Should you invest in mutual funds directly?

Last week I wrote an Opinion piece in Mint newspaper on the capital market regulator, Securities and Exchange Board of India's (Sebi) plans to mandate mutual funds to come out with a separate plan for those investors who invest directly, without any agent's advice. Called the Direct plan, this plan will have a slightly lower total expense ratio (TER), without the distributor commission element. The net asset value (NAV) will be different for the Direct Plan. As things would go, Sebi introduced the Direct Option in its board meeting last week. What this means is that in addition to the 'retail' and 'institutional' plans, there will now be a Direct Plan. Only those investors who invest directly will be able to avail of the Direct Plan that comes with a lower expense ratio. Will investors transfer to the Direct Plan in droves?

My estimate is though initially there might be a rush, in the long run many such investors will suffer. Investing in mutual funds (MF) in not as easy as it sounds. There are operational hurdles. Numerous forms to be filled up (for Know-Your-Customer norms, application and Systematic Investment Plan), forms getting rejected because of the tiniest of reasons, change of bank account mandates; these hassles can sometimes drive investors to the wall. A good distributor can be of great help here. But if you go 'Direct', then distributors can't  help you as they can only access your record if their stamp has gone on your form.

Is Personal Finance stale?

This is a rant; as a blogger for over three years now, I think I have a right to rant occasionally. There is not shortage of myths; this much I can tell you for sure. As a journalist covering personal finance, especially mutual funds, for the past 10 years, I should know. Ofcourse, new developments do not take place in the PF space everyday, especially in any one given beat, say, MFs that I cover. Often, people- especially fellow journalists (and this is where it kills me that the myth exists in ur own community rather than outside)- misunderstand or rather blatantly assume that things get repeated in the PF space. The same-old tale of asset allocation, invest in equities for long run, why you should invest in MFs and so on are repeated like 10 times in a year, they feel. Hence, a PF journalist leads a cushy life at work; if you don't have an idea, just pick an old story and recyle and voila, there's a 'new' story, they say.

Without going into a length tirade, here's what I think:

• Competition in the media space is as severe as it can get. On top of it, every publication worth its salt wants to get into PF, committing resources to hire talent and infrastructure and obviously need PF writers to perform to their best to stay ahead of the competition. If that is the aim, recycling is a bad idea. Any responsible editor would see through a recycled story and stop it from going to press.
• Because of changing market scenario and dynamics, there isn't really a shortage of story ideas. There isn't a dearth of topics because the entire world is changing. Changing regulations, new and more complex products are the new order. A good PF writer is paid to spot these trends and there's enough to write
• Last, but not the least, financial illiteracy is a huge nuisance. Just because I wrote seven years back advising retail investors to invest in equity funds for the long run, that doesn't mean every tom, dick and harry have since started to do the same. You've got to drill first principles into the reader's mind, even then you will find it won't be enough. By that time, several other things may have happened. This merits passing on the same message if you will, but with a new twist like new data, fresh arguments and so on. And if fellow journalists are so financially illiterate (so many do not even bother to track their provident fund, for instance) how can I expect my readers to head my advice? 

Do Headlines Cause Pain?

Are attention grabbing headlines the right way to project a media report (story) who's conclusions turn out to be contrary?

http://mintmoney.livemint.com/featured/2010/07/balancing-news-with-reader’s-interest/

Mint: Can Trustees Be Held Accountable?

Mint's story on where the mutual fund trustees stand.

http://mintmoney.livemint.com/mutual-funds/2010/07/can-trustees-be-held-accountable/

Gullible Investors or Gullible Agents?

That Indian mutual funds (MF) are not supposed to ask for a no-objection certificate (NOC) from us if and when we change our broker and transfer our existing MF investments to a new broker, is a fact that is not well known. Although I have written on this in the magazine that I work for, more than once, (read here and here), many of us aren't aware of it. And MFs and agents are only too happy to exploit this.

A couple of days back, I had called for my stock broker, who is also an MF distributor. Since they offer online MF buying and selling, I wish to open an online MF account with them and thereafter transfer all my existing MF investments to them. I already have a direct equity account with them; an offline mode though presently, wherein a broker executes trades on my behalf. To this, now I want my MFs. This will enable me to get a consolidated statement, one that will give me a summary (as well as details) of all my equity and MF holdings.

Much to my surprise, my relationship manager told me that I would need an NOC from my old agents. He obviously did not know who I was (I don't mean to say this in the immature VIP-culture fashion amply seen these days at airports;) ) and which publication I write for and the stand that our publication holds in this regard. I reminded him that I am quite aware of my rights as a MF investor and that an NOC is not really required, but falsely demanded to make agent-changing a time-consuming affair. I do not know whether I have convinced him or not, but I intend to go pursue this matter to its logical end. I shall keep you posted on how smooth or otherwise my transfer is going to be.

The problem, as I often highlighted, is that when the Association of Mutual Funds of India (Amfi) says anything, it is not legally binding on MFs. Amfi is a trade body. It is not a regulator. For it to become a law, the Securities and Exchange Board of India (Sebi) needs to pass the order. And with Sebi recently asking MFs whether or not they are demanding NOCs in this regard and reasons if they are, shows that the market regulator is serious. Probably for the first time in my nine years of journalism career am I observing Sebi monitoring the Indian mutual funds (MF) industry this closely. It's been pretty quick in passing orders to ensure that the end-investor gets serviced adequately.

New Rules of the Mutual Funds Game

These are interesting time in the Indian mutual funds (MF) industry. The market regulator, the securities and exchange board of India (Sebi) has been acting in a most proactive manner, quite unlike anything we've observed in the past. I've seen the regulator acting in the past too, but the way it has responded, post October-2008 crisis that delivered a giant blow to the MF industry, is a bit, you may say, admirable. As you must be knowing, after 1 August, entry loads are abolished. These were upfront charges- usually 2.25%- that were levied on you at the time of investing. So if you had invested Rs 100 in a MF, Rs 2.25 (2.25% of Rs 100) was deducted as entry load and the remaining Rs 97.75 was invested in the market. The entry load was eventually passed onto the the distributor as his commission.

Now Sebi has said that you- the investor- will have to sit with your agent and jointly decide the amount you'd like to pay him. You will need to account the quality of your distributor's advice and the service he provides and figure out an amount you'd like to pay him.

While we wait for various distributors to think it through and devise new costing strategies, the first ques are coming from online distributors. ICICI Direct (www.icicidirect.com) has decided to charge Rs 100 per annum for a total investment amount of Rs 8 lakh. Kotak Securities has decided to offer MFs on its website for free. No charge. But in case if advisory services are wanted to get to know recommendations of which funds to buy, then Kotak securities will charge. It said that it will disclose such charges on its website in a month's time. Of course a free service is great, but even the charges imposed by ICICI Direct are most reasonable. For someone who wishes to buy and sell MFs on the net through one common window, these online brokerages offer a great service.

However, if you still wish to avail of your broker, you can continue to do so. Many brokers I know are offering to sell MFs free of charge. They aim to make money in trail fees. These are fees they earn on your investments till such time that you stay invested. It's also called loyalty bonus. But their total income that they used to earn from selling MFs will definitely take a hit, as most of them, in order to tackle competition, is charging NO LOAD. Customers too want free service.

I feel as customers, we must be considerate. Guy please understand, even if these agents do not give out much advice, even if they come to your house to pick up forms and deliver them to the registrar or the MF's offices, they are still doing some service. So what if it is just a courier service, but it is still a service. And for a service they need to be paid. Try going to the MF's offices yourself or even to your registrar's offices. You will need copies of PAN card, original PAN card and also Know-Your-Client (KYC) documents. It is a pain. It's easy, but a pain. If your agent is atleast doing all this for you, don't demand free service just because your agent's competitor is doing all this for you, for free.

True, for a courier service, he may not deserve 2.25% - the erstwhile norm for entry load that your all distributors used to get, irrespective for his service's quality. But he deserves something if he is giving you a service. A good regulation is one thing. But critics will always say that investors are not yet prepared. By demanding free services, we are giving fodder to critics and having eggs thrown at our faces. Let's own up some responsibility here too and start behaving in mature way.

See Your Money Work

A column that I recently wrote in the magazine where I work

Distributors will now, rightly, be paid for the service they give

FROM 1 August, when you go to buy a mutual fund (MF), you will not have to pay upfront commission, or entry loads, as they are called, typically, around 2.25 per cent. These loads are commissions that are presently coming from the amount that you invest with your fund and get passed to your agent. But market regulator Securities and Exchange Board of India (Sebi) has mandated that your agent and you will now have to mutually decide upon an amount that you would like to pay him and he will also have to disclose his commission.

