Passive investing helps

Vivek Kaul

If this year has been bad for the stock markets, it has been worse for mutual funds. Mutual fund net asset values (NAVs) have fallen much greater than the broader market.

Even those investing for 2-3 years have seen a substantial fall in the values of their portfolios. Fund managers who seemed to do no wrong until a few months back, are now an embarrassed lot. Even over longer periods, there is little evidence that active investing works.

As Peter L Bernstein writes in Capital Ideas Evolving, “In 2004, Burton Malkiel of Princeton, and author of A Random Walk Down Wall Street, studied all mutual funds in existence since 1970 — a total of 139 funds surviving over more than thirty years.
He found that 76 of the funds underperformed the market by more than one percentage point a year; only four funds outperformed by more than two percentage points a year. Malkiel reports that more than 80% of the actively managed large capitalisation funds covered in the Lipper Analytical Services failed to match the returns of S&P 500 over periods longer than 10 years ending in 2003. Malkiel also points out that “there’s almost no persistence in excess performance… In decade after decade, the top funds in one period are often the bottom funds in the next… There’s no way to tell in advance which funds will outperform.””

So, the five star funds of today may not be the best performing funds of tomorrow. Take the Sundaram Select Midcap Fund, which was the darling of investors till about a year back. The scheme has given a return of 15.78%, against the category average of 20.745%. The fund managers were clearly not able to manage the deluge of new money into the scheme.

So, the best option for investors is to invest in index funds — mutual fund that index stocks in the same proportion as their proportion in the index. But, often fund managers are guilty of trying to actively manage these funds. In this situation, it makes sense to invest in the few exchange traded funds currently available.

8 key ratios for picking good stocks

The following 8 financial ratios offer terrific insights into the financial health of a company -- and the prospects for a rise in its share price.

1. Ploughback and reserves
After deduction of all expenses, including taxes, the net profits of a company are split into two parts -- dividends and ploughback.
Dividend is that portion of a company's profits which is distributed to its shareholders, whereas ploughback is the portion that the company retains and gets added to its reserves.
The figures for ploughback and reserves of any company can be obtained by a cursory glance at its balance sheet and profit and loss account.
Ploughback is important because it not only increases the reserves of a company but also provides the company with funds required for its growth and expansion. All growth companies maintain a high level of ploughback. So if you are looking for a growth company to invest in, you should examine its ploughback figures.
Companies that have no intention of expanding are unlikely to plough back a large portion of their profits.
Reserves constitute the accumulated retained profits of a company. It is important to compare the size of a company's reserves with the size of its equity capital. This will indicate whether the company is in a position to issue bonus shares.
As a rule-of-thumb, a company whose reserves are double that of its equity capital should be in a position to make a liberal bonus issue.
Retained profits also belong to the shareholders. This is why reserves are often referred to as shareholders' funds. Therefore, any addition to the reserves of a company will normally lead to a corresponding an increase in the price of your shares.
The higher the reserves, the greater will be the value of your shareholding. Retained profits (ploughback) may not come to you in the form of cash, but they benefit you by pushing up the price of your shares.

2. Book value per share
You will come across this term very often in investment discussions. Book value per share indicates what each share of a company is worth according to the company's books of accounts.
The company's books of account maintain a record of what the company owns (assets), and what it owes to its creditors (liabilities). If you subtract the total liabilities of a company from its total assets, then what is left belongs to the shareholders, called the shareholders' funds.
If you divide shareholders' funds by the total number of equity shares issued by the company, the figure that you get will be the book value per share.
Book Value per share = Shareholders' funds / Total number of equity shares issued
The figure for shareholders' funds can also be obtained by adding the equity capital and reserves of the company.
Book value is a historical record based on the original prices at which assets of the company were originally purchased. It doesn't reflect the current market value of the company's assets.
Therefore, book value per share has limited usage as a tool for evaluating the market value or price of a company's shares. It can, at best, give you a rough idea of what a company's shares should at least be worth.
The market prices of shares are generally much higher than what their book values indicate. Therefore, if you come across a share whose market price is around its book value, the chances are that it is under-priced. This is one way in which the book value per share ratio can prove useful to you while assessing whether a particular share is over- or under-priced.

