A taxing question – Which Option would you opt for?

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

A taxing question – Which Option would you opt for?

The choices are endless. You decided what type of fund to invest in and that was a mammoth task in itself. But it did not stop there. An array of questions were then hurled at you. "Would you choose the dividend option or the growth option? "Would you opt for a dividend payout or dividend reinvestment?" Don't get bogged down by these innumerable questions.

An illustration will aid you in finding answers to these questions. Let us say you own 100 units of a Mutual Fund whose current NAV is 20. Your investment value is Rs 2,000 (100 x 20). Now, the scheme declares a dividend of 10%. It is pertinent to note that dividend is always a percentage of the face value. Face value is the price of one unit of a fund and is Rs 10. So 10% of face value would be Re 1 per unit. For the bonus plan, the scheme declares a bonus of 1:10. This means an additional unit for every 10 units held.

This is what will happen under the various options.

In the growth option the fund reinvests the money it would otherwise pay out in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund. That is why the NAV of the growth option is higher than that of the dividend option. You can realize a higher capital gain on the same number of units you originally purchased. The onus of booking profits (by way of redemption) lies solely on you. Selling of units results in a decrease in the number of units held by you with the NAV remaining unchanged.

In the dividend payout option, you will get Rs 100 as dividend while the NAV falls to Rs 19. Effectively, the dividend received from the fund house is set-off by a reduction in the fund’s NAV. Moreover, your investment value falls to Rs. 1900 (unlike all other options where the investment value remains unchanged).

In the dividend re-investment option, the dividend of R.100 is not paid to you. Instead, 5.2631 more units are purchased at the revised NAV of Rs.19. Usually, no entry load is charged. Consequently, you have more units at your disposal every time a dividend is declared, but the NAV witnesses a depreciation.

The bonus option is similar to dividend re-investment, except that the fund announces the bonus ratio instead of dividend. You get 10 more units, because of which the NAV falls to Rs 18.1818. (Earlier long-term capital gains were taxed at a lower rate than dividends. This option is no longer offered since dividends do not attract tax.)

Clearly, there is very little differentiating the various options in terms of returns. If you are keen on receiving an income at various intervals, go in for the dividend option. But the dividend is not guaranteed. In case of a downturn in markets, you would have returns to show for by way of dividends received earlier. Conversely, in case of a long-term investment (which is the norm for equity investments), the growth option enables you to enjoy the benefits of compounding. If you are looking at a long-term investment and are not interested in money being given to you at various intervals, the growth option is meant for you. Choose between the various options based solely on your need for liquidity and tax planning.

Systematically narrow your choices

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Systematically narrow your choices.

Having researched for consistent performers with sound credentials, you must have got a long list of such Funds. You can quickly whittle down the Fund list by using a few criteria like costs (already dealt with in detail in the articles dated 8, 15 and 22 October, 2006), size, investor concentration, customer service and tax implications.

Size of the Fund

When it comes to assessing the impact of a scheme’s size on its performance, the dynamics vary for Debt Funds and for Equity Funds.

Scheme size is an important consideration for income funds (debt funds that invest primarily in corporate debt), but not as much for their two cousins, gilt funds and money market funds. Corporates tend to peg the minimum subscription amount in debt at Rs 5 crore. A portfolio of 10 top-rated holdings is adequately diversified, and diversification beyond that does not reduce the risk proportionately. Assuming 10 holdings and a minimum lot of Rs 5 crore, Rs 50 crore is the bare minimum you should look for in an income fund. Since there is not an abundance of top-rated paper around, large-sized income funds are compelled to look at paper that does not have the highest rating or government securities which offer lower yields compared to corporate paper of identical maturity. Given that just Rs 300 crore worth of corporate paper is traded in a day, it is easier for a smaller fund than a large-sized fund to meet redemptions. In practice, though, it boils down to how well a fund manager manages its redemptions. An important advantage of a big corpus is that it helps in negotiating better terms in private placement deals. In fact, a performance analysis of income funds shows that schemes with a corpus of over Rs 500 crore delivered healthy, consistent returns. On the other hand, schemes with a corpus of Rs 50 crore and below under-performed and failed to deliver consistently.

In the context of the present asset sizes of the Indian Equity Funds, a huge asset size is more of a concern for schemes, investing predominantly in mid and small-cap stocks. The main reason is that such stocks happen to be relatively less liquid. The increasing corpus of a mid-cap fund can translate into disproportionately high amounts of money being invested into less liquid mid-cap stocks. This could be detrimental to your interest, if markets experience a sudden decline. A huge size can become a drag on performance. This is because even a large amount of money invested in a small but promising stock would constitute only a miniscule portion of the fund's portfolio. And should the stock perform very well subsequently, its impact on the fund returns would be meagre. Unlike mid-cap stocks, large-cap stocks are much more liquid and have the potential to absorb much higher volumes of transactions without impacting the stock price too much.

Investor concentration in the Fund

According to a study, almost 20% of India’s equity schemes are dominated by a handful of investors. Hard numbers show that a single investor holds 25-94% of the corpus of 23 equity schemes. The dominance by a handful of investors indicates the presence of corporate money, which is mostly short term in nature. Retail investors are vulnerable to investment decisions of such big investors. If they decide to redeem their holdings at short notice, the scheme might have to press panic sales, to the detriment of residual unitholders. If the single investor exits the scheme, the rest will be left in the lurch. Such schemes should be avoided.

