Does your index fund mirror index returns?

Does your index fund mirror index returns?: "

As an investor in an index fund, most of you would be clear—you do not want fund managers to manage your money, but want your returns to mimic those from the benchmark index. Since buying all 50 scrips that are part of, say, the Nifty is not possible, you invest in an index fund that tracks Nifty. But when your index fund starts to outperform, or worse underperform, the index consistently, should you be worried?

Deviating performance

We took a look at the performance of index funds across different time periods. We looked at their one-year returns over four different month-ends (March, June, September and December) in 2009 and 2008. Though index funds are mandated to return almost in line with their respective benchmark indices, often many of them have given returns that are way off the mark. For instance, as on December 2009-end, LIC Index-Nifty returned 65.86% against its benchmark index, Nifty (total return index), which gave 73.2%. As on June 2009-end, while Sensex (total returns index) returned 11.8%, HDFC Index Fund–Sensex returned just 3.85%. Such examples are not uncommon in the space.

Also See The great divide (Graphic)

Passive management

If your index fund is underperforming its benchmark index by a huge margin, it’s bad news. But if it outperforms the index, it’s not good news in the long run either. Here’s why.

Index funds are mandated to be passively managed. Unlike actively managed funds that decide which scrips to buy, sell and when, index funds merely invest in all the scrips—in the same proportion in which they lie—in the benchmark index. So, even if your index fund occasionally outperforms, it doesn’t necessarily mean it will always do so. It is not an index fund’s mandate to actively outperform the index. If you are looking for outperformance, you may want a fund manager’s intervention through actively managed funds.

Tracking error

Index funds, much like other mutual fund schemes, incur expenses on cost heads, such as marketing, advertising, office administration, brokerage and so on. These expenses reduce your scheme’s returns. This deviation in performance is called tracking error and is expressed in percentage terms.

The lower the tracking error, the better the fund. Most mutual funds have mentioned an upper limit of 2% as the permissible tracking error limit in their offer document.

Managing inflows

How well an index fund manages its inflows and outflows also determines tracking error. While investors can invest in a fund till 3pm to get the same day’s net asset value (NAV), index funds only have between 3pm and 3.30pm to realign their portfolios (buy and sell existing or new scrips that may have entered or exited the index) and deploy additional inflows in the market by buying a fresh stock of scrips. If application comes in the last moment, close to, say, 3pm, but the fund comes to know about it much later, it can deploy this application in the market only the next day.

However, the investor gets the same day’s NAV as he invested before 3pm. Any sharp movement in the markets in the interim distorts the inflows and leads to a tracking error.

Fund houses are increasingly working to improve their internal communication and sensitize their branches so that information about inflows reach the fund managers in time. “We have focused on setting right procedural issues involved in reporting of inflows. We are confident that these have been set right and, hence, our tracking record is expected to reduce in future,” says Vinay R. Kulkarni, senior fund manager, HDFC Asset Management Co. Ltd.

Additionally, funds such as LIC MF have stopped accepting large-sized inflows on days that it feels it can distort the fund’s balance. “We don’t want volatile entries,” says S. Ramasamy, fund manager, LIC Mutual Fund Asset Management Co. Ltd.

At times, when the weights of the underlying scrips of an index change, index funds are mandated to buy and sell accordingly to rebalance their portfolios. Selling scrips would fetch them money after two days, but they need to pay money for scrips they have bought within a day. “Such imbalances of payment also lead to tracking error,” says Krishnan Daga, fund manager, Reliance Capital Asset Management Ltd.

High cash levels

Though most index funds can hold cash up to 10%, some exceed their cash levels at times to account for unexpected inflows or to make provision for unexpected redemption. If index funds have high cash levels, they don’t move in tandem with their benchmark index, thereby causing a higher tracking error.

Industry sources say that apart from small corpus sizes, some index funds also delay deploying their cash if they feel that the equity market will drop. Sources add that some index funds invest in derivative instruments. For instance, if the fund manager feels that markets are going to fall, they hedge their portfolios by selling index futures. Though such moves bring temporary relief, they can backfire if your fund manager fails to predict the market correctly.

What’s the alternative?

With investors yet to warm up to the idea of index funds, their tiny corpuses will always be susceptible to a sudden gush of money coming in every once in a while. It’s how your index fund manages its internal systems that will ensure timely deployment of money and lower tracking error.

Index funds from fund houses, such as Franklin Templeton, UTI, Principal, ICICI Prudential and so on, have consistently managed a low tracking error.

Alternatively, you can opt for exchange-traded funds (ETFs). These are close cousins of index funds as they, too, invest in a basket of index scrips. However, on account of their superior structure, these funds mimic their respective indices as closely as possible, incur lower expenses and also sport a much lower tracking error.