3. Earnings per share (EPS)
EPS is a well-known and widely used investment ratio. It is calculated as:
Earnings Per Share (EPS) = Profit After Tax / Total number of equity shares issued
This ratio gives the earnings of a company on a per share basis. In order to get a clear idea of what this ratio signifies, let us assume that you possess 100 shares with a face value of Rs 10 each in XYZ Ltd. Suppose the earnings per share of XYZ Ltd. is Rs 6 per share and the dividend declared by it is 20 per cent, or Rs 2 per share. This means that each share of XYZ Ltd. earns Rs 6 every year, even though you receive only Rs 2 out of it as dividend.
The remaining amount, Rs 4 per share, constitutes the ploughback or retained earnings. If you had bought these shares at par, it would mean a 60 per cent return on your investment, out of which you would receive 20 per cent as dividend and 40 per cent would be the ploughback. This ploughback of 40 per cent would benefit you by pushing up the market price of your shares. Ideally speaking, your shares should appreciate by 40 per cent from Rs 10 to Rs 14 per share.
This illustration serves to drive home a basic investment lesson. You should evaluate your investment returns not on the basis of the dividend you receive, but on the basis of the earnings per share. Earnings per share is the true indicator of the returns on your share investments.
Suppose you had bought shares in XYZ Ltd at double their face value, i.e. at Rs 20 per share. Then an EPS of Rs 6 per share would mean a 30 per cent return on your investment, of which 10 per cent (Rs 2 per share) is dividend, and 20 per cent (Rs 4 per share) the ploughback.
Under ideal conditions, ploughback should push up the price of your shares by 20 per cent, i.e. from Rs 20 to 24 per share. Therefore, irrespective of what price you buy a particular company's shares at its EPS will provide you with an invaluable tool for calculating the returns on your investment.

4. Price earnings ratio (P/E)
The price earnings ratio (P/E) expresses the relationship between the market price of a company's share and its earnings per share:
Price/Earnings Ratio (P/E) = Price of the share / Earnings per share
This ratio indicates the extent to which earnings of a share are covered by its price. If P/E is 5, it means that the price of a share is 5 times its earnings. In other words, the company's EPS remaining constant, it will take you approximately five years through dividends plus capital appreciation to recover the cost of buying the share. The lower the P/E, lesser the time it will take for you to recover your investment.
P/E ratio is a reflection of the market's opinion of the earnings capacity and future business prospects of a company. Companies which enjoy the confidence of investors and have a higher market standing usually command high P/E ratios.
For example, blue chip companies often have P/E ratios that are as high as 20 to 60. However, most other companies in India have P/E ratios ranging between 5 and 20.
On the face of it, it would seem that companies with low P/E ratios would offer the most attractive investment opportunities. This is not always true. Companies with high current earnings but dim future prospects often have low P/E ratios.
Obviously such companies are not good investments, notwithstanding their P/E ratios. As an investor your primary concern is with the future prospects of a company and not so much with its present performance. This is the main reason why companies with low current earnings but bright future prospects usually command high P/E ratios.
To a great extent, the present price of a share, discounts, i.e. anticipates, its future earnings.
All this may seem very perplexing to you because it leaves the basic question unanswered: How does one use the P/E ratio for making sound investment decisions?
The answer lies in utilising the P/E ratio in conjunction with your assessment of the future earnings and growth prospects of a company. You have to judge the extent to which its P/E ratio reflects the company's future prospects.
If it is low compared to the future prospects of a company, then the company's shares are good for investment. Therefore, even if you come across a company with a high P/E ratio of 25 or 30 don't summarily reject it because even this level of P/E ratio may actually be low if the company is poised for meteoric future growth. On the other hand, a low P/E ratio of 4 or 5 may actually be high if your assessment of the company's future indicates sharply declining sales and large losses.