A sweeping impact...Understandably, agents are finding this tough to swallow. A senior manager of one of India’s largest distributors said that if customers don’t ask what the retailer’s commission is when buying a washing machine, for instance, then why has Sebi asked distributors to disclose commissions to investors.

He may be right, but comparing a financial product with a consumer durable is a stretch. It is true that as customers we do not, and are not qualified to, ask white goods salesmen pertinent questions about the products and swallow whatever sales pitch they throw. This, however, doesn’t mean that we have to be similarly unquestioning about our financial products as well.

Moreover, there is no doubt that commissions play a big role in any kind of sale. I hear that one of India’s largest private sector banks does not pay any commission to its investment advisors who sell debt funds to customers. It’s quite evident that even when the interest rate scene is bullish, this bank’s investors would hardly be getting the right advice.

MF distributors also claim that their income will drop significantly. That is true. Small-time agents will find the going tough, but only initially. In the new scenario, your agent will have to justify the fees he charges. By writing out two separate cheques, one for investment and one for the agent, investors will be aware of what they are paying for and, more importantly, how much. Discount brokers—those who merely give out forms with insignificant advice, will, and should, be wiped out.

With entry loads curbed, agent commissions could have been shifted to and clubbed with exit loads. But, as a pre-emptive tactic, Sebi has put a cap of 1 per cent on exit loads. This will prevent distributors from arm-twisting MFs into raising exit loads to compensate for the entry load losses, if any.

Value additions. What most agents and distributors fail to realise is that it is not as easy for an investor to make do without agents as it sounds. Picking and choosing the right fund from out of over a thousand available, filling multiple forms all by yourself, going to a Registrar & Transfer agent’s office before the cut-off time with as many forms and copies of PAN card and all the paraphernalia documents, isn’t easy at all. Even if one knows which fund to invest in, the paperwork and physically delivering the forms and supporting documents is itself a task. This last process may not be worth 2.25 per cent, but it sure is worth some charge.

What a discussion between investors and agents over commissions will do is that price discovery for various types of services, rather than a fl at fee for all, will now begin.

Interestingly, India is not the only country where agent commissions are being made transparent. The same week that Sebi passed the order, big changes were also seen in the UK and Australian financial markets where upfront commissions are being banned and agents will be required to clearly communicate their commissions. Finally, fees is replacing commissions.

Buying Mutual Funds To Get Simpler

A story that I wrote in the magazine where I work...

Get ready to trade in Funds as simply as it is to trade in equity shares

Isn’t it ironical that when you need to invest in, say, five different mutual fund (MF) schemes, you need to sub­mit five forms and five cheques, but when you want to invest in equity shares of five companies, you either phone your broker or log on to the Internet and complete your transaction? You get a con­solidated account statement of all your equity holdings from your depository par­ticipant (DP), but get statements from as many MFs as you have invested in.

Wouldn’t it be easier if MF transactions could happen as they take place for equity shares? Thanks to the Securities and Exchange Board of India’s (Sebi) chair­man Chandrasekhar Bhaskar Bhave, the Association of Mutual Funds of India (Amfi) has appointed a committee of six MF officials to devise a platform for trad­ing in MF units. The objective is three-fold: to make buying and selling of MF units less cumbersome, to increase pene­tration of the product by encouraging participants across India and subsequent­ly to reduce costs.

MF platforms are not entirely new in India. Three platforms already exist, one of which was launched recently. MF dis­tribution and transacting through dedi­cated platforms promises to be the next big wave in the industry. 

What is anMF platform?

Ideally, MF platforms are a common meeting point for MF houses, agents and investors. What you get to see on a web­site has a whole machinery working at the backstage that integrates your data and investments and channelises it to appropriate partners. Typically, agents have to open accounts on such platforms to be able to trade MF units on behalf of their investors. These platforms also dou­ble up as an agent’s back office. So, he need not invest in sophisticated software or spend time manually preparing com­plex reports for clients. He can just use the ample tools available on the platform (like in a website), cull out statements of hold­ings with the latest net asset values (NAV) and other information about the portfoli­os, and send you newsletters or state­ments or even answer any queries.

In countries like the US and Canada, platforms also enable investors to open accounts and trade in MF units directly, bypassing agents. Advanced platforms enable you to trade in MF units electroni­cally and help eliminate or at least mini­mise the paper work.

MF platforms in India, however, are as yet not open directly to investors; only agents can access them. They are simply a link between agents and MF houses. NJ Fundz Network, launched in July 2003, is by NJ Invest, one of India’s largest MF distribution houses. FUNDSNet, launched in 2006, is by Computer Age Management Services (Cams), India’s largest registrar and transfer (R&T) agent. iFast (launched in May) is run by iFast Financial India, a Singapore-based entity that already has a successful platform in Singapore, manag­ing assets of around $1.8 billion.

How does it work?

There are differences in the way the three existing platforms work.

FUNDSNet. When agents join the FUNDSNet network, they get a username and a password. With these they can store their data and information. All that the agent needs is a computer, a printer, a scanner and a good Internet connection. When he gets a form and a cheque, he scans both and the images, as they are being scanned, reach FUNDSNet. Since FUNDSNet is a subsidiary of Cams, it can, therefore, also accept MF applications and attest a time stamp on the application. 

The advantage with this facility is that if the distributor sends in an application at 2.59 p.m., he can still get the same day’s NAV. (The cut-off time for accepting MF applications is 3 p.m., after which the next day’s NAV is applicable). So, with FUNDSNet, the agent doesn’t have to go to the local R&T’s or MF’s offices before the cut-off time to submit the application. For collecting cheques, FUNDSNet has a tie-up with HDFC Bank. 

All records of an agent’s clients, subse­quent transactions, additional purchases, switches and redemptions are stored on the FUNDSNet servers and are accessible by agents. Data maintained on this plat­form is password-protected. 

There are several online tools and calcu­lators also available using which agents can bring out complex reports for their clients. So, the agent doesn’t need to invest in software to handle client information. NJ Fundz Network. Agents who join the NJ platform become NJ Invest’s sub-bro­kers. This platform does not allow scan­ning and electronic dispatch of applica­tion forms. The rest of the process is simi­lar to FUNDSNet’s although the tools offered by the two platforms may differ. 

The advantage with NJ is that it provides schemes from all MFs unlike FUNDSNet which offers schemes only from the 17 MF houses that are serviced by Cams. NJ also has a training program for new recruits and assists them in getting the mandatory Amfi certification. NJ’s platform also offers sophisticated tools that absolve the agent of the need to maintain a full-fledged back-office replete with systems and staff. “We help develop an advisor’s business and train him to handle clients. It is more of a business development platform,” says Jignesh Desai, joint managing director, NJ India Invest. 

Reducing costs 

The existing platforms are more attuned to agents’ needs. A more wholistic plat­form would be able to cut down paper work, make transacting easier, and reduce costs. India’s latest MF platform, iFast, is a step in this direction. It offers schemes in the form of a Portfolio Management Service (PMS). Whenever you wish to invest, your agent will collect your money and invest the entire amount in Deutsche Asset Management’s PMS (DeAM Wrap Portfolio), a division of Deutsche MF which is partnering iFast. 

As against a discretionary PMS where one common portfolio caters to several PMS investors, this is a non-discretionary portfolio where each investor would be able to invest in a unique bunch of schemes across MFs. You need to give only one cheque to DeAM PMS and fill only one form. Depending on the advisor’s choice, DeAM will invest across schemes. 

Apart from the modalities, iFast also dif­fers from the other two platforms on its cost structure which hinges on advisory rather than on sales. So, with iFast, if you want to invest in, say, five schemes, you will not have to pay entry loads on all of them. You can pay a consolidated amount (0.15-2.50 per cent) as the entry load. No entry load is charged on switches though the exit load is applicable. Apart from this, there is the agent’s annual fee of 0.5-1.5 per cent of your prevailing portfolio value. This would include a charge to your agent for using the iFast platform. iFast discourages frequent churning since switches are free and ensures that your money grows. 

In terms of solutions and tools offered, iFast is somewhat similar to NJFundz Network. However, with Sebi having abol­ished entry loads, advisory platforms such as iFast will gain an edge over the rest, eventually. The disadvantage is with iFast’s PMS structure. The minimum investment required is Rs 5 lakh, which could be a deterrent, and, being a PMS, it also attracts a higher dividend distribu­tion tax for all its investors (22.44 per cent, including surcharge and cess). Besides, if your agent gets logged on to iFast, he won’t be able to integrate your current portfolio with the schemes that you would be buying from iFast, for now. 

