Sharia investments are also known as Halal investments. They encourage people to invest in a socially-responsible way according to Islamic principles. These investments have to follow a detailed set of Sharia requirements and rules.
Shariah investments or Sharia compliant investments follow the principles of Islamic law. They encourage people to invest in a socially responsible way. There is a lot of scope for Shariah-compliant mutual funds in India because many Muslims believe that it is wrong to give or take interest on loans.
Here we will look at the goals of Shariah investment and the different investment options in India.
Sharia investments are also known as Halal investments. They encourage people to invest in a socially-responsible way according to Islamic principles. These investments have to follow a detailed set of Sharia requirements and rules. A considerable effort is necessary to ensure that investments follow Sharia principles.
Investments in gambling, alcohol, weapons, pork products, smoking, pornography, etc., are not permitted. A Sharia board ensures compliance with rules, and there is an annual Sharia audit. Certain types of income, like interest, must be purified through donations to charity.
Islam encourages investments, trade, and charity. It disapproves of receiving and giving interest, or Riba, which is considered to be exploitation. Shariah rules do not allow people to earn a fixed income, like interest. They also caution against too much speculation.
Anyone who believes in socially-responsible investing can invest in Sharia mutual funds. Unfortunately, there are very few Shariah-compliant mutual funds in India.
At present, there are three Shariah-compliant mutual funds/ETFs in India:
Reliance ETF ShariahBeES
Taurus Ethical Fund
Tata Ethical Fund
The Reliance ETF ShariahBeES is an exchange-traded fund (ETF). It invests in the Nifty 50 Sharia Index. The Taurus Ethical Fund and the Tata Ethical Fund are open-ended, actively-managed, multi-cap funds. They both have the Nifty 500 Shariah TRI as their benchmark.
Also Read: Mutual Funds Vs. ETFs: Where to invest?
What is the Sharia Index?
The Sharia Index can be the basis for Sharia-compliant investment products. These products attract Muslims who want to invest without violating Sharia principles. They avoid investing in companies that engage in activities that Islam does not allow.
The NIFTY 50 Shariah Index is based on the Nifty 50 Index. Companies that follow Sharia principles are part of the NIFTY 50 Shariah Index. The NIFTY 50 Shariah Index tracks the performance of the parent index.
The NIFTY 500 Shariah Index is based on the Nifty 500 Index. Companies that follow Sharia principles are part of the NIFTY 500 Shariah Index, which tracks the performance of the parent index.
This ETF aims to provide returns that correspond with the total returns of the Nifty 50 Shariah Index. It does this by investing in securities that make up the Nifty 50 Shariah Index in the same ratio as the index. Its benchmark is the Nifty 50 Shariah (TRI).
It suits investors seeking capital growth by investing in the Nifty 50 Shariah Index. However, the fund’s website states that it is not a Shariah-compliant scheme.
According to Value Research, this unrated exchange-traded fund (ETF) is in the equity large cap category. Its assets were worth ₹3 crores, and it had an expense ratio of 1.16% as on February 28, 2019. It’s one-year, three-year, and five-year returns as on March 26, 2019, are given below:
Taurus Ethical Fund
The Taurus Ethical Fund is a multi-cap fund, which invests according to the Islamic investment philosophy. The fund manager uses specific screening norms to pick companies.
It invests in stocks from the S&P BSE 500 Shariah Index. The excluded sectors are financials, banks, tobacco, alcohol, gambling, pork, pornography, etc.
This fund suits investors seeking long-term capital appreciation from Sharia-compliant investments. Its benchmark is the S&P BSE 500 Shariah TRI.
According to Value Research, this unrated mutual fund is in the equity thematic category. Its assets were worth₹36 crores as on February 28, 2019, and it had an expense ratio of 2.60% as on January 31, 2019. It’s one-year, three-year, and five-year returns as on March 26, 2019, are given below:
This fund aims to provide capital appreciation from Shariah-compliant, diversified equity investments. It invests in growth and value-oriented companies, and its benchmark is the Nifty 500 Shariah TRI.
The excluded sectors are casinos/gaming, alcoholic beverages, and non-halal food products, etc. Investments are not allowed in financial institutions that earn from interest (Riba).
It invests in companies with low leverage and avoids companies with high debt-to-equity ratios. A Sharia adviser ensures purification of any prohibited income every year. It suits investors who want to invest in a Sharia-compliant mutual fund.
The Tata Ethical Fund has obtained Shariah compliance certification. This certification is from Taqwa Advisory and Shariah Investment Solutions (TASIS).
Which of these mutual funds/ETFs is right for me?
Reliance ETF ShariahBeES may be the right choice if you want to invest in the Nifty 50 Shariah Index. However, this fund’s website states that it is not a Sharia-compliant scheme. It invests in the Nifty 50 Shariah Index and is suitable for passive investors who want to get returns that beat inflation.
You will have to open a Depository and Trading Account to invest in the Reliance ETF ShariahBeES. Liquidity may be inadequate because of low trading volumes in this ETF. One of the reasons for this is the lack of awareness about this ETF within the community.
The Taurus Ethical Fund and the Tata Ethical Fund are actively-managed multi-cap funds. They may offer higher returns than an ETF as they can invest across market caps. You will not have to open a Depository and Trading Account to invest and will enjoy much more liquidity.
Sharia funds suit people who want to invest according to the principles of Islam. These mutual funds do not invest in companies that deal with prohibited products and services. Earning interest and too much speculation are also not allowed. An actively-managed, multi-cap, Sharia-compliant mutual fund may offer higher returns than an ETF.
An inverted yield curve shows that an economic slowdown may be imminent.
The yield curve is one of the leading indicators that analysts use to predict the direction of the stock markets. In the United States, analysts have used it to forecast all the recessions in the last five decades. The yield curve has not been given much attention in India.
