Do expenses really matter?

Do expenses really matter?

Having discussed the various costs and expenses involved while investing in a mutual fund scheme, let’s now find out if they really matter. To understand this better, we shall compare two mutual fund schemes, one with a low cost structure (say Fund A) and the other which isn’t quite as charitable (say Fund B). Investments in Fund A attract an entry load of 1.0%, while the number is 2.5% for Fund B. Similarly, the recurring expenses are 1.5% and 2.5% for fund A and fund B respectively. Assume that Rs 100,000 (one-time investment) is invested in each fund for a 10-Yr period and that both the investments grow at 15.0% per annum.

Fund A vs............... Fund B
................................Fund A ........Fund B
...........Entry load................ 1.00% ............2.50%
Recurring expenses............ 1.50% ..............2.50%
Amount invested ........(Rs) 100,000.......100,000
Growth rate (per annum)...... 15.00% ............15.00%
Maturity amount 10 yr (Rs) ...344,331 ........306,217

On maturity (i.e. at the end of 10 years), the investment in fund A would be worth Rs 344, 331, while that in fund B would be worth Rs 306, 217. The differential can be traced to Fund A’s cost effectiveness.

While evaluating a mutual fund scheme, factors like the AMC’s investment philosophy and style, track record across parameters (risk and return) are usually given due weightage. To that list, investors would do well to add the fund’s cost efficiency. After all, as we have observed, over the long-term the costs involved can have a significant impact on the fund’s performance.

Stock market still trading 25-30% higher

In the high-flying world of equities, it’s seldom that investors talk about dividends. This is surprising; given that one of the best things about investing in a well-managed company is that it provides investors with regular tax-free dividend income that also grows along with the company.

In fact, for purists, the truest form of investment is the one that is done for dividends. Everything else is speculation, with varied time frames.

But do dividends teach us any lesson, given the current meltdown? And do they help in our efforts to find the bottom? An ETIGanalysis suggests that the answer to both these questions may lie in the history of dividend payouts of listed companies rather than their forward-earning estimates, as many traditionalists will like to believe.

A historical trend line of the dividend paid out by Nifty companies offers interesting insights — the current bull run began in April ’03 at an all-time high dividend yield of about 3.2% and the correction in January ’08 began at a seven-year low Nifty dividend yield of 0.8%.

Even more interesting is the fact that over the long term, there seems to be a close correlation between the growth in the dividend payout and the movement in the Nifty. To find this out, we indexed Nifty and the dividend-payout of Nifty stocks, beginning January 1999.

As the chart shows, whenever the Nifty has shot past and stayed above this dividend trend line for a sustained period, a correction has followed. And greater the gap, the sharper has been the ensuing correction. This phenomenon was first observed during the May ’04 correction and then, in May ’06.

Interestingly, just prior to that crash, Nifty had overshot its par value by close to 50%. What is striking, however, is that the Nifty started its recovery the very day the two trend lines converged. Even though the Nifty nearly doubled its value from its June ’06 lows over the next 18 months, dividend payments grew by less than 1/6th the rise in Nifty.

No wonder, the gap between these two trend lines had assumed dangerous proportions by January ’08, with the Nifty overshooting its fair value by over 100%! What followed was for every one to see. What’s even scarier is that the gap between these two trend lines continues to be what the gap was at the beginning of the May ’06 correction!

This means that to close the gap, either the Nifty has to fall by another 25-30% or India Inc’s dividend payout has to grow proportionally. With the latter looking unlikely, we seemed to be destined for an extended, painful and bloody bear market.

Mutual Funds: Cost to investor

The utility that mutual funds can offer to investors has been discussed and often eulogised in great detail. However, there is another vital aspect to mutual funds that is rarely spoken about – the costs. Investing in mutual funds entails bearing certain costs on the investor’s part. These costs, in turn have an impact on the returns clocked by the investor. In this article, we take a closer look at the various costs and expenses borne by investors while investing in a mutual fund scheme.

1. One-time charges
Entry/exit loads and initial issue expenses qualify as one-time charges, as opposed to recurring expenses which have been dealt with later in the article. First, let’s consider the case of new fund offers (NFOs). Over the last few years, investors have been faced with a deluge of NFOs. But in recent times, a perceptible trend in NFOs has been a rise in the number of close-ended funds. This phenomenon can be traced to the rules governing initial issue expenses. Close-ended funds are not permitted to charge any entry load; instead 6% of the sum mobilised during the NFO period can be utilised to meet the initial issue expenses. The same can be amortised (charged to the fund) over the fund’s close-ended tenure.