The next level

The mother of all platforms, the Amfi MF trading platform, aims to remove most of your troubles of investing in funds. Although the Amfi committee refused to comment on how the platform and its modalities would work, sources close to the development say it would be Internet-based where agents would be able to buy and sell units on an investor’s behalf without leaving their offices. 

Sources also say that a tie-up with National Stock Exchange terminals (78,000 at present), is being contemplat­ed. This way brokers would double up as MF agents. Ultimately, the Amfi trading platform aims to switch to a system where investors would have to fill just one form and give one cheque, and would receive one account statement, much like a demat account, irrespective of the number of schemes they invest in. This platform has Sebi’s blessings and is currently being developed by Amfi, an industry body. Sources claim that on account of this, Amfi would hold some ground in convinc­ing Sebi to bring in sweeping changes in its MF guidelines to ensure that the plat­form does not result in duplication. 

Take, for instance, a common account statement. Although all three existing platforms allow agents to get a common account statement for their investors, the latter still continue to get another set of account statements from all their MFs. The present guidelines require all MFs to send statements to their investors. 

Although with iFast, you need to fill just one form and submit one cheque for mul­tiple MF investments, the PMS structure and lack of integration of new and exist­ing portfolios are not user-friendly. Further, though FUNDSNet allows your agent to scan and transmit your forms and cheques, you still have to hand over the physical forms and write out cheques. 

Things would change once Amfi’s plat­form goes live. Paper work, and, therefore, cost, are expected to go down. Also, once transactions take place online, advisors would be able to focus more on giving advice and less on transacting and data maintenance. To an extent, the changes are already starting to happen for small-time advisors who are unable to set up their own infrastructure. But, once the Amfi platform gets launched, transacting in MFs would become much easier and penetration would get a further boost.

Budget 2009 and mutual funds

There was nothing much for mutual funds (MF) in this year's budget. One small change though. Customs duty on gold bars increased to Rs 200 per 10 grams, up from Rs 100 per 10 grams, earlier.

Impact: The net asset values (NAV) of gold exchange-traded funds (ETF) will increase (it did so on Tuesday 7 July; a day after the budget was announced) by Rs 10. Since one unit of most Gold ETFs is equivalent to one gram of gold in a majority of gold ETFs, the increase of Rs 100 in customs duty per every 10 grams of gold would translate to an increase of Rs 10 in the NAV of an average gold ETF.

Apart from the marginal rise of the gold ETFs, there’s not much impact. The reasons for holding gold ETFs still remain true. There’s nothing more to it. Since customs duties of such nature are not in the hands of funds managers and are imposed universally on all gold ETFs, it does not alter your gold ETF holdings. The benefits of holding gold ETF in your portfolio still remains. Stay invested.

What about other MFs?

Budget 2009 brings no change to your MF portfolio. If you have a time horizon of atleast three years and upwards, equities is the way to go. Stick to large-cap schemes, such as DSP BlackRock Top 100, Birla Frontline Equity, Benchmark Nifty BeES and so on if you wish low volatility and steady returns. Mid-cap schemes such as IDFC Premier Equity and Birla Mid Cap Fund would do well for risky investors. Beware of a mad rush for infrastructure funds. Because of the mad rush thanks to the potential of the sector for the next five to 10 years atleast, you'll see a lot of new fund offers (NFO) coming up. These are high-risk, high-return funds and only one or, maximum two, of such funds in your portfolio should be more than enough. And from the looks of it, existing ones like DSP BR TIGER, ICICI Prudential Infrastructure, Tata Infrastructure and so on are good enough.

Freedom of Choice

This is a column I recently wrote in Outlook Money 

Freedom of Choice

Variable loads will give MF investors more say, but it might be too much too soon

There’s a perennial joke I share with my neighbours, the Batliwalas, that whenever I advise them on mutual fund (MF) schemes, I don’t get any commission. Their agent gets it, the entire 2.25 per cent entry load that MFs pass on to agents as commission. And all for just providing them with the forms, or, at best, giving some advice that may not always be in their best interest. I may not get any commission, but thanks to a new proposal by the markets regulator, investors like the Batliwalas will now be able to decide how much commission their agent should get. 

After abolishing entry loads on direct investments in MFs in January 2008, the Securities and Exchange Board of India (Sebi) now wants to introduce variable entry loads. This means that investors will now decide the how much fees (0-6 per cent) they want to pay to their agents. Sebi aims to shift the pricing power from the MFs to the investor. Prima facie, this is good news. But with freedom comes responsibility. Are investors ready for this? 

The modus operandi. 

Sebi has given two options in its proposal. The first proposal says that the investor has to indicate the quantum of the load in the application form that he wishes to pay the agent, and the investor and the agent have to sign on the application form. The MF would then pay the commission to the agent out of the amount invested and issue units from the remaining balance. The other option is that the investor writes out two  separate cheques; one for the investment amount and the other for the agent’s commission that will go directly to the will give the agent’s cheque directly to the agent. 

Variable entry loads also seems to be the legalised version of rebating. Although Sebi had put a stop to this practice in 2001, it still continued. Now, instead of you paying 2.5 per cent commission to the agent and then getting him to give you a rebate, say, of 1 per cent, you will pay your agent that much less to start with. 

Which option is better? 

Of the two, the first option, in which the investor indicates the amount of load, makes sense. Already, filling out long application forms (more, if you are investing in multiple schemes) is a cumbersome exercise. Giving out two separate cheques will only add to the process. 

Lurking danger. 

Empowering the investor also comes with risks. For instance, in option two where the investor pays the agent and the fund house separately, there is a possibility of an agent misguiding the investor to give a commission that’s more than 7 per cent, the maximum entry load MFs can charge. Even 7 per cent is much higher than the present standards. Even in the first option, those investors who merely sign the application forms and leave the rest of the details to their agents to fill, will now have to ensure that the commission agreed upon jointly, is what actually goes on the form. 

What about insurance agents? 

Ultimately, no matter how many proactive steps Sebi takes to make MFs more consumer-friendly, unless similar discipline is enforced on the insurance industry, they will yield precious little. The commission of around 2.25 per cent that MFs pay brokers is dwarfed in front of the 20 per cent-plus commission that insurance agents get in the first three years of selling unit-linked insurance plans (Ulip). The insurance regulator seems to be in a coma and has taken baby steps to curb the evil. It’s not fair that of the two segments that are directly in competition for more assets, one is made to toe the line, while the other gets away with almost anything.

ARE STAR FUND MANAGERS A MYTH?

A recent exit of a star fund manager rekindles the old debate:to trust the fund managers or the pedigreed fund houses?

Just when we thought that it could be a good idea to follow fund managers instead of fund houses, on the back of the stupendous market rise that saw some fund managers outshine their peers, comes the news of star fund manager Sandip Sabharwal and JM Financial Mutual Fund (MF) parting ways. Although both denied the presence of any significant rift, markets are abuzz with rumours that JM Financial—the fund house’s sponsor—had serious differences with the star fund manager’s aggressive style and the severe underperformance of the fund’s equity schemes.

 THE GOOD TIMES...

When Sabharwal joined JM MF in November 2006, the fund house’s equity funds were in the dumps. But after his entry, things changed for the better. For instance, in 2007, out of 241 equity schemes, only four schemes gave more than 100 per cent returns; JM Basic Fund (JBF; 110.6 per cent returns), an infrastructure fund, was one of them. Two of its other schemes, JM Financial Services Sector Fund (a financial services sector fund) and JM Emerging Leaders Fund (JELF; a mid-cap fund) gave 94.5 per cent and 93.8 per cent returns, respectively. 

MF agents and investors poured in. Within a year, JBF crossed Rs 1,000 crore in assets under management (AUM), up from Rs 9 crore. By the end of 2007, the MF’s total AUM had reached Rs 12,613 crore, up from a mere Rs 3,851 crore during December 2006.

...CAME CRASHING DOWN

Trouble started in 2008 when Indian equity markets followed the global market crash. Any memories of phenomenal performance were soon erased when JM’s equity funds began to fall too. Though Sabharwal may not have been directly responsible for all the equity funds, the buck stopped at his desk as he headed the equities team. Five of the ten worst-performing equity funds in 2008 belonged to JM MF. JBF, JM Small & Mid Cap and JELF were the three worst performers of 2008 with returns of -75.6 per cent, -79.1 per cent and -80.3 per cent, respectively. 

