Sunday, October 29, 2006

Fund Flavours …

Fund Flavours …

If the concept of Mutual Fund is so simple, why does Mutual Fund investing seem so complex? A common man is so much confused about the various kinds of Mutual Funds that he is afraid of investing in these funds as he cannot differentiate between various types of Mutual Funds with fancy names. There are nearly 30 AMCs offering close to 500 schemes in India today. A systematic categorization will put things in the proper perspective and guide you while investing in Mutual Funds. Let's go over the many different flavors of funds.

Mutual Funds can be classified into the following 4 broad categories:

1. Portfolio 2. Functional 3. Geographical and 4. Specialised

In the first place, we have the Portfolio Classification on the following basis

Equity/Growth Funds, Debt/Income Funds, Balanced Funds, Money Market Mutual Funds (MMMFs), Gilt Funds, Index Funds, Sector Funds, Hedge Funds and Leveraged Funds.

Secondly, the Functional or Operational Classification is done on the following basis

Liquidity - Open-ended Funds, Close-ended Funds and Interval Funds
Investment Strategy – Growth and Value Funds
Trading Strategy - Active and Passive Funds
Security Selection – Top Down, Bottom Up Funds and Technical Funds
Market Capitalisation – Small Cap, Mid Cap and Large Cap Funds
Load and Expenses – Load Funds and No Load Funds

Thirdly, under the Geographical Classification, we have the Domestic Mutual Funds and Offshore Mutual Funds.

Last but not the least, we have Specialized Funds like Exchange Traded Funds (ETFs), the Funds of Funds, Mutual Funds with Tax Benefits and Socially Responsible or Ethical Funds which are all attempting to take the Mutual Fund concept to the next level.

A detailed discussion of each category, taken one at a time , will be taken up in the subsequent blogs.

Sunday, October 22, 2006

Expenses Exposed !!!!

Expenses Exposed!!

"Dazzled by performance, indifferent to cost," is a common accusation hurled at Mutual Fund investors. I would have succeeded in my endeavour if I elevate you to well above the average in the next 500 words or so.

Management Expense Ratio or MER.
The MER is the total expense of operating a Mutual Fund expressed as a percentage of the fund's Net Asset Value (NAV).

The major components of Expense Ratio are

The Investment Advisory Fee or The Management Fee: This is the money that goes to pay the salaries of the fund managers and other employees of the Mutual Funds. The management fees (which could range from 1% to 1.25% of the fund's corpus) are one of the highest expenses incurred by a Mutual Fund.

Administrative Costs: These are the costs associated with the daily activities of the fund. These include the costs of record keeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The thriftiest funds can keep these costs below 0.20% of fund assets, while the ones who use engraved paper, colorful graphics etc. might fail to keep administrative costs below 0.40% of fund assets.

Limits have been mandated by SEBI on operating expenses. On the

First Rs. 100 crores 2.25%
Next Rs. 300 crores 2.00%
Next Rs. 300 crores 1.75%
On the balance of assets 1.50%

Any excess over the specified limits has to be borne by the asset management company, the trustees or the sponsor.

One ongoing expense that is not included in the expense ratio is brokerage costs incurred by a fund as it buys and sells securities. These costs are listed separately in a fund's annual report. When mutual fund managers buy and sell a high number of stocks, with frequency, within a fund, it will have a high turnover rate, causing a higher capital gains tax and vice versa. Check the fund reports for the turnover rate. A rate of 80 or less is usually considered low.

For actively managed funds, the average expense ratio is rising as funds shift fees away from the up-front loads that they know are driving sales away, into the annual expense ratios where they are more easily hidden. This fee is charged and deducted from the fund regardless of its performance and for as long as you hold this Mutual Fund.

All these expenses that we have mentioned so far can be thought of as coming out of the portfolio's raw return, skimmed off the top, so to speak. For a full understanding of fund expenses, a careful perusal of the Offer Document and the Annual Report is absolutely essential. An informed investor knows where his money is going. He keeps tab on the toll he doles out on the highway to big money.

Sunday, October 15, 2006

Loaded !!!!


A quick review…

Loads are fees or expenses recovered by Mutual Funds against compensation paid to brokers, their distribution and marketing costs. These expenses are generally called as sales loads. These are also referred to as front end loads and along the same line of thought there are back end loads that are charged on you even while you exit from the share holding of the fund (sales fees). Entry loads generally vary between 1.00% and 2.25%. Exit loads vary between 0.25% and 3.00%.

