Author: admin

We get a large number of queries from our readers asking us whether the mutual funds they have selected for their portfolios are the “best” funds. Good fund selection definitely makes a difference to your investment returns and therefore investors should try to select the top performing funds. The chart below shows the difference in returns between the best performer, the average performer and the bottom performer, over the last 3 years (based on October 27 2015 NAVs) for various equity fund categories.

 

We can see that there is a significant performance differential between the best performer and the average performer, not to mention the bottom performer. However, asset allocation plays a much more important role in your overall investment returns than fund selection. In this blog we will discuss asset allocation influences your investment returns versus fund selection within a specific asset category.

What is asset allocation?

Asset is the percentage mix of different asset classes like debt, equity, real estate and gold in your total asset or investment portfolio. In its simplest form asset allocation often refers to the percentage split between debt and equity investment. In the Indian context, real estate and gold are also very important asset classes. On an average, in India, the allocation to physical assets like real estate and gold is more than financial assets. However, for the sake of discussion in this blog, we will keep our definition of asset allocation simple and refer to it as the percentage allocation to equity versus debt. Asset allocation is the most important aspect of financial planning, since it plays a bigger role in meeting your financial goals than any other factor.

Role of asset allocation versus fund selection in final portfolio returns

We will understand this by walking through an example. Let us assume that, 10 years back you had an amount of र 500,000 to invest for your long term goals. For the sake of simplicity, we will assume that you had two investment options

• • Investing in a risk free fixed income investment, e.g. Fixed Deposit, National Savings Certificate etc.

 

• Investing in an equity mutual fund

Let us first see how much returns you would have got from your risk free fixed income investment over the last 10 years. The chart below shows the 10 year Government Bond yield from October 27, 2005 to October 27, 2015.

 

 

The average 10 year Government Bond yield over this period was around 8%. Your average risk free interest during this period therefore, would also have been around 8%. Interest from most fixed income investments are taxable as per the income tax rate of the investor. If you are in the 30% tax bracket, your effective post tax return is 5.6%.

Let us now see, how the different equity mutual fund categories performed in the last 10 years. The chart below shows the difference in returns between the best performer, the average performer and the bottom performer, over the last 10 years (based on October 27 2015 NAVs) for various equity fund categories.

 

If you chose the best performing large cap equity fund, over the last 10 years you would have got an annualized return of 19%. If you chose an average performer from the large cap equity fund category, your annualized return would have been around 14%. Please note that long term (holding period of more than 1 year) capital gains from equity fund will be tax free.

Let us assume you had split your र 500,000 investment between a large cap equity fund and a risk free fixed income investment, e.g. bank fixed deposit. The table below shows the current investment value if your equity to debt allocation was 10%:90%.

 

 

If you invested the best performing large cap equity fund, your current investment value, including the debt portion will be र 10.7 lacs, whereas if you invested in an average large fund your current investment value will be around र 9.7 lacs.

Let us now see, what your investment value would have been if you altered you equity to debt allocation to 30%:70%.

 

 

Not only is your investment value much higher with higher equity allocation, even if you chose an average large cap fund with 30% equity and 70% debt allocation, the overall returns will still beat the best case return of the 10% equity and 90% debt asset allocation. That is why we say, that asset allocation plays a more important role than fund selection in your final investment returns. Many investors devote more time in identifying the best performer and less time in determining their optimal asset allocation. On the contrary, if they get their asset allocation correct, they can get much better results even with average performers. The table below shows the current investment values for different asset allocation percentages.

 

 

It is evident from the table above that, while selecting the best performer makes a significant difference, asset allocation has a bigger impact on your final returns. Selecting the mutual fund scheme which will give the highest returns in the future is an extremely difficult, if not an impossible task. On the other hand getting your asset allocation right is a relatively simple task. While your optimal asset allocation will depend on risk profile and financial objectives, you can use some thumb rules as a starting point to determine your optimal asset allocation.

Rule of 100

This is a very popular thumb rule for measuring risk tolerance. Simply put, you should subtract the investor’s age from 100, and the result suggests the maximum percentage amount of the investor’s portfolio that should be exposed to equities. So for a 25 year old investor, this rule suggests that 75% of his or her portfolio should be invested in equities, and for a 40 year old investor, this rule suggests that 60% of the portfolio should be invested in equities. This is the conventional asset allocation model, and is ideally suited for a passive investor. The table below shows the asset allocation guidance for different age groups.