Apart from his expertise of picking small-sized companies ahead of the market, Sabharwal also relished the freedom the MF gave. With the MF being a non-starter on equity side, the two were a perfect fit. Freedom came at a cost. When equity markets crashed by more than 50 per cent, small- and medium-sized companies were hit badly. 

Funds with highly concentrated portfolios and low cash levels, such as JM’s, were the worst hit. Even though the period of underperformance was just one year, its severity across the board caused heartburn at the MF. JM’s AUM saw a fall of Rs 6,756 crore, or 54 per cent, in 2008. Sources also add that two private equity funds have taken an 8 per cent stake and invested close to Rs 64 crore in the asset management company a month or so back and will also now have their representatives on the MF’s investment committee. Sources say the tighter control and monitoring may not have gone down well with Sabharwal. Both Sabharwal and JM MF declined to give specific reasons though both confirmed they have parted ways.

WHAT SHOULD YOU DO?

Our past recommendations of JM MF schemes were based on Sabharwal’s track record and the belief that he is going to stick around. Since that has changed, avoid fresh investments in JM MF’s equity funds. Here’s what you should do if you were invested in scheme’s from the fund that we had recommended—JBF investors should switch to DSP BR Tiger and JELF investors to Birla Sun Life Mid Cap Fund. 

This brings us back to the age-old question: should you opt for fund managers or MFs? While rising markets may bring the former into spotlight, just one year of market turmoil brings the focus back to well-pedigreed MFs that strike a balance between fund management freedom and systems and processes

Good time to invest in Debt funds

When equity markets are giving sizzling returns, we tend to forget about asset allocation and join the herd in maximising returns by aggressively tilting our portfolios towards equities. It’s only when equities land with a thud, like it has done in 2008 (the Sensex has dropped 60 per cent from its highest closing on 8 January, to its lowest closing on 20 November), that we flock towards alternate asset classes. Asset allocation is about striking a balance according to your needs and risk profile, across all asset classes. One important asset class that was long forgotten has staged a quiet comeback. It’s safer and less volatile, and merits attention in 2009. Reintroducing the humble debt fund.

Low interest rates
Debt funds and interest rates are inversely proportional. When interest rates fall, net asset values (NAV) of debt funds rise, and vice versa. India, as in the rest of the world, is witnessing drastic rate cuts. The global credit crisis has slowed down economies across the globe. India’s industrial production recorded a negative growth of -0.4 per cent in the month of October, as against a positive growth of 12.2 per cent the same time last year. Due to an unprecedented decline in domestic and foreign demand, industrial productivity has dipped for the first time in more than 13 years.

The ensuing liquidity crunch has hit us hard and the banking system has been starved of cash. Already banks have been finding it difficult to lend money and are also facing the threats of defaults. Companies are expected to deliver poorer results because of fall in demand for goods and services. Added to that are the revised growth projection of 7.5 per cent for India, down from 8 per cent earlier. India, like many other economies, is facing a slowdown, if not a recession.

As a move towards boosting economic activity and ensuring liquidity, central banks all over the world have been cutting interest rates. Says Laxmi Iyer, head, fixed income, Kotak MF: “Interest rate cuts have now become a worldwide phenomenon so that economies do not go into recession. Interest rates are cut to spur growth in the economy, to make funds available at cheaper costs to facilitate low-cost borrowing and increased production activity.”

In India too, the Reserve Bank of India has cut its key rates repeatedly between October and the first week of December and made over Rs 3,00,000 crore available to the banking system. The benchmark interest rates were again reduced on 6 December 2008 as part of the government’s economy stimulus package as a signal of a benign interest rates regime.

Drop in inflation
Another reason why interest rates in India are headed south is a drop in inflation. From a high of 12.91 per cent in August, inflation has fallen to 8.90 per cent, as on 8 November, due to a fall in oil and commodity prices. typically, when inflation is high, interest rates are kept at a higher level to keep the real rate of return (interest rate earned after deducting inflation) high.

Says Ritesh Jain, head, fixed income, Canara Robeco MF: “Inflation is expected to come down to around 4-5 per cent levels around March 2009 and to near-zero levels in June 2009. If inflation is low, the government’s monetary policy will be in your favour as, in India, monetary policy follows inflation.” In short, in India, low inflation indicates low interest rates.

Reduction in Spread
Typically, bond funds invest in two kinds of instruments, government securities and corporate bonds. A debt fund’s NAV largely depends on which of the two segments it has invested in and in what proportion. When interest rates fall in these segments, bond funds’ NAVs appreciate. Although interest rates on debt scrips have come down, rates of
government securities have fallen more than those of corporate bonds.

For instance, the benchmark 10-year government security rate has fallen to 6.79 per cent as on 3 December, from 9.47 per cent on 15 July, a reduction of 269 basis points. In comparison, interest rates of a similar AAA-rated corporate paper haven’t dropped as significantly. The difference in the interest rates, called spread, between the two kinds of papers has in
fact widened to around 396 basis points in November, up from around 138 points in July.

Says Nandkumar Surti, chief investment officer, fixed income, JP Morgan MF: “This spread will have to narrow down as interest rates are on their way down. Interest rates of corporate bonds will, therefore, have to come down too.” When spreads reduce, bond funds will benefit more than gilt funds.

Debt funds
We suggest you consider long-term gilt funds and long-term bond funds. While gilt funds will solely invest in government securities, bond funds would invest across all debt asset classes such as government securities, corporate
bonds or certificates of deposit.





Asset allocation. “Invest around 50 per cent of your corpus in gilt funds and the rest in bond funds,” says Iyer. Note that while government securities are safer than corporate bonds since the former comes with a government guarantee, they could also be more volatile as they are the most liquid of all debt scrips and, hence, change more hands. However, Surti recommends a tilt towards bond funds as he believes the spread compression, when it happens, will result in bond funds outperforming gilt funds. By one estimate, well-performing debt funds are expected to give 15-20 per cent returns in 2009.

Some of the fund houses listed in Outlook Money recommendations (‘Strongest Bond Funds’ and ‘The Brightest’) have both bond and gilt funds. Although both kinds of schemes from all these MFs are worth investing in, we suggest you diversify across fund houses.

Duration. Look at long-term debt funds with a time horizon of one year. Avoid them if your limit is less than six months. Go for liquid funds if you want temporary parking space for your funds. Or, you could go for short-term bond funds if you are willing to take the risk, for tenures of not more than three to six months.

Watch out for...
...Credit quality. While government securities are guaranteed by the government, a bond fund’s portfolio carries credit risk. The more your fund’s assets are in higher-rated securities (AAA-rated and equivalent, including government securities), the better it is, for two reasons. One, fund insiders say that the default risk that plagued the fixed maturity plans (FMPs) not so
long back, is still around. A bond fund that takes on too much credit risk might put your principal amount at risk. Two, higher rated securities are also more liquid and can be easily sold by your debt funds.

...Maturity. As long-term funds will benefit more than the short-term funds going ahead, look at your fund’s average maturity. Avoid funds with a lower maturity.

RELIGARE AEGON MF ACQUIRES LOTUS MF

After suffering their worst month ever, the Indian MF industry sees consolidation. Is this just a start?

It came with a bang but went out in a whimper. Barely two years after setting up shop in India Lotus MF is acquired by Religare-Aegon mutual fund. Both MFs have signed the agreement and the deal now awaits the securities and exchange board of India’s (Sebi) clearance.

Desperate times

After suffering its worst month ever, Indian MFs saw massive erosion in their assets under management (AUM). Lotus MF was no different as it lost Rs 2,479 crore or 31 per cent of its corpus in October, down from Rs 7,937 crore a month ago. 

However, sources say, its sponsor Alexandra Fund Management - a subsidiary of Singapore’s Temasek Holdings, was keen to exit Lotus on account of the mayhem caused due to the global credit crisis and also the state of Lotus MF. Sabre Capital was the other partner in this joint venture. 

In reality, the MF has been jinxed right from its start. Even before it launched its first equity scheme, its ex-star fund manager Sandip Sabharwal was shown the door when news reports of his alleged involvement in the Ketan Parikh stock market scam, when he was a fund manager at SBI MF earlier, surfaced. Soon, another of its star manager – this time its ex-head of debt funds – Nandkumar Surti also quit. There was much heartburn amongst the disgruntled staff and loyalists of these two fund managers soon followed their way out. 

