both, without investing directly in equity or debt.
Mutual funds: The advantages...
And that, naturally, begs the question: why can’t I invest directly in, say, equity? Why go through a mutual fund at all? Here are some compelling arguments in favour of mutual funds:
Professional management
Take equities. Most of us have neither the skill to find good stocks that suit our risk and returns profile nor the time to track our investments–but still want the returns that can be had from equities. That’s where mutual funds come in.
When you invest in mutual funds, it is your fund manager who will take care of your investments. A fund manager is an investment specialist, who brings to the table an in-depth understanding of the financial markets. By virtue of being in the market, the fund manager is ideally placed to research various investment options, and invest accordingly for you.
Small investments
Today, if you wanted to buy government securities, you would have to invest a minimum amount of Rs 25,000. Much the same is the case if you want to build a decent-sized portfolio of shares of blue-chips. Now, that might be too large an amount for many small investors.
A mutual fund, however, gives you an ownership of the same investment pie– at an outlay of Rs 1,000-5,000. That’s because a mutual fund pools the monies of several investors, and invests the resultant large sum in a number of securities. So, on a small outlay, you get to participate in the investment prospects of a number of securities.
Diversified portfolio
One of the oft-mentioned tenets of portfolio management is: diversify. In other words, don’t put all your eggs in one basket. The rationale for this is that even if one pick in your portfolio turns bad, the others can check the erosion in the portfolio value.
Take a simple–even if extreme– example. Say, you have Rs 10,000 invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of your investment will halve to Rs 5,000. Now, say you had invested the same amount in a mutual fund, which had parked 10 per cent of its corpus in the Reliance stock. Assuming prices of other stocks in its portfolio stay the same, the depreciation in the fund’s portfolio– and hence, your investment–will be 5 per cent. That’s one of the merits of diversification.
Liquidity
You are free to take your money out of open-ended mutual funds whenever you want, no questions asked. Most open-ended funds mail your redemption proceeds, which are linked to the fund’s prevailing NAV (net asset value), within three to five working days of your putting in your request.
Tax breaks
Last but not the least, mutual funds offer significant tax advantages. Dividends distributed by them are tax-free in the hands of the investor.
They also give you the advantages of capital gains taxation. If you hold units beyond one year, you get the benefits of indexation. Simply put, indexation benefits increase your purchase cost by a certain portion, depending upon the yearly cost-inflation index (which is calculated to account for rising inflation), thereby reducing the gap between your actual purchase cost and selling price. This reduces your tax liability.
What’s more, tax-saving schemes and pension schemes give you the added advantage of benefits under Section 88. You can avail of a 20 per cent tax exemption on an investment of up to Rs 10,000 in the scheme in a year.
...And disadvantages
Mutual funds are good investment vehicles to navigate the complex and unpredictable world of investments. However, even mutual funds have some inherent drawbacks. Understand these before you commit your money to a mutual fund.
No assured returns and no protection of capital
If you are planning to go with a mutual fund, this must be your mantra: mutual funds do not offer assured returns and carry risk. For instance, unlike bank deposits, your investment in a mutual fund can fall in value. In addition, mutual funds are not insured or guaranteed by any government body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India).
There are strict norms for any fund that assures returns and it is now compulsory for funds to establish that they have resources to back such assurances. This is because most closed-end funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to investors.
Restrictive gains
Diversification helps, if risk minimisation is your objective. However, the lack of investment focus also means you gain less than if you had invested directly in a single security.
In our earlier example, say, Reliance appreciated 50 per cent. A direct investment in the stock would appreciate by 50 per cent. But your investment in the mutual fund, which had invested 10 per cent of its corpus in Reliance, will see only a 5 per cent appreciation.
Types of mutual funds
Many people tend to wrongly equate mutual fund investing with equity investing. Fact is, equity is just one of the various asset classes mutual funds invest in. They also invest in debt instruments such as bonds, debentures, commercial paper and government securities.
Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the class(es) of securities it can invest in. Based on the asset classes, broadly speaking, the following types of mutual funds currently operate in the country.
Equity funds. The highest rung on the mutual fund risk ladder, such funds invest only in stocks. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. There are also ‘specialised’ equity funds, such as index funds and sector funds, which invest only in specific categories of stocks.
