Prakhar Jain, 27, has been working for a few years. He usually invests in fixed deposits for saving tax. This year, encouraged by rising stock markets, he wants to put money in mutual funds. He admits he stayed away from mutual funds earlier as he did not know much about them. The main trigger now is the fall in rates offered by banks on fixed deposits.
Nilesh Baddi, a Mumbai-based software engineer, used to invest intermittently in mutual funds and keep most of his savings in fixed deposits. He has now shifted completely to mutual funds and enrolled for a systematic investment plan, or SIP, in tax saving mutual funds.
Nilesh, and other like him, are a happy bunch -- the S&P BSE Sensex, the broad equity market indicator, has delivered a return of 25 per cent so far in 2017, after a decent run over the past two-three years. Investors, encouraged by this and facing a shortage of alternatives offering decent returns, are pouring money into mutual funds like never before. For instance, equity mutual funds received net inflows of `1.05 lakh crore between January and October, as per AMFI (Association of Mutual Funds of India) data compiled by CMIE. Over the past three years, there has been a net inflow of close to `1.67 lakh crore in equity mutual funds. Industry assets under management, or AUM, touched an all-time high of `21.4 lakh crore as on October-end with equity AUM at `6.3 lakh crore. The trend has pushed up returns too. For instance, large-cap equity funds have delivered an annualised return of close to 11 per cent over the past three years. The best performing category, small-cap, has delivered 23 per cent (See The Top Performers).
Although it is encouraging to see investors put money into mutual funds to build wealth for the long term, it is important for investors to enter with the right expectations and clear understanding. Otherwise, they will be left with a bad taste for equity investing.
In our 12th anniversary isssue, we discuss some aspects of mutual fund investing after analysing the recent behaviour of investors. We have also shortlisted, in partnership with ValueResearch, 50 best mutual funds for you.
The SIP Way
SIPs have gained a lot of popularity in the recent past. As per the data by CAMS (Computer Age Management Services), the registrar for asset management companies (AMCs) accounting for over 64 per cent of the industry AUM, live SIP accounts more than doubled in the past three years and touched 1.10 crore in September 2017, from 50 lakh in September 2015. The average size of a SIP increased from `2,550 to `2,955 over this period. CAMS CEO N.K.Prasad attributes the surge to increasing awareness among investors. "Concerted efforts by mutual funds, AMFI and intermediaries have contributed to spreading awareness. Investor conveniences such as Aadhaar-based eKYC and digital platforms have also helped," he says.
The best part is that most of these SIPs are coming from those looking at investing for the long term, say experts. "While in the 2005-2007 boom period, investors registered SIPs for one-two years, this time the majority of SIPs are being done by people in the age group of 25-30 for perpetuity or with a tenure of 8-10 years. This indicates that these people will continue investing and not run away at small corrections," says Manoj Nagpal, CEO, Outlook Asia Capital.
When an overwhelming number is investing through SIP, it is important to know a few things about SIP.
Is SIP Risk-proof?
Every investor should understand that risk and volatility are part of equity investing. Under SIP, one invests a fixed sum at regular intervals. This provides the benefit of rupee-cost averaging - basically, as a person invests across market cycles, the cost is lower when markets are down and investors are rewarded when markets go up. There is no need to time the market. In a lumpsum investment, there is always a chance that the person is investing at a market peak.
However, investors should understand that SIP does not guarantee any return, and you may lose money in a prolonged bear phase. Data compiled by Value Research show that even five-year SIP (average SIP return of all open-ended equity funds) gave negative returns on a few occasions during the first quarter of 2009, when markets touched bottom in the bear phase starting January 2008.
Making SIP work
However, if one looks at the 10-year graph, there is only a brief period during which a five-year SIP yielded negative returns. The highest (average of equity funds) five-year SIP return over the past 10 years is 54 per cent, while the lowest is negative 5 per cent.
SIP works best in a bell curve-like market; you get more units when the market is down or is just starting to rise. However, as one can't predict market bottoms and peaks, its best to start as soon as one can. And remember, the worst thing an investor can do is to stop his or her SIP in a falling market. So, even if markets fall just after you start a SIP, don't stop. Even if you had started investing at the peak of the bull phase (the worst time to invest), in January 2008, your five-year returns wouldn't have been negative.
"SIPs should ideally be for long tenures. One should not discontinue midway on account of market conditions as it helps investors make the most of market corrections, especially when it comes to long-term investments, through rupee cost averaging," says S. Naren, ED & CIO, ICICI Prudential AMC.
