Mutual Funds- A safe way to be in stocks

MUTUAL FUNDS- THE BEST INVESTMENT VEHICLE We always talk about long term investing. However, it seems to have become a buzzword rather than a demonstrated fact. I just came across an interesting study on the industry and this table perhaps illustrates the best example of the role of Mutual Funds in Wealth Creation: Table 1 - Category-wise returns generated by mutual funds across time frames 3 Years(%) 5 Years (%) 7 Years (%) 10 Years (%) Equity Funds 23.80 8.19 18.93 25.46 Balance Funds 23.69 10.02 17.26 20.87 Income Funds 8.86 7.76 7.10 7.41 GILT Funds 4.65 5.99 5.83 7.25 Returns are AUM weighted returns as of November 11, 2011 (From a CRISIL Research Study) Several key takeaways from this useful information: i) These returns are possible only without churn; ii) Patience is important; iii) Risk and Reward go hand in hand, over a period of time; and iv) Equities are the only financial asset class that can help create wealth over the long term. Of course, within mutual funds, there is a wide divergence in the returns. Hence, choosing the right fund becomes important. Luckily for us, we now have sufficient track record in the industry to separate the wheat from chaff. There are good funds that have consistently been in the top five or ten. So long as one sticks to that, these kinds of returns are possible. What is remarkable is the long term performance of balanced funds. They have been showing strong performance. It is perhaps due to their rebalancing act in the face of continuing volatility in the equity market. To my mind, they are surely an asset class to own, within the mutual fund universe. Turning to our markets, they have had a spectacular January in respect of equities. Most mutual funds have delivered better than the indices, in spite of not being fully invested. That surely demonstrates the superiority of diversified equity funds in the longer term. This study also carries out some data on how a ten year SIP in the ‘best’ performing fund has done as opposed to mere passive index investing. For instance, one table shows up that the ‘best’ equity fund delivering a total value of Rs. 4,92.506 over a ten year SIP of Rs.1,000 per month as opposed to an S&P 500 Index return of Rs.2,78,811 . This is a ten percent annualised difference between a mutual fund and the index! And it is over a ten year period and not a one off thing. Now, the next question that one wants to ask is that the example and the data relate to the past. Will the same thing repeat itself? We tend to look at the environment around us and our thoughts get clouded accordingly. If we look back at the past ten years, there have been enough periods of gloom and happiness. So, the setting is kind of similar. The other question, to my mind, is more relevant. Will India Inc’s growth in the next ten years be better or worse than the previous ten years? If the answer is positive, then our equities should deliver good returns. And the other factor to note is that at this point in time, there is no bubble or a valuation concern. So, it is as good a time as any to start off an equity investment plan for the next ten years. So, I would urge those of us who have dark thoughts on equity, to put aside our worries and take the plunge in to a ten year SIP in to diversified equities. From the above table, we will see that Income funds have returned a seven to eight percent kind of return over time. Today, we can lock in our money at higher rates for the next five to ten years at higher rates. The only issue is that of taxation. And another thing about income funds is that the returns have not been straight. Perhaps, now is a good time to park some money in to income funds. As interest rates fall, the values of the assets go up and vice versa. Today, interest rates in India should start to come off. As to the timing, it is unclear, but it can be a reasonable assumption that interest rates are less likely to go up. If we assume or believe that the interest rates should start to come down, this is a good time to invest in to income funds and take the benefit of high coupon returns that the funds have locked in to as well as play the fall in interest rates over the next year or more.

2G and beyond...

