… Curtains down on Classification..Specialty Funds …(contd.)

… Curtains down on Classification

Specialty Funds …(contd.)

The Arbitrage / Derivative Fund is the closest any mutual fund scheme in India can get to a Hedge Fund. SEBI has not allowed any AMC to float a Hedge Fund in India. Presently, there are arbitrage funds from JM (JM Equity & Derivative and JM Arbitrage Advantage), Kotak (Kotak Cash Plus), Prudential ICICI (Prudential ICICI Blended Plan),UTI Mutual (UTI Spread) and SBI (SBI Arbitrage Opportunities Fund).

A fund manager would buy the equities in the capital market and sell it in the futures market, making good the difference. This is how it works: if company ABC's stock is trading today at Rs 30 per share and is expected to rise over the next month, the one-month futures price of the stock will be higher, say, Rs 35. A fund manager would then buy the underlying stock and sell it in the futures market, making a gain of Rs 5. When settlement day arrives, it is irrelevant whether the share price of ABC Ltd. has risen or fallen. One would still make the same amount of money. This happens because on the date of expiry (settlement date) the price of the equity shares and their stock futures will tend to coincide. Now, all one has to do is to reverse the initial transaction i.e. buy back the contract in the futures market and sell off the equity. So four transactions have taken place - buy stock, sell futures, sell stock, buy futures. In this manner, irrespective of the share price, the investor earns the spread between the purchase price of the equity shares and the sale price of futures contract.

The equity arbitrage fund is market neutral; hence, it will not be affected by temporary fluctuations in the Sensex. It does sound like a very simple and effective way of making money in the market. If only life were indeed that simple…

The first hurdle is the presence of arbitrage opportunities. In a given period of time, the market may or may not provide any meaningful arbitrage opportunities that hold the key to the amount of money the fund will earn. No doubt, the fund management team has sophisticated softwares that flag such mispricing the moment it occurs and is extra vigilant in identifying such opportunities.

Secondly, there is the issue of costs. Each leg of the entire transaction i.e. buying stock, selling future, selling stock and buying futures will entail the payment of brokerage and security transaction tax (STT). These costs directly dilute the earnings.

Derivative Funds always yield limited returns. However, it is the risk free nature of the returns that is the USP of the product. After all, the problem that most investors have with entering into the equity market is the lack of assured risk free returns. Arbitrage/Derivative Fund is a product that gives you exactly that.

Mutual funds with tax benefits

Mutual Funds by their very nature are not tax saving instruments but investment products that may offer tax concessions. But the question is whether these can be looked at as tax saving instruments?

For an Equity Fund:
· Long-term capital gains are tax-free
· Short-term capital gains are taxed at only 10%
· Dividend is not subject to dividend distribution tax
· Redemption of units is subject to a Securities Transaction Tax (STT) of 0.25%.

Equity Linked Savings Scheme (ELSS) are special Equity Funds, which have to invest at least 80% of their corpus in equity and offer a tax benefit over and above those mentioned above. Any investment in an ELSS fund offers Sec. 80C deduction i.e. the amount invested is deductible from taxable income. However, Sec. 80C has a cap of Rs. 1 lakh and presupposes a lock-in of 3 years. Sec 80 C covers principal on housing loan, PF, pension plan, life premiums, so only what is left after that can give a tax benefit if invested in ELSS.

ELSS funds, in general, have been found to out-perform their Equity Diversified counterparts. This happens essentially as the fund manager has the money at his disposal over the long-term without having to cater to everyday redemptions. Therefore, regardless of the tax benefit, even investing over Rs. 1 lakh may be an idea to consider.

Socially Responsible (Ethical Funds) invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience. Such funds are not common in India.

In developed countries like the U.S.A there are funds to satisfy everybody's requirement, but in India only the tip of the iceberg has been explored. Innovation, they say, is the key to success. So, in the universe of mutual fund schemes, new ones keep passing by but it is those that stand apart that catch the discerning investor's eye.

Curtains down on Classification

Curtains down on Classification

Specialty Funds …(contd.)

A "Fund of Fund" (FoF) is a mutual fund scheme that uses an investment strategy of holding a portfolio of other mutual funds rather than investing directly in shares or bonds or other securities. This type of investing is often referred to as Multi-manager Investments. A Fettered FoF limits the fund selection to only include the range of funds they manage whereas Unfettered FoF includes funds from various AMCs.