Let’s take a closer look at what an inverted yield curve is and what it means:
The yield curve is a line on a graph that tracks the yield of bonds that have the same credit quality against their maturities. Most reports compare the yield curve of three-month, two-year, five-year, and thirty-year US treasury debt. The yield curve serves as a benchmark for different types of debt, such as bank loan rates and mortgage loan rates.
What are the main types of yield curves?
The yield curve’s shape predicts changes in future economic activity and interest rates. The primary forms that a yield curve can take are normal, flat, and inverted.
Normal yield curve
Normally, bonds with a longer maturity have a higher yield than shorter maturity bonds because of the risks related to time.
The basic premise of the yield curve is that longer-term bonds should offer a higher yield than shorter-term bonds. Investors usually expect lower returns when they invest for shorter periods. They expect higher gains when they invest for more extended periods. For example, a one-year bond ought to offer a lower yield than a ten-year bond.
However, at times, shorter duration bonds offer higher yields than longer duration bonds at times when investors lack confidence in the economy. They invest in shorter duration bonds because they expect the value of short-term bills to fall in the future.
What does an inverted yield curve show?
An inverted yield curve is the rarest of the three main types of yield curves. It is also called a negative yield curve and is a predictor of a recession. The yield curve inverts when long-term debt instruments have a lower yield than short-term debt instruments with the same credit quality.
Yield curve inversion has occurred before many US recessions, showing that the yield curve can predict turning points in the business cycle. Yield curve inversion had also predicted the global financial crisis of 2008, two years before it occurred.
What did the yield curve inversion of December 2018 indicate?
The yield curve inverted on December 3, 2018, and this was the first yield curve inversion since the global financial crisis of 2008. The yield curve was back to normal on December 14, 2018.
Investors and analysts are keeping a close watch on the movements of the yield curve. If it inverts once again and remains inverted, it could mean that a recession is imminent.
Is the yield curve relevant in India?
The yield curve has not been a reliable indicator of recessions in India, but once it inverts, equity markets start falling. In the last 15 years, yield curve inversion occurred on four occasions in 2008, 2011, 2013, and 2015. The markets had delivered negative returns during these periods.
There is a negative correlation between stock market indices and the gap between the ten-year bond yield and the one-year bond yield. As this gap narrows, the likelihood of a fall in the equity indices increases.
There is a time lag between yield curve inversion and an economic slowdown. A slowdown may not occur immediately after the yield curve inverts. Yield curve inversion occurred more than two years before the global financial crisis of 2008.
Worries about an imminent economic slowdown in the US have increased in recent months. Investors are worried about the disturbing signals emanating from the US bond market.
The US yield curve has been flattening, and some parts of it inverted in December 2018, indicating the direction in which the economy is heading.
Yield curve inversion causes negative sentiment
The yield curve is making markets nervous, and investors have been dumping stocks. Yield curve inversion is considered to be the top predictor of a recession. Yield curve inversions have occurred before the last seven recessions.
Yield curve inversion impacts investor sentiment, creating a negative feedback loop. Worries about stocks and the economy result in lower bond yields, leading to misgivings about yield curve inversion, which causes even more stock market weakness.
Markets are aware of the implications of yield curve inversion, and this can turn into a self-fulfilling prophecy. A recession could occur because people believe that it is likely to happen.
People start behaving like a recession is beginning and turn their worries and fears into reality. While you shouldn’t ignore the flattening of the yield curve, this isn’t the only indicator to consider.
Financial conditions are still relatively accommodative, and the recent tightening is limited compared to the shocks that came earlier. Economic conditions could ease if leaders can resolve risks like the US-China trade war and Brexit.
Yield curve inversion is one of the main predictors of a recession. The yield curve had inverted more than two years before the global financial crisis of 2008. A flattening yield curve impacts investor sentiment and this can create a self-fulfilling prophecy. However, the yield curve isn’t the only indicator to consider.
It’s important to have big dreams, but it isn’t easy to turn your dreams into reality. Pick goals that you are passionate about and believe that you can achieve them. Make realistic plans that you can meet and track your progress. Here are six simple steps to reach your financial goals,
“Set your goals high, and don’t stop till you get there.”
I am sure like many, you are also inspired by the above quote, while it’s true that you have to set your goals high, at the same time it’s imperative to keep it realistic.
You may dream about starting a business, buying a house, being debt-free, or going for a round-the-world trip. Planning can help you to make it happen.
If you don’t have any goals or objectives, you will not be clear about what you want to do. You will keep living from day to day without any sense of direction. Those who achieve great things have clear goals and make plans to reach them.
It’s important to have big dreams, but it isn’t easy to turn your dreams into reality. Pick goals that you are passionate about and believe that you can achieve them. Make realistic plans that you can meet and track your progress.
I am hereby listing six simple steps to reach your financial goals.
Set goals that you are passionate about
Ask yourself if you want to achieve your goal. It’s not enough to want something because everyone else wants it or because you think it will make you look good. If your heart’s not in it, you will not be passionate about achieving the goal. You will not have the motivation to do whatever it takes to succeed.
If you are half-hearted about the goal, you will probably lose interest. For example, you are more likely to own your dream house if you have a burning desire to make it happen.
Choose realistic goals
Pick realistic goals that you can achieve in the given time frame. Consider the gap between where you are and where you want to go. Can you get what you want within a reasonable period? If you believe that you can achieve the goal within the given time frame, you are more likely to succeed.
You need to choose an achievable goal to avoid frustration. Break the goal down into smaller milestones. Reaching each of them will motivate you to move forward.