 

 

You can modify this rule, based on your risk profile and investment objectives. You can also consult with an experienced financial planner who can help you determine your most optimal asset allocation.

Conclusion

In this blog we have seen that asset allocation plays the most important in determining your overall portfolio returns. Investors should also educate themselves about asset allocation and determine which the most suitable asset allocation for the long term financial goals.

Most investors dedicate a fair amount of time and energy into drawing up a doable plan when saving for retirement. Rightly so. But if you think saving for retirement is an ordeal, you have not given adequate thought to the post retirement scenario. Once you have built your investment portfolio, your focus needs to shift on how to best convert your accumulated financial resources into a cash flow. To be more explicit, figuring out how to consistently obtain a periodic amount from your savings is a much bigger challenge. There are two things you should do to your savings in retirement. 1) Try to make your savings last as long as possible. One cannot have a myopic view when looking at retirement. It is not an event which is an end in itself. It is the start of another phase in your life where the cash flow will no longer come from your monthly paycheck. Let’s say you decide to retire at the age of 60. There is a high possibility that you could be alive for the next 25 years. During this period, you will deal with medical bills and a cost of living that only goes higher. So the conventional wisdom of offloading all your equity holdings before you retire and getting into fixed income is not the best solution. Your portfolio must be given the opportunity to grow. You cannot afford to ignore equity at this stage. 2) Tap your savings to create an income stream. This is obvious. Since you no longer earn a regular monthly salary, money has to come from somewhere else. Most investments are designed to provide some form of income. Your income stream could take the shape of interest payments from your fixed deposits/bonds, dividends from your mutual funds/stocks, an annuity plan, rental income, or a pension from your erstwhile employer. There is another avenue which services both the above criteria; a Systematic Withdrawal Plan, or SWP. To build wealth over the long haul, some amount of equity exposure is a must. As mentioned above, liquidating your entire portfolio of accumulated equity assets is not the smartest thing to do. Instead, you should keep some amount of your money invested in a large-cap or balanced fund. Then, by opting for a SWP, you can get a periodic flow of cash. This would serve the dual purpose of helping your capital grow over the years as well as provide you with income. A SWP is a facility that allows an investor to withdraw money from an existing mutual fund at predetermined intervals. This generates an additional cash flow without the need for liquidating your entire investment. How does it work? When you automatically take money out of your mutual fund on a regular basis (fortnightly, monthly, quarterly), it is called a systematic withdrawal. At the set, predetermined date, units from your fund are sold and the money is sent to your bank account.  All very convenient. Start by picking up a good fund. Once you do so, you can put in a lumpsum investment. From that investment, you can opt for an SWP. Alternatively, pick a fund to systematically invest in over a number of years, an SIP in other words. Once you retire, stop the SIP and opt for an SWP. When opting for an SWP, you have to decide whether you want to withdraw a specific amount or an appreciated amount. Also choose the periodicity of the withdrawal, such as quarterly or monthly. Once you settle on those parameters, you are dusted and done.

Source: https://www.morningstar.in/posts/41928/reitrement.aspx

A common accusation many readers make about this column is that while it encourages investing in equity, it does not carry
specific recommendations about where to invest and how much. That kind of specific investment advice is quite dangerous,
though it makes life easier for the investor. Unless one is a financial adviser, it is simply unethical to reel off names. The
question is not of expertise, but of the nature of equity investing itself.
Even the most intensive research can come up short when unexpected events impact businesses and markets. It is not as if I
hold back something precious from the readers of this column; it is just that I cannot forecast the future.
A very comforting emotion is the sense of control. Investors want to believe that the equity investments they make will behave
in a manner that they can predict, understand, control, and therefore not worry much about. When they realise that things could
go wrong; that their money could be at risk; or that their choices will perform poorly, not doing anything seems better. The
comfort of a small fixed interest in the bank seems like a safer option. But that so harshly short changes your wealth. Many
investors know about the benefits of long-term investments in equity. What holds them back from acting, then? Two primary
reasons I would think. First, the idea of a higher return must be associated with something concrete.
The inability to associate a high return with a specific product makes them think such examples are hypothetical. Second, the
lack of conviction in the process that can enable a higher return. When I point out that diversification is the only way to achieve
better returns, I have lost my investor already. They want me to tell them whether they should buy stock A or stock B, and if I
say that they should have both, and a dozen more, to manage risks better, they fail to grasp the merit of this process. Let me
offer a four-step process, which I hope will help many such investors.
Needless to add, equity is for the long run and for growth in the value of the investment. If you think you will need to draw the
money in a short period of time, it is best left in the bank. First, investing in equity is not about picking the right stocks. If you
spend your time trying to pick stocks, you will have to allow for the many mistakes you will make in the process.

