Sunday, May 29, 2011

When should I redeem my mutual fund?

For most people the decision of the redemption of a mutual fund is as daunting as that of picking the right mutual fund. Again if you try to run a google search on ‘when to redeem your mutual fund’ it returns a lot less relevant results than when you search for ‘how to select a mutual fund’! And I have heard an investment manager once remark on TV that it takes a certain degree of expertise and proficiency to redeem your mutual fund investment at the right time. However, it is not all rocket science and all it takes is just basic common sense decisions. This article is not on learning how to ‘time’ the market and redeem your mutual fund but on when to redeem it since it is no longer prudent to hold your mutual fund. There are several reasons as to why you should redeem your mutual fund but the most common and top reasons for the same are as follows:

1. You have achieved your investment objective: Every investment is made with some specific objective like paying for your child’s education, marriage, purchasing a house or any other objective. If your fund is performing more or less on expected lines and you haven’t met your investment objective then it makes no sense to redeem your fund. However if you have achieved your investment objective or are close to achieving your investment objective, then you should slowly start redeeming your fund, so that you are completely liquid in cash by the time you would need to pay for your goal (like purchasing a house).

2. The Star Mutual Fund Manager has quit: The performance of your mutual fund is inextricably tied to the capability and investment acumen of the fund manager. A lot of investors check the track record of the mutual fund manager and not just the performance of the fund which is indeed a wise decision. However, in the mutual fund industry, you would see a lot of churn amongst fund managers and trying to follow a star fund manager may result in you having to switch among fund managers quite a bit. Unless you are sure that the fund manager can give really significant results with respect to others, it makes sense to invest in process-driven fund house since this is a more reliable way of investing.

3. Your mutual fund is not performing: I have heard several people complaining about the performance of their mutual fund. However most people tend to look at the performance of their fund in the short term. Evaluating a mutual fund in the short term would give you an erroneous view of the performance depending on the state of the markets. To correctly understand the performance of a mutual fund, you should consider its performance over a period of at least 3 -5 years. However, even after all this you are convinced that your mutual fund’s performance is below par, then it’s best you redeem it.

4. You have invested in a thematic fund: In one of my earlier articles, I had mentioned the dangers of investing in a thematic fund. The problem of investing in thematic or sectoral funds is that if the whole sector is hit by some macro economical or regulatory factors, your mutual fund performance would dip significantly. You should not invest in a thematic fund unless you have sufficient knowledge about the particular sector and you have good reasons to believe that the particular sector is poised for considerable growth. Most investors do not have the necessary skills and resources to track the underlying sector/theme. They only got invested in them either because everyone they knew was investing in them or their agent made a compelling marketing pitch for the fund. Either ways they are invested in the fund and want to know when they can redeem. If you are one of them, then the right time to redeem your thematic fund is when the stock markets give you the opportunity. A market rally is an opportunity for you to sell that thematic/sector fund that you always wanted to redeem but could not because of unsuitable market conditions.

For example: Several people had invested in Telecom Sectoral funds 3-5 years back when the telecom sector was booming but currently due to the intense competition and a price war in the sector, the companies and the funds in that sector aren’t doing too well.

5. Your mutual fund has revised its investment process/mandate: Mutual fund managers have certain guidelines’ about how they should manage their funds which is commonly known as the fund mandate. A mandate has been formally stated and hence a lot of investors choose funds based on this mandate. Sometimes mutual funds revise their mandate, if they believe that they can perform better following another investment process. In the event of a revision in the mandate, regulations require that investors be given the option to redeem the mutual fund without an exit load, so you can redeem the investment without worrying about the exit load (if any). So if you had invested in a fund because of a certain mandate and if the revised mandate does not interest you, then you should redeem your fund.

Saving vs Investing

I had lunch with an old friend of mine last week whom I was meeting after a couple of years. My friend, a young hardworking guy, had recently made a smart career move and was now thinking of settling down and during my discussion with him, we were reviewing some investment decisions he had made a few years back and he was telling me about how he felt that his ‘savings’ weren’t satisfactory enough. However I noticed throughout my discussion that my friend was using the words ‘investments’ and ‘savings’ interchangeably. However I discovered that a lot of people confuse between the two and there are some similarities between the two, however they are two very different entities with different objectives and characteristics.