Think about whether you are trying to do too much. You need to have enough time to focus on each of your goals. Time is your most precious resource, and it isn’t possible to do everything at the same time. It’s best to be clear about your priorities and do the things that matter most to you.
You must have a plan if you are to achieve your financial goals. Be specific, and define the objective, the timeframe and the milestones in monetary terms. Be realistic and set achievable goals. Set deadlines for each goal and milestone. Since you are making the plan, you are more likely to succeed.
A flexible plan will help you to stay on course even if you are unable to reach some of the milestones as scheduled. Unforeseen events can cause delays, and at times the goal may seem unreachable. There is no need to get disheartened and give up. Your plan needs to factor in such unexpected delays so you can keep moving towards your goal.
Use standing instructions to invest money every month. There should not be any need for you to do anything to move your money to an account or mutual fund. You can issue standing instructions to your bank to transfer funds, and set up systematic investment plans (SIPs) to invest in mutual funds.
You can transfer money to a recurring deposit account or a few mutual funds every month. Everything will happen automatically, and you will keep moving towards your goal every month. You are more likely to reach your targets because you will not have to do anything to make it happen.
Move money out of your main bank account
If you set up a recurring deposit account or SIP, money will move out of your main bank account every month. You will get used to making do with the remaining amount. You are less likely to spend the money if you move it to an account in a different bank. As soon as your main bank account’s balance falls, you will have to curtail spending.
Funds invested in mutual funds are not instantly accessible, so impulsive spending is less likely. It’s unlikely that you will redeem your mutual fund investments unless you must.
You need to be positive while setting goals and visualize success. Spend time thinking about success every day. If you are full of doubts and think about all the things that could go wrong, you may not succeed. Your mind creates an environment for success.
If you can visualize a goal and believe that you can achieve it, you will succeed. That’s why you must to choose a goal that you think is achievable. If you picture yourself achieving your goal, you will make it happen. Being positive is one of the critical factors for success.
You can make your dreams come true by setting specific goals, defining them in monetary terms, and preparing detailed plans. Break each goal down into milestones and track your progress. Give standing instructions to your bank to invest money every month. Move money out of your main bank account to avoid impulsive spending. Be positive and visualize success to achieve your goals.
Mutual fund advisers use jargon that can be quite confusing for newbie investors. Here we discuss some of the most commonly used mutual fund terms. Knowledge of these terms will help you to understand what your financial adviser says.
Mutual fund advisers use jargon that can be quite confusing for newbie investors. Here we discuss some of the most commonly used mutual fund terms. Knowledge of these terms will help you to understand what your financial adviser says. You will be able to make the right investment decisions as an informed investor.
These terms will also help you to make sense of advice provided by news channels, websites, and financial publications.
Let’s take a closer look at some of the terms that are often used by mutual fund advisers and analysts:
Let’s take a closer look at some of the terms that are often used by mutual fund advisers and analysts:
What is indexation?
Indexation is a technique used to adjust taxes using a price index. It accounts for inflation from the time when you purchase an asset to the time when you sell it. It inflates the price at which you bought the asset, which reduces your tax liability.
Indexation applies to long term capital gains earned from debt mutual funds after three years. It does not apply to equity mutual funds and portfolio management schemes.
Rupee cost averaging is a technique used to invest a fixed amount of money at regular intervals in a mutual fund scheme. Systematic investment plans (SIPs) use Rupee cost averaging.
You buy more units when the market falls, and fewer units when the stock market rises. This method distributes investment risk across movements in market levels.
This approach is a lot safer than investing a lump sum at one time because you avoid the risk of catching a market top. If you keep waiting to buy when the market bottoms, you may miss out if the market rises suddenly.
What is an entry load?
An entry load is a fee that a mutual fund charges at the time of investment. SEBI abolished entry loads in June 2009, so mutual funds stopped making deductions at the time of investment.
The following example will help you to understand how entry loads worked before they SEBI abolished them in 2009. If you invested Rs.1 lakh in a mutual fund with an entry load of 1%, the fund house would deduct Rs.1,000 and invest Rs. 99,000 in the fund.
An exit load is a fee that you may have to pay if you withdraw your money from a mutual fund within a specified period. Exit loads don’t apply to liquid mutual funds. They are more likely to apply to duration debt funds and equity funds.
Exit loads penalize short-term investors who enter and exit mutual funds frequently. Short-term investors can cause volatility. They reward long-term investors who stay invested for the long term.
For example, an equity mutual fund may charge an exit load of 3%of the redemption proceeds if you withdraw your money within 90 days. If you take out Rs.100,000 within 90 days, you will have to pay an exit load of Rs.3,000.
What is the turnover ratio?
The turnover ratio is the percentage of the portfolio that a mutual fund replaces in a year. It can depend on the type of fund, its goal, and the fund manager’s investment style.
For example, if a mutual fund has a turnover ratio of 100%, it replaces all its holdings in a year. A fund with a low turnover may incur lower trading costs and pay less short-term capital gains tax. However,a low turnover, buy-and-hold strategy does not assure higher returns in the long term.
Risk grade is the quality rating of a mutual fund, which depends on the risk of loss associated with it. Analysts use it to assess the risk-return profile of a mutual fund.
Overnight funds, which invest in securities with a maturity of one day, are the least risky. Liquid mutual funds invest in debt and money market securities with a maturity of up to 91 days. Liquid funds are slightly more hazardous than overnight funds. The level of risk increases as the duration goes up.
In the same way, hybrid mutual funds are less risky than pure equity mutual funds. Large-cap funds are less dangerous than mid-cap funds, which are less risky than small-cap funds.
You can pick a product that aligns with your goals, risk tolerance, and time horizon. A liquid fund may not be the safest investment if you have a time horizon of 10 years.