5. Dividend and yield
There are many investors who buy shares with the objective of earning a regular income from their investment. Their primary concern is with the amount that a company gives as dividends -- capital appreciation being only a secondary consideration. For such investors, dividends obviously play a crucial role in their investment calculations.
It is illogical to draw a distinction between capital appreciation and dividends. Money is money -- it doesn't really matter whether it comes from capital appreciation or from dividends.
A wise investor is primarily concerned with the total returns on his investment -- he doesn't really care whether these returns come from capital appreciation or dividends, or through varying combinations of both. In fact, investors in high tax brackets prefer to get most of their returns through long-term capital appreciation because of tax considerations.
Companies that give high dividends not only have a poor growth record but often also poor future growth prospects. If a company distributes the bulk of its earnings in the form of dividends, there will not be enough ploughback for financing future growth.
On the other hand, high growth companies generally have a poor dividend record. This is because such companies use only a relatively small proportion of their earnings to pay dividends. In the long run, however, high growth companies not only offer steep capital appreciation but also end up paying higher dividends.
On the whole, therefore, you are likely to get much higher total returns on your investment if you invest for capital appreciation rather than for dividends. In short, it all boils down to whether you are prepared to sacrifice a part of your immediate dividend income in the expectation of greater capital appreciation and higher dividends in the years to come and the whole issue is basically a trade-off between capital appreciation and income.
Investors are not really interested in dividends but in the relationship that dividends bear to the market price of the company's shares. This relationship is best expressed by the ratio called yield or dividend yield:
Yield = (Dividend per share / market price per share) x 100
Yield indicates the percentage of return that you can expect by way of dividends on your investment made at the prevailing market price. The concept of yield is best clarified by the following illustration.
Let us suppose you have invested Rs 2,000 in buying 100 shares of XYZ Ltd at Rs 20 per share with a face value of Rs 10 each.
If XYZ announces a dividend of 20 per cent (Rs 2 per share), then you stand to get a total dividend of Rs 200. Since you bought these shares at Rs 20 per share, the yield on your investment is 10 per cent (Yield = 2/20 x 100). Thus, while the dividend was 20 per cent; but your yield is actually 10 per cent.
The concept of yield is of far greater practical utility than dividends. It gives you an idea of what you are earning through dividends on the current market price of your shares.
Average yield figures in India usually vary around 2 per cent of the market value of the shares. If you have a share portfolio consisting of shares belonging to a large number of both high-growth and high-dividend companies, then on an average your dividend in-come is likely to be around 2 per cent of the total market value of your portfolio.

6. Return on Capital Employed (ROCE), and
7. Return on Net Worth (RONW)
While analysing a company, the most important thing you would like to know is whether the company is efficiently using the capital (shareholders' funds plus borrowed funds) entrusted to it.
While valuing the efficiency and worth of companies, we need to know the return that a company is able to earn on its capital, namely its equity plus debt. A company that earns a higher return on the capital it employs is more valuable than one which earns a lower return on its capital. The tools for measuring these returns are:
1. Return on Capital Employed (ROCE), and
2. Return on Net Worth (RONW).
Return on Capital Employed and Return on Net Worth (shareholders funds) are valuable financial ratios for evaluating a company's efficiency and the quality of its management. The figures for these ratios are commonly available in business magazines, annual reports and economic newspapers and financial Web sites.
Return on capital employed
Return on capital employed (ROCE) is best defined as operating profit divided by capital employed (net worth plus debt).
The figure for operating profit is arrived at after adding back taxes paid, depreciation, extraordinary one-time expenses, and deducting extraordinary one-time income and other income (income not earned through mainline operations), to the net profit figure.
The operating profit of a company is a better indicator of the profits earned by it than is the net profit.
ROCE thus reflects the overall earnings performance and operational efficiency of a company's business. It is an important basic ratio that permits an investor to make inter-company comparisons.
Return on net worth
Return on net worth (RONW) is defined as net profit divided by net worth. It is a basic ratio that tells a shareholder what he is getting out of his investment in the company.
ROCE is a better measure to get an idea of the overall profitability of the company's operations, while RONW is a better measure for judging the returns that a shareholder gets on his investment.
The use of both these ratios will give you a broad picture of a company's efficiency, financial viability and its ability to earn returns on shareholders' funds and capital employed.