The learning curve is steep and the lessons harsh. If you are a first-time investor, choosing to let money idle in the bank rather than invest in
equity, you could make expensive mistakes trying to dabble in stocks. Equity means the market as a whole or the asset class
that invests in growing businesses. That is the orientation you must keep.
Second, a portfolio of stocks is better than individual bets. Since you cannot foresee the future, you have to begin with a bunch
of stocks, and weed out whatever is going bad as you go along. If you are buying stocks, you should hold 20-25 equity stocks
to be able to cushion yourself from the wrong decisions you could make. If you cannot construct and manage such a portfolio,
buy an equity fund or an index fund. Define your search thus: You are looking for a portfolio of stocks, that will be actively
managed to throw out what is not performing. You can buy and hold a portfolio passively, only if someone else is monitoring it
for quality.
Third, equity investing involves both strategic and tactical choices. For example, if your intention is to be invested in large
companies that are market leaders in their segment, an investment in a large-cap equity fund or a narrow index like the Nifty
will serve your purpose. You will find that large-cap funds tactically modify their holdings in sectors and stocks to do better than
the index. The choices in equity funds and indices expands this choice of tactical holdings further, to mid-cap stocks, small-cap
stocks, themes and sectors. Take a pyramid approach—more in strategic choices at the bottom and a tapered smaller holding
in tactical portfolios.
Fourth, the process of selecting a specific fund can be simplified. Each fund house offers a lengthy list of products, but you are
looking specifically for large-cap funds, mid- and small-cap funds, and themes and sectors if you are taking tactical calls. Look
for a diversified portfolio and check if the fund has a 10-year track record. Compare its performance with the benchmark index
year-on-year. If the fund has done better than the index in 7 out of 10 years, you should do fine.
I routinely receive queries that ask SIP or lump sum? How much should the SIP be? How many SIPs? In the larger scheme of
things this will not matter; that you invested it in equity will. Once you begin investing, you will receive a folio number. You can
add to it by buying at any time you wish, whenever you have surplus funds. Choose 4-5 funds or indices at the most, and start
investing.

If you want to invest in equities in India, there are two common avenues available to you. You can open demat and trading accounts with a stock-broker to buy or sell equity shares in the stock market. Alternatively, you can invest in equity mutual fund schemes. Mutual fund pools the money of different people and invests them in different securities like stocks, bonds etc. Many retail investors think that, whether you are investing in mutual funds or through stock brokers, at the end of the day, you are investing in stock markets and therefore both types of investments are the same; hence the dilemma, whether to invest in mutual funds or directly in equity shares?

In this article, we will discuss the key differences of investing in mutual funds and investing directly in stocks. Before we discuss the differences between mutual funds (henceforth, in this article, we will be referring to equity mutual funds as simply mutual funds) and stocks, let us spend some time understanding, the concepts of risk and return, attributes which are fundamental to stock, mutual funds and most other investment types.

Risk and Return

Risk and Returns are the two most important aspects of investing. We invest our money because we expect some returns. There are some investment products where you can earn returns without taking any risk, e.g. bank fixed deposits, traditional life insurance plans, government bonds, etc. However, risk free return is always the lowest expected return. Historically, in India, it has often been seen that, risk free returns, on a post tax basis, has not been able to keep pace with inflation over a long time horizon. If you want to earn higher returns, then obviously you have to take risks. Higher the risk, higher the potential return. Higher risk and higher returns are fundamental attributes of both stocks and mutual funds, but from an investor’s perspective the question is, how much risk is the investor willing to take relative to returns he or she expects from his or her investments? A deeper understanding of risk is required.

