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ELSS Mutual Funds or Equity Linked Saving Schemes offer you a simple way to get tax benefits under Section 80C of The Income Tax Act 1961, while aiming to make the most of the potential of the equity market investing. Therefore, if the question how to save tax is bothering you, you can have a look at investing in ELSS tax saving mutual funds!

ELSS tax savings schemes are an open-ended equity mutual fund that doesn’t just help you save taxes, but also gives an opportunity to grow your money. It qualifies for tax exemptions under section (u/s) 80C of the Indian Income Tax Act 1961. Equity Linked Saving Schemes (ELSS) are essentially diversified equity mutual fund schemes, which invest in a diversified portfolio of stocks across different sectors and market capitalization segments for generating capital appreciation for investors over a sufficiently long investment horizon.

Section 80C and how do the deductions work

If you are worried about how to save tax, please note that when you invest in certain schemes like ELSS Tax Saving funds, Public Provident Fund (PPF), Tax saving bank fixed deposits, NSC and Life insurance premiums etc. you can claim up to Rs. 150,000 in a financial year as a deduction from your gross total income under The Income Tax Act, 1961.

The Table below will help further explain how this works –

 

(Illustration of Tax exemption for an individual less than 60 years in receipt of salary income for the assessment year 2019-20)

 

From the above chart you can see that, if you invest Rs 150,000 in any investment option under Section 80C including Equity Linked Saving Schemes, you can save substantial amount of taxes.

Why invest in Tax Saving Mutual Funds?

• • High returns

    – By investing in tax saving mutual funds, you get an opportunity to grow your money by investing in equity mutual funds. In the last 5 years, ELSS tax savings mutual funds category average returns have been over 18.50% annualized (source: Valueresearchonline)

 

• • Tax efficient

    – Long term capital gains (LTCG) realized from ELSS mutual funds is taxed at only 10% if your total capital gain in the year of withdrawal is over Rs 1 Lakh. There is no capital gains tax if the total profit is less than Rs 1 Lakh in a FY. There is also no short term capital gains as the units of ELSS mutual funds are locked-in for 3 years from the date of investment.

 

• • Least lock-in period

    – ELSS mutual funds has the least lock-in period, i.e. only 3 years compared to PPF which is 15 years and NSC and bank fixed deposits which is 5 years.

 

• • Dividend payout option

    – You can opt for dividend payout option on your investments in ELSS mutual funds. It helps you realize some potential gain during the lock-in period of 3 years. However, if your investment horizon is long and you do not need any earnings in the interim, you should opt for the growth option. You must also note that dividend payments are made from the NAV of the Scheme and therefore, the NAV of the scheme will fall to the extent of the dividend payment on the date of dividend. Dividend payments are also subject to availability of distributable surplus/ profit made by the scheme and totally at the discretion of the fund manager.

 

• Systematic investing

  – If you do not have lump sum amount in hand and worried about how to save tax, you may start investing in ELSS mutual funds through systematic investment plans (SIP). SIPs help you invest a fixed amount every month on a fixed date in the ELSS mutual fund scheme of your choice. A SIP inculcates the saving habit and brings a sense of discipline in you without having to worry about investing a big amount at the end of the financial year for saving taxes.

Features of ELSS and other tax saving instruments under Section 80C

Let us now compare the features of Equity Linked Savings Schemes and other popular tax saving investment options under Section 80C of The Income Tax Act 1961.

 

 

As you can see in the above chart the feature of ELSS Mutual Funds are most attractive as it has the least lock-in period of 3 years and the potential returns are much more than the returns of any other tax saving investment options. Over and above this the returns of ELSS mutual funds are tax efficient too!

Therefore, knowing how to save tax is important but knowing where to invest for saving taxes is even more important. Even though the investments in tax saving mutual Funds are subject to market risks, they are one of the best tax saving investment options for investors with a long investment horizon. ELSS mutual funds has given annualized returns of over 18%, 12% and 11% respectively in the last 5 years, 7 years and 10 years period (Source: CRISIL – AMFIELSS Fund Performance Index March 2018) which makes it the most attractive investment option for savings taxes provided you are ready to take a bit of risk with your investment.

Many of us approach tax planning as a recurring headache that has to be got rid of somehow. As the end of the financial year approaches and the accountant asks for investment proofs, we tend to scramble for any tax-saving investments. Many of us even fall prey to unscrupulous salespeople, who peddle us some investment product not quite suited to our needs. Once we have unwittingly put our money into some investment, we feel the job is done. Later, we forget about the money.

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Not planning for your income tax properly is a serious investment mistake. As the process described above is repeated over the years, your chances for wealth creation are diminished. Here is how. Let’s say you invest the entire tax-exempt amount of Rs1.5 lakh in a mutual fund every year for 40 years at 12 per cent rate of return. After 40 years, you will have Rs12.89 crore. You get this enormous sum without making any additional investments but just by carefully investing your tax-saving money. So by not taking your tax-saving investments seriously, you actually lose the opportunity to build wealth in a simple manner.

But what exactly stops us from making prudent tax-planning decisions? The devil lies in deferring the tax-planning activity to the last moment. The right way to plan for your taxes is to start investing at the beginning of a financial year, not when it is drawing to a close. By systematically investing in tax-saving plans, also called equity-linked savings schemes (ELSS), you can bring discipline to your approach.

Just pick one or two good tax-savers and start SIPs in them at the start of the financial year. You can even opt for the auto-deduction facility. With it, the specified amount gets debited from your bank account periodically and is invested in a fund. This does away with manual intervention and hence precludes missing out on your monthly investment.