8. PEG ratio
PEG is an important and widely used ratio for forming an estimate of the intrinsic value of a share. It tells you whether the share that you are interested in buying or selling is under-priced, fully priced or over-priced.
For this you need to link the P/E ratio discussed earlier to the future growth rate of the company. This is based on the assumption that the higher the expected growth rate of the company, the higher will be the P/E ratio that the company's share commands in the market.
The reverse is equally true. The P/E ratio cannot be viewed in isolation. It has to be viewed in the context of the company's future growth rate. The PEG is calculated by dividing the P/E by the forecasted growth rate in the EPS (earnings per share) of the company.
As a broad rule of the thumb, a PEG value below 0.5 indicates a very attractive buying opportunity, whereas a selling opportunity emerges when the PEG crosses 1.5, or even 2 for that matter.
The catch here is to accurately calculate the future growth rate of earnings (EPS) of the company. Wide and intensive reading of investment and business news and analysis, combined with experience will certainly help you to make more accurate forecasts of company earnings.

[Excerpt from Profitable Investment in Shares: A Beginner's Guide by S S Grewal and Navjot Grewal.]

Seven things to remember in bear run

The year 2008 has been unkind to investors so far. Many have suffered huge losses. Who knows, there could be more pain ahead. It’s worth reminding ourselves of basic lessons that every retail investor ought to keep in mind to avoid, or at least minimise, losses in one’s portfolio.

1. High rewards don’t come without taking high risk.
During a bull market, retail investors get taken in by the rise in the stock market. They don’t want to be left out. So, they rush in and buy in an indiscriminate way, without realising that they might be taking on too much risk. Remember, if you chase high returns, high risk will follow you. Let’s take the example of publicly-listed real estate sector in India. The industry has a very favourable long-term future. However, the rapid rise in the sector’s stock prices over the past year made a short-term investment in these stocks a risky bet. As it turns out, the risks have been borne out and this sector has collapsed spectacularly. Understand your own risk profile and how you emotionally deal with volatility in stock prices.

2. Understand what you own — don’t always rely on the latest tip or prediction.
If you knew the secret location to some buried treasure, would you share it with others around you? If someone really has a hot tip on an investment that is going to earn high returns, always ask why they are sharing it with you. In today’s wired world, it is possible even for retail investors to understand, even if in basic ways, what is it that you are about to invest in — what does the company do, who its customers are, is the company profitable and so on. You must form your own view about the company’s prospects. Stay away from fast risers. The more you understand investments that you have made, the more confident you will become.

3. Leverage is a double-edged sword that can destroy you in falling markets.
The recent collapse of various hedge funds and banks has shown that living on borrowed money can be dangerous. During good times, leverage can amplify your returns. But in rough times, it can kill you. Currently, even the world’s best risk managers on Wall Street are having a tough time dealing with their leveraged exposure to markets. Be careful about making investments using leverage. Remember, nobody is going to flash an emergency light announcing the arrival of the next crisis.

4. Keep some of your powder dry — you don’t always need to be fully invested.
This is where the professionals really distinguish themselves from amateur retail investors, because they keep some cash available to take advantage of falling prices. Professionals think of a correction in stock prices as a sale in stocks. But to benefit from these sales, they keep some cash ready. They don’t feel the need to be fully invested all the time. If you use up all your cash to make your investments, you will never be able to take advantage of the cut price sales that will happen in times of severe correction like now. Corrections occur periodically — be prepared to take advantage of these situations.

5. Build portfolio on a strong foundation.
Just like you cannot build a house on a weak foundation, your stock portfolio also needs to be built on the back of strong companies and predictable stability. The more junk you have and poor quality stocks you own, the quicker your portfolio will also collapse during a correction. Weak companies with unfavourable long-term business prospects, weak balance sheets and poor operating performance might look tempting as they promise short-term growth. They may go up faster than the market in a bull phase, but come racing down at the slightest evidence of any stock market trouble.Build your portfolio on the back of stable, blue-chip companies that have long track records of success across economic conditions.

6. Keep a wishlist of companies.
Smart investors keep a wishlist of companies whose shares they want to buy when the opportunity and price are right. Corrections will give you the opportunity to pick through names. But, like we said in point 4 above, you need to have some dry powder to be able to add your wishlist to your portfolio. Warren Buffett has been known to keep his eye on his wishlist companies for decades before he finally finds a good entry point for an investment.