Savings is defined in the dictionary as ‘The accumulation of money for future use’ while an Investment is defined as ‘the laying out of money or capital in an enterprise with the expectation of profit’. Dictionary definitions aside, an investment is where you can grow your money at a significant rate after taxes. The current inflation in India is at about 8-9% which is pretty high. There are a lot of people who say that this is an aberration and in the long term inflation would settle down at about 5%. I do not know what the future holds or when the inflation would settle down at a more reasonable rate but what I do know is that if you keep your money in your savings bank account, you are losing the purchase value of your hard earned money which is akin to losing money. If you have put in your money in some financial instrument which earns you a ‘real’ return which exceeds the inflation rate, I would say that it has the characteristics of an investment.

A ‘saving’ is basically the accumulation of a certain amount of money in your ordinary savings account or even debt funds or in your piggy bank to fund some big ticket purchase like a swanky vacation, a car, a higher education degree, an iPod or that new plasma TV! (Cars, LCD TVs etc are not investments since they start depreciating in value the moment you step out of the showroom!).Your savings rarely return more than inflation after accounting for taxes.

Investments usually employ two methods through which they grow the invested money

1) By giving a regular cash flow like rent from real estate, royalty from books or art etc.

2) Value appreciation of the assets purchased (eg. Value appreciation of stocks, real estate, gold and other commodities)

Most investments are based on value appreciation, since the opportunities for cash flow are limited. Investments which give a high return in the long term (like shares or equity mutual funds) usually carry a certain amount of risk. However it has been historically proved that no investment can beat the returns that equity can give in the long term.

Investments are for your future while savings are for your present needs. It would be prudent to keep at least 40% of your surplus cash in investments which by their very nature are for a long term holding. Keep some amount as savings also to meet your planned purchases and any unexpected expenses (like hospitalization or an unforeseen expense). The more you are able to invest, the more corpus would you have in your future. The more you have in your long term fund, the more stable our future is financially.

Sunday, May 22, 2011

The problem with (too much) Diversification

Diversification (n) - The act of introducing variety (especially in investments or in the variety of goods and services offered). Diversification is something all financial planners suggest sticking to the adage – ‘Not putting all the eggs in one basket’. Though this strategy makes a lot of sense, I have rarely seen people follow this strategy in its right sense. People other over-diversify or diversify within a sector (like buying a lot of funds all which invest in real estate stocks), both of which defeats the purpose of the strategy of diversifying. The real purpose of diversification is to minimize risk by spreading your investments across different stocks or assets, so that in case one of them does badly, the performance of the other assets or stocks would ensure that the average performance of your investments are good.
I was prompted to write this article when a friend of mine recently showed me his portfolio of funds. He owned a total of 23 funds! And his reason for investing in so many funds was because he thought that was ‘diversifying’ and by doing so he would get good returns at a lower risk! The result

Monday, May 16, 2011

Fixed Deposits: To Switch or not to Switch?

Fixed Deposit rates have in the recent 2 weeks gone up significantly. If you remember the rate offered by banks last year (May 2010) for a 2 - 3 year Fixed Deposit, it was around 7 – 7.5%. The current rates offered are significantly higher at almost 9% with some banks offering even up to 9.5% for a 3 year fixed deposit (check the section on Fixed Deposits to see the table with details of bank Fixed Deposit rates). So the question now is – ‘Do I switch my fixed deposit by foreclosing my Fixed Deposit and re-investing it at the higher rates?’ This question may seem a no-brainer and may seem ridiculous because you can see that you can clearly earn a higher return! However before you take the plunge you must look closely at your current Fixed Deposit and ask yourself the following questions:

1. What is the pre-closure penalty that I will be charged?

      2.   When will my original fixed deposit mature (check the tenure)?

1. Pre-closure penalty: When you put your money in a Fixed Deposit after listening to your friendly manager, you probably did not ask about and neither were you told much about the pre-closure rate, in case you closed your Fixed Deposit before the term ended. The pre-closure rate varies from bank to bank and also may vary depending on how much of the term has passed. This pre-closure penalty is charged irrespective of whether you reinvest in the same bank. Therefore as a depositor it is paramount that you assess whether the new rates that you will receive will cover the penalty that may be charged to you when you pre-close your Fixed Deposit.

2. Tenure of the Fixed Deposit: If your Fixed Deposit term is just about to end, then it may not make sense to pre-close your Fixed Deposit. Also the current 1 year deposit rate available in the market is a maximum of 9.25%. But with pre-closure charges of 0.5%-1%, it doesn’t make sense to break an FD if you are going to reinvest it for less than 2 years, since you wouldn’t be able to get any advantage of a higher return after the pre-closure penalty.

A switching strategy is advantageous if a depositor wants to re-invest for a period of more than 2 years and a depositor should look out for the best deposit rates available and invest accordingly. For a list of deposit rates, check the section on Fixed Deposits.