The MF never recovered from its initial debacle. And though Tridib Pathak eventually came on board as Sabharwal’s replacement, he couldn’t recreate the magic. None of its schemes have yet turned three years yet but their performances till date has been sober. Meanwhile Sabharwal has since joined JM Financial MF and was a key factor in resurrecting the MF! 

New equations

What has surprised the industry is the quickness in which this deal was struck. And although Religare Aegon did not comment on the price of the deal, news reports estimate about two per cent of Lotus’s AUM. As per the MF’s October-end corpus of Rs 5,458 crore, the deal works out to be approximately Rs 109 crore, considered to be the cheapest MF deal in recent times, especially in the wake of the recent acquisition of the erstwhile Standard Chartered MF by IDFC for a price of Rs 825 crore. Further, market sources also add that this deal has a clause wherein the Lotus’s sponsor would make good the loss (sources claim it to be around Rs 100 crore), if any, that arises from any possible defaults of any of Lotus’ underlying instruments. This further sweetens the deal for Religare Aegon.  

Another reason why the deal is rumoured to be so cheap is Lotus’ huge debt assets as compared to equities. The MF has yet not disclosed its complete October-end portfolio, but as per its September-end portfolio, only seven percent of its total AUM was in equities, the rest in debt and more than half of its AUM was in FMPs. Further, 32.55 per cent of its AUM was in liquid and liquid-plus schemes. Not only are Debt, especially FMP, schemes earn much lesser income than equities, liquid schemes also see very short-term investors and no sticky money. That apart, Lotus Asset Management Company has been incurring losses; Rs 21.95 crore loss after tax as on 31 March 2008 and Rs 32.26 crore loss after tax as on 31 March 2007. 

For Religare Aegon though, it seems to be a decent catch. Even before the MF has launched its first scheme (it got Sebi approval in September and has filed draft offer documents of a total of five schemes with Sebi for approval), Religare Aegon gets an instant access to 64 cities where Lotus MF already has a sales presence and its branches across 38 cities. Religare Aegon has also acquired Lotus’s fund management team but it remains to be seen how many of the team comes on board. 

This latest acquisition may not be a one-off case. Atleast three other MFs are rumoured to be put up on sale soon. One of these MFs, say market sources, is a new entrant that has already cut salaries of its employees across board by around 30 per cent!  

HOW SAFE ARE YOUR LIQUID FUNDS?

Panic redemptions and tight money have resulted in liquid funds declaring losses for the first time in many years. But is there a way out? 

If you think that liquid funds are absolutely safe and protect your capital at all times, then think again. On 8 October, three liquid plus funds, Mirae Asset Liquid Plus (MALP), DSP Merrill Lynch Liquid Plus and Templeton India Ultra Short Bond funds gave one-day negative returns. MALP was the worst hit as it lost 0.40 per cent that day. While a day’s loss may not sound catastrophic in any other funds, in the case of liquid funds it grabs headlines because many large investors and companies park their surplus cash in these funds for a day or a week or a fortnight. To make matters worse, some schemes limited redemptions. On 15 October, ABN Amro MF limited redemptions on few of its fixed maturity plans (FMP) to Rs one lakh per folio. What went wrong?  

Bad assets…

After a series of media reports about the illiquidity of the underlying assets in which many liquid, liquid-plus and especially fixed maturity plans (FMP) had invested in and their questionable credit quality, large investors who were already facing tough times and a cash crunch began withdrawing money from these schemes. Soaring short-term bank fixed deposit (FD) rates did not help MFs, as these investors started pulling money out from these schemes and invest in bank FDs.

In this melee, not just the culprit FMPs but even those that had comparatively cleaner portfolios were also affected. As a result, many investors who withdrew from FMPs made a loss on their investments because they did not get the indicative yield they were told – albeit unofficially, as MFs are not allowed to assure returns - as they withdrew much before the scheme’s maturity. MFs arrive at indicative yields based on the assumption that investors will stay till maturity. But such yields go for a toss when MFs have to make a distress sale to generate cash to meet redemptions. Add to them the exit loads that most FMPs impose on pre-mature withdrawals, and investors who got out last month most likely made a loss.

Whilst Outlook Money was amongst the first ones to warn readers of such assets in which many FMPs had invested in (See, ‘Are Fixed Maturity Plans A Ticking Time Bomb’, 10 September 2008), the rot runs much deeper.  

In addition to investing in illiquid real-asset papers, many liquid and liquid-plus funds have also invested in instruments called pass-through certificates (PTC). These are essentially loans issued by banks to borrowers that are then bundled off as securities and sold off to buyers such as mutual funds. Assume a bank issues a five-year loan XZY at an interest rate of 10 per cent. Since it would take five years for this bank to recover the loan, it sells off this loan to, say, a mutual fund, at say, seven per cent. The bank would earn the spread (difference in interest rates) of three per cent (10 per cent – seven per cent). The MF would pay the lumpsum to the bank, who in-turn would get back the principal amount (that it had originally lent to XYZ company) upfront; interest payments that XYZ company would keep paying to the bank, in the meantime, would be forwarded (after deducting the spread) to the MF. 

PTCs can be quite toxic if the loan originator (XYZ company in the case, above) is a low-rated one. MF sources say that even if the original borrower is a top-rated company, there are no buyers these days in the markets for PTCs that MFs may want to sell, to raise cash to meet redemptions. On account of a slow economic growth and poor result forecasts, there seems to be a perception about the companies’ ability to repay loans. Hence, PTCs are pretty illiquid these days. 

As per the September-end portfolio of liquid and liquid-plus, some schemes have invested significant chunks in PTCs. There’s little transparency here, as in the absence of the regulator’s mandate, most MFs do not publish details of these PTCs. ICICI Prudential MF was the first, and till date the only MF, that publishes details of its PTC investments. Not just the PTCs, but some short-term funds, including FMPs, suffer from poor credit quality. The problem is compounded here since most FMPs do not disclose their portfolios regularly. 

Funds, especially liquid-plus funds (liquid-type funds that have a mark-to-market portfolio component of more than 10 per cent; their maturities are therefore higher than liquid funds) with longer maturities got hit too; it’s harder to find buyers for longer-dated securities when liquidity is tight. 

…Low liquidity
The problem of the rush on redemptions was compounded by the lack of liquidity in the system on account of several reasons that had resulted in banks also withdrawing their funds from liquid and liquid-plus funds earlier. The rush on redemptions compelled liquid funds to sell their most liquid assets at throw-away prices that resulted in their losses. Fund sources say that although Sebi allows MFs to borrow up to 20 per cent of their corpus from banks to meet redemption pressures, money wasn’t available.

Even fixed maturity plans (FMP) saw a rush on redemptions on the back of news reports of bad assets held by them. Although the October-end corpus figures are yet to be disclosed, market reports suggest that liquid and liquid-plus funds have already seen redemptions of around Rs 50,000 crore in October.

Regulatory help
On 14 October, the reserve bank of India (RBI) allowed MFs to take loans from banks to meet their redemption proceeds by directly pledging their certificate of deposits (CDs; these are one of the short-term and liquid instruments that debt funds invest in) for a period of 15 days. This was a reversal of an earlier RBI stand wherein banks were not allowed to grant loans against CDs and were also not allowed to buy-back their own CDs before maturity.

But this measure seems to have come a little late, because out of Rs 20,000 crore that’s been made available to funds, MFs have utilised only Rs 8,800 crore up till 24 October. “Since the panic redemptions had already landed up on MF’s doorstep before RBI came out with his rule, MFs had already sold most of the CDs by then”, says Ashish Nigam, Head-fixed income, Religare Aegon mutual fund. Later, on 18 October, Sebi eased the guidelines for valuing debt securities too.

What should you do?
Understand that even if liquid funds are less risky than other MF schemes, they still carry risk. No MF is risk-free. Though liquid funds are not volatile to the interest rate scenario because their assets are not marked-to-market (Sebi mandates only instruments more than six months maturity to be marked-to-market; liquid funds hold scrips with a less than six months maturity), they do turn volatile at times. Liquid funds have to mark-to-market their instruments when they sell them and then book a profit or a loss at that time. And if there’s a liquidity crunch or a huge redemption pressure - like the one we’ve seen so far in October – they could be forced to sell instruments at panic prices, resulting in a loss, even if the scrips being sold are of a good quality, like Mirae Liquid Funds’. Despite having a high-quality portfolio (highest credit rating, no PTCs and only CDs), Mirae schemes incurred losses.