Debt funds. Such funds invest only in debt instruments, and are a good option for investors averse to taking on the risk associated with equities. Here too, there are specialised schemes, namely liquid funds and gilt funds. While the former invests predominantly in money market instruments, gilt funds do so in securities issued by the central and state governments.
Balanced funds. Lastly, there are balanced funds, whose investment portfolio includes both debt and equity. As a result, on the risk ladder, they fall somewhere between equity and debt funds. Balanced funds are the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments.
Let’s now take a closer look at the working of each of these three categories of funds, the investment options they offer, and how best you can make money from them.
Equity funds
As explained earlier, such funds invest only in stocks, the riskiest of asset classes. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are:
Index funds
These funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portfolio mirrors the index they track, both in terms of composition and the individual stock weightages. For instance, an index fund that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds don’t need fund managers, as there is no stock selection involved.
Investing through index funds is a passive investment strategy, as a fund’s performance will invariably mimic the index concerned, barring a minor "tracking error". Usually, there’s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unitholders. So, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent.
To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualised return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualised return to 16.2 per cent. Obviously, the lower the tracking error, the better the index fund.
Diversified funds
Such funds have the mandate to invest in the entire universe of stocks. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager.
This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager’s picks languish, the returns will be far lower.
The crux of the matter is that your returns from a diversified fund depend a lot on the fund manager’s capabilities to make the right investment decisions. On your part, watch out for the extent of diversification prescribed and practised by your fund manager. Understand that a portfolio concentrated in a few sectors or companies is a high risk, high return proposition. If you don’t want to take on a high degree of risk, stick to funds that are diversified not just in name but also in appearance.
Tax-saving funds
Also known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, you can claim a tax exemption of 20 per cent from your taxable income. You can invest more than Rs 10,000, but you won’t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that you are locked into the scheme for three years.
In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.
Sector funds
The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG. A sector fund’s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme’s NAV too will stay depressed.
Barring a few defensive, evergreen sectors like FMCG and pharma, most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cycles–get in when the sector is poised for an upswing and exit before it slips back. Therefore, unless you understand a sector well enough to make such calls, and get them right, avoid sector funds.
How to pick an equity fund
Now, that you have an idea of the investment profile and objective behind each type of equity fund, let’s get down to specifics: what you should look for while evaluating an equity fund. First, narrow down your investment universe by deciding which category of equity fund you would like to invest in. That decided, seek the following four attributes from a prospective fund.
Track record. It’s always safer to opt for a fund that’s been around for a while, as you can study its track record. You can see how the fund has performed over the years, which will facilitate historical comparison across its peer set.
Although past trends are no guarantee of future performance, it does give an indication of how well a fund has capitalised on upturns and weathered downturns in the past. The fund’s track record also gives an indication of the volatility in its returns. Avoid funds that show a volatile returns patterns.
Diversified portfolio. Unless you are willing to take on high risk, avoid funds that have a high exposure to a few sectors or a handful of stocks. Such funds will give superior returns when the selected sectors are doing well, but if the market crashes or the sector performs badly, the fall in NAV will be equally sharp. Ideally, a diversified equity fund should have an exposure to at least four sectors and seven to 10 scrips.
Diversified investor base. Just as the fund needs diversified investments, it also needs to have a diversified investor base. This ensures that a few investors do not own a significant part of the fund, as it would belie the very principle of a mutual fund.
Sebi (Securities and Exchange Board of India) regulations stipulate that a fund must publish, in its half-yearly disclosures, details of the number of investors who hold more than 25 per cent of the scheme’s corpus. Avoid such funds, as they could well be catering to the interests of the large investors–at your expense.
Transparency in operations. Before investing in a fund, always go through its offer document and fact sheet. If the fund house doesn’t give out such information regularly, avoid that fund. Funds that do not disclose details on a regular basis to their unitholders are better left alone, as you may not be told what will happen to your money once you invest.
Debt funds
Such funds attempt to generate a steady income while preserving investors’ capital. Therefore, they invest exclusively in fixed-income instruments securities like bonds, debentures, Government of India securities, and money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money. There are basically three types of debt funds.