Monday, May 9, 2011

Endowment Policies - Are they really good products?

Endowment policies are a very popular asset class in India and are promoted by most insurance companies and insurance agents. Life Insurance Corporation of India (LIC) has a lot of products which are endowment insurance products and these are one of the most popular products in its kitty. This is another product which tries to combine insurance and investment. I have seen a lot of people buy this product without properly understanding what an endowment policy is and simply buy it because it is being sold by a ‘known’ agent from LIC. In this article, I shall explore the merits and demerit of an endowment plan and shall let the reader decide for himself/herself if it makes sense for them to take an endowment plan.

Firstly, an endowment policy is like I have mentioned before, tries to combine insurance and investment. The life of the individual is insured for a certain amount (referred to as sum assured in an endowment policy), So the amount you pay every year or quarter (known as ‘premiums’ in insurance parlance), is allocated towards the sum assured, administrative charges and what remains is then invested.

An endowment policy rewards its investors by means of a ‘bonus’ every year. The amount of bonus declared every year, differs from company to company and on fund performance. The bonus declared is declared in the form of a proportion of the sum assured. For example if the sum assured is Rs 5 lakhs (Rs 500,000), and the company declares a bonus of Rs 50 per Rs 1000 of the sum assured, then the bonus works out to be Rs 25,000. However, unlike stock dividends or mutual funds, the company does not pay out the bonus immediately. It is paid only when the policy matures or the policy owner passes away. The bonus does not compound but only accumulates (unlike your Bank Fixed Deposits where your interest compounds). To explain how this works, I shall illustrate using an example: Take the case of a 35 year old person who takes a policy with an assured sum of Rs 5 lakhs with a term of 20 years. The premium for this would be roughly around Rs 25,000. If at the end of the first year, the insurance company declares a dividend of Rs 50 per thousand or 5% of the sum assured which works out to be Rs 25,000. Since this bonus does not compound, this amount stays the same till the end of the remaining 19 years and this is the same for all the further bonuses being declared. However I must point out that it is not very likely that an insurance company would declare a 5% bonus every year. There could be years where the bonus payments could be lower.

Why is compounding important?

To answer this question, let us continue with our above example. If the insurance company continues to pay you 5% bonus every year, you would have accumulated Rs 5 lakhs of bonus by the end of the 20 year period. Hence you get Rs 5 lakh of assured sum and Rs 5 lakh of your bonus at the end of 20 years. You have achieved this by paying Rs 25,000 per year for 20 years. This is NOT an impressive return at all! This actually amounts to a return of just 6.39% per annum!
Had an individual taken a term insurance which covered the person for Rs 5 lakhs and invested in Provident Fund his returns would have been much higher. For example, a term insurance covering a person for Rs 5 lakhs for a period of 20 years would amount to an annual premium of about Rs 2,500. Subtract this amount from the Rs 25,000 premium you are paying for the endowment policy and it comes to Rs 22,500. Invest this amount in a provident fund for 20 years (at the rate of 8.5%). At the end of 20 years you receive 10.88 lakhs viz. Rs 88,000 more! The other point to be noted is that the return from a Provident fund is non-taxable and guaranteed while you can never be sure of the amount of bonus being paid out by an insurance company!

Conclusion: I would advise risk averse investors who do not want to invest in mutual funds or equity products to take a term insurance and invest in Provident Fund Account instead of buying an endowment plan. Once again I would like to re-iterate that insurance and investment are two important albeit different goals. Do not try to mix up both and be very careful about products which try to mix both!

Tuesday, May 3, 2011

The Quandary of Investing

Have you ever had a relative or family friend call you up and tell you - “Now that you are earning, have you thought about your future and investments to save tax?” And you are surprised and start thinking as to why your relative/family friend suddenly was interested in you saving tax and making investments, till they drop in their next line – “ I am an ‘investment advisor’ and I have this product wherein you have to make yearly payments and you see an overwhelming return on your investment.” You now really don’t know what to say and then he/she starts off with the story of how Mr. Ravi – another relative/family friend that both of you are acquainted with, doubled his money in 2-3 years by investing in this particular fund/instrument. If you are somebody who earns more than Rs 50,000 per month (varies from bank to bank), you may even have ‘wealth advisors’ call you from your bank who would want to advise you on investments! A few of my classmates from my MBA class are wealth advisors with certain banks and from what they have told me, you really wouldn’t want to take your wealth advisor’s call seriously especially if the advice comes ‘free since you are a premium client’. Wealth advisors in most banks are given a target of the number of products to sell and these poor souls call up their clients and try to pitch in as many products as possible! So much for wealth management!