There are two kinds of risk in equity investments, Systematic Risk and Unsystematic Risk. Let us understand both types of risks, with the help of an example. Let us assume that, you invest in a bank stock. If the bank makes a quarterly loss, for whatever reason, then the share price of the bank will go down. This is a company specific risk. Even during the quarter, if the RBI, hikes interest rates, for whatever reason, the share price of banks (including the one, you have invested in) are likely to go down. This is a sector specific risk. Both types of risks, company risk or sector risk, are unsystematic risks.

Let us now assume that the Nifty, the index of the largest market cap stocks in India, of which your bank stock is also a part of, goes up or down by 3% in a day. If Nifty goes down by 3%, your bank stock, is also likely to go down in price. This is because your bank stock is part of the stock market, and therefore subject to market sentiments and risk. This is known as systematic risks or market risk.

We have no control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks; how? Let us assume, in addition to investing in the bank stock, you also invest in a pharmaceutical stock. If the pharmaceutical company that, you invested in, makes a profit in the quarter in which your bank stock made a loss, then the share price of the pharmaceutical company will rise, which may fully or partially, cancel out the loss made in the banking stock. Also, the pharmaceutical sector is unrelated to banking sector and therefore, even if the entire banking sector is affected due to an event, the pharmaceutical sector may not be affected. Therefore, by adding, a pharmaceutical stock to your portfolio, you will be able to reduce your overall portfolio risks. You will not be able to diversify all risks, because if the Nifty falls 3%, there is a chance that both your bank and pharmaceutical stock will fall, but you will be able to diversify the risks, that are specific to stocks and sectors. When investing in equities, it is important to have a portfolio mindset, rather than a purely stock mindset. With a portfolio mindset, you can diversify stock specific or unsystematic risks.

Risk Diversification in Mutual Funds with lower capital outlay

To create a diversified portfolio, you need to invest in a sufficiently large number of stocks. Let us assume that, you need 50 stocks to create to an adequately diversified portfolio. The share prices of the 50 stocks may range from Rs 50 to Rs 2,500 per share. Remember, you cannot buy fractional shares through your stock broker. Even if you buy just 1 share each of the 50 companies, assuming the share prices of the 50 stocks are uniformly distributed in the Rs 50 to Rs 2,500 per share range, your minimum capital outlay can be more than Rs 60,000. If you have to buy more shares, your capital outlay will be higher. To achieve adequate diversification through direct equity shares, you need a large capital investment.

Mutual funds, as discussed earlier, pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger than the investible capital of an individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio. By investing, just Rs 5,000 in a diversified equity mutual fund, you can get diversification benefits that would have required a few lakhs, if you had invested directly in equity shares.

Therefore, risk diversification should be an important consideration because it reduces the probability of losses. In terms of risk profile, for the same amount of investment, diversified equity mutual funds are less risky compared to investing directly in equity shares.

Market expertise versus guesswork or tips

Most retail investors do not have the experience or expertise in stock selections. A large percentage of retail investments in direct equity shares are purely speculative or based on guesswork or tips from friends, relatives or their brokers. If you are investing in a stock, just because, the price has been rising for the last 3 weeks or a month or even a few months, it is still purely guesswork; just because a stock has been rising for the last few weeks or months, it does not mean it will continue to rise.

Mutual Fund managers rely on fundamental analysis to forecast long term asset prices. In fundamental analysis, they look at a variety of macro and micro economic factors. It also includes analysis of the companies balance sheets, income statements, cash-flow statements, management commentaries etc. Based on the forecast of these factors, employing a variety of methodologies, the fund managers and analysts forecast the future price of the asset.

It requires a certain set of skills and capabilities (which often includes speaking with the managements of the companies), which retail investors do not have.

Stock selection, requires deep expertise and experience, which only fund managers possess and most retail investors do not. Fortunately, mutual fund investors do not have to worry about stock selection. Mutual Fund investors have to select the right fund category and the right fund manager. As far as selecting the right fund manager is concerned, the investor has to look at the past performance of the fund manager and also the fund house. A fund manager who has performed well in the past can be expected to do well in the future as well.