Income funds
By definition, such funds can invest in the entire gamut of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the higher than those available on government-backed paper. But there is also the risk of default–a company could fail to service its debt obligations.
Gilt funds
They invest only in government securities and T-bills–instruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don’t face the spectre of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds.
Liquid funds
They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses.
The ‘risk’ in debt funds
Although debt funds invest in fixed-income instruments, it doesn’t follow that they are risk-free. Sure, debt funds are insulated from the vagaries of the stock market, and so don’t show the same degree of volatility in their performance as equity funds. Still, they face some inherent risk, namely credit risk, interest rate risk and liquidity risk.
Interest rate risk. This is common to all three types of debt funds, and is the prime reason why the NAVs of debt funds don’t show a steady, consistent rise. Interest rate risk arises as a result of the inverse relationship between interest rates and prices of debt securities.
Prices of debt securities react to changes in investor perceptions on interest rates in the economy and on the prevelant demand and supply for debt paper. If interest rates rise, prices of existing debt securities fall to realign themselves with the new market yield. This, in turn, brings down the NAV of a debt fund. On the other hand, if interest rates fall, existing debt securities become more precious, and rise in value, in line with the new market yield. This pushes up the NAVs of debt funds.
Credit risk. This throws light on the quality of debt instruments a fund holds. In the case of debt instruments, safety of principal and timely payment of interest is paramount. There is no credit risk attached with government paper, but that is not the case with debt securities issued by companies.
The ability of a company to meet its obligations on the debt securities issued by it is determined by the credit rating given to its debt paper. The higher the credit rating of the instrument, the lower is the chance of the issuer defaulting on the underlying commitments, and vice-versa. A higher-rated debt paper is also normally much more liquid than lower-rated paper.
Credit risk is not an issue with gilt funds and liquid funds. Gilt funds invest only in government paper, which are safe. Liquid funds too make a bulk of their investments in avenues that promise a high degree of safety. For income funds, however, credit risk is real, as they invest primarily in corporate paper.
Liquidity risk. This refers to the ease with which a security can be sold in the market. While there is brisk trading in government securities and money market instruments, corporate securities aren’t actively traded. More so, when you go down the rating scale–there is little demand for low-rated debt paper.
As with credit risk, gilt funds and liquid risk don’t face any liquidity risk. That’s not the case with income funds, though. An income fund that has a big exposure to low-rated debt instruments could find it difficult to raise money when faced with large redemptions.
How to pick a debt fund
It’s evident there is an element of risk associated with debt funds. Hence, some care and thought has to go into picking a debt fund. Here are some factors you ought to look at while scouting for a debt fund.
Investment horizon. The first thing you need to get a fix on is your investment horizon. If you wish to invest in a debt fund for anything up to one year, opt for a liquid fund. Anything above that, you should be looking at a gilt fund or an income fund.
Track record. As with equity funds, a debt fund with a good track record is always preferable. The longer the track record, the better–to be on the safe side, choose funds that have been in the market for at least a year.
Credit quality. One of the most important factors you need to look for in an income fund is the credit rating of the debt instruments in its portfolio.
A credit rating of AAA denotes the highest safety, while a rating of below BBB is classified as non-investment grade. Although rating agencies classify BBB paper as investment grade, you should budget for downgrades, and set the minimum acceptable rating benchmark at AA. In order to ensure the safety of your investment, opt for a fund that has at least 75 per cent of its corpus in AAA-rated paper, and 90 per cent in AA and AAA paper.
Diversification. In order to limit the loss from a possible default, an income fund should be reasonably diversified across companies. Say, a fund manager invests his entire corpus in debt instruments of just one company. If the company goes under, the fund loses everything. Now, had the fund manager diversified and invested 10 per cent of his corpus in 10 companies, with one-tenth in the troubled company, his loss would be lower. Assuming the other companies meet their debt obligations, the fund’s loss would be restricted to 10 per cent.
Diversified investor base. Similar to the pre-condition for equity funds, avoid debt funds where a few large investors account for an abnormally high portion of the corpus.