Alpha is return earned by a mutual fund that exceeds its underlying benchmark. It is the value that a fund manager adds when someone invests in an actively-managed mutual fund.
People invest in actively-managed mutual funds because they believe the fund manager’s skills will help them to beat the index. For example, if the Sensex delivers a return of 12% in a year and your mutual fund returns 14%, the 2% excess return is the Alpha.
What is Beta?
Beta can be defined as the systematic risk or volatility associated with a portfolio as compared to a benchmark or the entire market. It mirrors the tendency of a portfolio to respond to swings in the market.
The market has a beta of 1%. If a mutual fund’s beta is more than 1%, it is high, and if it is less than 1%, it is low.
For example, if your mutual fund has a beta of 1.3, it means that if the market goes up by 1%, your mutual fund will go up by 1.3%. And, if the market goes down by 1%, your mutual fund will go down by 1.3%. A mutual fund with a beta of 1.3 is aggressive and riskier than the market.
Understanding financial terms relating to mutual funds can help you to make the right investment decisions. You can compare different investments and maximize your returns in the long run as an informed investor. Bank relationship managers and agents will not be able to push you to invest your hard-earned money in products that don’t suit you.
Let’s take a closer look at John Bogle’s ideas and how he used them to provide higher returns to mutual fund investors:
How Bogle transformed the mutual fund industry
Bogle said that investors’ returns depend to a great extent on lower costs. He believed that it is not possible for fund managers to beat the market indices consistently. He put these ideas into practice at Vanguard, the mutual fund company that he founded.
Bogle’s ideas and the success of Vanguard have resulted in continuous efforts to reduce mutual fund costs across the world. Lower expenses have helped investors to earn higher returns.
Investors have realized that fund managers cannot outperform the markets consistently. As a result, low-cost, passively-managed index mutual funds and ETFs have become popular.
Bogle founded Vanguard in 1976. It was the first mutual fund in the world to offer low-cost index investing to individuals. Vanguard is a non-profit organization owned by the mutual funds it manages. These mutual funds are in turn owned by the people who put their money in them.
Today, Vanguard is the largest mutual fund company in the world, managing assets worth $5 trillion (around Rs.355 lakh crore). $5 trillion is a little more than the U.S. government’s budget and nearly 12 times the annual budget of the Indian government.
He made mutual fund investors rich
Another remarkable aspect of Bogle’s personality is that he didn’t set up Vanguard as a business venture owned by him. Vanguard is like a cooperative, and its profits go to the people who invest in it in the form of higher returns. In any other Wall Street company, the benefits would have gone to the investors.
Vanguard has made its investors richer, but it didn’t make Bogle very wealthy. He said that he was proud that he was not a billionaire. He was worth less than $100 million at the time of his death. Others who set up much smaller and less significant business ventures earned a lot more.
Bogle understood the importance of money because he was born just before the start of the Great Depression in the United States. He published a paper titled ‘The Economic Role of the Investment Company’ at Princeton University. This paper became the foundation of his career and life. It urged mutual funds to cut sales and management fees and not claim to be superior to market averages.
This paper helped Bogle to land his first job with Wellington Management. He convinced the board to allow the mutual funds to own the company and run it at zero cost to benefit its investors. He named the company Vanguard and launched the Vanguard 500 Index Fund in December 1975, which was the first index fund in the world. Investors were not happy, and agents and distributors opposed him.
Bogle’s desire to help investors instead of trying to accumulate wealth is unique in the competitive world of finance. Even though Bogle retired nearly 20 years ago, his ideas and Vanguard command unmatched respect in the financial world today.
Bogle’s ideas helped millions of investors to make more money, but as a result, the financial industry is earning lower profits. Both outcomes are welcome because of the way the financial sector has been functioning. Investors are getting the returns they deserve. The financial sector has also become more transparent and efficient.
Index investing in India
In India, actively-managed mutual funds have been outperforming passively-managed index funds. As a result, index funds and ETFs have not been popular. However, this may change because fund managers will have to show that they can keep beating the index.
The outperformance provided by fund managers is likely to become less common in the future due to the following reasons:
SEBI’s categorization has made things transparent and forced mutual fund managers to stick to their mandate.
SEBI has asked mutual funds to benchmark their performance against the total return index (TRI). The use of the TRI shows actual mutual fund performance.
As markets become more efficient and transparent, there will be less room for fund managers to outperform the index.
Will index funds become more popular than actively-managed funds?
Index funds have not been popular in India because actively-managed funds have beaten their benchmarks. People prefer to invest in actively-managed funds because they outperform passively-managed index funds.
However, most actively-managed mutual funds were not able to beat the Nifty in 2018. Index funds and ETFs provided better results than most of the actively-managed funds. Time will tell if this trend will continue in the future.
It’s clear that index funds will gain ground, but actively-managed funds may provide better returns than the index for some more time.
We need to thank John Bogle for helping us to earn higher returns from our mutual funds. He said that investors’ return depends to a great extent on lower costs, and most fund managers could not beat market indices consistently. He put these ideas into practice at Vanguard, the mutual fund company that he founded. Passively-managed, low-cost index funds, and ETFs have become popular because of him.
If you are wondering whether or how to benchmark your investment portfolio, this is must read for you.
Most investors and advisors measure the performance of their portfolios against benchmarks. They use different yardsticks to measure the performance of their portfolio. Some of these yardsticks are index returns, category returns, expected returns, last year’s gains, and inflation.
You need to pick the right benchmark and measure your portfolio’s performance against it. If the benchmark is outperforming your portfolio, you can also consider switching to the benchmark. Benchmarking is necessary even if your portfolio is helping you to achieve your goals.
Let’s take a closer look at how you can pick the right benchmark and use it to analyze your portfolio:
What is a benchmark?