MFs also have a clause in their offer documents to initiate stagger payments in case of panic redemptions and thereby its inability to generate enough cash to meet the redemptions. ABN Amro MF merely used this provision in its FMPs at the time of redeeming them.

Look at average maturity
But there are a few things that you could look at, such as the average maturity of your liquid funds. The lower the maturity, the safer is your fund, because scrips of lower maturity are easier to sell and are also less volatile, compared to those with higher maturity. Funds with lower maturities are conservative and give lesser returns than those with higher maturities, but in volatile times, their downside is limited.

Corpus
Stick to larger liquid funds, preferably, with a corpus size of more than Rs 1,000 crore. Although panic redemptions in times like these hit almost all funds, the larger ones are comparatively less hit. Even a few large investors who withdraw from small-sized liquid funds can leave a much bigger impact.





Credit quality
Credit quality. Check out your liquid fund’s credit quality. Monthly portfolios of existing
schemes (if you are investing in liquid and liquid-plus schemes) are available on the MF’s website. Else, tell your broker to get you a monthly factsheet and have him take you through the portfolio’s credit quality if you are unable to decipher these details yourself.

Avoid schemes that have a large holding in assets below a AA or an equivalent credit rating (OLM’s threshold; see table 2) or in PTCs. “The lower your liquid funds’ portfolio quality, the harder it is for them to sell their scrips to fund redemptions”, adds Amit Trivedi, Proprietor, Karmayog Knowledge Academy, an MF training institute. If you are investing in FMPs, make sure you read the offer document. Some FMPs explicitly say in the offer documents that they will avoid low-rated scrips. Look out for any such portfolio credit-quality related statements in the offer document while choosing.

Stay invested in FMPs
Assuming you have already invested in an FMP belonging to a well-pedigreed fund house, do not panic. When FMPs give you an indicative yield you’re most likely to earn, they arrive at these calculations assuming that you’d stay invested till maturity. But when faced with panic redemptions, especially in times like these when buyers are few and far between, FMPs are forced to sell their scrips in a hurry and at throwaway prices. This negatively impacts your yield and you are most likely to incur a loss, especially since exit loads are levied for premature withdrawals.

For fresh investments, stick to well-pedigreed FMP and only if you are willing to stick around till maturity. Infact news reports indicate that Sebi is contemplating banning early withdrawals from FMPs. “Fixed income segment still remains attractive. But don’t get greedy and avoid going for FMPs that necessarily give higher indicative yields. Look at safety and consistent returns”, adds Nigam.

Invest in Benchmark's Nifty BeES

Buying an index at these levels offers a great opportunity to make good, long-term gains

The turmoil in the US equity markets has had a devastating effect globally and also the Indian equity markets. Sensex has dropped nearly 40 per cent from its highest closing on 8 January. Ideally, when there’s mayhem and bloodshed everywhere and equity prices are dropping, it’s a good opportunity to buy equities at cheaper levels. And what better way to enter the equity markets – if you haven’t already or were waiting for the right time buy – than buying the index itself? Take a look Benchmark Nifty BeES. 

About the fund

Nifty BeES is an exchange-traded fund (ETF) that passively tracks the Nifty index. Like an index fund, ETFs invest their entire corpuses – save a small percentage that it keeps aside as cash – in all the stocks and in exactly the same proportion as they lie in their benchmark indices. Launched in December 2001, Nifty BeES was India’s first exchange-traded fund and comes from a fund house (Benchmark mutual fund) that specialises and manages only exchange-traded funds.

 The Nifty index consists of the 50 most liquid stocks on the national stock exchange. The companies that form a part of Nifty are also considered to be amongst India’s largest and most well-managed companies. Since the value of Nifty BeES will always move in tandem to that of the Nifty, one unit of Nifty BeES will be approximately one-tenth the value of Nifty index. For instance, on 29 September while Nifty closed at 3,850.05, Nifty BeES closed at 387.48. Over the past one year, the difference between its net asset value (NAV) and market price has been 0.04 per cent on an average. 

Why does an ETF make sense?

Typically, an index fund too tracks the index passively and there are a dozen of them in the Indian mutual funds industry. However, I have always recommended that you buy an ETF instead of an index fund. Here’s why.

 Low cost

As Nifty BeES is a passively-managed fund, its expense ratio is much lesser as compared to actively-managed funds that charge as high as 2.50 per cent. Further due to the structure of an ETF, its expense ratio is also lower than traditional index funds. As against index funds that charge as high as 1.50 per cent, Nifty BeES scores over them as well. At 0.50 per cent, its cost structure is the second lowest – after Reliance Banking ETF – amongst equity schemes in the market today.

 Low tracking error

The TE of an index fund is essentially the difference in returns generated by itself and its own benchmark index. The lower the TE, the better is the index fund.

 A low expense ratio and an ETF’s structure are responsible for a low tracking error for Nifty BeES (0.33 per cent as on 31 August). Nifty BeES’s TE is the least amongst all passive funds.

 Anytime trading

Unlike a typical MF scheme that can be bought or sold only at the end of the day’s NAV, you could buy Nifty BeES throughout the day, during market hours.

 How to buy?

You need a demat account to buy Nifty BeES. Also enroll with a stock broker who transacts on the NSE; there are close to 50,000 NSE terminals throughout the country.

There’s no telling as to when the carnage on the stock markets will stop. Already stock market experts are predicting that the worse is not yet over. It’s tough to predict the exact bottom levels; we suggest that you allocate around 50 per cent of your total ETF allocation now. As markets fall further, you can continue to deploy more money in Nifty BeES. 

HOW TO BUY AN FMP?

Unlike regular open-ended or closed-end mutual fund (MF) schemes that are open in their 'New Fund Offer' (NFO) period for around 20 to 21 days - or sometimes even for a month - fixed maturity plans (FMP) are open for a few days only. Companies require money for their daily needs on a regular basis, hence they tap various sources like banks and MFs, regularly. Hence, to keep the money supply going, and at the same time to tap the prevailing high interest rates as soon as possible, FMPs are launched in quick succession. 

It is also rare that your agent will push FMPs to you because FMPs are low-margin products. Unlike equity funds where agents earn as much as 2.25 per cent front-end commission (and trailing fees of up to 0.50 per cent for as long as you stay invested), FMPs have a very low cost structure. MFs earn only upto 0.50 to 0.75 per cent or so from your FMP, out of which they have to pay agents commission. Online brokerages also sell FMPs selectively. Kotak bank (online broker) and www.icicidirect.com do not, to the best of my knowledge. www.sharekhan.com does; it has a special FMP section on its internet trading website.  

So how do you buy an FMP then?

It's best to keep checking with your broker. He gets information of all the on-going FMPs. You have to take the initiative, because FMPs come and go very quickly. He may not want to go out of his way to sell you FMPs, but if you take the initiative and ask him, there are more chances of you coming to know. 

Scout MF websites. All MFs have details and application forms of on-going FMPs on their websites. Download the forms, fill them up (make sure you write 'DIRECT' in the agent's code box on the top part of your application form) and visit your nearest MF's office or its registrar & transfer agents' and submit the form. To get a list of 'point of acceptance', check out your MF'swebsites. 

If you are investing more than Rs 50,000, make sure your KYC is done. Also, ensure that you carry a copy of your PAN card. If you can carry your original PAN card, better. 

ARE FIXED MATURITY PLANS A TICKING TIME-BOMB?

FMPs are walking a tightrope and amassing credit risk

In an urge to attract investors and taking advantage of the rising interest rates, mutual funds (MF) have been launching fixed maturity plans (FMP) almost every week. But in an attempt to earn a higher yield than its competitors, some FMPs are taking on undue risk. Market sources have told Outlook Money that one FMP launched by a large public-sector MF recently got into trouble with one of its underlying instruments. The company in whose debt paper this FMP had invested in, defaulted on the principal payment and the MF’s parent company – itself one of India’s biggest financial houses – had to bail out the MF.

Beware of credit risk
Credit risk denotes the quality of your scheme’s underlying instruments and their ability repay the interest and principal amounts. Whenever your FMP invests its corpus in debt papers of various companies, it hopes that when the tenures ends, it gets the monies back and pays them back to you – the investor.

But what happens if one of the underlying company defaults? There’s a good chance that your FMP might also default in that case and you may not get the yield that was indicated to you at the time of investment. Typically, FMPs roll-over such bad debts into a forthcoming FMP and in the interim, borrow money to repay the existing FMP unitholders.