Another benefit of SIPs is that they help you invest over the market cycle and hence you don’t catch a market peak. What does this mean? Let’s say you are suddenly reminded that there is something such as tax planning and you have to invest in the next two days to avail tax benefits. You quickly find an investment, say, a mutual fund. You invest Rs1.5 lakh in it in one go and feel happy that the job is over. But you don’t realise that the stock market was at its peak when you made that investment. As the stock market corrects, your investment goes into red. It takes many months or perhaps years to recoup your losses.

With SIPs, you could have avoided this. Since SIPs help you invest over the market cycle, you invest at both market highs and lows. This averages your cost. You automatically buy fewer units when the market is high and more when it’s low. A market downturn doesn’t hit you as much hard as it would have if you had invested a lump sum.

Properly investing your tax-saving money through SIPs kills two birds with one stone: you save the tax outgo and you build wealth. What else could be a better deal?

As an investor, I like to keep myself abreast with latest developments in the market by regularly visiting stock market and mutual fund related websites. Also, my interest in what investors are thinking, takes me to discussion threads on a few online discussion boards. A lot of the content on these portals, especially stock market related portals and discussion boards are centered on specific stocks. The mutual fund portals often have content on broader investment principles, but based on the comments and queries received by Advisorkhoj, I get a sense that investors are looking to invest in the best mutual funds.

While multi-bagger stocks have created wealth for investors, these stocks are very difficult to identify by average retail investors, more so at the right price – the endeavor to create wealth by investing heavily in stocks that you expect to multiply 10 – 15 times can be risky. The secret to wealth creation is actually much simpler, the power of compounding.

What is power of compounding?

Power of compounding is essentially making your money work for you. Think about a daily wage laborer – if he works for 300 days, he will get more money than if he works for 100 days. Your money, if invested wisely over a long investment horizon, is like a daily wage laborer; every extra day your money works, will get you incremental money. Let us now understand it from a theoretical perspective.

Money when invested earns returns – how much returns it earns, depends on the asset class and asset type. Historical data shows us that, equity is the best performing asset class in the long term. Returns earned by your investments get added to your investments and the overall amount earns higher returns.

Let us assume you invested Rs 10 lakh @ 15% returns. After 1 year, you will make a profit of Rs 1.5 lakhs. This profit, unless it is withdrawn, will get added to your investment and your investment amount will be Rs 11.5 lakhs. In the second year, at the same rate of return, you will make a profit of Rs 1.72 lakhs, more than what you made in year one. This profit of Rs 1.72 lakhs will get added to your investment and your investment amount at the end of year two will be Rs 13.2 lakhs. In the third year, at the same rate of return, you will make a profit of Rs 1.98 lakhs. The chart below shows the cumulative profit growth every year.

 

 

You can see that the profit growth is not linear but exponential. By year 5, the cumulative profit is more than your investment amount. By year 8, the cumulative profit is more than double your investment amount and by year 10, the cumulative profit is more than three times your investment amount.

SIP and the power compounding

Power of compounding is not as much about what you buy and how much you buy, as it is about how you buy and how you manage. Sounds confusing? Let us illustrate with the help of an example.

Let us assume that you invest Rs 10 lakhs in lump sum in a mutual fund, which will give 20% CAGR returns, for 10 years. 20% CAGR over 10 years, is a pretty aggressive assumption, but for the sake of the argument, let us assume you were lucky enough to invest in such a fund. What will be your investment value after 10 years? Rs 62 lakhs, more than 6 times returns in 10 years, which is quite impressive.

Let us now assume, you invest Rs 30,000 every year over the next 30 years – in total, you invest Rs 9 lakhs. Let us further assume that you get a CAGR return of 15% over 30 years. What will be your investment value after 30 years? Rs 1.5 Crores, nearly 2.5 times what you got by investing in lump-sum, that too by investing Rs 1 lakh less and at lower annualized returns. The chart below shows the cumulative profit growth for annual investments.

 

 

Investing is not just about money, it is more about time. This is the essence of power of compounding. The power of compounding is more magnified in SIP, because you can start with a smaller amount, invest regularly and remain invested longer.

Let us take this example further. You got Rs 1.5 Crores by investing Rs 9 lakh over 30 years (Rs 30,000 per annum) versus Rs 62 lakhs by investing Rs 10 lakhs in lump sum over 10 years. Let us now assume that, instead of investing Rs 30,000 on an annual basis, you spread the same annual amount over 12 months, in other words, you invest Rs 2,500 per month over the next 30 years. The tenor of investment remains the exactly the same to what it was when you were investing annually, but what will be your investment value after 30 years? Rs 1.75 Crores, which is Rs 25 lakhs more than what you got from the same investment capital, over the same tenor!

You got the extra returns because you were investing monthly instead investing annually – this again is a demonstration of the awesome power of compounding. By investing on a monthly basis you made your money work harder (instead of being idle throughout the year).The chart below shows the cumulative profit growth for annual investments.

 

 

Rupee Cost Averaging

Apart from the power of compounding, SIPs enjoy another major advantage, especially in equity mutual funds. Equity as an asset class is intrinsically volatile – prices move up and down on a daily basis. You may like to read here why mutual funds are the best investment class?

By investing through mutual fund monthly SIPs, you will be able to take advantage of volatility by investing at various price levels. This is known as Rupee Cost Averaging. Over long investment tenors, asset prices will follow a secular trend (unaffected by short term volatility). Therefore, rupee cost averaging of purchase price can help you get enhanced returns in the long term.

