Monday, April 03, 2017

How to Invest in Mutual Funds?

“Do not save what is left after spending, but spend what is left after saving.” - Warren Buffet

As is common knowledge, there are many ways to save and invest your funds and generate wealth. After hearing a lot of stories, reading a lot of testimonials and seeing my friend’s experiences, I am on the Mutual Funds bandwagon right now. From my experience, investing in Stocks on a regular basis demands a lot more time, dedication, research and market knowledge than what I can afford. Real Estate is not really my forte and I am doubtful if the returns are going to be as exciting as they used to be. If you are a salaried individual and is looking for a steady investment plan for future wealth generation, a systematic investment plan in Mutual Funds is a good bet. As they say, the earlier you start, the better.

Rupee cost averaging (RCA) is one of the main reasons why I am inclined towards a systematic investment plan (SIP) in Mutual Funds (as against Stocks). In simple terms, because you are investing the same amount every month, you end up getting less units when the price is higher and more units when the price is lower. On an average, this will help you average out the costs over the entire period. This takes away one of the major risks of directly investing in Stocks, which is timing the market. If you don’t follow a SIP approach, you will have to make sure you are buying when the prices are low. How do you ensure you do that month after month? Considering a long term investment approach, rupee cost averaging can even out any market ups and downs in the long term, allowing the investor to gain maximum benefits on his or her investments over time.

Power of compounding is the next important aspect to be considered. We often don’t understand the full impact of this. Consider you are able to invest 10,000/- every month in a plan which gives you 8% interest (standard for fixed deposit bank plans these days). Let us say tax is deducted on the accumulated interest every year at the rate of 30%. If you can sustain this investment plan for 10 years, you will end up having around 16 lakhs. You will have around 44 lakhs by the 20th year and 93 lakhs by the 30th year. Let us say you manage to find a fund which gives you 15% return, in which case you will get around 21 lakhs in 10 years, 80 lakhs by the 20th year and 2.3 crore by the 30th year. If you can invest 50,000 rupees per month at an interest rate of 15%, you will have around 12 crores in 30 years. This kind of multiplication is the power of compounding. Two factors are important here – being steady and systematic and finding a plan which can offer good returns. Traditional bank fixed deposits give you a return of around 8% these days. A good Mutual Fund can give you returns anywhere above 12%, and there are many which can afford 15% or more. You will be generating a lot more wealth for yourself by shifting your investment plan from a classic fixed deposit to a Mutual Funds plan.

Can’t you do all these through Stocks? Yes, you can. But you need to be spending a considerable time each month finding out the best Stocks to invest in the given month. You have to make sure your picks are diversified and risk-free. If you are ready to find a list of good performing Stocks, read up about the companies and keep adjusting your investments by moving it off of a poor performing stock to a better performing stock at periodic intervals, you should be able to beat the 12% year-on-year returns that a typical Mutual Fund offers. But trust me, that is an expert undertaking and will need considerable knowledge and effort from your part. Investing in Mutual Funds is more passive and much more secure for somebody who has another full time job to manage.

Type of Mutual Funds
Once you decide on Mutual Funds, your journey doesn’t end there. You have to decide on the type of Mutual Fund you want to invest in and then narrow down on a specific Mutual Fund within that type. My pick right now is to concentrate on Index funds. Look at this article for an experimental reason - J. In 2007, Buffett took the challenge that an S&P 500 index fund would best a carefully chosen investment in hedge funds over 10 years. Smart call. As The Wall Street Journal calculated last week, Buffett’s chosen Vanguard’s S&P 500 fund (Admiral shares) is way, way ahead with just under 10 months to go.