Here’s how a typical FMP works. Companies borrow money from several sources like banks and financial institutions to meet their day to day needs. They also borrow from MFs and regularly issue debt instruments like certificate of deposits or commercial papers to MFs. These MFs then invest their monies – that they collect through FMPs - in such papers and stay invested in them till maturity. Higher the scrip’s credit rating, lower the yield it fetches the FMP and vice-versa.

When these scrips mature, the companies pay back to the MFs that in-turn redeems the FMPs and pay the money back to unitholders. If, however, a company is unable to repay the loan, this particular scrip is then rolled over to another FMP that the MF would have just launched or will launch soon. In other words, this scrip would then start to appear in the portfolio of the second FMP. The MF, in the interim, borrows the shortfall from the market and ensures that first FMP’s redemption doesn’t take a hit.

A bitter truth
Many FMPs have taken high exposures to the real-estate sector. The slump in this sector has resulted in many companies defaulting and thus landing the latter in a repayment soup. The MF - about whom the market is abuzz with rumours lately –denied the problem. However, the reality is many FMPs, including our protagonist, have taken on additional risks to offer that extra bit of return.

For example, as per the LIC MF’s March 2008-end portfolio that it published in the newspapers, many of its FMPs have exposures to the real-estate and construction sector. LIC MF FMP Series 35 had invested a whopping 86 per cent to just one sector; construction. 24.66 per cent of this FMP’s corpus was invested in assets whose credit rating was below AA – OLM’s threshold of safe investments. This was just one example; there are several FMPs in the market that invest in low-rated scrips and put themselves – and your money – at considerable risk. The problem is compounded as most of these FMPs disclose their portfolios only twice year – the bare minimum required as per the securities and exchange board of India (Sebi)’s mandate.

What should you do?
Don’t get swayed by higher indicative yields. Apart from these being just indicative – and not a guarantee – higher the yield, higher is the amount of risk your FMP could be taking to earn that yield.

Look also at your MF’s pedigree. “It’s always better to sacrifice a little bit of return, if you are offered a good quality portfolio”, says Santosh Kamat, CIO-fixed income, Franklin Templeton MF. FMPs are low-risk instruments and capital protection is important.

It would also bode well if disclosers are enhanced. Presently MFs are made to disclose their portfolios at least twice a year. Although most MFs disclose portfolios of all their other schemes on a monthly basis, they stick to the bare minimum when it comes to FMPs. This is woefully inadequate as MFs have already shown their capability for frequent disclosures. If FMPs disclose their portfolios on a monthly basis, it would give a good idea to the investor about the credit quality that the MF is used to taking. Additionally, FMPs must mention in their offer documents the lowest bar in terms of credit quality they are willing to take on.

Sebi Allows Real Estate Mutual Funds

India’s first real estate mutual fund could be just around three months away. What will it offer?

How often have you stared at a gleaming skyscraper in a tony address in your town and wished you could afford to buy a house there? If you have ended up sighing wistfully and walking away, here's some good news. Now, you may easily be able to own a small portion of a very swanky address.

After years of deliberation and planning, the Securities and Exchange Board of India (Sebi) has approved the launch real estate mutual funds (Remf); it issued a detailed set of guidelines on 16 April. All you may now need to shell out is as low as Rs five to 10 thousand to participate in real estate investing.

How will it work?
A Remf is a scheme much like any other MF scheme (which invest in shares and bonds) but it will invest in real estate. The Sebi guidelines mandate that a Remf has to invest at least 35 per cent in completed real estate assets (read flats, row houses, bungalows, shops). These could be either residential or commercial properties, but must be finished and ready-to-use and not under construction. The Remf will get title deeds and will be owners of these premises – it’s like you buying a second home or a small office. In simple words, instead of reading a name like ‘Ms Shirin Batliwala’ against, say a first floor flat number on the name-plate board at your building’s entrance, you could now have a neighbour by the name of, say, ‘HDFC Real Estate Fund.

Your Remf will then rent out these properties and earn rental income that it will pass on to you – the unitholder. When your Remf’s tenure ends, it will sell off these properties and earn – and eventually pass - capital appreciation to you. With as low as Rs 5,000, you can now own a part of this flat through your Remf. Assume your Remf collects Rs 500 crore and invests Rs 200 crore out of it (40 per cent of the collections) in 40 flats costing Rs 5 crore each. If you have invested Rs 10,000 in this fund, then your share out of the appreciation and rental income of these flats would be 0.0002 per cent.

Over and above this, your Remf can invest in under-developed properties. But it can neither buy a barren land nor can it undertake construction activities. What then? It will partner with a real-estate developer and then take a stake in a special purpose vehicle (SPV), that the developer would have set up for constructing a particular project. Note, that your Remf will take a stake in that project and not in the developer company or its other projects across the country. Your Remf will buy unlisted shares in that SPV. Once the project is ready and complete, the gains arising out of it are your Remf’s to the extent to its stake.

Additionally, your Remf can also invest in debentures of real estate companies and mortgage-backed securities and equity shares of real estate companies listed on stock exchanges. All of the above must be at least 75 per cent of the scheme’s corpus. A Remf will be closed-end (this means limited tenure and no on-going sales of units) and units will be listed on the stock exchanges. You can trade units on the exchanges though, much likes shares.

Remf not the same as Reit
If you remember sometime back Sebi had issued a draft set of guidelines for Real Estate Investment Trusts (Reit) So what is the difference between a Reit and Remf?

A Reit is also an investment vehicle to invest in real estate. Like Remfs, these too are closed-end schemes and listed on the stock exchanges. But there’s a big technical difference between the two though. A Reit is mandated to distribute at least 90 per cent of the gains that it makes in a year, to its unitholders. Secondly, Reits can only invest in finished projects and not those that are under-construction. Hence it earns its major chunk from rental income. “While Reits help you to earn a regular income, Remfs give you capital appreciation”, adds Milind Barve, managing director, HDFC MF and head of the Amfi appointed sub-committee to recommend norms for Remfs.

Note that Sebi guidelines mandate a Remf to invest at least 35 per cent in completed and ready-to-use properties, it resembles a Reit to that extent and can infact invest this portion in a Reit.

Many countries across the world, especially the developed markets like US, have both Reits and Remfs running simultaneously. India is set to follow that path as Sebi has shown enough intent to allow both these products to be launched.

Of checks and balances
For a beginning, the Sebi Remf guidelines cover a lot of ground. They mandate that each real estate property is to be valued by two valuers - these must be rated by a credit rating agency - and the Remf will invest in that property at the lower of the two values. Each property will be valued once in 90 days. So if your Remf has invested in four properties, say in March, June, September and December, respectively, then each of those four properties will be valued once each of them completes 90 days.

However, your Remf will have to declare its net asset value daily. Your fund’s NAV will also change on a daily basis because apart from real estate assets, it would have also invested in marked-to-market securities such as debentures and mortgage-backed securities.

While your Remf will charge you an expense ratio of a maximum of 2.5 per cent, just like equity funds, the tax status is unclear. Sources say that Remfs will carry a tax status akin debt funds – long-term capital gains tax of 11.33 per cent, and short-term capital gains tax as per your income-tax rates. This compares well to investing in physical real estate directly, as there the long-term capital gains tax kicks in after three years as against a year in a Remf.

…but beware of risks
Although a Remf opens up a new asset class to investors that was otherwise restrictive, it comes with its set of risks.

The ‘others’: A Remf is mandated to invest at least 75 per cent of its corpus in real-estate securities. Beyond that it is free to invest in any security, related or unrelated to real-estate. It can either invest this 25 per cent corpus directly across equity market or debt instruments or can even sit on cash; Sebi has left it for Remfs to decide. How your Remf decides to invest this portion can have a bearing on its risk profile.

Flexible asset allocation: That’s not the only flexibility that Sebi has awarded to Remfs. Beyond the mandated 35 per cent in finished real-estate projects and within 75 per cent of the scheme’ corpus, it has about four different types of securities to choose from. Here’s where one Remf can significantly look and behave different from another.

For instance, a Remf can choose to hold 35 per cent in completed real-estate assets and hold the next 40 per cent in equity shares of real-estate companies and then hold the balance 25 per cent in another set of equity shares. Or a Remf can invest up to 50 per cent in completed real-estate assets and the rest in an SPV of an under-construction project. Such Remfs will be riskier compared to those that have a healthy dose of mortgage-backed securities and debentures of real-estate companies that earn a fixed interest income. Look up the Remf’s asset allocation before investing.