A benchmark is a point of reference or standard. You can analyze the return, risk, and allocation of your portfolio against it. Investors usually compare their portfolios and mutual funds with specific benchmarks.
You can use an index, ETF or another person’s portfolio as a benchmark. Many investors prefer to use an index or a few indices because they represent the average. However, there are many indices and you need to pick the right one.
Benchmarking is very important, especially when you start investing. It can help you to determine what returns are possible and which risks you are willing to take. A benchmark serves as a reference point and helps you to specify your preferences and priorities.
If you have been investing for a while, a benchmark can help you to measure your progress. It can also help you to think about how much you are willing to deviate from the plan.
A good benchmark needs to be:
Suitable The benchmark needs to be in line with your investment style. It should also align with your preferences and priorities.
Quantifiable The returns on the benchmark need to be measurable at frequent intervals.
Investable You need to have the option to give up active management and invest in the benchmark.
Definite The names of the securities that make up the benchmark and their proportions need to be clear.
Representative The benchmark should represent investors’ current views on the securities that constitute it.
Investors who want to outperform the market use equity indices to measure performance. The equity indices are not meant to measure the performance of diversified portfolios. A stock index provides higher returns with more volatility than a diversified portfolio.
Total Return Index (TRI) vs Price Return Index (PRI)
In the past, the Price Return Index (PRI) served as the benchmark for all mutual fund schemes. SEBI asked mutual funds to start using the Total Return Index (TRI) as the benchmark from February 1, 2018. The aim was to give investors a real picture of mutual fund performance.
A mutual fund generates returns through capital appreciation and dividends. Capital appreciation occurs when the market price of a security goes up. The PRI only captured capital appreciation. It ignored dividends. The TRI includes both capital appreciation and dividends.
The TRI helped to make the data more credible and transparent. The TRI will always be higher than the PRI because it includes dividends. Using the PRI alone exaggerates the outperformance of the index by a mutual fund, and this can be deceptive.
News about mutual funds outperforming benchmarks attracts investors. SEBI’s move to use the TRI aims to show mutual fund investors the real picture.
Why you should use the TRI to assess mutual fund performance
The PRI did not include dividends. The dividend in an index is usually around 1.5% per year. As the PRI did not include dividends, it understated returns by about 1.5% per year.
The TRI tracks both capital gains and dividend payouts. It assumes the reinvestment of any cash distribution back in the index.
If we use the TRI instead of the PRI, the index returns will go up by between 1% and 1.5% per year. A mutual fund scheme that outperformed the PRI by 3% in a year will beat the TRI by only 1.5%. Mutual funds used to include dividends in their NAV, which helped them to raise their returns against the benchmark in the past.
Now that the TRI is being used, you may see that the outperformance of your mutual fund is much lower than before. In some cases, you may find that your mutual fund is underperforming the TRI.
If there is no outperformance or if it is small, you can consider other options. You can switch to a low-cost index fund or an ETF that tracks the index.
Some analysts feel that benchmarking is of no use and it could even be dangerous. The financial services industry creates benchmarks to make people move their money around. Investors are in a constant quest for higher returns. These moves generate commissions and fees for the financial services industry.
Many studies show that less than 1 in 4 mutual fund managers beat the index in the long run. The outperformance is very small. The expenses and fees are higher than the outperformance, and this is before considering taxes on gains.
Some analysts think that trying to beat a benchmark index doesn’t make sense because:
The investor has to take too much risk to get similar performance. This is fine when markets are rising, but it hurts when markets fall.
The index does not pay any costs, expenses or taxes, but the investor does.
The index does not have to distribute money for living expenses, but the investor does.
The index benefits from stock buybacks, but the investor doesn’t.
The index can replace a bankrupt company with another one at no cost, but the investor can’t.
The index does not contain any cash and has no life expectancy, but the investor does.
Benchmarking can be good or bad depending on how you use it. You need to focus on the things that matter most to you. Be conscious of your time horizon and try to preserve your capital. Have realistic expectations and aim for a rate of return that beats inflation. A big profit requires a massive increase in risk. Remember, you can recover from losses, but lost time never comes back.
Read this article to understand how side pocketing can impact your mutual fund investments,
Market regulator SEBI recently allowed debt mutual funds to “side pocket” stressed assets. This will enable them to separate bad and illiquid assets from the rest of the portfolio. It is then possible to trade the liquid assets at a separate NAV.
SEBI’s move came after the IL&FS group defaulted on its commitments to lenders. The rating agencies downgraded the IL&FS papers to default grade in September 2018.The NAVs of debt mutual funds holding the IL&FS group’s papers plummeted. The debt funds received large numbers of redemption requests.
On December 12, 2018, SEBI allowed side pocketing to avoid panic and disruptions.
A similar event occurred in 2015 when the downgrade of Amtek Auto’s debt happened. JP Morgan AMC, which held Amtek Auto’s instruments in its debt funds, had to suspend redemptions. This caused panic among investors.
Let’s take a closer look at how side pocketing works:
What is side pocketing?
Side pocketing is a type of accounting procedure. It separates stressed assets from quality assets in debt funds. If there is a rating downgrade, the mutual fund can separate the stressed assets and put them in a side pocket. Existing investors get a pro rata share in the side pocket.
The debt fund’s NAV then reflects the value of the liquid assets. The assets in the side pocket get a separate NAV and redemptions are not allowed. The side pocket’s NAV reflects the estimated value that investors can realize.
Side pocketing helps to avoid panic redemptions. Only existing investors gain from any future recovery from the stressed assets.
Side pocketing ensures liquidity for investors who hold units of the main scheme. Allotment and redemption of the liquid assets can continue as before.