Analyzing past performance of a fund manager may seem complicated, but there is a quantitative measure to analyze the performance of a fund manager. A fund manager’s mandate is to outperform the relevant market benchmark returns. A good manager creates value for the investors through, what is known as, “Alpha”. Alpha is the excess return that the fund manager generates, over and above, the returns expected by the investor for taking a certain amount of risk.

Disciplined Investing versus trading

Share prices are highly volatile and can affect the emotions of an investor and thus can induce the investors to buy or sell in short time periods. This practise, more often than not, leads the investor to incur losses. Mutual funds, through a variety of mechanisms, encourage investors to invest over a long time horizon to meet a variety of long term investment objectives like retirement planning, children’s education, wealth creation etc.

Historical data shows that, long term buy and hold is the best strategy to create wealth in the long term. Equity mutual funds provide solutions to investors to meet their long term financial goals through capital appreciation. Historical data analysis suggests that, the effect of volatility reduces considerably, with increase in the investment horizon.

Systematic investment plans (SIPs) encourage investors to take advantage of short term volatility and invest in a disciplined manner to meet their long term financial objectives. Many investors fail to build a substantial investment corpus because they are not able to invest in a disciplined way. Savings not invested regularly often gets spent on discretionary lifestyle related expenses.

Through SIPs, you can invest a portion of your monthly savings in a mutual fund scheme for long term capital appreciation. SIPs also help investors take emotions out of the investment process, which is critical to achieving your long term financial objectives. Very often investors get very enthusiastic in bull market conditions, but get nervous in bear markets. It is an established fact that investments made in bear markets help investors get high returns in the long term.

Through SIPs, you can also take advantage of Rupee Cost Averaging by investing irrespective of whether the markets are low or high. This method helps you buy units of a mutual fund scheme, both in rising and falling markets, which will enable you to average out the purchase price of your units, which in turn will enable you to get higher returns on your investments.

Unlike equity shares, mutual funds provides a variety of effective solutions for a wide range of financial needs of retail investors. For example, if you have lump sum funds to invest but you are not sure about the market timing due to volatile conditions, you can invest in a low risk fund, such as liquid fund, and then purchase units of equity fund of your choice through a systematic transfer plan (STP).

This help you average out the cost of purchase like in SIPs, while enabling you to earn higher return on investment (liquid fund returns are usually much higher than savings bank interest). Such a facility is not available in direct equity investing. Similarly, if you have income needs from your mutual fund portfolio, you can draw a fixed or variable amount of funds from your portfolio through systematic withdrawal plans (SWPs). The withdrawals will help you meet your regular income needs while, the balance invested will continue to earn returns. You can also opt for dividend options of mutual fund schemes to get tax free dividends.

Conclusion

Are mutual funds definitely better than investing directly in equity shares? If you have the necessary stock selection and portfolio management skills, you can invest directly in shares through a stock broker. Investing in shares gives you the freedom of selecting the shares you want to buy or sell, while in mutual funds, you will have to depend on the judgement of the portfolio manager. As discussed earlier, the knowledge, experience and judgement of a fund manager, is likely to be much better than that of a typical retail investor. As such, for most of the retail investors, mutual funds are more beneficial for meeting their long term financial goals.

In our previous blog post on this topic, Why do we love gold: The economic value of gold, we had discussed the love for the Gold in our country. Despite several legislations aimed at reducing imports of foreign exchange guzzling yellow metal, our attraction to the precious yellow metal still persists and gold is one of the largest components of our import basket, even as recent as last year. In the previous post, we also discussed the economic value of gold and we saw that, gold returns are much lower in the post liberalization period (1991 onwards) compared to pre liberalization period. In this post, we will discuss equity versus gold as an asset class.

Is Equity superior to Gold as an Asset Class? The answer may be obvious to many of our readers, who read investment blogs on the web or follow investment experts on television business channels. These blogs cite historical returns of equity versus gold and conclude that equity is the superior asset class because over a long investment horizon, equity has outperformed gold. Many a times I feel that, investment experts and bloggers give their expert opinion on a topic without delving into the psyche of the Indian investor. So despite the merits of these expert opinions, mostly, it has limited or no appeal to the investor.