Balanced funds
As the name suggests, balanced funds have an exposure to both equity and debt instruments. They invest in a pre-determined proportion in equity and debt–normally 60:40 in favour of equity. On the risk ladder, they fall somewhere between equity and debt funds, depending on the fund’s debt-equity spilt–the higher the equity holding, the higher the risk. Therefore, they are a good option for investors who would like greater returns than from pure debt, and are willing to take on a little more risk in the process.
How to pick a balanced fund
The same criterion that applies to selecting an equity fund holds good when choosing a balanced fund. The one additional factor you should check for a balanced fund is the equity and debt split. The offer document will state the ratio of equity and debt investments the fund plans to have. Mostly, this takes on a range, and varies from time to time depending on the fund manager’s perception of the financial markets.
Before investing in an existing balanced fund, go through a few of its past fund fact sheets, and look up the equity-debt split. If you are a conservative investor, opt for a fund where equity investments are capped at 60 per cent of corpus. However, if you are the aggressive sort, you could even go along with a higher equity holding.
The intelligent investor's seven rules
It’s one thing to understand mutual funds and their working; it’s another to ride on this potent investment vehicle to create wealth in tune with your risk profile and investment needs. Here are seven must-dos that go a long way in helping you meet your investment objectives.
Know your risk profile
Can you live with volatility? Or are you a low-risk investor? Would you be satisfied if your fund invests in fixed-income securities, and yields low but sure-shot returns? These are some of the questions you need to ask yourself before investing in a fund.
Your investments should reflect your risk-taking capacity.
Equity funds might lure when the market is rising and your neighbour is making money, but if you are not cut out for the risk that accompanies it, don’t bite the bait. So, check if the fund’s objective matches yours. Invest only after you have found your match. If you are racked by uncertainty, seek expert advice from a qualified financial advisor.
Identify your investment horizon
How long you want to stay invested in a fund is as important as deciding upon your risk profile. A mutual fund is essentially a savings vehicle, not a speculation vehicle–don’t get in with the intention of making overnight gains.
Invest in an equity fund only if you are willing to stay on for at least two years. For income and gilt funds, have a one-year perspective at least. Anything less than one year, the only option among mutual funds is liquid funds.
Read the offer document carefully
This is a must before you commit your money to a fund. The offer document contains essential details pertaining to the fund, including the summary information (type of scheme, name of the asset management company and price of units, among other things), investment objectives and investment procedure, financial information and risk factors.
Go through the fund fact sheet
Fund fact sheets give you valuable information of how the fund has performed in the past. You can check the fund’s portfolio, its diversification levels and its performance in the past. The more fact sheets you examine, the better.
Diversify across fund houses
If you are routing a substantial sum through mutual funds, you should diversify across fund houses. That way, you spread your risk.
Do not chase incentives
Don’t get lured by investment incentives. Some financial intermediaries give upfront incentives, in the form of a percentage of your initial investment, to invest in a particular fund. Don’t buy it. Your focus should be to find a fund that matches your investment needs and risk profile, and is a performer.
Track your investments
Your job doesn’t end at the point of making the investment. It’s important you track your investment on a regular basis, be it in an equity, debt or balanced fund. One easy way to keep track of your fund is to keep track of the Intelligent Investor rankings of mutual funds, which are complied on a quarterly basis (log on to iinvestor.com to see the rankings for the quarter ended June 2001). These rankings allow you to take note of your fund’s performance and risk profile, and compare it across various time periods as well as across its peer set. In addition, you should run some basic checks in the fund fact sheets and the quarterly reports you get from your fund.
Equity funds are subject to market volatility, and the pace of change can be quite brisk. Check your fund’s quarterly reports for changes that could have severe implications on your investment. If you find a high degree of concentration in a few stocks or sectors, it means the fund manager is banking on the performance of these sectors. If they keep up to his expectations, you could end up making hefty returns, but if they don’t, chances are that the NAV will depreciate heavily.
In the case of debt funds, check the portfolio distribution and the fund’s holding in AAA and equivalent papers. If you find your fund is holding a significant quantity (above 10 per cent) in below AA-rated paper, your investment is not safe. Remember, even a single default can drag the NAV of your debt down.
If you come across negative reports of the fund, ask your financial advisor or broker about it, especially if there’s a possibility of your investment depreciating in value. If the threat is real, reduce your exposure to the fund.
Source : money.outlookindia.com
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