One of the main benefits of side pocketing is that it prevents panic. It can prevent market disruptions that are likely due to frozen redemptions. Side pocketing is particularly important when the fund cannot suspend redemptions.
It benefits investors who don’t redeem their investments. This includes those who may not even be aware of the downgrades. Without side pocketing, those who stay invested would lose out. They would end up holding more bad and illiquid assets. The fund manager would have to sell the quality assets to pay the investors who exited.
If a stressed asset is side-pocketed, redemption pressure is likely to be low. The investor gets units in the side scheme, which is not open for redemption. After that, transactions continue as usual in the main scheme.
Side pocketing may offer more transparent accounting with an illusion of safety. Real safety is only possible if the fund manager sticks to the fund’s mandate and focuses on liquidity.
Side pocketing may make fund managers complacent. They may invest in low-quality securities to get higher returns. If there is a downgrade or default, they can hive off the bad assets and continue doing business as usual.
Side pocketing should be the last resort, as any repetition would impact the image of the fund house.
SEBI rules govern restrictions by mutual funds on redemptions. Fund managers may use side pocketing to circumvent these rules. Side pocketing would allow them to freeze redemptions of the illiquid component.
If a debt mutual fund is split into two parts with separate NAVs, investors may find it hard to keep track of both. It will also be difficult to determine the fair value of the stressed assets.
It may take several years to wind up the stressed assets and realize their value. Mutual fund managers could misuse side pocketing.
The impact of the IL&FS default on debt mutual funds
IL&FS used to be an AAA-rated debt instrument. Investors assumed that it offered the highest level of safety. The rating agencies downgraded IL&FS to default rating within days in September 2018.
There were 18 open-ended debt mutual funds with an exposure of about Rs.2,500 crores to the affected IL&FS papers. These funds included liquid and ultra-short funds.
The NAVs of each of these funds fell by more than 5%. Some funds fell by as much as 6% and 8%, wiping out the gains of the entire year.
Such heavy losses are unusual in liquid, ultra-short and short-term debt mutual funds. They are more often seen in high-risk debt funds. Debt funds received many redemption requests, especially from big corporate and institutional investors.
Worries about the IL&FS default are now abating and investors are returning to liquid funds. However, corporates are still concerned about credit risk. They prefer the safest short-term investments and are focusing on overnight funds.
Fund managers had to sell quality securities to meet redemptions during the IL&FS crisis. Side pocketing would have allowed them to avoid selling quality instruments.
On December 12, 2018, SEBI allowed mutual funds to side pocket stressed and bad assets. Details of how side pocketing will work have still not come.
Side pocketing protects investors from the impact of any default or downgrade. Without side pocketing, such events can result in panic redemptions. The fund manager has to sell quality assets to meet the redemptions. This leaves the fund with more bad and illiquid instruments.
Side pocketing protects investors who remain invested. They don’t have to worry about the sale of quality assets, which would result in a drop in the NAV. Investors who exit will get an accurate NAV that reflects the value of the liquid assets.
Existing investors get units in a separate stressed assets fund. The allotment of units is according to their holdings at the time of segregation. Redemptions are not allowed in this fund until evaluation of its assets. Investors can sell their units if there is a recovery from the stressed assets.
Side pocketing provides transparency in accounting. It protects investors who remain invested in a debt fund after a downgrade. Investors need to pick debt funds with proven track records. Although the sudden IL&FS defaults show that ratings can be unreliable, they do show the level of safety.
If you think timing the markets will give you more returns, there is a fair chance that you might be wrong.
It isn’t easy to make money by timing the markets. Investors who try to time the markets usually lose out because of timing errors. You need to do research and invest with discipline and patience to make money in the stock markets.
Uncertainty and volatility have increased in recent times. This has caused confusion and investors are unsure of what they should do next. Should they invest through SIPs or STPs? Should they buy on dips? Should they follow a buy-and-hold strategy? Or, should they sell and wait on the sidelines?
It isn’t easy to find answers to such questions. However, investors can use tried and tested strategies that have worked in the past.
Volatility and uncertainty are a part of investing in stock markets. Markets go up and down and we have no control over them. However, we do have control over how we react to these changes. Time and again, research has proven that to be profitable while timing the markets one has to be right consistently 7 out of 10 times, which is not achievable feat for most investors.
You can withdraw from the market when you believe that it is very high. You may think that this will help you to lock in your gains. You will also be ready to re-enter the market at lower levels when it corrects.
This may not work out as expected. If you miss out on the few good days when the market rises, your returns, in the long run, will be lower. Bear markets tend to be shorter than bull markets, which are more powerful and last longer.
Those who try to catch the market tops and bottoms are likely to miss out on the best days. Most people lose money while trying to find market tops and bottoms. Even the top investors in the world have not succeeded in timing the market over time.
This means that an investor who stays invested will earn higher returns. One who tries to buy low and sell high may lose out.
It pays to invest in a systematic way on the basis of a sound asset allocation strategy. Pick the right investments for your goals, return expectations, period and risk tolerance. Invest according to your plan regardless of market valuations. You can invest more at times when market levels are very low.
A buy-and-hold strategy works well for most investors. There is no need to withdraw your money when the market seems to be close to a top. The right time to exit from investments is when your goals are close.
It’s important not to let emotions cloud your judgment. Greed and fear are an investor’s biggest enemies. They drive us to make irrational decisions that reduce long-term returns. All you need to do is to invest according to your plan and allow your money grow over time.
The best time to invest in the stock markets was yesterday. If you missed that opportunity, today is an excellent time to start. Any further delay may result in lost opportunities. You will miss out on returns, and the market may move to higher levels.
Investors tend to fret about entering the market at the perfect level. They want to earn exceptional returns. There’s no need to be nervous about timing your entry. Consider your asset allocation first. Pick investments that are in line with your profile.
