Tuesday, 4 September 2012

The Best Fund for You

Do you know which is the best mutual fund (MF) investment for you? Have you ever known what is the actual return which you get from your MF investments? If you believe the difference between your sale and purchase NAV is the return which you earn from MF investments then your belief is far from truth – that is just the arithmetically correct return which you earn from the fund but certainly not the best return which you could have earned from your MF investments. There are numerous factors which affect your return from MFs. So, to find out which is the best fund for you we have to consider the various “expenses of investing in funds” which are as follows:

Entry and exit loads are one of the most punitive charges on your investments which eat into your money at the very source of the investment decision – whether at the time of buying or selling. While MF schemes are not allowed to charge entry loads but they very well charge exit loads – these are nothing but the charges which you pay for selling your MF investment. This is ridiculous as it attacks the very foundation of “open ended MF” and “daily NAV” – if the fund is really open ended than why does it need to charge you for exiting or selling the fund. While the MF or the Distributor will say that it is for “discouraging” short term investments in the fund, the prime reason for “exit load” is to protect the MF against the compensation which it has already paid to the distributor virtually from its own pocket since “entry load” is not allowed.

While “entry loads” are not permissible in MF schemes but they are very much allowed in “Portfolio Management Services” offered by MFs as well as other entities and other investment options like “private equity”. The “entry loads” vary from anywhere between 100 to 400 bps. Entry Loads can be the worst robbery which a portfolio manager can inflict on your investments because it takes away money from your pocket even before it is invested. For example, assume the entry load of a fund is 4%, what it actually means is that the fund will invest only Rs.96 (100 -4) and hence has robbed you of Rs.4 or 4% even before that money could be profitably invested. This is pure robbery of your investment funds even before a penny is invested!

Fund Management Fees   
Every fund has “fund management charges” which in essence is nothing but the fees for managing your money. It is the right of the fund manager to charge you for managing your money as this is his bread and butter. However, it is his duty to transparently disclose such charges. However, the problem is that most of the time these fund management charges are not properly disclosed by the concerned funds. For example, a typical MF factsheet will disclose the loads but it’s very difficult to find the “expense ratio” which is nothing but the fund management fees. The irony of the fact is that most of the investors are not even aware that there is something like expense ratios or fund management fees because the NAV which is declared by the Fund house is “net” of such charges and a breakup of the NAV is never given. 

The other problem with fund management fees is that it is discriminatory, particularly in the case of Debt Funds. This is because generally a very high “expense ratio” is charged in the case of duration based debt products – the common rule being, the longer the duration of the fund, the higher the fund management fees. The logic of the fund house might be correct as higher Fund Management expertise is required to manage a high duration product (like an Income or Gilt Fund) as opposed to an accrual product (like a Liquid Fund). However, the problem for the investor is that the high expense ratios simply “eat into” the interest component of a Debt Fund leaving the “Net Portfolio Yield” of a “high duration high fee Debt Fund” lower than that of a “low duration low expense accrual fund”. For example, if the interest yield of a liquid fund is 9.2% while the expense ratio is 20 bps, the running yield accruing to the investor is 9%. Now, compare this to a Gild Fund with an interest yield of 8.3% and expense ratio of 150 bps leading to a dismally low running yield of just 6.8%. Simply put, the Gild fund is under yielding 220 bps (9.0% - 6.8%) and hence if it has to beat the liquid fund then it has to invariably generate “capital gains”. In effect, unless the fund is able to generate capital gains, it would miserably fail to beat a pure accrual product leaving me wondering as to whether it was justified for the investor to take high risk in a long duration fund paying extra fees for higher risk and volatility in effect to earn lower return in the end. Don’t forget one thing; in the investment world under performance does not come cheap, the investor has to pay heavily for it.     

Veiled Charges
PMS and private equity products often do not clearly disclose all the charges like set up costs, marketing costs, brokerages etc. Many a times, broker driven PMS products charge low management fees and make it up in high brokerage charges. This also encourages them to churn the portfolio because whether the churning makes money for the investor or no, but it invariably does make money for the broker fund manager.