7. Invest for the long-term.
Serious investors put money to work for the long-term. They don’t get distracted by seasonal or cyclical fads, or get caught up in short-term performance. Don’t day trade, and especially not on margin. For every day trader who wins, there is another trader on the other side of the trade who has lost. In this speculative game, its likely that you will on average have as many bad days as good days. If you invest for the long-term, you will be less affected by all the noise in the market that will clutter your thinking and cause you to make impulsive and short-sighted decisions. You will also avoid the tax liability associated with short-term trading that can add more complexity to your finances.

It is never too late for serious investors who want to build long-term wealth to learn and apply the above lessons. With a little bit of discipline, your portfolio too can survive any stock market correction and achieve excellent long-term performance.

Mid Cap Funds: For the long-term

The recent stock market crash has been particularly harsh on one investment category – mid cap stocks/funds. Compared to their large cap peers, mid cap stocks/funds have fallen more sharply. The view that many frustrated investors might take is that investing in mid caps was a bad idea in the first place. And they can’t really be blamed, in many ways mid caps were presented as an opportunity to make quick money without informing the investor of the higher risk involved.

At Personalfn, we have a different view on mid caps. There is no doubt that if identified correctly, mid caps can contribute significantly to an investor’s wealth. For investors, there is merit in including mid cap stocks/funds in their portfolios; the allocations will vary depending on their risk appetites (aggressive investors can invest larger amounts in mid caps). Of course the higher gains in mid caps don’t come easy; investors have to brace themselves for higher volatility as well. For various reasons like evolving systems and corporate governance (vis-à-vis the large caps) the mid cap segment is prone to uncertainty. This explains why mid cap stocks/funds usually bear the brunt of stock market volatility. If anyone needed proof of that, the latest market crash provides it in adequate measure.

The biggest losers in 2008 have been mid cap funds (as also thematic funds with higher allocations to mid caps). That is not surprising because when markets hit the panic button, generally stocks with the highest risk get dumped first. And mid caps carry higher risk than large caps. Since systems and corporate governance are still evolving in most mid caps, investors may overlook some of these critical issues during a market rally. However, when markets are volatile, nervous investors consider these issues in a new light and are quick to abandon mid caps if there is any uncertainty. To that end, large caps given their stable fundamentals (like profitability and sales) and systems are evaluated differently and even when they are abandoned in times of nervousness, at least they are not the first ones to be dumped; that ignominy is reserved for mid caps.

Unfortunately, even investors who have a long-term view on mid caps find it difficult to deal with the extreme volatility. There are doubts about whether mid caps are worth it at all and if markets are in a freefall how long should they remain invested.

To answer these questions, it’s important to revisit some points about mid caps:

a) Not all mid caps prove to be worthy investments, even if they are held onto for the long-term. For every HDFC Bank that began as a mid cap to blossom into a large cap, there is a Global Trust Bank that nearly went bust. As a lay investor what are your chances of identifying the right mid cap stock? Not very bright, which is why a professional fund manager is a good bet to identify the best mid caps. Fund managers are more likely to identify the reasons ‘not to invest’ in mid caps and in this way considerably lower the risk of investing in mid caps.

b) The other way to reduce the risk, after having identified a ‘sound’ mid cap investment is to always have a long investment time frame (for mid caps we recommend at least 5 years). As a reputed fund manager observed – equities are the least risky asset over the long-term and the riskiest assets over the short-term. So if you have taken the mid cap route to generate wealth be prepared for the long haul. This way you will be relatively unaffected by intermittent volatility because you are clear that you expect to remain invested for at least 5 years (which we recommend strongly to our clients).

Over the last 5 years (which is when the mid cap rally began picking up steam) mid caps have performed relatively well compared to large caps. Over the last five years, Rs 100 invested in the CNX Mid Cap would have yielded Rs 624 compared to the Rs 473 that the BSE Sensex would have yielded. This gives investors an idea about how mid caps can help their money grow relative to large caps. However, mid caps have also lost more money for investors over certain time frames; a case in point is the present market decline, which has hit mid caps harder than large caps (refer to the graph for the more pronounced dip in the CNX Mid Cap index over the last few months compared to the BSE Sensex).