It’s best to stagger your investments over some time. Invest a small amount at regular intervals to reduce the risk of catching a market top.
Invest more in debt and less in equity for short periods. Invest more in equity and less in debt for long periods. Review your investments every 6 months or year to see if everything is going according to plan. There is no need to review your investments every day or to make frequent changes to your portfolio.
You can set up a systematic transfer plan (STP) to stagger investments in equity mutual funds. To do this, invest a lump sum in a liquid fund, which offers a reasonable return and has no exit load.
Set up an STP that will transfer a fixed amount to an equity mutual fund of the same fund house. A specified amount will move from the liquid fund to the equity fund every week or month. This will help you to average out your investments over time.
This is much safer than investing a lump sum in an equity fund at one go. Your money will be earning a return while it is in the liquid fund.
If you want to invest at regular intervals, you can set up a systematic investment plan (SIP). The SIP will transfer funds from your bank account to the mutual fund.
The bank will transfer a specified amount every month. This means that you are less likely to spend it on impulse purchases. A SIP is the best way to build a large corpus from your regular income over a period of time.
Spend time in the market instead of trying to time the market
You can earn handsome returns by spending time in the market. A buy-and-hold strategy works well for most investors. If you remain invested, you will enjoy the power of compounding.
You need to follow your asset allocation strategy while investing. Track your investments and rebalance your portfolio when your asset allocation changes. If your equity investments lose value, you can transfer money from debt to equity. If equity exceeds your planned allocation, you can transfer funds from equity to debt.
This has proved to be one of the most effective ways of profiting from stock market investments. You also need to monitor individual investments regularly.
If your fund has not been performing as well as its benchmark and category for 3 years, switch to another fund. Sell risky investments about 2 years before your goal and move your money to safer options.
You can earn good returns by spending time in the market rather than trying to time the market. Decide your asset allocation and invest through SIPs or STPs to reduce risk. Track your investments and rebalance your portfolio when your asset allocation changes.
If you believe that it’s the security or fund selection
that is crucial to your financial success, you might be in for a surprise!
Asset allocation provides stable risk-adjusted returns. If you get your asset allocation right, your portfolio will take care of itself. Most people search for the best mutual funds and try to invest when market valuations are cheap. They think these are the most important factors for getting high portfolio returns.
In reality, asset allocation is the most critical factor. It can help you to get stable risk-adjusted returns in the long run. The first step is to decide how much you will invest in different asset classes. This includes equities, debt, gold and real estate.
Asset allocation is much more important than choosing top-rated mutual funds. It is also more important than investing when markets are cheap.
Asset allocation refers to how much money you invest in different types of assets. This includes equity, debt, gold and real estate. For mutual funds, it relates to the division of funds between equity and debt mutual funds.
We can divide equity mutual funds into different categories. Some of these are large-cap funds, mid-cap funds, small-cap funds, and multi-cap funds. There are also large & mid-cap funds, ELSS funds, sectoral funds, value funds, etc.
We can divide debt funds into liquid funds, ultra-short funds, and short-duration funds. There are also medium-duration funds, long-duration funds, corporate bond funds, etc.
We can divide hybrid funds into conservative hybrid funds and balanced hybrid funds. There are also aggressive hybrid funds, dynamic asset allocation funds, arbitrage funds, etc.
Each of these categories has different risk and return characteristics. You need to pick the right mix of funds based on your goals, age, return expectations, and risk tolerance.
A study conducted in 1986 examined the effects of asset allocation on pension funds. It showed that asset allocation accounted for more than 90% of total return variation. Market timing and stock selection played a minimal role.
Asset correlation measures, how different assets move in relation to each other. Correlated assets tend to move up or down at the same time. Assets that are not correlated tend to move in opposite directions. When one goes up, the other tends to go down.
Investing in non-correlated assets reduces risk and increases returns in the long term. Diversification across different asset classes helps to reduce volatility.
The level of correlation between different asset classes can change. This seems to have happened after the financial crisis of 2008. Since then, many uncorrelated assets have started moving up and down together.
Asset allocation in unpredictable market conditions
It isn’t easy to invest at times when global and local uncertainty is very high. A mix of diversified equities and debt can provide higher returns with lower risk.
Diversification across asset classes, sectors and regions acts as a hedge. It can protect investors during unpredictable market movements.
Mutual fund investors need to find the right balance between equity and debt. While it can be tempting to invest all your money in aggressive equity funds, this can be risky. Equities provide high returns, but they are volatile and risky.
Debt is safer and less volatile than equity, and it provides decent returns. However, at times, debt investments may not even beat inflation.
You can invest a fixed percentage in equity and put the rest in debt. The debt-equity ratio depends on your return expectations and risk tolerance. Rebalance your portfolio if the equity or debt part exceeds the planned allocation.
Decide on the debt-equity ratio based on your age. When you are young, you can take more risk by investing more in equity. As you grow older, you can reduce your equity exposure and move your money to debt.
You can deduct your age from 100 to do this. For example, if you are 35 years old, you can invest up to 65% in equity and 35% in debt. When you reach 60, you can invest 40% in equity and 60% in debt.
You can have separate investments for different goals. For short-term goals, invest more in debt and less in equity. For long-term goals, invest more in equity and less in debt. For example, if you need the money within 3 years, consider investing in debt. If you need the money after Seven years, consider investing in equity.
Dynamic asset allocation involves changing your allocation based on market valuations. When markets are expensive, reduce equity allocation. Increase the equity allocation when markets are cheap. Use the price-to-earnings (PE) ratio and price-to-book (PB) ratio to assess valuations.