Since ETFs are only available on stock exchanges, you need a demat account to invest in them. The other drawback is that you cannot start a systematic investment plan (SIP) through them. For SIPs, you still need an index fund.

Graphic by Ahmed Raza Khan/Mint

kayezad.a@livemint.com

"

News notes

News notes: "

Sebi moves to protect MF investors’ money

On 29 March, the Securities and Exchange Board of India (Sebi) sent an email to mutual fund (MF) houses that they can’t dip into their scheme’s pockets to pay upfront commissions to agents.

Dipping into savings: MFs pay a combination of upfront fees and trail (loyalty) fees to agents. While upfront fee is paid when the agent gets fresh subscriptions, trail fee is paid based on the time the clients stay invested in the fund. Ever since Sebi banned entry loads (charges up to 2.25% imposed at the time of investing, which eventually used to get passed on to agents as their commission), fund houses appear to have been dipping into their reserves to pay upfront commissions.

Before Sebi banned entry loads on direct applications in January 2008, investors used to pay 2.25% entry loads to fund houses. Since fund houses did not pay the agents for such applications, this amount was accumulated in the scheme’s profit and loss account. Further, though entry loads on direct applications were abolished in January 2008, they used to save money from the scheme that would have otherwise been paid to agents as trail commission. Additionally, equity funds charge up to 2.5% expenses to the scheme every year as annual expenses, out of which they meet their administration and office costs, besides their marketing and selling expenses. Any savings here, too, got accumulated in the scheme’s account.

Putting a stop: Ever since Sebi abolished entry loads in August 2009, fund houses have come up with ways to compensate the agents. One way was to dip into the scheme’s reserves out of the money accumulated or saved in the past, to pay distributors.

With the latest directive, Sebi has reiterated that the burden of upfront commissions should not be passed on to the investor. “The spirit behind scrapping entry loads is that investors should get the benefit of lower costs. Else, if loads are paid out from the scheme’s reserves, the purpose behind the regulation is defeated,” says Rajesh Krishnamoorthy, managing director, iFast Financial India Pvt. Ltd.

--Kayezad E. Adajania

‘Ulips more popular in Tier II, Tier III cities’

Fiscal year 2010-11 will see the continuation of two broad trends in the life insurance space: changing distribution strategy and guaranteed products. The global financial crisis exposed the hit-and-run sales practices of the industry that focused on getting more first-year policyholders than continuity. Says Anand Pejawar, executive director, marketing, SBI Life Insurance Co. Ltd: “The focus initially was to grab a larger market pie—in this case, the first-year premium. Mis-selling was rampant. Now the industry has woken up to the fact that continuous flow of premiums is important.”

The stock market crash brought home the risks of unit-linked insurance plans (Ulips) and lapsation rates zoomed. Adds Pejawar: “The rate of lapsation increased in 2008 and 2009 because of the slowdown. Investors who were ill-informed and had invested mainly due to the prior market boom skipped premiums during the crash.”

To address these issues, 2009 saw a spurt of guaranteed products in the Ulip space. Guarantees, ranging from maturity bonuses to capital protection, became the flavour of the year.

A recent survey conducted by Boston Analytics, a financial research firm, has confirmed this trend. According to the Monthly Indian Consumer’s Savings and Investment Behaviour Report, there has been a marked rise in investments in Ulips in smaller cities. But the preference for Ulips has remained almost the same in metros and tier I cities over the past seven months, says the study.

The report surveyed about 10,000 people across 15 cities and towns. “Among those insured, about 80% of consumers surveyed in tier II cities and 75% in tier III cities had invested in at least one Ulip in the past year. Compared with this, just 61% of consumers in metros and tier I cities invested in Ulips in the previous year,” says the report.

Says Debopam Chaudhuri, economist, Boston Analytics: “Ulips that offer guarantees are becoming popular with tier II and tier III cities because they dabble in equities and, at the same time, offer some capital protection by way of guarantees.”

-- Deepti Bhaskaran

"

Did you know? | Group mediclaim can’t be carried forward

Did you know? Group mediclaim can’t be carried forward: "

If you have a group insurance cover from your employer and you quit mid-year, you can’t carry your insurance benefits with you even if you have paid the premium for the entire year.

Why you can’t carry the cover:

In a group cover, you get health insurance from your employer and not the insurer. Till the time your insurer continues the cover, you have an insurance under the group policy. However, as soon as you quit, you are out of the group health cover that the insurer gives to your employer. By that logic, you can no longer use the insurance card.

But you paid an annual premium:

It doesn’t matter if you paid the premium at the beginning of the year. The minute you leave the firm, the insurance benefits will stop. Typically, the employer deducts this premium from your salary. Some companies, however, pay the premiums on the employees’ behalf for the entire year.

Is the money refunded?