Some Jargon and some concepts
It is important that you have an investment story and a plan. You should do your own research and find out basics about some funds, observe their performance, invest trial amounts, track progress and adjust your investments accordingly. To understand more about Mutual Funds, the following terms may come handy.
·        Benchmark - A group of securities, usually a market index, whose performance is used as a standard or benchmark to measure investment performance of Mutual Funds, among other investments. Some typical benchmarks include the Nifty, Sensex, BSE200, BSE500, 10-Year Gsec.
·        NAV - The NAV or the net asset value is the total asset value per unit of the Mutual Fund after deducting all related and permissible expenses. The NAV is calculated at the end of every business day. NAV of a mutual fund is the market value of the assets of the scheme minus its liabilities. It is calculated by dividing the value of net assets by the outstanding number of units. In simple words, NAV is the value of each unit of a particular mutual fund scheme on any given business day. It varies day to day as the market value of securities changes every day. NAV helps in determining the price at which an investor can purchase or sell mutual fund units.
·        AUM - AUM or assets under management refers to the recent/updated cumulative market value of investments managed by a Mutual Fund or any investment firm.
·        SIP - SIP or systematic investment plan works on the principle of making periodic investments of a fixed sum. It works similar to a recurring bank deposit. For instance, an investor may opt for an SIP that invests Rs 500 every 15th of the month in an equity fund for a period of three years.
·        Alpha - The simplest definition of an alpha would be the excess return of a fund compared to its benchmark index. If a fund has an alpha of 10%, it means it has outperformed its benchmark by 10% during a specified period.
·        Beta - It measures a fund's volatility compared to that of a benchmark. It tells you how much a fund's performance would swing compared to a benchmark. A fund with a beta of 1 means, it will move as much as the benchmark. If a fund has a beta of 1.5, it means that for every 10% upside or downside, the fund's NAV would be 15% in the respective direction.
·        Standard deviation (SD) - Standard deviation is a statistical measure of the range of an investment's performance. When a Mutual Fund has a high standard deviation, its means its range of performance is wide, implying greater volatility. Standard deviation measures the volatility of the returns from a Mutual Fund scheme over a particular period. It tells you how much the fund's return can deviate from the historical mean return of the scheme. If a fund has a 12% average rate of return and a standard deviation of 4%, its return will range from 8-16%.
·        Sharpe Ratio - This measures how well the fund has performed vis-Ã vis the risk taken by it. It is the excess return over risk-free return (usually return from treasury bills or government securities) divided by the standard deviation. The higher the Sharpe Ratio, the better the fund has performed in proportion to the risk taken by it. Tells how volatile the returns of the fund have been over a period.
·        Entry Load - A Mutual Fund may have a sales charge or load at the time of entry and/or exit to compensate the distributor/agent. Entry load is charged at the time an investor purchases the units of a Mutual Fund. The entry load is added to the prevailing NAV at the time of investment. For instance, if the NAV is Rs. 100 and the entry load is 1%, the investor will enter the fund at Rs 101.
·        Exit Load - Exit load is charged at the time an investor redeems the units of a Mutual Fund. The entry load is added to the prevailing NAV at the time of redemption. For instance, if the NAV is Rs 100 and the exit load is 1%, the investor will redeem the fund at Rs 101.
·        Yield to Maturity - The Yield to Maturity or the YTM is the rate of return anticipated on a bond if held until maturity. YTM is expressed as an annual rate. The YTM factors in the bond's current market price, par value, coupon interest rate and time to maturity.
·        Compounded Annualised Growth Rate (CAGR) - It is the return of a fund from one point to the other after factoring in the time for holding investments. It gives an idea about the value of investment during its tenure. While investments usually do not grow at a constant rate, the compound annual return smoothens out returns by assuming constant growth. For example, an investment of Rs 5,000 over a five-year period has grown to Rs 6,500 and given absolute returns of 30%, which is very high, but the gains are over five years and, hence, the CAGR is 5.38% obtained in the following manner - ((6500/5000)^(1/5))-1. CAGR calculates the growth rate of investment per annum by considering the compounding effect.
·        NPV - Net Present Value - The cash that we have today is more valuable than the cash that we will receive after five years due to inflation. Hence, when you decide to invest money each year, you need to first check how much that money is worth today. This is called net present value of money.Assume IRR is around 8% for project ‘A’. IRR is also called discount rate. To calculate NPV of this project, discount each cash flow with IRR keeping in mind the time lapse. The formula to compute NPV is cash flow / discount rate + 1^N. The term ‘N’ stands for the number of years
·        IRR (Internal rate of return) - usually used to calculate the profitability of investments made in a financial product or projects. Internal rate of return or IRR is that rate of return at which NPV from the above investment & cash flows will become zero. IRR is the rate of interest that makes the sum of all cash flows zero, and is useful to compare one investment to another. Therefore, IRR is defined as the discount rate at which the NPV of a project becomes zero. Higher the IRR, the more profitable it is to invest in a financial scheme or project.
·        XIRR is a more powerful function in Excel for calculating annualized yield for a schedule of cash flows occurring at irregular periods.

How to select the right Mutual Fund?

Within a category the right scheme can be selected based on criteria such as past performance of the scheme, comparison with peer set and benchmark, volatility measures and risk adjusted performance of the scheme, scheme size, expense ratio of the scheme etc.

Growth Vs Dividend
This is a choice which can confuse a novice investor. Dividend option means just that – whenever you Mutual Fund announces profit; it offers a dividend to the investor. The dividend won’t be invested back into the fund. Growth option does just that – ie, the interim profits which are made are invested back to the fund so that the overall wealth grows. So if you are accumulating wealth for future, Growth should be your choice.

Be concerned about expenses
If you start with high costs, whether you’re paying extra for a sales fee, a commission, or in pricey expense ratios, you’re setting the bar higher at the beginning of each year for the investment to outperform the market. What’s the likelihood that will happen every year?
One of the ways of avoiding higher fees is to go for ‘Direct’ plans instead of ‘Regular’ plans. In case of Regular plans, a broker is involved as an intermediary, and he/she often gets a hidden fee of around a 1% of your investments. When this is compounded over the life of your investment, this accounts to a huge sum. Always avoid the middlemen. Do not invest in third party mutual funds from within your Demat account’s dashboard just for the convenience it offers. Your Demat account provider will act as an agent with the Mutual Funds provider and extract a commission from you. Always deal directly with the Mutual Fund.

Annual reviews
So how can you push your portfolio in the right direction and what’s the best way to screen your portfolio for excessively high fees? Consider an investment detox to rid your portfolio of excessive fees. Commit to a regular review, much like an annual checkup and compare your funds to their peers — the easiest way is to type each fund’s ticker into fund tracker Morningstar’s website and look for the category average. Or if you’re working with advisors, ask them to run the numbers.

Three steps for trimming costs:
•Schedule an annual review of investment costs; if you’re a do-it-yourselfer, compare each fund’s expense ratio against its category average on Type your fund ticker in the quote box, click on the expense tab to compare the expense relative to the category average. As an example, check out that Vanguard S&P 500 fund and you can see at a glance its 0.16 % expense ratio has been nearly a full percentage point below the category average over the last few years. And if you’re working with advisors, ask them for a breakdown showing cost comparisons
•Perform the same exercise with your investments in your 401(k)s or IRAs
•If you have an advisor, review your fees there too. There are ample choices to still get help with investment advice at lower costs, including fee-only financial planners and robo-advisors. Even Mutual Fund companies offer guidance

Bottom line
Consider whether the gains you’re getting are worth the haircut you’re taking. Now extrapolate that over a decade or more. Chances are you’ll come to the same conclusion Warren Buffett did: That unless you’re Warren Buffett, the best bet for prospering in the markets is to cut the costs of investing. Index funds are a reliable way of doing that.