Would you not like to know why continue with SIPs even in higher markets

Conclusion

Power of compounding is simple to understand, but we often do not realize its potential. In this blog post, we discussed the importance of power of compounding in wealth creation. Once you get a sense of the potential of compounding, you will realize that you can have considerable control over your financial destiny – more than what you would have imagined earlier.

Mutual SIP is a convenient, hassle free way of exploiting the power of compounding from your regular monthly savings – in fact, once initiated your financial plan can run on auto-pilot with SIPs. All that is required on your part is patience and discipline.

In case you are looking for superior investment planning with mutual fund SIPs, do read this.

A doctor friend will occasionally send a desperate SMS asking for clarity on the Narendra Modi government’s track record. He says he can’t make sense of the truth, flooded as he is with WhatsApp forwards, news, views and chatter that is so polarized that it looks like the messages are talking about two different countries. The next 10 months will see this divide get sharper and nastier as we roll up to Elections 2019.

The first thing we need to do when we enter this debate is to discard evidence by anecdote. For every anecdote from one side of the debate, the other side can give two more. My anecdote will always be more real to me than your story. Let’s stay with numbers. But numbers can also be hotly debated—depending on whether the GDP number is up or down, the validity of the data has been discarded or accepted. While numbers like the GDP or inflation or even manufacturing growth or investment are subject to a methodology which can be open to debate, the one number we can’t either fix or ignore is the Sensex, the broad market index made up of 30 companies. The Sensex seems to like it when Modi Sarkar wins elections. Look how it rose and then fell as the Karnataka elections changed colour from saffron to a muddled something.

What does the Sensex reflect and why should we take it seriously? The stock market is a place where a firm lists seeking public participation in its equity shares. The largest, best capitalised and most representative firms of the market find their way into a bellwether index such as the Sensex. A price on the stock market is that one number that carries in it all available public information about a firm, and when we extend this to a board market index, we get a number in which the expectations of the future are reflected. The price today is a call on what the market expects will happen tomorrow.

The stock market loves Modi Sarkar, as it does any other sarkar that promises growth; the Sensex is neutral to the colour of the political party. What does the market know today that the rest of us don’t or are debating? I think the market is reacting to three things coming together. One, political stability. Two, attack on corruption. Three, structural reform.

While political stability was seen in the preceding decade, it is the clear majority along with the political will to bring about change that is different with this government. The market clearly likes that. But what change do we need? Modi Sarkar correctly identified endemic, deep rooted, institutionalised graft as the epicentre of the problem with the Indian story. When the problem is a way of life, where does change even begin? In hindsight, it looks as if Modi Sarkar identified one area of work that has multiple linkages, and then built a reform plan around it, and that is to get people to pay their taxes—as individuals, as employees, as business owners, as traders. This is not an easy thing to do and governments in the past have struggled with getting more people to pay their dues. This needs structural reform. What is that?

Structural reform is not selling Air India. It is not tinkering with visible metrics but changing the way business is done in India. I will pick just four changes, although there are many others. One, the Insolvency and Bankruptcy Code (IBC) went from committee report to law in just six months and is already changing the way Indian firms pay back their debts. A creaky judicial system and toothless laws have kept the balance in favour of defaulting debtors and crony capitalism. The IBC has swept through this mess and we’ve already seen 2,100 firms quickly find Rs83,000 crore to pay back rather than lose control of their business. The goods and services tax is the second reform that will add to tax revenues and formalise the Indian economy. Not paying taxes is going to get tougher and tougher. The third change is the amendment to the Benami Transaction Act, which gave it teeth and punitive powers. The Act has already been used to attach 240 properties worth about Rs600 crore. Small potatoes right now, but it is a start. Four, linking Aadhar to PAN is a deep cut to weed out tax evasion. Increasingly people are finding it difficult to hide their untaxed income. The use of big data will make this harder and harder.

These are brave moves that needed political courage. These changes disrupt the way business is done in India. These changes can hurt the chances of the government returning to power. But without these changes the reset button on corruption will never be pressed. The stock market is reacting to the big reset that is underway, and therefore it celebrates each Modi Sarkar victory.

There are early signs of success in this effort to formalise the economy and get more people under the tax net. The number of tax returns filed is up more than 80% over a four-year period ending 31 March 2018. Total tax collection is up almost 60% over the same time period. GST has added 3.4 million new tax payers.

How should we negotiate the coming barrage of false news from both sides in the next 10 months? Remember that there is a big body of vocal elite who benefitted from the earlier system of being a part of a small minority of being near those in power. They cry the loudest. Ignore them. On the other extreme is a loony fringe that takes India back to some imaginary utopia of the past. Ignore them as well. Look for data and not anecdotes or mythological history lessons.

Financial advisors may ask investors to have modest return expectations from equities, at 12 to 15 per cent. But the secret desire of most retail investors is to unearth multi-bagger stocks that can mint millions. This dream is often fuelled by stories from their friends and family about obscure stocks that turned out to be diamonds in the rough.

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Stocks versus mutual funds
There are certainly many small-cap stocks in the Indian market that boast rags-to-riches stories in the last 10 years. Take the case of Ajanta Pharma, a small-sized pharma company focused on domestic sales, which featured a mere Rs 100 crore market cap in March 2008. It has seen its stock price zoom from Rs 12 to Rs 1,398 in 10 years. (All stock price data in this story are adjusted for bonus/splits and capture returns from March 2008 to March 2018). Or take the crockery maker La Opala RG, which starting out at a mere Rs 32 crore market cap, has seen its stocks soar from Rs 33 to Rs 3,589.