For example, if a close-ended fund were to mobilise Rs 5 billion (Rs 500 crores) during the NFO period, the asset management company (AMC) can utilise Rs 300 million (Rs 30 crores) to meet the sales, marketing and distribution expenses. Furthermore, the stated sum will be charged to the fund. This will impact the returns clocked by the fund. Any amount over the stated 6% has to be borne by the AMC.

Conversely, in the case of open-ended NFOs, funds are required to meet all the sales, marketing and distribution expenses from the entry load. They are not permitted to charge any initial issue expenses. The rules governing entry/exit loads state that taken together, the two cannot account for more than 6% of the net asset value (NAV). Charging an entry load for the entire 6% upfront would adversely affect the fund’s performance in the initial period. Hence AMCs choose to have rather “rational” entry loads in the range of 2.25%-2.50%. Like initial issue expenses, entry loads also eat into the investor’s returns, since the investor has that much less money working for him.

For example, say an investor invests Rs 5,000 in an open-ended fund that charges an entry load of 2.50%. Effectively, only Rs 4,875 is invested in the fund.

It is not difficult to understand why AMCs have a newfound liking for close-ended funds. With the provision for charging 6% of amount mobilised towards initial issue expenses, AMCs are better equipped to compensate the distributors and agents, who in turn help the fund houses in accumulating more assets. Higher assets translate into higher revenues for the AMCs. Of course, close-ended funds do offer advantages as well. For example, the fund manager can make investments from a long-term perspective and investors are given the opportunity to invest for a pre-defined investment horizon. However, investors would do well to factor in the costs involved.


2. Recurring expenses
Investors also have to contend with recurring expenses, which are charged annually to the fund. These expenses are revealed in the form of an expense ratio that is declared twice a year. Recurring expenses (as is the case with amortised initial issue expenses) are “silent” in nature since they don’t necessarily attract the investor’s attention. The reason being that the fund’s NAV is declared after the recurring expenses have been accounted for.

The Securities and Exchange Board of India (SEBI) has laid out guidelines defining the manner in which recurring expenses can be charged; the same is a factor of the fund’s average weekly assets (however most AMCs choose to compute it as a percentage of the average daily assets).

The expense ratio
Average daily net assets........% Limit

First Rs 1,000 m............2.50%
Next Rs 3,000 m............2.25%
Next Rs 3,000 m............2.00%

On balance assets...........1.75%

As can be seen from the table above, the grid for recurring expenses has been structured in a manner to ensure that the expenses charged to the fund reduce with an increase in the asset size. The recurring expenses include marketing and selling expenses (including agents’ commission), brokerage and transaction costs, custodian fees and fund management expenses (paid to the AMC), among other expenses. A typical list of recurring expenses for an equity fund would look like the following:

Recurring expenses for an equity fund
Expenses.........................% Of average daily net assets
Fund Management..................................................1.25%
Marketing & Selling................................................0.50%
Custodian Fees........................................................0.25%
Investor Communication.......................................0.20%
Registrar Fees..........................................................0.15%
Trustee & Audit Fees..............................................0.15%
Total Recurring Expenses..................................... 2.50%

The expense head which merits attention is “fund management”; this represents the AMC’s revenue stream. In other words, the salaries and other compensation offered to the fund management team is charged to the mutual fund scheme under this head. SEBI guidelines explicitly state the manner for computing fund management charges and limits for the same.

Fund management expenses
Average daily net assets............... Limit
First Rs 1,000 m................................1.25%
On balance assets..............................1.00%

Don't exit SIPs in a falling market

Joydeep Ghosh

Sunil Shah is a worried man today. He entered the market in October 2007, when the Sensex was rising by 1,000 points in a single week.

At that time, his already-invested friends advised him to enter the market through systematic investment plans of mutual funds. Since he had never invested in the markets before, he decided to go the whole hog and started four SIPs of Rs 5,000 each.

In the last eight months, he has invested Rs 160,000. However, the erosion in the net asset value of his mutual funds has meant that the value of his invested money has dropped to Rs 120,000. He does not know if continuing with the SIPs makes any sense now.

"In such cases, investors call up to stop their SIPs or exit them. But, we try to convince them as much as possible to the contrary," says a financial planner. And this Monday, when the Sensex slipped by 506 points, Shah did the same. He called his mutual fund distributor to stop his SIPs.