In the 2003-2007 bull run, many first-time investors started with thematic/sectoral funds as they were performing well then. Infrastructure funds, in particular, received huge inflows. A lot of people also invested in new fund offers, or NFOs, without understanding if the fund was right for them or not. As markets tanked in 2008, many saw their investments go down by more than half. Some mid- and small-cap funds destroyed as much as 80-90 per cent investor wealth. However, investors no longer chase NFOs, as fund houses also refrain from launching too many new funds with specific themes, partly due to regulatory pressure.
However, inflows in good performing funds have been robust. This is especially true of some mid- and small-cap funds. But before you get all excited, remember the disclaimer that "past performance is no guarantee of future returns". While it is true for all categories of funds, mid- and small-cap funds generally do better during market rallies but are likely to hit harder during slumps compared to their larger counterparts. Therefore, investors should not chase funds that have done well in the recent past and look at asset allocation and performance across market cycles. "When evaluating funds, we recommend investors analyse their performance across market cycles and also in terms of style consistency," says Anand Radhakrishnan, CIO, Franklin Equity, Franklin Templeton Investments India. "The average weight an investor gives to past performance while selecting a fund is 70-80 per cent. The rest is brand," says Nagpal of Outlook Asia Capital. And most look at the performance over just one year, he says. Nagpal says 25-30 per cent weightage should be given to past performance and the rest to investment philosophy of the fund house, consistency of returns and capabilities of the fund manager. "People should not invest only after seeing returns of a couple of years because a true test of a fund manager is not his performance in a bull market but his performance across market cycles," says Vikash Agarwal, Co-founder, CAGRfunds.
Some funds keep changing allocation to large-, mid- and small-cap stocks. Many mid- and small-cap funds can end up holding a significant portion of money in large-cap stocks after a run-up in the market. Many multi-cap funds also focus on just large-caps. This may impact the asset allocation of investors and make it difficult for them to compare the different funds.
To avoid this, Sebi, the capital market regulator, has come out with a new classification of mutual funds which Nagpal believes will make it easier for investors to understand their investments and discourage funds from straying from their mandate. As per the new classification, mutual fund schemes will be classified into five broad categories - equity schemes, debt schemes, hybrid schemes, solution-oriented schemes and other schemes. Solution-oriented schemes will be retirement/childrens funds.
The step will make the schemes comparable, which is right now difficult, as each fund has its own definition of large-, mid- and small-cap stocks. That is why, even in the large-cap category, the weighted average market capitalisation, according to Value Research, ranges between `29,000 crore and `1,90,000 crore. In order to ensure uniformity, Sebi has given definitions of large-, mid- and small-cap stocks. Large-cap will be defined as 1-100 companies in terms of full market capitalisation. Companies from 101 to 250 will be termed as mid-cap companies. Companies starting from the 251 rank will be classified as small-cap companies. "This new classification will ensure that if a person has invested in a large-cap fund, he will remain invested in a large-cap fund throughout," says Nagpal of Outlook Asia Capital. Also, there will be no duplication of schemes, as it is happening now, where fund houses have two or more schemes in the same category that are run according to a similar strategy. The classification of debt funds has also been made clearer on the basis of the weighted average maturity of the portfolio. New categories have been introduced, such as overnight funds, which will invest in securities with a duration of just one day. For hybrid funds, the nomenclature has been given according to the equity-debt allocation.
Another trend in this bull run is the rising popularity of balanced funds. As per the AMFI data compiled by CMIE, these funds have received an inflow of `1 lakh crore over the past three years. As per Sebi's new classification, these funds will be called aggressive hybrid funds. Funds which allocate 40 per cent assets to equity and 60 per cent to debt will be called balanced funds. However, as fund houses are yet to make these changes in their names, we will continue to refer them as per the old system for ease of understanding.
Balanced funds are hybrid funds. They invest at least 65 per cent assets in equities and the rest in debt. The debt provides cushion when equity markets fall and, hence, makes these funds less volatile than pure equity funds. Over the long term, balanced funds have delivered similar returns as large-cap equity funds and that too with lesser volatility. During the 10-year period ended October 27, balanced funds delivered an annualised return of 9.23 per cent while large-cap funds returned 7.72 per cent. During market falls of 2008 and 2011, balanced funds had fallen 41 per cent and 19 per cent, respectively, compared to the 52 per cent and 24 per cent fall registered by large-cap funds on an average. However, during market rallies, returns by balanced funds may not be as high as those delivered by pure equity funds. The ability of balanced funds to deliver equity-like returns with lesser risk makes them suitable for first-time investors or those who want to take exposure to equities but are conservative. Balanced funds also offer tax advantages. Any fund that invests at least 65 per cent in stocks is termed an equity fund for taxation purposes. Therefore, dividends and capital gains after one year are tax free despite balanced funds investing 35 per cent money in debt instruments.