The experts cite historical returns of gold versus equity, but return is not the most important factor for people investing in gold. Since time immemorial, gold was thought of as a safe asset; an asset whose value never diminishes. Right or wrong, this perception still persists. Therefore, any discussion on gold versus equitycannot simply be limited to returns; we have to discuss risks also. In this blog post, we will discuss risk to return trade-off in gold versus equity investments.

Let us first discuss, what safe asset means from a practical standpoint. Safe asset, in the strictest sense, is something, which never diminishes in value. The price of gold changes every day; it can go up one day and fall another day. Therefore, in the strictest sense, gold is not a safe asset. In 2013, the average price per 10 grams of gold was Rs 29,600 and in 2015,the average price per 10 grams of gold was Rs 28,000. We have said a number of times in our blog that, investment horizon is an important factor in risk.People who invest in gold have a long investment horizon and over a long tenure perceive gold to be a safe asset. At the same time, while equity is volatile in the short term, we discussed in our post, How Investing in Equities for the long term reduces risk, that the volatility of equity as an asset class reduces with increase in investment tenures. Let us now discuss gold versus equity on various risk return parameters.

The chart below shows the annual average price of 10 grams of gold in India over the past 25 years. The annualized return of gold over the past 25 years was around 8.1%.

 

 

Let us now see, how gold compares with equity. The chart below shows the average annual price of BSE-Sensex over the past 25 years. The annualized return of Sensex over the past 25 years was around 9.6%.

 

 

Clearly over the past 25 years, the Sensex outperformed Gold, which would not be surprising to many of our readers. But how has it performed versus Gold over other time-scales.

 

 

Clearly Sensex outperformed Gold over most time-scales, but Gold outperformed Sensex over the last trailing 7 and 10 years timescales. For example, some can argue that, the last 5 years was largely a period of bullish equity market and bearish gold market. On other hand, others will argue that the last 10 year period involved the worst period for equity (2008) and the best period for gold in many years. The problem with trailing returns is that, it is dependent on market conditions during the period.

We can resolve the dependence on market conditions by using rolling returns as a measure of performance. We have discussed a number of times in our post that, rolling returns is the best measure of an asset’s performance in various market conditions. Rolling returns tell us how an asset performed in bull market, bear market, mildly bullish market, mildly bearish market, mixed market, so on so forth. Rolling returns as a measure of performance is therefore independent of market conditions.

The chart below shows the 5 year annual rolling returns of Gold versus Sensex from 1992 onwards.

 

 

You can see that the Sensex outperformed Gold in most except in the late 90s and early 2000s, and then from 2008 to 2014. Since 2014, Sensex has been outperforming gold again. More insights related to risk and return are revealed when we look at the rolling returns parameters, as shown in the table below.

 

 

You can see that the maximum rolling return (best case scenario) of Sensex was higher than Gold. At the same time the minimum rolling return (worst case scenario) of Sensex was lower than Gold. The average rolling returns of the Sensex was also higher than Gold. Therefore, we can say that, the risk return trade-off in Sensex was better than Gold.

Many traders / investors use risk return to make investment decision. Risk return trade-off tells the trader or investor if the higher returns justify the risk taken. You can see that, the maximum and average returns of Sensex was higher than Gold, while the maximum loss was lower. Therefore, the risk return trade-off is better in Sensex compared to Gold. We can also use Sharpe Ratio (a measure of risk adjusted returns) to compare risk return of these two asset classes, but average investors may find Sharpe Ratio difficult to comprehend; so we looked at some simpler risk versus return measures like maximum, minimum and average.

Conclusion

Earlier in the post, we saw that, over the last 15 to 20 year period, Sensex outperformed Gold. From the 5 year rolling return analysis, we can conclude that, the risk return trade-off is better in Sensex compared to Gold. We can also use Sharpe Ratio (a measure of risk adjusted returns) to compare risk return of these two asset classes, but average investors may find Sharpe Ratio difficult to comprehend; so we looked at some simpler risk versus return measures like maximum, minimum and average. When you make investment decisions, with respect to different asset classes, you should look at risk return trade-off objectively instead of going by commonly held perceptions. A knowledgeable investor is a smarter and eventually richer investor.