Wealth management Fees
With MFs doing away with the “entry loads” its important for an investor to properly compensate the MF Distributor or the Financial Planner. Most Wealth advisors offer two kind of models – an advisory model which charges a flat fee on the total assets while a transactional model that charges no general fee. However, in such cases, the wealth manager earns from product commissions. Generally speaking, transactional model is better for a “debt oriented product” because the variation in the return is contained while advisory model would be superior for an “equity oriented product” since the disparity in return and performance can be high.

Taking advantages of the discriminating Tax Laws
Remember that Income tax reduces your gross income; interest on loans (on revenue expenditures / bad assets) diminishes your net incomes and inflation eats out your remaining income. And tax laws are discriminating – the more you work for your money, the more you pay in taxes while the more your money works for you, the lower you pay in taxes. You must be aware of the discerning tax laws so as to take maximum advantage of it. Remember the following general rules while planning income tax on your investments:

Ø  As a general rule, equity oriented investments are less taxed than debt oriented investments.
Ø  Long term capital gains tax is most probabilities is lower than short term capital gains tax.
Ø  Tax free debt investments usually offer higher after tax yield to the investor in the highest tax bucket as compared to taxable fixed income instruments.  
Ø  Because of the set off provisions in the Income Tax laws, losses of unrelated investments can be set off against gains from unrelated investments. The moot point is that it should be profits and losses on investments or capital gains / losses and not income from other sources like interest income. For example, the short term capital loss on equities (direct or MF) can be set off against gains from liquid funds. This is ridiculous as equity losses are allowed to be set off against liquid fund gains which is nothing but interest. But, if the taxman wants to give you this benefit then just embrace it with both your hands. However, the important point to keep in mind is that the return from liquid fund should be in the form of a capital gain and not dividend. Now, although the nature of the return earned on a liquid fund or a bank fixed deposit is same – accrual of interest – but if somebody would have invested in a bank fixed deposit he would have not got this tax set off advantage on it because the bank fixed deposit earns interest and not capital gains. Another illustration of unrelated asset set off is loss from a commodity like gold can be set off against gains on real estate and vice versa. So, it’s not always that you work for the taxman, sometimes the taxman also works for you, its only that you should know how to convert “tax losses” into profits for yourself.      
Ø  Dividends on debt oriented funds are taxed at a significantly lower (less than 50%) rate as compared to capital gains. Hence, the taxman is again giving a tax arbitrage without any real logic and hence it would be prudent to invest in dividend paying debt schemes as growth schemes. As a general rule, if you have any kind of capital loss to set off then invest in growth oriented debt schemes or else you are better off investing in dividend oriented debt schemes.

Dividend Temptation
You may be advised by the MF Distributors and marketers that a fund has declared dividend and it is trading cum-dividend and therefore take the advantage of earning free dividends. But, there is no free lunch in this world – particularly not in the world of investments and mutual funds. The dividend which a fund pays to an investor is immediately reduced from the NAV of the fund. So what is the sense of the dividend when on one hand you receive the cash and on other hand your NAV falls by that much amount? On the contrary, I would say that don’t invest in a fund which has declared lofty dividends because that is against your purpose of investments –you are entrusting your money to the Fund Manager to manage it on your behalf and not to return back to you! (unless ofcouse you require regular income in the form of dividends).

Every unsuccessful investment by an investor profits somebody else like the company promoter, mutual fund house, broker, investment advisor, mutual fund distributor, financial planner, fund & credit rating agencies etc. Therefore, stop making others rich with you hard earned money.  Always bear in mind that finding the next best performing MF scheme is a zero sum game, simply put a derivative of the “law of averages”. Its hard to wait for something which you know might never happen, but it’s even harder to give up on something which you know is certainly going to happen. Remember that nobody can time the market or select the next best performing fund. The probability of succeeding in timing the market or selecting the next best performing fund is undoubtedly the same as shooting a spot in the dark. So, rather than trying to venture into all those risky adventures which are inadvertently going to make you lose, invest in the best fund. And the best fund for you is a no exit load index or large cap Fund with minimum expense ratios and fund management fees as also no unnecessary veiled charges while taking advantage of the discriminatory tax laws.