The Mutual Fund Regulations Act, 1996, has not clearly defined 'load'. However, the Act stipulates that the redemption price cannot be lower than 93% of the NAV, while resale price cannot be higher than 107% of the NAV in case of open-end schemes. In case of closed-end scheme, the repurchase price of units shall not be lower than 95% of the NAV.

Schemes cannot charge an entry load beyond 6% during the initial launch. If the load during the initial launch of a scheme is borne by the AMC, then these schemes are known as no-load funds. However, these no-load funds will have an exit load when the initial investor gets out of the scheme before a stipulated period, which is clearly stated during the initial offer. This is done to restrict short-term investors from getting into the scheme. Besides restricting short-term investors, the AMC can levy an additional management fee not exceeding 1% of the daily net assets in schemes floated on a 'no-load basis'. Under the exit load, besides the flat load, an AMC may be entitled to levy a contingent deferred sales charge (CDSC) for redemption during the first four years after purchase. However, the CDSC cannot exceed 4% of the redemption proceeds in the first year, 3% in the second year, 2% in the third year, and 1% in the fourth year.

Normally, closed-end schemes charge an entry load while having no exit load. But open-ended schemes do charge the load either at entry level/exit level, or at both stages. Equity-oriented schemes entail a higher cost in terms of brokerage, as these schemes require a greater persuasion from the intermediaries. Therefore, debt-oriented schemes do have a lower load when compared to equity-oriented schemes. Almost 98% of the debt-oriented schemes do not carry an entry load, but most of these schemes carry an exit load if the investor exits within 6 months from the date of making investments. The primary reason for this might be due to the returns generated by the schemes. The returns from these schemes generally hover around 12-13% per annum. If the scheme imposes a load, the real returns of investors from these schemes further come down making the scheme unattractive for investors.

Besides this, the funds do review the load structure periodically and have been using this as a selling proposition for mobilising new funds. Funds have also moved out from a uniform slab structure to a differential slab structure. This is done with the objective of mobilising funds from high net worth individuals and corporates.

The load might differ with the amount invested. The larger the amount invested, the lower the sales load. For example, Reliance Growth fund charges a 2.25 per cent sales load for investments up to Rs 1.999 Crores but only 1.25 per cent load is charged for investments over Rs 2.0 crores to 4.999 Crores.

Besides, the load could also depend on the period of investments. Birla Advantage charges a back load of 2 per cent for investments of less than two years and is a no load fund for investments over two years.

Funds also charge different loads from different class of investors. Initial investors, who had a no load entry into Chola Triple Ace are being charged a 2 per cent exit load. On the other hand, new investors in the scheme are being charged an entry load of 0.5 per cent and redemption is at NAV.

Mutual funds cannot increase the load beyond the level mentioned in the offer document. Any change in the load will be applicable only to prospective investments and not to the original investments. In case of imposition of fresh loads or increase in existing loads, the mutual funds are required to amend their offer documents so that the new investors are aware of loads at the time of investment.

Entry Load; Exit Load; Contingent Deferred Sales Charge –Within proper limits,Don't look at these as a burden, just think of them as tolls you pay on the highway to big money!

Sunday, October 08, 2006

Further Concepts Clarified… !!!!

Further Concepts Clarified…

NAV is the most important measure of the performance of a Mutual Fund. Let us say you have invested Rs 10000 in a scheme at Rs 13 a unit and now its NAV is Rs 15. Quite simply, that means your investment has appreciated by 15%. But wait before you jump in joy - you may not actually get that much when you redeem your units. That is because of the expenses charged by Mutual Funds.

Let me introduce you to some concepts associated with Mutual Fund expenses before we proceed with the example. Mutual Fund’s costs are categorized as Sales charges or Loads and Operating expenses or Expense Ratio.

Loads include expenses like agent’s commission, marketing and selling expenses that are charged directly to the investor. Front End load or Entry load is a fee that is charged up-front, when you purchase the mutual fund units. It is charged on a percentage basis (eg. 1%, 1.5%, 2%, 3%, etc) based on the amount of purchase. Back End or Rear End load or Exit load is a fee that is charged at redemption.