If you paid the premium for an entire year and you quit mid-way, the insurer refunds the premium on a pro-rata basis to your employer. While some employers reimburse this amount in your full and final settlement, most of them do not. If you have paid for your health insurance policy under the group scheme, its worthwhile to ask your employer to reimburse the money. They may. They may not.

"

livemint.com - Highest NAV guaranteed, but not the best returns

Highest NAV guaranteed, but not the best returns

Deepti Bhaskaran
What do you think when you see the giant ads promising you the highest net asset value (NAV) in a unit-linked insurance plan (Ulip)? Most of us would believe that we’d get the highest possible return with zero risk.


But knowing, as you do too, that nothing comes for free, we put all the products that are guaranteeing NAVs under scanner. The quick conclusion: your returns will be between 6% and 15% in the long term. Shave off another 3% for cost and suddenly the guarantee looks a bit weak.

Concept
Essentially, these are capital guarantee products that ensure that the amount you invest does not lose value and you get some upside of equity. It is erroneous to think that you get Sensex-linked return, with zero risk. Ashwani Gujral, chief market strategist, Ashwanigujral.com, a stocks investment advisory portal, says: “These funds can’t guarantee the pure return of an equity fund. To guarantee returns on equity, you need to assume the risk on equity.”

Let’s understand how these funds work. Most of them use an investing strategy called dynamic hedging or constant proportion portfolio insurance (CPPI). Under this, the fund manager will constantly reallocate money between debt and equity classes to assure the previous highest NAV.


In year one, your investment will be split between debt and equity in such a manner that you get an assured NAV of Rs10 at the end of 10 years. Over the year, if the equity market goes down, your capital stays put as you have bonds. But if the market goes up, you will see the NAV rising. So, let’s say, we are at an NAV of Rs15 after a year and the market sinks 15%. The fund manager will sell equity and buy bonds to secure the highest NAV till then.

In a market that has no volatility, the product will work because the NAV will go up only in a linear manner. But real life is less neat. Each time the market falls and your allocation in debt rises, the reverse allocation to equity may not happen when markets recover. Remember, the debt part of your portfolio is holding bonds that ensure the highest NAV at maturity. So over a period of time, your portfolio in equity may become smaller and smaller and would move towards a pure debt fund.

Says Shashi Krishnan, chief investment officer, Bajaj Allianz Life Insurance Co. Ltd: “Depending on how much the markets fall, and at what point during the tenure, we reserve the right to exit the stock market and keep all the money in debt.” Given the “go-anywhere” mandate—or 0-100% allocation in equity, debt and money market instruments—that the policy document allows, these funds can technically move fully into debt and stay there, making your Sensex-linked dream just that. A dream.


Says Manish Kumar, head (investments), ICICI Prudential Life Insurance Co. Ltd: “Since these have exposure to both equity and debt asset classes, under normal circumstances, the returns can be somewhere between what a debt fund and an equity fund would give.” In the long term, that’s between 6% and 15%.

Has the product started looking less happy? There’s worse to follow.

Costs and more
The guarantees come at a cost making these products some of the most expensive in the market. Also, the guarantee frees them from the cost caps introduced recently.

You need to pay an annual cost for the guarantee, apart from the fund management fee. ICICI Pru’s Pinnacle offers the highest NAV in the first seven years of the policy and charges 0.10% above the fund management charge of 1.35%. Result? Your returns are about 3 percentage points lower—a 15% return will mean a post-cost return of 12%.

These plans also look like investment plans masquerading as insurance plans. The sum assured is capped at five times the premiums (on a premium of Rs1 lakh, you will get a maximum sum assured of Rs5 lakh). Also, most of these are available for a term of up to 10 years. An insurance cover is necessary for most people (other than Shah Rukh Khan and Sachin Tendulkar, who do need insurance) till they retire. So a 10-year policy with just a Rs5 lakh cover looks very much like an investment product under the garb of an insurance policy.

Worse, this guarantee is available to you only on maturity, usually 10 years. If you die during the term, your nominees will get the prevailing value of the fund—the guarantee on NAV works only if you live till the end of the policy.

Should you buy?

Guaranteed products work for investors who do not want a risk to their principal amount, but would like a small upside of equity. If you are looking for a Sensex-linked return kicker with zero risk, please get real. Such products do not exist.

Says Manik Nangia, corporate vice-president and head (product management), Max New York Life Insurance Co. Ltd: “It is possible that the implications of such structures are not well understood. We believe this can create unreasonable expectations. For instance, the allocation to debt can increase substantially when the market falls, while the consumer may have bought on the premise of participating in equity. Besides, there is criticism that this technique necessitates selling equity holdings when the market falls and that is opposite to the principle of value investing for long-term returns.”

Says Veer Sardesai, a Pune-based financial planner: “There is lack of transparency on asset allocation and the insurer doesn’t guarantee that he would stay invested entirely in the stock market during the term. So, we don’t know what high is guaranteed.”