Then there are those success stories of companies that have graduated from small-cap to large-cap status by rapidly scaling up their business. Eicher Motors, originally a truck company, acquired the Royal Enfield brand to become a go-to brand for upmarket motorcycles. It has seen its adjusted stock price zoom from Rs 277 to Rs 27,740 a 100-fold gain in 10 years. This has taken its market-cap up from about Rs 800 crore to Rs 75,000 crore. Or there is Bajaj Finance, which has grown from the captive financing arm of Bajaj Auto to a consumer financing giant in just about 10 years. Its stock price has soared from Rs 39 to Rs 1,659 and market cap from about Rs 1,400 crore to nearly Rs 1 lakh crore.

On a CAGR basis, the top small-cap stars have managed a CAGR of anywhere between 40 and 60 per cent over the last 10 years. Investors measuring small-cap equity mutual funds against these stocks may be dissatisfied. Over a similar 10-year window, leading small-cap equity funds have managed an 18 to 20 per cent CAGR.

But while it is such comparisons that have retail investors dabbling directly in small caps, the above stock examples suffer seriously from hindsight bias. In real life, retail investors looking to take the do-it-yourself route to small-cap investing have to surmount three big hurdles to create long-term wealth.

Selecting the survivors
Searching for quality small-cap stocks in the Indian market is like looking for a needle in haystack because there are literally hundreds of sub-par stocks littering up the listed space. To arrive at the odds of an investor latching onto a multi-bagger small-cap, Value Research ran a screener on all NSE-listed stocks that featured a market cap of Rs 2,000 crore or less exactly 10 years ago, in March 2008 and calculated their CAGR returns on their adjusted stock price (for bonuses and splits).

Of the 715 stocks on our list in March 2008, as many as 224 delivered losses to investors after a10-year holding period to March 2018. That’s a 31 per cent chance of picking a lemon and losing money on a small-cap despite a 10-year wait. These loss-makers included some names that really decimated investor wealth. There’s pipe maker PSL, which nosedived from Rs 355 to Rs 4 in 10 years; power-equipment firm Bilpower, which tumbled from Rs 100 to Rs 2; Subex, a software company, which saw its stock price fall from Rs 258 to Rs 9. In fact, there were 29 stocks in the list that wiped out at least half of their investor’s capital in the last 10 years.

Therefore, while it may appear to be quite an easy task to explain why Eicher Motors or Bajaj Finance have turned out multi-baggers, it would have been very difficult indeed to take this call in March 2008, when Eicher or Bajaj were one among a thousand stock choices that one could have made.

If you go wrong, the chances of a small-cap company not surviving a decade are quite high because scaling up from a tiny to a mid-sized firm in any industry is far more challenging than scaling up from a mid-sized firm to a large one.

Scaling problems
For a small-sized firm to turn into a multi-bagger, it isn’t just enough for the company to survive. It has to thrive and deliver faster growth than all its peers in the industry. Most small-cap firms stumble at this task. Of the 715 small-caps we started out with in 2008, 383 stocks or 54 per cent, did not manage even a 10 per cent CAGR in their stock over the next 10 years. In fact, only a third of the small caps on the list managed the minimum investor expectation of a 15 per cent CAGR.

It is also hard to estimate when a small-cap may turn the corner. When a small company you own stays at a midget size for many years, it is natural to get frustrated and exit the stock. Often, you find the business suddenly picking up and delivering just after you exited it!

Stocks that turned out to be multi-baggers or managed bumper CAGRs of over 26 per cent per annum numbered 109. Basically, for every 100 small-caps that were traded on the NSE in March 2008, only 14 turned out to be the kind of multi-baggers that investors love to own.

Picking winners isn’t quite as easy as a monkey throwing darts because you find no common sectoral or macro ‘theme’ to those 10-year winners. The top five wealth creators over a decade feature a pharma firm (Ajanta Pharma), a crockery maker (La Opala RG), an agrochemicals company (Bharat Rasayan), a pressure-cooker maker (TTK Prestige) and a sanitaryware maker (Cera Sanitaryware), all of which would have been difficult to identify as scalable opportunities 10 years ago.

Hanging on
Ask any HNI owning small-cap stocks or professional fund manager and they will tell you that biggest challenge in making money from small-caps lies not in buying them but in hanging onto them.

Though looking at the CAGR returns on small-caps can give the impression of a steadily soaring price graph, real-life returns on these stocks came in a very ad-hoc fashion over the years, where the stock would do nothing for a long time and then rise by leaps and bounds. For instance, Avanti Feeds, now a mid-cap, managed barely any returns for a three-year period from 2008 to 2011. Relaxo Footwear, now a crowd favourite, fell steeply from Rs 560 to Rs 360 between July 2015 and March 2016. Only investors who were brave enough and confident enough to hold during this fall would have experienced its next high at over Rs 670.

Enjoying their multi-bagger returns at the end of 10 or 20 years, therefore, means holding onto these stocks through turbulent times as well as times when the stock or business does absolutely nothing. It also means not booking profits too early because you are afraid of losing money.

Finally, because they aren’t tracked by an army of analysts, small-cap stocks are far more prone to governance risks than mid-caps or large-caps.

Mutual fund route
To cut a long story short, yes, DIY investing in small-caps can be immensely rewarding for you if you are skilled, lucky and patient enough to buy and hold the right stocks. But the costs of going wrong are extremely high and you should be willing to watch over your portfolio like a mother hen. Most investors who have a full-time job or profession to pursue will find it difficult to do this on their own.