The distributor told him that it does not make sense to do so as he was getting more units of the same fund for the same money.

"So what? My portfolio is already down 25 per cent. This is like throwing good money after bad money," Shah argued.

His fund advisor explained, "When the NAV falls, you are going to get more units of the fund. That means when the market turns around, you will get much more returns."

Suppose the NAV of a fund is Rs 20. When you invest Rs 5,000 in that fund, the total number of units purchased would be 250 (Without considering 2.25 per cent entry load and an annual 2 per cent fund management charge in equity funds).

However, there is no entry load on investors if they approach the asset management company directly.

Now, if the NAV falls to Rs 18, the number of units that can be purchased is 277.7. A further fall to Rs 15 and the number of units in the kitty is 333.3. Let us take Shah's case. If he were to continue his SIPs, the numbers could look something like this.

Suppose, he accumulated 1,500 units in the first six months at the NAV of Rs 20, another 1110.8 for four months at Rs 18 and another 1333.2 units for another four months at Rs 15, the total number of units he got is 3,944.

If the markets were to turn around in, say, six months and the NAV was to rise to Rs 25, his portfolio would be worth Rs 98,600 (on an investment of Rs 70,000).

And the additional 444 units accumulated during the falling market have added Rs 11,100 to the corpus.

Moral of the story: It's a good idea to continue your SIPs in a falling market.

Patience and strategy lead to good investments

Suresh Sadagopan

If you dig in the same spot long enough, you'll eventually find water, goes an old saying. But many people dig in one place for a while, and then get impatient or distracted and start digging in another place, and then another... When they don't find water in any of those, they blame their luck. It's surprising that more people haven't figured out the simple trick. Of course, there's no denying the importance of choosing the best place to dig in the first place.

Many people dart in a new direction randomly. Many get caught up in the latest investing fads. There are broad trends like equity and mutual fund investing. Then, real estate, commodities, and gold. And then there are micro-trends - read 'fads' - like going overboard on mid-caps, banking stocks, the communications sector, and infrastructure. In pursuit of the latest trend, investors churn their portfolio.

These are the people you find glued to the TV, watching business channels, where post-mortems and predictions are doled out incessantly to viewers who wait with bated breath for the latest, as if they could get the news and act on it before anyone else. But what's on the TV channels is 'news ' only to the retail investor. The rest of the investing world usually not only knows about it, but has often also acted on it. The result is that retail investors are often the last to rush in, and get the empty shell, after the kernel has already been eaten by those higher up in the investing food chain.

The investing topography also has its share of whirlpools and quicksand. These feature things like rumors floated by vested interests, and often aimed at retail investors. Trusting investors follow the trail laid out for them. Then the cowboys who floated the rumours unwind their positions and move on to the next pasture, leaving trapped investors bleating plaintively.

Retail investors are fascinated by day trading. Who hasn't heard a story about someone's neighbor or cousin who makes money hand-over-fist on a daily basis? Isn't it remarkable that one hardly ever hears stories about the losses made by these legends? Many investors have great faith that there exist fail-proof methods to become really rich really quick.

They underestimate the risks they take, and rely too heavily on the instincts of themselves and of others, often at the expense of plain logic. The tide of optimism exposes their gambling streak, and they end up making bets that may not be as sound as they first appeared. Fact is, it's very difficult to predict equity markets, because there are simply too many variables involved

For those who want to get rich fast, investing time frames are measured in days rather than years. All those talk about wealth creation over time - how boring! What could be tamer than returns of 12-15 percent a year? The hot-blooded investor will settle for nothing less than doubling his money in six months. But the fact is that risk and return normally have a direct correlation - the higher the risk, the higher the returns. However, the chances of good returns increase - while risk does not - when one gives one's investment time to perform.

When investors burn their fingers, they leap to the conclusion that investing is dangerous, and swear they will never return to it... until the next fad comes along. Drifting from one investment to another without any strategy will not help anyone reach their long-term goals. It amounts to digging in too many places for water.

If there's no strategy for achieving goals, it may never happen. Many simply chase money. But that money is required for achieving certain milestones, fulfilling aspirations and meeting goals. Making money is fine - who could argue against that! But just chasing money, and letting oneself be led in any direction that seems appropriate at a given moment, will render the whole exercise futile.