If you are a risk-averse equity investor and can lock in money for 10 years, look at index funds to ride the Sensex and Nifty.

How much you really Get?

Don’t go by the figures, peel off the return sticker

Don’t go by the figures, peel off the return sticker: "

So you make news around the office coffee table when you announce that you have found a product that will give you 100% return. Till the quiet guy across the room gently pricks the bubble of hope. The 100% return was actually a smart sales push—over the 10-year investment period—this works out to just 7% a year. Yes, Rs1 lakh becomes Rs2 lakh. But in eight years seven months, even the staid Kisan Vikas Patra will do the same.

The advertisement is good to lure non-investors, but for smarter investors, actual return matters. So, what is it that you get in hand in terms of what that money can buy? Says Veer Sardesai, chief executive, Sardesai Finance, a Pune-based financial planning firm: “The advertised return should be per annum and should be compounded. From this rate of return, deduct your tax liability and inflation. If, after this, the return on your investment is negative, the investment is not worthwhile unless you want to just protect the money and are ready to sacrifice return.”

Cost, inflation, tax and compounding are four key things that can melt a fat looking return figure into nothing. Here are five questions to ask before you swallow any sales push that is using returns to make the pitch.

Also See How much you really get (Graphic)

Is it annual?

What an investment will throw off each year is the relevant number and not what the corpus will grow to. Sellers use the big fat final corpus numbers to lure investors, like in the case of the 100% advertisement. The 100% return winds down to a mere 7% per year. Remember to benchmark an annual return to a comparative fixed deposit (FD) return or the 8% on government schemes for long-term products.

Simple or compounded?

Simple interest is when the amount you invest, say Rs1 lakh, yields a return that is not added back to the principal, but usually paid out, like in a fixed deposit. Compound interest will add back the interest to the principal and calculate the interest due for the next year on the combined amount of the principal and interest. And this it will do repeatedly, over the life of the investment. Simple interest of 10% on Rs1 lakh over 10 years will give a final corpus of Rs2 lakh and compound interest will give Rs2.59 lakh.

Is it post-cost?

A rate of return is the rate at which your money grows, it does not reflect the corpus that you get at the end of the term. Apart from fixed-return investment vehicles such as the Public Provident Fund (PPF), actively managed investment avenues such as mutual funds (MFs) charge you for managing your money. MFs cap charges at 2.5%, unit-linked insurance plans with tenors over 10 years cap it at 2.25%. Deduct the charges and you get the actual yield on your investment.

Is it post-tax?

Taxes eat up a substantial part of your return. So, taxable instruments, such as FDs, are not so popular with savvy investors. An attractive 9% FD may lose its sheen after you pay 30% tax on the interest and find that your net return is just 6%.

What after inflation?

The silent purchasing power killer is more difficult to build in since it is money that goes to nobody directly but value we lose to inflation. An 8% return means a real return of just 2% if inflation is at 6%.

What should you do?

What happens when we build in all these costs into one product? A FD that pays 8% turns into a negative return of -0.4% if we build in tax at the rate of 30% and inflation at 6%. A 15% MF return, after 2% cost and 6% inflation, comes down to 4.5%. Advises Pallav Sinha, managing director and CEO, Fullerton Securities India, an investment firm: “It is important that you break the headline return into net return which you get in hand.” So, watch out for the return shavers as they silently remove layers from that fat number in the sales pitch.

Graphic by Yogesh Kumar/Mint

deepti.bh@livemint.com

"

De-jargoned | Price-earnings

De-jargoned Price-earnings: "

What is it?

A price-earnings (P-E) multiple is the valuation of each rupee of profit made by a company through the stock market. It is a valuation ratio of a company’s current share price compared with its per share earnings. A P-E multiple of four would mean that each rupee of profit is valued at Rs4, or that you will pay Rs4 for each rupee of profit the company earns.

How to calculate it?

P-E is calculated by dividing the share’s market price by the earnings per share (EPS). EPS is a company’s net profit divided by the number of outstanding shares. If the EPS is Rs10 and the price Rs100, the P-E multiple would be 10.

How to assess it?

A P-E multiple indicates a firm’s growth prospects. Firms on a growth path generally have a high P-E multiple. A high multiple, in such cases, doesn’t necessarily mean that a stock is expensive. Companies with a good track record and steady dividend payments also enjoy relatively high P-E multiples. Companies that have weak growth prospects or have a product suite that is considered a “commodity”, typically, have low P-E multiples.

Watch out for

This figure can’t be manipulated directly. But some companies may inflate their profit figures, leading to a high EPS, which, in turn, would mean a low P-E, making the shares look attractive. This figure is important, but before buying a stock you must look at factors such as the business model, the management and other fundamental indicators.

"