Customer Service

Performance alone does not make a Fund a winner. Equally important is the service standards, speedy solutions to grievances of investors and transparency in actions. The reputation of the fund house among its investors and public at large indicates how well the fund scores on this front. Check with friends about easy accessibility, time taken for disbursing payments, regular portfolio updates and investor newsletters.

Tax implications of investment in Mutual Funds will be dealt with in detail in the forthcoming blogs.

Performance Evaluation of Mutual Funds - Delving deep for Debt Funds

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Delving deep for Debt Funds

The process of performance evaluation of Mutual Funds discussed so far applies to Debt Funds as well. But you need to familiarize yourself with certain aspects unique to Debt Funds. I shall outline some critical points you should consider to make an educated choice while selecting a Debt Fund.

Asset allocation

A Debt Fund invests primarily in corporate debt, government securities and money market instruments. You need to evaluate the asset allocation of the Fund to gauge its volatility. For example, prices of government securities (gilts) in times of economic and political turbulence can be volatile, and this leads to higher uncertainty i.e. more risk. A well-diversified portfolio is a strong positive. The Ideal Debt Fund has 25% in gilts, 70% in corporate debt (including financial institutions) and 5% in cash/call.

Rating profile

The quality of the portfolio is of paramount importance. Look out for securities with ‘AAA’ rating, as this will reduce the credit or default risk. The Ideal Debt Fund has 60% exposure to AAA-rated securities and 25% exposure to gilts, which have a sovereign rating.

Maturity profile

You need to see the maturity breakup of the securities and look out for paper that is at the lower end of the yield curve. This is because an instrument having low maturity carries a low coupon rate and vice versa. So any change in the interest rate has less effect on the price of the instrument of low maturity than the higher one. Moreover, there is an inverse relationship between the bond prices and the interest rate, when the interest rate falls the bond prices move up and vice versa. There is no standard maturity. Depending on the interest rate view of the fund house, the fund manager increases the fund’s average maturity or shortens it mainly through the gilt route. Maturity is normally controlled through investments in gilts which are normally at the longer end while the investments in corporate debt are normally at the short to medium end. The Ideal Debt Fund has about 40% in less than 3-year paper and 35% in 4-6-year paper.

Debt Funds come with various options - short-term plans, long-term plans and so on. You should invest in the debt schemes looking at your investment horizon. For short-term horizons you should look at investing in the liquid (for a 1 month horizon) or the short term debt plans (for 1-6 months). For horizons above 6 months you should look at the debt schemes or the long term gilt schemes. Debt funds generally don’t have entry load but most of them are subject to an exit load. A good Debt Fund has an exit load of 0.25% to 0.5% if redeemed within 3 or 6 months. You should avoid a Debt Fund having a higher load structure than stated above.

As far as performance is concerned, look at the returns given by the fund over a period of time – at least over 12 months to get a fairly good idea and 36 months to judge consistency in performance. If you want to evaluate its dividend-paying track record then look at the dividend history for consistency.

Performance Evaluation of Mutual Funds (contd.)

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Understand the risks...

THAT risk and return are two sides of the same coin is an old cliché but highly relevant in the context of Mutual Fund performance. The performance assessment of Mutual Funds should be based not only on how much a Fund gains in a bull market, but also on how gradually it falls in a bear market. This throws light on the importance of reducing risks in a falling market. But the task of the Fund Manager to add value cannot be underplayed. A fund manager who reduces risks by booking profits has also to be careful in reinvesting. If the reinvesting is badly managed, the returns may not be superior.

In general, Mutual Funds are not considered to be too risky because they invest in dozens or even hundreds of stocks. But Mutual Funds being market-linked, are prime candidates for stock market related risks. The four aspects that you should take into account while analyzing risk in Mutual Fund investment are volatility of the fund as indicated by the Standard Deviation, risk-adjusted returns as calculated by the Sharpe Ratio, Beta and Alpha. While Standard Deviation shows the degree of risk taken on by the fund, Sharpe Ratio shows the return generated by the fund per unit of risk taken. Beta shows how much a fund moves when compared to an appropriate index. Alpha represents the difference between a Mutual Fund's actual performance and the performance that would be expected based on the level of risk taken by the manager.

A Fund with low risk is the one with the lowest Standard Deviation, the highest Sharpe Ratio within its peer group, Beta closer to one and Alpha above one. It is advisable for you to evaluate these measures on a historical basis so as to identify the most consistent performers. Such rigorous research is done by some Mutual Fund sites like Valueresearch which rate the risk profile of Funds on a five-point scale.

While no amount of research can guarantee future fund performance, it certainly can reduce the likelihood of unintended risk by carefully analyzing and interpreting risk statistics. In a declining market, sometimes this understanding may just provide the marginal comfort that separates those who ride out storms from those who do not.

Diversify

Diversification can reduce risk. Depending on your risk tolerance and how long you will be investing it may be advisable to own some Equity Funds and some Bond Funds. Select funds in each asset allocation category and spread your investment. You might not get as much diversification as you think if all your funds are with the same AMC, since they may share research and recommendations. The same is true if you have multiple funds with the same profile or investing strategy; their returns will most likely be similar. Too many funds, on the other hand, will give you about the same effect as an index fund, except that your expenses will be higher. Don't underestimate the value of diversification by putting all your money into one single fund. People who put all their eggs in one basket may come home to find someone has been making scrambled eggs in their kitchen.

Like any other investment, Mutual Fund investing also has a lot of risks involved. Though the funds are managed by professionals and fund houses have adequate risk management policies in place, understanding the various risks involved in investment strategies adopted by fund managers will help you in choosing the right scheme depending on your risk appetite.