Investors need to work with goals in mind, and work towards reaching them in the appropriate time frame, which is what financial planning is all about. There is no compelling reason to arbitrarily gun for some high threshold of return (say 40 percent a year) which will only drive the investors towards riskier options. Responsible investments made over a period help in achieving goals, even if they give modest returns. Investors need to give them time. Like everything else in life, it takes time for an investment to bear fruit.

Less is more. There's no need to keep moving your money around. If you have invested in good options in a diversified manner, just let it be. That way you don't have to constantly look around for options to shift to.
Remember, if something seems too good to be true, it probably is. Schemes which promise stratospheric returns deserve your skepticism.

So do those who claim to be sure about which way the stock market will turn, which stock will do well this year, and the like. When someone is that sure, take their views with a proportionately big pinch of salt.

As for knowing where to dig for water, you would consult a hydrologist, engineer, or some other professional, wouldn't you? Why should it be different with money? Find a consultant you can trust, who will guide you responsibly

5 not to do's in stock market

1. Not to give in to greed and fear: This is an important point, which you, as an investor, must keep in mind owing to its great influencing ability in equity investment decisions. This point simply means that in a bull run - control the greed factor, which could entice you, the investor, to compromise with your investment principles. By this we mean that while an investor could get lured into investing in penny and small-cap stocks owing to their eye-popping returns, it must be noted that these stocks have the potential to wipe out almost the entire invested capital. Another way greed affects investor behaviour is when they buy/hold stocks above the price justified by its fundamentals. Similarly, in a vice-versa scenario (bear market), investors must control their fear when stock markets turn unfavourable and stock prices collapse. Panic selling would serve no purpose and if the company has strong fundamentals, the stock is more than likely to bounce back. It is apt to note here what Warren Buffett, the legendary investor, had to say when he was asked about his abstinence from the software sector during the tech boom, "It means we miss a lot of very big winners but it also means we have very few big losers.... We're perfectly willing to trade away a big payoff for a certain payoff".
2. Not to time the market: This is one factor, which many experts/investors claim to have understood but are more often wrong than right. We believe that it is rather impossible to time the market on a day-to-day basis and by adopting such an approach, an investor would most probably be at the losers' end. In fact, investors should take advantage of the huge volatility that is witnessed in the markets time and again (and will be in 2008). In Benjamin Graham's words, "Basically, price fluctuations have only one significant meaning for the 'true' investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market".

3. Not to act based on rumours and sentiments: Rumours are a part and parcel of stock markets, which do influence investor sentiments to some extent. However, investing on the basis of this could prove to be detrimental to an investor’s portfolio, as these largely originate from sources with vested interests, which more often than not, turn out to be false. This then leads to carnage in the related stock(s) leaving retail investors in the lurch. However, if we consider this from another point of view, when sentiments turn sour but fundamentals remain intact, investors could take the opportunity to build a fundamentally strong portfolio. This scenario is aptly described by Warren Buffett, "Be fearful when others are greedy and be greedy when others are fearful".

4. Not to attach emotionally with stocks: It is very much possible that the company you have invested in fails to perform as per your expectations. This consequently gets reflected on the stock price. However, in such a scenario, it would not be wise to continue to hold onto the stock/buy more at lower levels on the back of expectations that the company's performance may improve for the better and the stock would provide an opportunity to exit at higher levels. Here it is advisable to switch to some other stock, which has promising prospects. In Warren Buffett's words, "Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks".

5. Not to borrow and buy stocks: This behaviour is typical in times of a bull run when investors invest more than what they can manage with the hope of making smart returns on the borrowed money. Though this move may sound intelligent, it is smart only till the time markets display a unidirectional move (i.e. northwards). However, things take a scary turn when the markets reverse direction or move sideways for a long time. This is because it leads to additional margin calls by the lender, which might force the investor to book losses in order to meet the margin requirements. In a graver situation, a stock market fall could severely distort the asset allocation scenario of the investor putting his other finances at risk.

Systematic Transfer Plans (STPs)

The functioning of STPs is quite similar to that of SIPs in terms of depositing a fixed sum into a fund at regular intervals. The difference here is that a lump sum can be invested in debt funds with nominal risk, and periodically, a specific amount can be transferred to a diversified equity fund.

STPs score over SIPs in a situation where you have the money to invest, but are wary of the turbulence in the market. In such a scenario, it’s better to park your money in debt funds that give decent returns, rather than opting for short-term fixed deposits/savings accounts that earn lacklustre interest. Also, the regular flow of your money into equity funds will ensure that you don’t lose out on the attractive returns they offer.