This is why mutual funds specialising in small-cap or micro-cap stocks may be a better choice for retail investors who would like to reap riches in this space. Given that there are only four or five small-cap equity funds with a long-term track record, choosing the right small-cap fund and hanging on is far easier than navigating the minefield of DIY investing. The pay-offs may be lower, but the probability of making a good return is many times higher than direct investing.

Below, you will find the links to our interviews with the fund managers of the small-cap funds we have recommended.

SBI Smallcap Fund

DSP Blackrock Smallcap Fund

Franklin India Smaller Companies Fund

Reliance Smallcap Fund

L&T Emerging Businesses Fund

Imagine you have got an annual bonus of Rs 8 Lakhs and decided to invest the entire sum into equity mutual funds. However, looking at the current market level which is almost at an all-time high, you may feel unsure to invest the entire bonus amount in one go.

You can take a smart decision and opt for Systematic Investment Plan (SIPs) or go with Systematic Transfer Plans (STPs).

What are the advantages of Systematic Transfer Plans (STPs)? Systematic Transfer Plan (STP) is a mechanism by which an investor is able to transfer a fixed or variable amount from one mutual fund scheme to another mutual fund scheme.For example – An investor can park a lump sum amount in a liquid fund that can be transferred in a staggered manner into another scheme, say an equity fund of the same mutual fund house (AMC) at regular intervals.

The systematic transfer frequency from one fund to the other can be on a daily, weekly, fortnightly, monthly or quarterly basis depending on the option offered by the AMC. There is a minimum fixed amount that needs to be transferred on these frequencies.

Investors who are investing for their long term financial goals like, retirement, children education etc. and at the same time, are concerned about market volatility, they can invest their capital in a low risk debt or money market (e.g. liquid or ultra-short term funds) and use STP to transfer a fixed amount from liquid or ultra-short term funds to equity mutual funds on a regular basis over a period of time suitable to them. On the other hand, if the investors are nearing their financial goals and are worried that markets may be volatile or get into correction when they need the fund, they can transfer a fixed amount from their equity mutual fund scheme to liquid or ultra-short term funds via STP.

STP is a proven way that an investor can take to invest in mutual funds to get the maximum exposure to the equity markets while minimizing the risk. Needless to mention you also get the expertise of a professional fund manager who helps you to get the best return on your investments.

In today’s dynamic equity market scenario, there is an inherent risk involved when taking an advantage of the favorable weather in both equity and debt markets. Therefore, it is advisable to be cautious when taking exposure to these respective assets classes and proceed smartly and prudently. The idea should be to balance between these two assets while minimizing overall risk. The method of STP investing helps you achieve this very easily.

By reading this how STPs can be a useful mechanism to manage asset allocation, you can learn more.

How does mutual fund STP work?

With STP, investors can maintain a balance of risk and return by splitting the investment amount over a period of time. One of the benefits of STP is that during volatile market the investors can invest systematically in equity mutual funds and earn risk free returns by investing in liquid or ultra- short term mutual fund schemes.

Therefore, in your case you can invest your bonus amount of Rs.8 Lakhs as lump sum in a liquid or ultra-short term fund, and then transfer a fixed amount at an interval decided by you to an equity or balanced fund (fund selection should be based on your risk taking ability).

Let us see how STP actually works – We have taken an example of Rs 8 Lakhs invested in a liquid fundon 1st January 2013 and started weekly STP of Rs 10,000 to an equity fund. The STP is still continuing. The above STP is generating an annualized return of 15.45% ! Please check the results yourself to believe this.

Benefits of Mutual Fund STP

Power of Compounding

Investors also get to compound their wealth and allow it to grow substantially with the help of power of compounding over a long period of time via Systematic Transfer Plans (STP).

Tactical asset allocation and rebalancing

You can change funds as and when you like with STP. For instance, if you have invested in a liquid fund but you perceive the equity to do well and want to take a gradual exposure towards equity then, STP will help you in doing so. On the other hand, if you expect the markets to undergo a corrective phase, and take a decision to gradually disinvest from equity mutual funds, as a smart investor would prefer, again STP can act as potent tool to transfer to the liquid fund from the equity fund.

Learn more about asset allocation and market cycles

Mostly, it is seen that investors give redemption request forms, while reallocating assets within categories of mutual fund schemes, and then invest into another mutual fund scheme as they deem fit. Instead investors can choose STPs that is considered as the best mode to transfer the money systematically in such cases.

Therefore, an investor can re-balance the portfolio by switching investments from debt to equity or vice versa with the help of STP.

Therefore, STP enables you:

• • Take advantage of the market scenario

 

• Rebalance your portfolio

In this context you may like to read how STPs can provide volatility defence and portfolio management

You can also read simple asset allocation strategies for different risk profiles

Help in financial planning

If you are planning for any important long-term financial goals then STPs can be of great utility to help you create a long term corpus in equities while taking minimal risk and rupee cost averaging. Thereafter, transfer back gradually from equities to debt when you are nearing your long term financial goals.

Disciplined investment

While there will be some judgement involved in your STP investments, financial experts feet that, plan based disciplined investing gives better results than investments made on gut feel or tips or ups and lows of the market levels. As disciplined investing also takes emotions out of the investment process, it helps you remain objective. You should not discontinue or break your STP because of market movements in the short term as it may end up harming your long term investment returns.

For example – You have initiated a 6 months STP from a liquid fund to equity mutual fund. You find that markets are rising post you have started the STP to equity fund, you should not break your STP just because the market rises or falls sharply in a month. STP is a defence mechanism against volatility. Breaking your STP based on sharp stock market movements either ways is trying to time the market which is nearly impossible.Therefore, we can say that the primary objective of an STP is to preclude the need of market timing.