Lessons for investors

1) Mid caps, as we have seen, can prove very rewarding over the long-term, but that is no green signal to go overboard on mid caps.

2) Invest in mid caps in line with your risk profile. If you have appetite for high risk then you can invest higher in mid caps (your financial planner can recommend a mid cap allocation that is suitable to you). On the other hand, investors with moderate risk appetite can invest smaller amounts. The present market crash is an easy way to determine your risk appetite. If the sharp decline in mid caps has left you a very worried investor, then your risk appetite is perhaps not as high as you had previously imagined. This is a signal for you to tone down your mid cap investments.

3) Regardless of your risk appetite and mid cap allocation, you must be prepared to remain invested in mid caps for the long haul. That is the only way you will be relatively indifferent to intermittent volatility in that segment.

Don’t time the market

It is more important to spend time in there

The law of demand tells us that higher prices bring down demand and vice versa. But, there are exceptions to this rule, the biggest being the stock market — as prices go up, more investors flock to the stock market, and when the markets fall and stocks become cheap, more investors want to leave the stock market.

Counterproductive as it is, most investors thus end up buying when prices are high and selling when prices are low.

Do not follow the herd
Investors typically follow what everybody around them happens to be doing - buy if everyone is buying, sell if they are selling. But, this does not help because investors are essentially trying to enter or leave the stock market based on their perception of where it is headed. In short, they are trying to time the market, something even professional investors would agree is very difficult.

Invest regularly
A number of experts have been shouting from the rooftops since the Sensex touched 6,000 that the market is overvalued. But, that didn’t stop the index from rising 250% to cross the 21,000 level or falling by around 30% from that level. And now, when the markets are around 16,000, the experts seem to be suggesting that it’s the right time to buy, as stocks are available at lesser prices.

How does an individual protect his or her investments from volatility in the stock market? The answer lies in the age-old adage, “invest regularly.” How does regular investing help? The simplest answer seems to be that an investor can keep investing even if he does not have a large amount of money to invest. Also, with regular investment, money earmarked for investment does not go towards spending.

Regular investing also brings “cost averaging” into play. Say an individual invests Rs5,000 to buy 100 shares of A Ltd at the rate of Rs50 per share. Some time later, say the price drops to Rs25. Now if he decides to invest Rs5,000 again in A Ltd, he ends up buying 200 more shares. Now he has 300 shares of A Ltd. Thus, his average price per share now is Rs33.33. Hence, he can make a profit once the share price goes beyond Rs33.33 and doesn’t have to wait till it reaches Rs50 again.

Mr. Market and YOU

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.' This was how Benjamin Graham defined 'investment'. And rightly so! At these times, when the markets are witnessing high levels of volatility, it becomes an ardent need for stockbuyers to understand this difference between a speculative activity and investment. It requires just a misguided step for investor to turn his investment venture into a speculative misadventure.

In this regard, Graham's parable of 'Mr. Market' stands in good stead. This is, probably, one of the best metaphors ever created for explaining how stocks can become mispriced. Through this parable, Graham asks investors to imagine a non-existing person called Mr. Market who is your (investor's) partner in a private business. He appears daily and names a price (stock quotation) at which he would either buy your interest or sell you his. Now, despite the fact that both Mr. Market and you have stable business interests, his quotations are rarely so. At times, he falls so ecstatic that he sees only the favourable factors affecting business. And this is the time he would name a very high buy-sell price because he fears that if he does not quote such a high price, you would buy his interest in the enterprise and rob him of imminent gains.

And then there are times when this very Mr. Market is so depressed that he sees nothing but trouble ahead for both business and the world. These are the occasions when he would name a very low price, as he is terrified that if he does not do so, you would burden him (sell him) with your interest in the business.

Now, Graham says that if you were a prudent investor or a sensible businessman, you would not let Mr. Market's daily communication determine your view of the value of your interest in the enterprise. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But at the rest of the time, you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.