The cancellation of the 2G licenses by the Supreme Court, throws up some interesting thoughts. It is reasonable to assume that these licenses will come up for auction and anyone wanting to get in, would have to fight off the present players who enjoyed these licenses thus far. The Courts have given a breather of four months by which time the Telecom Regulatory Authority (TRAI) would have hopefully finalised the modus operandi for an auction. Of course, there also exists the possibility that one of the affected companies could seek a review in which case the time frame gets extended. The judgement does not impose any thing stringent on the players in the drama. Some fines have been imposed on a couple of players, but that is only so much money. Other players have not been touched in any way except having their licenses revoked and have not been barred from getting the same license again through some way or the other. The interesting thing would be to see whether the partnerships survive, in the case of those companies where the foreigner has subsequently come in by buying shares from the local players at a huge price. Surely, the foreign players would like to protect what money they have pumped in and would therefore be at the mercy of the Indian partner. It is highly unlikely that the foreign partners were unaware of what went in to getting the licenses. And now, they suddenly have to cough up more money (if there is an auction, it will be the foreign partner who has to cough up money) if they want to stay in business in India. Of course they will make noises about political uncertainties in India simply to put pressure. They know and we know that they all want to be in India and China. And of the two, India is much more amenable and open. So, they may have to keep the present partners and start afresh. Of course, the guys who made money by selling the stake to the foreign telcos have already laughed their way to the bank and neither the Courts nor the government would be motivated to catch them. It would be interesting to watch the auctions as they come up. Existing players like Vodafone / Airtel can simply create nuisance bids for the 122 circles to push the costs higher for the wannabe licensees. So, for four months (or for a further extended period if someone legally challenges the Court decision) there is going to be much mudslinging and speculation about whats and ifs. As far as the consumers are concerned, it should make no difference. Strangely, I have not seen any TRAI order prohibiting the companies from seeking new customers, unless the interpretation is that since their license is suspended and they have merely been given a license to “Carry On Business”, it follows that they cannot enrol new clients. Media will also make noise (perhaps motivated) that this decision will lead to increase in telecom charges. Do not believe it. These 122 licenses do not constitute more than five to six percent of the market. Yes, charges may go up, but that would have happened irrespective of this event. India has perhaps the cheapest calling rates in the world and a twenty percent hike would still keep it there. The industry players competed to grab market shares and brought down rates to unremunerative levels. This had to get corrected and we have seen one modest correction so far. As regards the noise about this creating uncertainty about FDI, it is all bunkum. This decision in no way should deter any genuine FDI. In this case, no foreign partner can deny ignorance about the antecedents or connexions of the Indian players, most of them who had nothing to do with the telco industry except being customers. Media space and time will be bought for propagating the FDI angle, but I firmly believe that this decision has zero impact on FDI. If anything, it creates a better climate for those who want to come in with strict compliance to the letter of the law. It is also a warning for the foreigners to choose their partners with care. I also suspect that noises being made by some players of their losing interest in the system, is just so much of hot air. All of them are under pressure to perform at home and the Indian market is a Hobson’s choice. Since everyone and his neighbour is in India, there is a problem a CEO will face, if India does well and his company is not there. India is not short of excitement. First we had Vodafone. Now this. What next?

Inflation- The termite in your wallet

(This appears in the recent issue of Moneylife) THE RACE AGAINST INFLATION The ideal situation for an investor is that our savings ‘grow’ in real terms. If we can invest our money without too much risk and at the same time protect its purchasing power, it would be great. In other words, if inflation is at ten percent and our savings give a return that is higher than ten percent, we have succeeded in doing this. The last three years have seen our savings getting eroded in the face of high inflation that kept eroding our purchasing power. This was primarily due to the lack of investment opportunities in fixed income at high rates. It is only in 2011 that we saw interest rates on bonds and bank deposits going up sharply. I think it is an excellent time to look at bonds and fixed deposits quickly, before interest rates start to come off. I am making a basic assumption that average annual inflation will remain at less than ten percent over the next three to five years. Is this possible? I cannot say with one hundred percent conviction, but my bet would be that inflation would remain under ten percent. This is because I expect our growth rate to slow down. This means a drop in the rate of demand for goods and services. This would help to keep inflation modest. High inflation is a worry, when our growth rate is beyond eight or nine percent is my understanding. Of course, the way the government finances are looking, there is a real risk of printing presses working overtime and pushing inflation higher. I am taking a most likely case that inflation would be just below double digits. Today, we can pick up decent double A rated paper, having three to five year maturity and giving us a yield of around twelve percent per annum. In fact, a recent issue of a NBFC had a coupon of over thirteen percent per annum. Locking in to such paper, according to me, protects our buying power. The main problem with this strategy is the vexed issue of taxation. Interest on fixed income instruments is fully taxable. Of course, when we put money in bonds that are ‘listed’ on the exchanges, there is no deduction of tax at source. So, this strategy can work well only if you are in the zone where your tax burden is zero to around twenty percent. Why twenty and not thirty? At twenty percent tax, the post tax return on a twelve percent paper is around 9.6% and at thirty percent, it would be 8.4%. Only if inflation stays below 8.4%, would there be any ‘real’ return. I am also assuming that over the next couple of years, equities are not going to give great returns. Even if they give a couple of percentage points higher, I do not mind locking my money for fixed returns. The risk reward ratio for investing in equity is still not very tempting. Let us for a moment assume that things are going to get very good in about a year or so and we would like to put some of the money in to equities. In such a case, I would assume that interest rates have fallen or will fall down first. Equities can be attractive only when interest rates are low. So, if interest rates fall across the board by two to three percent, then the bonds we have would appreciate in value. In which case, we can sell the bonds, say, at a gain of around two to three percent. Add to this the interest we have got, the total returns would be upward of fifteen percent. This strategy can be a loser only if equities take off from here in a big way and give us returns of over fifteen percent, year on year. The other situation is that inflation continues to remain high and interest rates keep going up. If both happen, then we lose out since we have locked in to present rates of interest. Or, simply that inflation keeps going up and interest rates stagnate. In such a case, we would have lost out anyways. Maybe then gold or commodities would give the returns, but I wonder how many of us are competent to park our investments in either. Yes, all of us do have gold as a part of our core assets, but we do not generally keep buying and selling gold. The other thing in these times is to keep an eye on our borrowings (home loans etc). If inflation remains high, it makes sense not to prepay any of our loans. I only hope that most of us have incomes which also rise in relation to inflation. In a slowing economy this is a tough ask. I only hope that the time does not come when we get in to a situation of job losses across the private sector.