Apart from STP what are the other 10 things you should do in volatile markets

Protection of profit

Sometimes a harsh bear market or crash can wipe out the profits accumulated by investors over the years. This can be very disappointing for investors as it may jeopardize their long term financial plan. A capital appreciation STP can help investors protect their profits by transferring capital appreciation in one scheme (e.g. equity mutual fund) to a low risk scheme (e.g. liquid fund). A capital appreciation STP helps the investors reduce their overall mutual fund portfolio risk, without changing the asset allocation.

Please check how the Profit Transfer STP plan works

Conclusion:

Mutual Fund Systematic Transfer Plan (STP) can be seen as an extension of SIP. In the case of SIPs you can invest in a mutual fund scheme with as low an amount as Rs.500. However, in STP, an investor gets an option to invest a lump sum amount in any debt mutual fund scheme and at periodic interval, can transfer a fixed or variable sum into an equity mutual scheme or any scheme of choice.

An investor who seeks stable returns while taking some exposure to equity or equity oriented mutual funds with an objective of wealth creation can opt for STP facility.

How do you strike a balance between today and tomorrow? This is the ultimate personal finance question that each of us need to answer. Each time I hear of an untimely death of somebody I know due to a heart attack, cancer or a stroke, I ask myself this question: life is fragile, why think so much about the future? But then there are stories of the old people who have outlived their retirement corpus or find current rates of inflation out of sync with their retirement corpuses built 15-20 years ago. Newspaper stories of aged people starving to death in their middle-class home because they ran out of money are not unusual. Life is fragile. Life is tenacious. How do you live each day knowing that it can end in a heartbeat and yet behave as if you will live forever?

This tightrope walk between the future and the present is the biggest personal finance lesson that I am still in the process of learning. I have found that the art of staying somewhat balanced between tomorrow and today goes through three stages. The first is when the viability of your today itself is in question, there is very little you can do for a tomorrow. You need to put on your today’s oxygen mask first before thinking about a tomorrow. The stressful 30s is the age when today is far more important financially than tomorrow. This is the decade in which the challenges are both personal and professional. Most people in this age band are married, are precariously balancing young kids, a home EMI, a car EMI and plenty of aspirational expenses. This is the stage in which planning for a retired life looks unreal because the body is strong and there are more years ahead than behind. This is the stage during which even a small contribution towards your future self will have a very big impact as the money will get time to compound. Other than your PF, if you can just do another 5% of your post-tax income towards your retirement in equity, you are fine.

Second, the settled 40s, when there is greater certainty about the overall direction of life. Today’s basic needs are mostly done, or are well on their way to being completed—a house, a car, a basic level of living. There is more money than before but the lifestyle demands can be strong. A still healthy body, a steady career, a growing family and a promising future can all contribute to thinking more about today than tomorrow. But this is the decade in which you can salt away more for the future than before. This is the decade over which a solid foundation is built for your future, older self. The surplus is more as incomes are higher, in addition, the release of money from the home EMI and the car EMI can easily be blown away in the next home and car upgrade or it can go to bump up the retirement pool. This threshold decade between the younger you and the older you, is financially crucial. If you are saving an extra 10% of your post-tax income over your PF in an equity-linked product, you should be doing fine.

Third, the cruising 50s, when most people are at the peak of their careers and retirement is no longer something that happens to others. This is the decade in which most of the goals you targeted, happen—children’s education, their marriage. This is also the decade in which you have the money to substantially add to the retirement pool. The home is fully bought, children are gone, salary is at the career peak and expenses mostly have settled down—an ageing body is no longer able to binge as much as before and possibly the lifestyle needs have settled down to what works for you rather than what your social group is doing. This is the decade in which tomorrow could take precedence over today. This is the decade in which you target your retirement most aggressively and the savings ratios depend on what your shortfall is. This is also the decade in which you look at pictures of yourself from 20 years ago and either thank your younger self for being financially mature or not.

The biggest mystery of our lives is the time and date of our death, but this philosophical question mark has a deep impact on our financial lives. So, we do both—insure our lives against living too short and then build our retirement pool against living too long, all the while remembering to make the balance between living today and tomorrow. What use is that fantastic retirement corpus if it means that your today is a hated treadmill? What use is the multi-crore net worth if it has come by way of shell companies and career-destroying conflicts of interest? At every life stage it helps to answer the question—how much is enough—both now and in the future.

With the fund industry brainstorming hard to woo fence-sitting investors into mutual funds, suggestions have been flying to and fro on what mutual fund features should be highlighted in mutual fund advertisements. The power of equities, the benefits of compounding, the wealth-creation potential of SIPs and explaining market risks seem to be some popular choices. But mutual funds offer one big benefit that makes a big difference to investors and leaves all other asset classes in the dust. That feature is anytime liquidity.

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Open-end mutual funds are the only investment product where the vendor offers to buy back your entire investment at a transparent price at the time of your choosing. As investors in open-end funds, we often take anytime liquidity for granted. But we realise its true value only when we try to liquidate our other assets and come up against a wall.

Really illiquid
The last few months post demonetisation have shown us how the property market can malfunction during sudden shocks to the financial system. However, buying or selling apartments or plots of land was never easy even before this event.
Illiquidity is also the primary problem most of us encounter when we try to cash in on the jewellery stashed in our bank lockers. During the six-year bull run in gold from 2006 to 2012, I know of quite a few folks who were keen to lock into their hefty profits by selling their old jewellery. But this entailed suffering a 20-30 per cent discount towards poor caratage, stone charges and wastage levied by the jeweller. Mostly you didn’t receive cash either; you had to buy new jewellery in exchange.