What Graham tells investors through this parable of Mr. Market is that they should look at market fluctuations in terms of the Mr. Market example. They should make these fluctuations as their friend rather then their enemy. This means that they should neither give in to temptations that rising markets bring with them nor should they think of doom when the markets are falling incessantly.

Coming back to the abovementioned definition of an investment operation, investors need to have a long-term (two to three years) perspective when making their investment decision. Only then would the promised safety of principal and an adequate return accrue to them. Now, the term 'adequate return' typically varies from investor to investor. A high-risk investor would demand a high return from his investment from the extra bit of risk he is taking. On the other hand, a low-risk investor would settle for a relatively lower return. Having said that, in a rising market, expectations tend to be on the higher side without a fundamental premise. Here is where 'Mr. Market' could mislead you. If you believe that 15% per annum is an 'adequate return', then stick to that irrespective of whether it is a bull market or a bear market. Otherwise, you are changing i.e. risk profile is changing, which is not required.

As Graham says, '...in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism.' Happy investing!

With index funds, choppiness won’t hurt

The passively managed funds are particularly good for building a milestone corpus Equity markets have undergone quite a bit of consolidation in the last few weeks. For a retail investor,stock-picking now seems much riskier than earlier.

That said, the low levels of current markets make many an investor wonder if they can enter at these levels. With a limited expertise in stock selection, it is a tough task to get the value buys right. Also, getting stuck to poor performers can be pretty disheartening when the bulls take charge of the market again.

Equity mutual funds, on the other hand, become somewhat unpredictable in their behavior in such turbulent times. Even if the investor wants to enter the markets at a certain level, the fund that he invests in might choose instead to stay put in cash. When taking a call on the overall market, therefore, index funds turn out to be a better choice for investments.

Index funds are passively managed funds and replicate the movement of an index like the BSE Sensex or NSE Nifty or any sector specific index without attempting to beat it. These will give the upside from the expected bull run in the exact proportion of the market movement and will not lag or lead the index. There is a common misconception that funds with a passive management style provide lesser returns as compared to actively managed equity funds. However, a large proportion of diversified equity funds underperform the index over long time horizons.

The following table shows the performance of equity mutual funds vis-à-vis the market indices.

Index returns (%) 1 yr 2 yrs 3 yrs

BSE Sensex 21.86 21.63 35.95

S&P CNX 26.08 21.88 34.18

NiftyCrisil Equity 17.46 12.49 28.65

Unfortunately, very rarely will you find any distributor recommending index funds, thanks to the low commissions they offer — another reason few people are aware that index funds so much as exist.

Most index funds have neither entry load nor exit load (beyond a minimum holding period), which ensures that the entire invested money is deployed in the equity markets. To add to this, the expense ratios are much lower for index funds ~1-1.5% and keep going down further as their AUMs increase. The composition of the target index is a known quantity; so the running costs are less for an index fund as no stock pickers or equity analysts are required.

One obvious disadvantage of index funds, however, is that they cannot outperform the broad markets unlike actively managed funds. However, for long-term investors who want to avail consistent gains and take advantage of the growth story in India without constantly churning their mutual funds portfolio, there is nothing better than an index fund. When it comes to building a corpus for milestones such as retirement, index funds are clearly a superior choice.

Index funds are offered by a majority of mutual fund houses like ICICI Prudential, Birla Sun Life, Franklin Templeton, HDFC, UTI, etc. All these are mutual funds and can be bought through mutual fund distributors. The Nifty BeES by Benchmark, though, is an exchange traded fund (ETF) listed on the NSE. To buy an ETF, an investor need to have a demat account and an equity broking account.

Unlike actively managed equity mutual funds, Index funds offered by different mutual fund houses do not vary in their returns significantly (see table: Index picks). Hence, the parameters to choose an index fund are different from those used for an actively managed fund. Expense ratio and tracking error are the most important factors while choosing an index fund. Expense ratio indicates the cost of investing in the fund and the tracking error indicates how much the returns of the index fund differs from its underlying index. Low tracking error and low expense ratio are desirable. Typically, higher AUM results in lower expense ratio. It also keeps an index fund stable and not prone to large withdrawals by major investors.