Expense Ratio is an annual operating expense expressed as a percentage of the fund's average daily net assets. It refers to costs incurred in operating a mutual fund and is paid out of the Fund’s earnings. It includes advisory fees paid to investment managers, audit fees, custodial fees, transfer agent fees, trustee fees etc. Operating expenses are calculated on an annualized basis and are normally accrued on a daily basis. Therefore, you pay expenses pro-rated for the time you are invested in the Fund.

Let us return to our example. If the entry load levied is 1.00%, the price at which you invest is Rs.13.13 per unit. This is the Purchase Price, the price paid by a customer to purchase a unit of the Fund. You receive 10000/13.13 = 761.6146 units.

Let us now assume that you decide to redeem your 761.6146 units and the exit load is 0.50%. The Redemption Price per unit works out to Rs.14.925. Redemption price is the price received by the customer on selling units of an open-ended scheme to the Fund. You, therefore, receive 761.6146 x 14.925 = Rs.11367.10. The returns have reduced to 13.6% as a result of entry and exit loads.

Repurchase Price is different from Redemption Price and refers to the price at which a close-ended scheme repurchases its units. Repurchase can either be at NAV or can have an exit load. (Open-ended and Close-ended Funds will be discussed under classification of Mutual Funds).

Suppose the Expense Ratio is 2%, you will see a return of only11.6%. So your returns have come down by 3.4 % as a result of the Loads and Expense Ratio.

Now, you can appreciate the extent to which Mutual Fund Expenses eat into your real returns. This should not scare you away from Mutual Funds since the associated cost for Mutual Funds is still very low when compared to making investments directly in equities. This notwithstanding, a proper understanding of Mutual Fund expenses will stand you in good stead when you have to choose from among equally well-performing Funds.

Mutual Fund expenses will be explained and analysed threadbare in the subsequent blogs.

Sunday, October 01, 2006

Exploding a myth - NAV

Exploding a myth

People carry the perception that a fund with a lower NAV is cheaper than that with a higher NAV since they are under the notion that the NAV of a Mutual Fund is similar to the market price of an equity share. This, however, is not true. There is no concept as market value for the Mutual Fund unit. Therefore, when we buy Mutual Fund units at NAV, we are buying at book value. We are paying the right price of the assets whether it be Rs 10 or Rs.100. There is no such thing as a higher or lower price. But the market price of a share is generally different from its book value depending on its fundamentals, the perception of the company’s future performance & the demand-supply scenario.

Now let me make this point clear by using an analogy. Consider this: If you are investing Rs 100,000 in Fixed Deposit (FD), there would be 4 Fixed Deposit Receipts (FDRs) if the denomination is Rs 25,000 and 2 FDRs, if the denomination is Rs 50,000. If you have Rs 1 lac to invest, you will get either 2 or 4 fixed deposit receipts on which your income (interest earning) will remain the same. If you choose to invest in 4 FDs of denomination 25,000, it does not mean you have got those cheaper and therefore you will earn more interest. Please appreciate that the level of NAV is as irrelevant in Mutual Fund investment decision as the number of the FDRs while investing in FD. It is just an equation; as long as the numerator (investment amount) does not change, the denominator (NAV / number of FDRs) does not have ANY material impact on the return potential of your investment.

An example will make it clear that returns from Mutual Funds are independent of the NAV. Let us say you have Rs 10,00000 to invest. You have two options, wherein the funds are the same as far as the portfolio is concerned. But say one Fund X has a NAV of Rs 10 and another Fund Y has a NAV of Rs 50. You will get 100000 units of Fund X or 20000 units of Fund Y. After one year, both funds would have grown equally as their portfolio is the same, say by 20%. Then NAV after one year would be Rs 12 for Fund X and Rs 60 for Fund Y. The value of your investment would be 100000*12 = Rs 12,00000 for Fund X and 20000*60 = Rs 12,00000 for Fund Y. Thus your returns would be same irrespective of the NAV.

It is quality of fund, which would make the difference to your returns. In fact, for equity shares also broadly this logic would apply. An IT company share at say Rs 1000 may give a better return than say a jute company share at Rs 50, since IT sector would show a much higher growth rate than jute industry (of course Rs 1000 may fundamentally’ be over or under priced, which will not be the case with Mutual Fund NAV).