Liquidity at a stiff price
Insurance products, as many sufferers will testify, extract a stiff penalty on anyone who tries to discontinue their investments or sell them before term. ULIPs allow you to exit with a nominal penalty but you are forced to stay locked in them for five years, even if you discontinue paying premiums earlier. Endowment plans, money-back plans and other traditional insurance policies extract extremely stiff surrender charges on any attempt to terminate them before your committed period so much so that most people prefer to sink good money into them year after year, rather than suffer huge losses on surrender.

Red tape
Most of the retirement vehicles where we Indians save towards our sunset years suffer from illiquidity on account of their onerous rules for premature exit. Taking an advance from the EPF account requires you to meet a number of conditions on end-use of that money. The NPS allows you to withdraw a fourth of your contributions before retirement, but that’s only after a ten-year lock-in and compliance with a plethora of nit-picky rules. Ditto with long-term small-savings vehicles such as the NSC and the PPF, which have long lock-ins and convoluted formulae to calculate your redemption amount in case of an early exit.

Fair-weather friend
Instruments such as bonds and bank deposits rank somewhat better on liquidity. Savings bank accounts offer you anytime exit, but they really cannot be counted as ‘investments’ given their measly returns – usually below inflation rates. Bank FDs offer you a premature exit option if you break the deposit, provided you cough up a penalty of 0.5 or 1 percent in interest.

Bonds offer premature exit through the secondary market route and many of the fancied tax-free bonds currently register very decent trading volumes in the debt market. But the Indian bond market is a fair-weather friend. Domestic bond buyers queue up mainly for top-quality bonds and that too mainly when we’re in a bull market (interest rates are falling). Volumes can be quite thin in less favourable market conditions and for issuers who are less than top quality.

Why do you need liquidity?
But why do you need liquidity at all? Surprisingly, quite a few investors make this argument. Many of them actually believe that forced lock-in periods and high penalties for premature exit are good for them because they inculcate saving discipline and force them to be ‘long-term’ oriented. Well, forced lock-in may be okay to live within an assured return product because you know exactly what you are getting when you invest. But it can be quite injurious to your wealth in a market-linked product.

For one, not all managers of market-linked products manage to protect your capital or consistently beat the benchmark. Given that your money manager can really mess up your investment plans in a market-linked product by underperforming the benchmark or making risky moves that expose you to losses, you need the flexibility to switch to better performers at the time of your choice.

Two, the asset-allocation decision that investors make is often based on the relative attractiveness of different asset classes at the time of their investment. But over the long term, these equations can change. So it helps to have the flexibility to exit mid-way based on changing regulatory or market conditions.

Three, exit at a time of your choice is also important for you to optimise returns from volatile market products. Investors who are working towards a goal may also like to take a phased exit to shield their final portfolio value from market volatility.
Finally, all of us may face situations like a family emergency or altered family circumstances which force us to rethink our investment goals and plans. Anytime liquidity is a great attribute for your investment to have in such times.

So, the facility to exit at any time at market price is the big benefit of open-ended mutual funds that the fund industry should shout out from the rooftops, especially when most other investments in India are like that line from the famous Eagles song Hotel California: ‘You can check out anytime you like, but you can never leave.’

The Indian stock market made its all-time high a few days back, with the Nifty scaling the 10,000 points mark. The market has been rallying from the beginning of this year and breaching the 10,000 level on the Nifty was seen as an important technical breakthrough for the market. Investors have reasons to cheer the stock market because the Nifty has risen 40% in the last 16 – 17 months and many investors would have made handsome profits. However, such a terrific rally also raises concerns whether the market is overheated and if a correction is round the corner.

Is the market overheated?

Though valuations (P/E ratios) are not as high as the heydays of 2007, current valuations are certainly higher than the historical average. The Nifty is trading at 19.36 times of expected FY 2018 earnings, while the 10 year historical average is 16.76. We are in the middle of Q1 results season and therefore it is too early to say, whether corporate India will be able to live up to the market’s earnings expectation; nonetheless, it is understandable that, some investors are concerned about stretched valuations. Should retail mutual fund investors worry about investing in this high market?

Market rise or fall is not always good or bad

We often view market movement (rally or crash) from a one-dimensional perspective. For example, a stock market crash or correction has varying effect on different investors depending on their investment strategy. While some investors may lose a lot of money in crashes or corrections, for some investors a correction might be very beneficial from a longer term perspective. Investors sitting on cash, for example, find corrections beneficial because they can buy stocks at cheap prices.

Similarly, stock market rally is not always a very happy situation for everyone. Investors who are invested in stocks or mutual funds are happy with a big rally, but investors sitting on cash waiting for market dips to invest are not happy with a big rally. I know friends, who are sitting on cash for the last 6 – 7 months, waiting for an opportunity to invest their annual bonuses; they are not happy because the market is 20% higher than what it was at the beginning of the year and they thought that, “they did not get an opportunity to invest in the market”.

Futility of trying to time the market

The joy and sorrow, of investing in stock market often boils down to the investor’s success in trying to time the market. If people are able to time the market successfully (buy when prices are low and sell when prices are high) they are overjoyed. Failure to time the market, like my friends mentioned earlier, brings sorrow. Based on my experience, retail investors who get their timing right are simply lucky. Why? Even experts cannot get the market timing right. At the peak of every bull market I saw (2007, 2010, 2015 etc.), experts were very optimistic, talking about momentum and secular growth.