In India, FoFs were initially offered by three funds- Franklin Templeton’s FT India Dynamic PE Ratio Fund of Funds, Birla SunLife’s Birla Asset Allocation Fund and Prudential ICICI Mutual Fund’s Prudential ICICI Advisor Series Plans. Now, there are more than a dozen FoFs.

“Does it make sense to invest in FoFs? “

Advantages

Double Diversification - A Fund of Fund diversifies across many different funds (which in turn diversify across securities). Thus there is diversification across asset classes and investment styles.

Simplicity - FoFs have access to the portfolio of various top-performing funds with just one investment. This allows for much less paperwork and easy monitoring.

Cheap for Beginning Investors -It is tough to diversify when starting out because of account minimums. Suppose you wanted to invest in 5 equity funds and 5 debt funds, assuming each fund has a minimum stipulated investment of Rs 5,000, you would need Rs 50,000. In a FoF, Rs 5,000 would suffice.

Institutional Advantages -Funds of funds can often invest in desirable institutional funds that are outside the purview of retail investors.They also have the ability to invest in some load funds without paying the load.

An investment manager may actively manage your investment with a view to selecting the best securities. A FoF manager will select the best performing funds to invest in based upon the managers’ performance. This additional level of selection can provide greater stability and take on some of the risk relating to the decisions of a single manager.

The in-built rebalancing feature ensures that market movements do not change the desired asset allocation. The fund composition can be altered in no time in FoFs whereas this process may take a long time to complete in a Balanced Fund since its constituents are instruments instead of funds. It is the difference between having 10 individual roses and a bouquet of 10 roses.The second benefit that FoF rebalancing offers is a psychological one. Usually people don't sell when the markets are rising and don't buy when the markets are falling. Yet this is exactly what one should be doing. FoF does it automatically (and it usually can be in your long term interest).

Disadvantages

Double diversification may at times introduce duplication as it is possible for the FoFs to own the same stock through several different funds and it can be difficult to keep track of the overall holdings. Investor may have to monitor whether the fund manager is sticking to the stated asset allocation. Investors should also be careful about the timing of their entry into the scheme.

As per the present tax laws, equity FoF does not enjoy the benefits available to a normal equity fund. Therefore, if one invested in an equity FoF he would be liable to pay dividend distribution tax of 14.03% or LTCG tax of 10% (without indexation), which is otherwise NIL for a normal equity MF. This higher tax can significantly reduce the post-tax returns.

Fund of Funds = Cost of costs

Investors should also be aware that cost heads like fund management fee and other expenses in each of the scheme, where FoF would be investing, reduce returns. The additional expense that an investor can incur is a maximum of 0.75 per cent that FoF is permitted to charge for meeting its expenses such as audit fees, statutory disclosures, etc. Thus the effective cost works out to around 3.25% and 2.25% for equity & debt MF respectively (the annual management fees are typically 2.5% for an equity MF and 1.5% for a debt MF).

The convenience that an FoF offers should more than make up for this marginally extra cost. Moreover, the entry load is taken at fund level. When the fund invests in underlying schemes, the load factor is waived off if the schemes are chosen from the same fund house.

The onus is on the investors to assess their profile in the light of these factors and then take a decision as to whether a FoF fits into their portfolio or not.

Curtains down on Classification --Specialty Funds …(contd.)

Curtains down on Classification

Specialty Funds …(contd.)

A "Fund of Fund" (FoF) is a mutual fund scheme that uses an investment strategy of holding a portfolio of other mutual funds rather than investing directly in shares or bonds or other securities. This type of investing is often referred to as Multi-manager Investments. A Fettered FoF limits the fund selection to only include the range of funds they manage whereas Unfettered FoF includes funds from various AMCs.

In India, FoFs were initially offered by three funds- Franklin Templeton’s FT India Dynamic PE Ratio Fund of Funds, Birla SunLife’s Birla Asset Allocation Fund and Prudential ICICI Mutual Fund’s Prudential ICICI Advisor Series Plans. Now, there are more than a dozen FoFs.

“Does it make sense to invest in FoFs? “

Advantages

Double Diversification - A Fund of Fund diversifies across many different funds (which in turn diversify across securities). Thus there is diversification across asset classes and investment styles.

Simplicity - FoFs have access to the portfolio of various top-performing funds with just one investment. This allows for much less paperwork and easy monitoring.

Cheap for Beginning Investors -It is tough to diversify when starting out because of account minimums. Suppose you wanted to invest in 5 equity funds and 5 debt funds, assuming each fund has a minimum stipulated investment of Rs 5,000, you would need Rs 50,000. In a FoF, Rs 5,000 would suffice.