However, it isn’t easy to time the markets and alters allocations based on valuations. It can also be risky. Portfolio rebalancing involves paying exit loads and short-term or long-term capital gains tax.
Using hybrid mutual funds to manage your asset allocation
Hybrid or balanced mutual funds invest in a mix of equity and debt. When the markets are expensive, the fund manager reduces equity and increases debt. When the markets are cheap, the fund manager increases equity and reduces debt. The investor doesn’t have to worry about exit loads or capital gains tax.
Conservative hybrid mutual funds invest 75% – 90% of their assets in debt and the rest in equity. They offer stable returns but don’t qualify for tax benefits allowed to equity mutual funds.
Balanced hybrid mutual funds invest 40% – 60% of their assets in debt and the rest in equity. They are less volatile than equity mutual funds but don’t qualify for tax benefits allowed to them.
Aggressive hybrid funds invest 65% – 80% of their assets in equity and the rest in debt. This allows them to qualify for tax benefits allowed to equity mutual funds.
Dynamic asset allocation mutual funds invest in a mix of equity and debt. The fund manager keeps altering the debt-equity ratio. The equity exposure can vary from 30% to 80% or even more. In most of them, the combined equity and arbitrage exposure remains above 65%. This allows them to qualify for tax benefits allowed to equity mutual funds.
Asset allocation is the most important determinant of portfolio returns. It is much more important than timing the market or choosing the best mutual funds. Diversifying across non-correlated assets helps to reduce risk and increase returns. Create an asset allocation strategy that suits you. The right mix of debt and equity will provide good returns with lower risk and volatility in the long term.
P/E and market cap-to-GDP ratios can be excellent indicators that you can rely on while investing in equities.
Investors can use the price-to-earnings (P/E), and the market cap-to-GDP to make sense of market valuations. The market or index P/E ratio helps investors to determine whether it’s the right time to invest or exit. The market cap-to-GDP ratio allows investors to assess market valuations against the GDP.
How ratios help investors to make investment decisions
Looking at market levels alone can be misleading. Investors may conclude after a big fall that it is a good time to invest. However, the index P/E ratio will reveal the real picture. If the index P/E ratio is high, fresh investments will not deliver good returns in the following years.
In the same way, a low market cap-to-GDP ratio shows that valuations are reasonable. This could be the case even if the index P/E ratio is quite high. It’s best to study different ratios before making up your mind about market valuations. A simple buy-and-hold strategy can also help you to avoid timing errors.
You can also consider the price-to-book value ratio (P/B ratio) and dividend yield. If the index P/E ratio shows a certain valuation picture, you can look at other ratios confirm this. Other indicators may reveal a different picture.
Trailing P/E ratio vs. forward P/E ratio
Investors use two variants of the P/E ratio to assess valuations. The trailing P/E ratio uses the earnings of the last 12 months. The forward P/E ratio uses the projected earnings for the next 12 months. The trailing P/E ratio is much more reliable. It uses historical data that everyone can access.
In comparison, the forward P/E ratio uses estimates of future earnings. They use data that is not available to everyone. These estimates are often flawed or biased. As a result, the forward PE ratio is not as reliable.
That’s why it makes sense to track the trailing P/E ratio to assess market valuations. This may be the most accurate way of determining whether the market is at an attractive level or not.
How to use the P/E ratio to make investment decisions
The price-to-earnings ratio or P/E ratio is one of the most important valuation tools. It is very easy to use and helps investors to assess valuations. When the index P/E ratio is low, valuations are cheap. Investments made at such times usually generate high returns in the following period.
P/E ratio = market price per share/earnings per share (EPS)
The Nifty P/E ratio is the average P/E ratio of the Nifty 50 companies. The Nifty P/E ratio is expensive when it is around or more than 22. It is oversold when it is less than 14. If the Nifty P/E ratio is around 26, as it is now, it shows that the Nifty is at 26 times its earnings.
In January 2008, the Nifty P/E ratio peaked at around 28. This meant that the market was very expensive. By October 2008, the Nifty P/E ratio had fallen to around 12. This showed that the market was very cheap. If you had invested at that time, you would have made spectacular gains.
You may miss out if you wait to invest at a time when the index P/E ratio is low. The market may keep raising without any indication. You may end up missing the rally. If you invest when the index P/E ratio is low, the market may fall further and may not rise for a long time.
If you sell when the index P/E ratio is high, the market may rise further. It may continue to go up for a long time and you may miss out on the gains.
It’s never easy to time the markets. Those who attempt to do it often miss out on returns because of timing errors. This happens even with experienced fund managers.
Besides, the P/E ratio only accounts for the total earnings of all the listed companies. It doesn’t consider unlisted businesses and companies and government-owned companies. This is where the market cap-to-GDP ratio helps investors.
How to use the market cap-to-GDP ratio
The market cap-to-GDP ratio provides a different viewpoint. It gives investors a more complete picture of valuations as compared to the economy.
Market cap-to-GDP ratio = the market capitalization of listed shares / annual real GDP
If the market cap-to-GDP ratio is less than 100%, stock market valuations may not be expensive. If it is higher than 100%, it indicates the stock market valuations may be expensive.
In 2017, India’s market cap-to-GDP ratio had crossed 100%. This happened after a gap of almost 10 years. It showed that the markets may have been expensive. In 2018, the market cap-to-GDP ratio has fallen to around 88%. This shows that India’s market valuations may not be expensive. This is despite the very high P/E ratio.
Investors cannot assess valuations by tracking market levels alone. The trailing P/E ratio helps investors to evaluate market valuations. It allows investors to decide about whether it’s the right time to invest or exit. The market cap-to-GDP ratio looks at market valuations against the GDP. Other metrics like the P/B ratio and dividend yield also provide valuable insights. Together they can help you to make the right investment decisions.