At the bottom of every bear market (2008, 2011, 2016 etc.), experts were very pessimistic about the prospects of either the domestic economy or the global economy or both. There were also a few false alarms like, when NDA – 1 (Vajpayee) lost elections in 2004 or when US Federal Reserve scaled back the Quantitative Easing Program (started in 2008) in 2013. If experts cannot get market timing right, then it is not possible for retail investors to get their market timing right, unless they are simply lucky.

Further, even if you get your timing right, the impact of market timing is usually only marginal over a long investment (5 – 7 years or longer) horizon for most investors. On the other hand, if you get timing wrong, you will regret your decision. The desire to time the market arises out of two primal instincts – greed and fear. These two instincts go hand in hand and prevent investors from taking decisions which are in their best financial interests.

We, in Advisorkhoj, are big advocates of systematic investing because it frees you from the clutches of greed and fear; over a sufficiently long investment horizon, irrespective of market conditions in the interim, systematic investing in good mutual fund schemes yield good results. Readers should note that, just because we advocate systematic investment, we are not against lump sum investing. From time to time, depending on your financial circumstances, your financial goals and market conditions, you should make lump sum investments, but it is the topic of another blog post.

What should mutual fund investors do?

Let us now discuss, what mutual fund investors should do, when the market is at its all-time high? Lump sum investments at such high levels can be a little risky, unless you have a long investment horizon. Systematic Investment Plans (SIP) work well in all market conditions including high markets, as will explain now. Readers should note that, since SIP investments are made with relatively small amounts from your regular savings, you should always have a long investment horizon, so that you create wealth from your regular savings.

SIP Investors

Let us assume you are investing in equity mutual funds through SIP. When the market is at its all- time high, there can be two scenarios – either the market goes up further or there is a correction (there can be a third scenario, which we will discuss later in this post, but let us restrict ourselves for the time being to these two scenarios). SIP works to the advantage of investors in both the scenarios.

Rising Market

Let us start with the first scenario – the market going up further. Should you stop your SIP investment or continue with it? If you continue with your SIP investment, you will be buying units of mutual funds at higher and higher prices. To some investors, buying mutual fund units at higher prices may not sound very logical; but long term SIP investors should ask themselves, whether they have not been buying units at higher and higher prices (except during bear markets) and yet they have made profits, because the current price of the unit is higher than the purchase price. If you are worried about buying units at a higher price, ask yourself what you should do instead? Stop your SIP, accumulate cash and invest in lump sum when the market falls? If you are thinking about it, ask yourself if you know, when the market will fall and by how much? Are you sure that, the market will fall below the current levels? You can never be sure. When investing in SIP in rising markets, each SIP instalment will be invested at a price which is lower than the peak of the rising market (bull market). So you always stand to benefit.

Falling Market

Let us now discuss the second scenario – a market correction. Should you stop your SIP investment or continue with it? If you continue with your SIP investment, you will be buying units of mutual funds at higher prices with each instalment and then when the market falls your investment will reduce in value. This is the worrying scenario for many investors; so what should you do? Should you stop your SIP and wait for the correction. Do you know when the correction will come?

There are a variety of market movements which are counter-trend and also temporary, e.g. a bull market correction or a bear market rally. These movements are difficult to spot and even more difficult to execute upon. You may end up waiting too long for the correction and you may suffer an opportunity loss during the waiting period. As an existing SIP investor, a correction is beneficial for you; you will buy units of mutual funds at lower and lower prices in a bear market or correction. As discussed earlier, it is almost impossible to get the timing of the correction right. Market movement may be quite significant between your timing and the actual market movement in the direction you want to; therefore, it is always wise to continue your SIP so that, you can benefit from Rupee Cost Averaging.

Range-bound Market

Thus far, we have discussed why continuing your SIP is beneficial both when, prices are expected to rise and prices are expected to fall but the timing is uncertain. Let us now discuss the third scenario, where market can remain range-bound for a period of time. Based on my experience of investing in and following stock market in India for more than 15 years, prices remain range-bound only for a limited period of time; eventually prices follow a direction (usually upwards, rarely downwards). But even in the scenario of range-bound market, SIP works wonderfully well, because equity markets are intrinsically volatile. By investing on a systematic / regular basis every month, you can take advantage of the volatility through Rupee Cost Averaging of purchase price of mutual fund units. Through Rupee Cost Averaging you can enhance your rate of returns over a long investment horizon.

Conclusion

We have discussed that, SIPs are win-win-win in all the three scenarios – rising market, falling market and range-bound market. Some of our readers may be sceptical, how SIP can work in all the three conflicting scenarios. The answer is quite simple, as some of readers may have already figured out. In SIP we are not looking to invest at the best price; we are only looking to invest at an average price, knowing that equity prices will appreciate over a sufficiently long investment horizon. If you are looking to invest at the best price then you are trying to time the market which, as we discussed earlier, is close to impossible and is likely to cause you stress, not to mention financial loss (opportunity loss or actual).

SIPs work on the fundamental premise that, equity as an asset class creates wealth for investors (by beating inflation on a post-tax basis) over a sufficiently long investment horizon. If you believe that, equity as an asset class creates wealth, which is supported by enough historical evidence around the world, you will not worry about investing in high market or low market. SIP is a wealth creation tool; market timing is irrelevant in SIP as we saw in this post. If you are a long term investor, continue with your SIP irrespective of market condition. Just make sure that, you have invested in good mutual fund schemes and be patient, unruffled by volatility or market movement (up or down).