Institutional Advantages -Funds of funds can often invest in desirable institutional funds that are outside the purview of retail investors.They also have the ability to invest in some load funds without paying the load.

An investment manager may actively manage your investment with a view to selecting the best securities. A FoF manager will select the best performing funds to invest in based upon the managers’ performance. This additional level of selection can provide greater stability and take on some of the risk relating to the decisions of a single manager.

The in-built rebalancing feature ensures that market movements do not change the desired asset allocation. The fund composition can be altered in no time in FoFs whereas this process may take a long time to complete in a Balanced Fund since its constituents are instruments instead of funds. It is the difference between having 10 individual roses and a bouquet of 10 roses.The second benefit that FoF rebalancing offers is a psychological one. Usually people don't sell when the markets are rising and don't buy when the markets are falling. Yet this is exactly what one should be doing. FoF does it automatically (and it usually can be in your long term interest).

Disadvantages

Double diversification may at times introduce duplication as it is possible for the FoFs to own the same stock through several different funds and it can be difficult to keep track of the overall holdings. Investor may have to monitor whether the fund manager is sticking to the stated asset allocation. Investors should also be careful about the timing of their entry into the scheme.

As per the present tax laws, equity FoF does not enjoy the benefits available to a normal equity fund. Therefore, if one invested in an equity FoF he would be liable to pay dividend distribution tax of 14.03% or LTCG tax of 10% (without indexation), which is otherwise NIL for a normal equity MF. This higher tax can significantly reduce the post-tax returns.

Fund of Funds = Cost of costs

Investors should also be aware that cost heads like fund management fee and other expenses in each of the scheme, where FoF would be investing, reduce returns. The additional expense that an investor can incur is a maximum of 0.75 per cent that FoF is permitted to charge for meeting its expenses such as audit fees, statutory disclosures, etc. Thus the effective cost works out to around 3.25% and 2.25% for equity & debt MF respectively (the annual management fees are typically 2.5% for an equity MF and 1.5% for a debt MF).

The convenience that an FoF offers should more than make up for this marginally extra cost. Moreover, the entry load is taken at fund level. When the fund invests in underlying schemes, the load factor is waived off if the schemes are chosen from the same fund house.

The onus is on the investors to assess their profile in the light of these factors and then take a decision as to whether a FoF fits into their portfolio or not.

… Curtains down on Classification…Specialty Funds

… Curtains down on Classification…

Specialty Funds

This classification of mutual funds is more of an all-encompassing category that consists of funds that have proved to be popular but don't necessarily belong to the categories that have been described so far.

Exchange Traded Fund

An Exchange Traded Fund (ETF) is a hybrid financial product, a cross between a stock and a mutual fund. Like a stock it can be traded on a stock exchange and like a mutual fund it behaves like a diversified portfolio and invests in the stocks of an index in approximately the same proportion as held in the index.

The ETFs represent ownership in a fund. Each ETF is designed as a share. Shares are only created or redeemed by institutional investors in large blocks (typically 50,000 shares). Investors purchase shares in small quantities through brokers at a small premium or discount to the net asset value through which the institutional investors make their profit.

The pros and cons of ETF investing are lucidly summed up below:

• ETFs replicate index products, although some benchmarks may be new and not have a track record;
• ETFs have lower expenses (institutional investors handle the majority of trades) and are tax efficient. ETFs do not buy and sell stocks, except to replace a stock that has been replaced on an index. Readjustments might generate small capital gains for investors, but generally the investor faces a tax liability only when he sells the ETF shares for a gain;
• ETFs trade throughout the day, giving investors flexibility;
• ETFs can be bought on margin;
• Buying or selling an ETF triggers a commission since it is bought through a broker. This may not be advantageous to someone investing every month or quarter.

Small investors, used to investing in units, need to remember that unlike mutual funds, the ETFs do not necessarily trade on NAV. Like stocks, they may trade at a premium or at a discount. This means that even if the underlying stocks in the basket are doing well, investors may still book a loss by buying the ETFs being traded at a discount. This apart, the ETFs may also be subject to a bid-ask spread. Simply explained, it means that while one may be able to buy an ETF at Rs 16.50 per share, he may be able to sell only at Rs 16. The 50 paise that he is unable to recover, denotes a hidden cost, which may be unknown to a novice not fully conversant with the downside of the new instrument. The ETFs are also not appropriate for investors who "rupee-cost average" their purchases or redemptions as they would have to pay brokerages on each transaction.