Mis-selling: The same agent through whom you invest in MFs will now also sell you Remfs. Only time will tell whether they will be able to tell the nuances of one Remf from another. And although Barve says that the MF industry is geared up to train the agents and spread awareness, it will take some time - and possibly some heart-burn - before investors realise the true worth and potential of Remf. Your only genuine hope currently will be your Remf’s offer document. And, of course, keep reading Outlook Money.

Apart from Sebi’s nomination of cities in which Remfs can invest their finished-projects’ composition and the taxation incidences on unitholders, most other things are in place. Hopefully, India’s first Remf should be born in another three months.

Is It Really Focussed?

ICICI Prudential Focused Equity Fund aims to limit its portfolio to around 20 stocks

You invest in a mutual fund (MF) scheme because apart from being unable to track direct equity investments, you also want diversification. So your MF that diversifies across 40 to 60, sometimes even more than 80, scrips, steps in. But too many scrips can also dampen your fund’s portfolio as a bunch of them should see their share prices appreciate to have any decent impact on your fund’s net asset value (NAV). ICICI Prudential aims to address this issue as it has launched a new scheme that will neither under nor over-diversify.

Called, ICICI Prudential Focused Equity Fund (IPFEF), this scheme will invest in around 20 scrips as that’s the ideal number of scrips the MF believes a scheme should have. IPFEF will choose from the top 200 companies as per their market capitalisation.

Should you invest?
While having a tight and an adequately diversified portfolio has its merits, there is no thumb rule on the number of stocks that a MF scheme should hold. Further, the number of stocks in a portfolio is just an approach to fund management; it does not guarantee performance.

Look closely at ICICI Prudential MF’s bouquet of schemes and you realise that the focused approach could just be an excuse to launch a new scheme, as typically all its schemes have a much higher number of stocks. Even its other large-cap oriented funds like ICICI Prudential Growth Fund and ICICI Prudential Power Fund hold more than 30 scrips. Ultimately, IPFEF’s offer document says it can diversify beyond 20 stocks if its assets cross Rs 1,000 crore. That is a low threshold to have for a large-cap oriented fund. With giants like ICICI Prudential having the marketing and financial muscle to woo distributors and investors alike, it doesn’t take time to either mop Rs 1,000 crore or come up to that level in case they mop up a lower amount.

Avoid IPFEF. Instead opt for some of JM’s well-performing equity funds if you want to get the most out of a tight portfolio.

US-64 DRAWS TO A CLOSE; WHAT SHOULD YOU DO?

As the country oldest mutual fund scheme, now US-64 Bonds, are set be redeemed, it’s tough to find an equally alternative investment. There are some that come close

The oldest mutual fund scheme in India, Unit Trust of India (UTI)’ Unit Scheme – 64 (US-64), will soon be no more. After more than 40 years of existence, curtains will fall on the US-64 bonds that mature on 31 May 2008. UTI has already sent out letters to all bond-holders about the redemption; investors are told to submit their original certificates, take their money back and leave.

For investors like Kolkata-based, Kumaresh Mukherjee, 72 it’s the end of an era. Soon after he retired from Philips India, he invested his provident fund corpus in fixed – return instruments like company fixed deposits. An electrical engineer by profession, in 1995 he also invested Rs 12 lakh or around one-third of his retirement corpus in the erstwhile US-64. After years of above-average returns, then trapped doors and turmoil that shook the Indian financial markets, and finally a repackage, the curtains are now set to fall on the ubiquitous run of US-64 scheme, now US-64 bonds. Like Mukherjee, if you’re invested in US-64 bonds and are about to get your principal money back, what to do?

The story so far
It was a red-letter day in the Indian financial markets on 2 July 2001 when India’s then-largest mutual fund the Unit Trust of India suspended the redemptions of its flagship scheme – US-64, for six months on account of its weak financials. All the skeletons came tumbling out of US-64’s closet.

For instance, up until then, US-64 could be bought or sold only at a fixed sale or repurchase price fixed by UTI and which was Rs 14.25 in May 2001; a month before the death knell was sounded. However, six months down the line on 2 January 2002 UTI disclosed its net asset value (NAV) for the first time in its history, under a huge public outcry, at Rs 6. All hell broke loose. After having used to its annual dividend – it rose from 16 per cent in 1987 to 26 per cent in 1993, where it stayed till 1995 – and therefore under an impression that US-64 was much like a assured-return scheme, investors felt trapped when UTI not only suspended redemption for six months, but also gave rise to aspersions whether investor money was safe or not. The difference between the scheme’s repurchase price of Rs 14.25 in May 2001 and its first-disclosed NAV was Rs 7.44 or 56 per cent, even after adjusting Re 1 dividend in the interim. In 2002, US-64 skipped its dividend – a first in 37 years of its history, up till then.

Then came the government of India’s bail-out package for US-64 investors. Apart from allowing investors to redeem up to a maximum of 5,000 units between August 2001 and May 2003 at an assured price between Rs 10 to Rs 12, UTI also gave a choice of US-64 bonds that paid an interest rate of 6.75 per cent to all the unitholders holding above 5,000 units. Investors were offered either that or redemptions at Rs 10 per unit. Not only did these bonds give 25 basis points more than what the Reserve Bank of India bonds yielded at that time, they were also completely tax-free at the hands of the unitholder. Around 75 per cent of investors, including Mukherjee, opted for the US-64 Bonds because of the assured returns and lack of attractive alternative options.

How to redeem your money?
The redemption process is pretty simple. If you hold up to 200 bonds, all you need to do is to give your bank account details, latest by 15 May 2008 to UTI if they do not already have it. If UTI has been sending you interest payments so far by Electronic Clearing Service or by cheques with your bank account details printed on them, it means that UTI already has your bank details. They’ll send your principal amount cheque in the first 10 days of June 2008. You need not surrender your bond certificates.

The key to look up the number of bonds is your customer identification number (ID). When the UTI letter says that its 200 bonds, it means 200 bonds per customer ID. So even if you have more than one folio but have less than 200 bonds in each of them, you do not need to submit your bond certificates.

If you have more than 200 bonds in a single folio, you need to send your bond certificates before 25 May 2008. Here too, bank account details are mandatory. Fill out the bank particulars form that UTI has sent you alongwith the redemption notice. Submit this form and bond certificates, if necessary, to the UTI Branch in your city (visit http://www.uti.co.in/ to know your nearest centre) or send them by courier or ordinary post.

Where to invest the redemption proceeds?
In the communication that UTI has sent you, it has suggested five of its existing schemes to invest your bond proceeds in. Although if you wish to invest in any other UTI MF scheme, you can do by just mentioning its name and the plan (dividend or growth) that you would like opt for.

We suggest you skip these schemes. Except for UTI Fixed Term Income Fund (UFTI), all other alternatives are diversified equity-oriented funds. UTI Infrastructure Fund (UIF) is a thematic fund and therefore riskier and we wouldn’t advise you increase the risk levels of your monthly income-yielding corpus by notches. And although UFTI is a fixed maturity plan where downside risk is minimal, it won’t pay you regular income.

Remember, you invested in US-64 bonds because you wanted some kind of regular income. Plus, it also offered tax efficiency like none other. For instance, if you are in the highest tax bracket, your effective tax rate works out to be 10.22 per cent. Ideally that is what you should get from your alternative instrument avenue where you will now park your redemption proceeds.

Presently, there are no instruments that pay you a tax free and assured return to the tune of 10.22 per cent. But if you are risk averse and like to avoid equities, your first priority should be Senior Citizens Savings Scheme (SCSS) if you haven’t already exhausted its upper limit of Rs 15 lakh. Mind the age requirement though.

The next best alternative is the Post Office Monthly Income Scheme (POMIS). The maximum limit has only recently been raised to Rs 4.5 lakh in a single account and Rs nine lakh in a joint account. If you have exhausted your SCSS limits, take advantage of the increased limit in POMIS. Both of the above carry the government of India’s guarantee.

If, however, you do not mind taking on some risk, try mutual fund schemes that invest zero to up to 40 per cent in equities. These are debt-oriented schemes that invest marginally into equities; we call them Equities – marginal exposure and Equities – significant exposure. <’Introducing the OLM 50’, 10-23 April 2008>

Or, if you to invest in equities the whole way, stick to exchange-traded funds. These are close cousins of index funds as they invest in all the scrips in the same proportion as they lie in their benchmark indices, like Nifty or Sensex. They are passively-managed and do not carry the fund manager’s risk. And due to their inherent structure, their expense ratios are lower than index funds.