Balanced funds also maintain their equity and debt allocation at the predetermined level and, as a result, provide automatic asset balancing. The fund manager keeps booking profit from the asset that is doing well and investing that in the asset that is underperforming and so is undervalued. These benefits make them a good core of a portfolio of first-time investors who want to benefit from equities but are relatively conservative.
Misselling in Balanced Funds
However, there are reports of misselling in balanced funds (aggressive hybrid equity) with investors buying them as an alternative to fixed deposits. Nagpal says, "The worrying part is that many 50-plus individuals are doing lumpsum investments in balanced funds. As balanced funds invest predominantly in equities, such investors may be hit hard."
Balanced funds are a good product and have the potential to deliver equity-like returns with lesser volatility. But remember these are market-linked products and, therefore, volatile. Also, no mutual fund, be it equity, debt or hybrid, can guarantee returns. "Investors should be aware that the dividends paid are their own money. If you are a long-term investor, you should rather keep your money invested in the growth option, unless you need regular income. Dividends can be paid only from realised gains, so guaranteeing dividends is impossible. As the fund grows, the ability to pay dividends reduces, unless there is regular profit-booking in portfolio stocks, which is not desirable for a long-term investor," says Kaustubh Belapurkar, Director of Fund Research, Morningstar Investment Adviser. There are a wide variety of hybrid funds depending on equity allocation and tax advantage. Investors should choose wisely depending on their risk appetite.
New Hybrid Funds
Fund houses have of late launched different types of hybrid funds with varied equity and debt allocations. The conventional options have been balanced funds and monthly income plans (which invest up to 5-25 per cent in equities). Then, there are asset allocation funds which invest in equity and debt depending on market valuation metrics such as price-to-equity (PE) ratios and/or price-to-book value (PBV) ratios. However, despite being in existence for over a decade, these funds haven't caught the fancy of investors as their returns haven't been very impressive. Apart from this, these funds get the same tax treatment as debt funds as they are mostly fund-of-funds.
Fund houses have come out with a new improved variant of hybrid funds which are more tax efficient (this is one reason for their rising popularity in recent times). Need to explain how. "The new type of hybrid funds (balanced advantage and equity savings) cater to investors who are conservative and are looking for alternatives to fixed deposits. This has increased their popularity in the recent times," says Nagpal of Outlook Asia Capital.
Balanced advantage funds, just like asset allocation funds, invest in equity and debt depending on quantitative models based on market valuation parameters such as PE and PBV ratios. However, they invest directly in equities and debt, unlike asset allocation funds, which are mostly fund of funds. They are designed to be more tax efficient as they use equity derivatives in case their equity allocation falls below the 65 per cent required to get the same tax treatment as equities. Dividends and returns after one year are tax free, just like from equity and balanced funds.
However, direct equity exposure can go up to 80 per cent if market valuations are favourable, while in case of unfavourable valuations, it can go as low as 30 per cent. By managing their asset allocation dynamically, these funds are likely to be less volatile than regular balanced funds, which deviate less from their predetermined asset allocation. These funds suit investors who don't want to take much risk and are willing to forgo some returns for a smoother ride.
Equity savings/income funds are basically a tax-efficient alternative to monthly income plans as direct equity exposure is 20-40 per cent depending on the market situation. However, to meet the threshold limit of 65 per cent (for tax advantage), these funds also use derivatives. The remaining goes into debt. The returns are much more predictable. Different hybrid funds have different allocations to equity, debt and derivatives. Therefore, investors should choose on the basis of the equity component they are comfortable with.
Have clarity about your financial goals and invest in line with them rather than randomly choosing any fund under anybody's influence. Ask as many questions as you can to your advisor to understand the product before investing. If you don't understand the product, you may invest with wrong expectations and be disappointed. Even returns from equity funds may not be as good as they have been in the recent past as markets are at all time high, say experts. Therefore, investors need to be realistic if they are entering now and continue investing for the long term through SIP.
"With interest rates and inflation at a low, investors shouldn't anchor at the past performance. Keep a firm grip on asset allocation," says Radhika Gupta, Chief Executive Officer, Edelweiss Mutual Fund.