India joined the ETF club in December 2001 with the launch of India's first ETF 'Nifty BeES' (Nifty Benchmark Exchange-traded Scheme) by Benchmark Mutual Fund, based on the S&P CNX Nifty Index. Since then, Benchmark has launched the Junior BeES and the Liquid BeES. There are five ETFs in India at present, of which three are based on the 50-share S&P CNX Nifty index ( including SUNDER by UTI), one on the 200-share CNX Nifty Junior, and one on the 30-share BSE Sensex (SPICE by Prudential ICICI).

India is soon slated to begin trading the Gold Exchange Traded Fund (GETF) which will track the price of gold. Its appointed custodians will buy and sell gold bullion as investors initiate or offset positions in the ETF. An issue currently being resolved concerns who the custodian(s) of the underlying metal will be, and where it will be stored. Rather than outsourcing this activity, it appears that domestic banks will become gold custodians, leading to the launch of several other ETFs by Indian fund houses.

ETFs open up a world of new possibilities to investors whose investment habits have thus far been honed only on investing in pure equity, debt, units and, recently, derivatives. But domestic investors, still not conversant with the downside of investing in the capital market, need to first evaluate if the ETFs are the best investment option going for them, before taking the plunge. While they look more attractive compared to open-ended mutual funds, there are several hidden costs and charges involved in dealing with the ETFs, which need to be factored before investors "spice" up their portfolios.

…Gyrating to Geographical Classification…

…Gyrating to Geographical Classification…

Classification by Geography

Domestic Mutual Funds are funds launched with a view to mobilizing the savings of the citizens of the country. These funds could fall under any of the categories mentioned under portfolio classification and operational classification.

Offshore Mutual Funds are funds launched with a view to mobilizing the savings of the foreign countries for investments in local markets. These funds facilitate cross border fund flow, which is a direct route for getting foreign investment. From the investment point of view, Offshore Funds open up domestic capital markets to the international investors.

Mutual funds that invest in foreign stocks and bonds provide an excellent opportunity to diversify your portfolio. They also reduce the country risk or the risk that all Indian investments could be affected by changes in Indian economy, politics, etc. If investments are chosen carefully, international mutual fund may be profitable when some markets are rising and others are declining. However, fund managers need to keep a close watch on foreign currencies and world markets as profitable investments in a rising market can lose money if the foreign currency rises against the dollar.

Offshore funds can invest in securities of foreign companies in accordance with the SEBI Regulations. Previously, Indian Mutual Funds were not allowed to invest overseas in stocks except in the case of quoted companies that had at least 10 per cent equity holding in Indian companies. This meant that hardly 40 or 50 global corporations (like Lever Brothers) qualified for Mutual Fund investment from India, thus reducing investment options. The latest budget has removed this rule and now Indian Mutual Funds can invest in any listed company on a foreign exchange anywhere in the world. So technically, an Indian MF can invest in Microsoft or Toyota or any listed company on any exchange.

Before the budget, Indian Mutual Funds were allowed to invest up to $1 billion abroad. Now this limit has been trebbled to $3 billion without any restrictions. Now Mutual Funds can spread their risk by investing more abroad and reducing their stake in Indian companies, if they so wish. With the rise in investment ceiling, each fund house will be able to invest approximately $125-$150 million. The Mutual Fund industry views the increase in overseas investment to $3 billion as a progressive roadmap for foreign investments through Mutual Funds in the future. Indian markets provide better returns currently. However, increased investment overseas imply increased risks and commensurate returns.

The combined corpus of the two existing schemes that invest a chunk of their assets in overseas instruments is just around $3.2 million. These are Principal PNB Mutual Fund’s Global Opportunity Fund and Franklin Templeton’s International Fund (the latter is a debt scheme that invests in US government securities). The first one off the block after the budget announcement was Franklin Templeton Investment, which launched the Templeton India Equity Income Fund. This is an open-ended diversified equity fund that can take an exposure of up to 50% in overseas stocks, which have a current or potentially attractive dividend yield.

Regional Funds make it easier to focus on a specific area of the world. This may mean focusing on a region (say Latin America) or an individual country (for example, only Brazil). An advantage of these funds is that they make it easier to buy stock in foreign countries, which is otherwise difficult and expensive. Similar to sector funds, you have to accept the high risk of loss, which occurs if the region goes into a bad recession. They are not found in India.