Points to consider before investing in SIPs

1. SIP is a 'means', not an 'end'

Investors would do well to realise that the SIP is a means for achieving one's financial goals and not an end by itself. Starting off aimlessly with an SIP in isolation may not be the right step. The SIP needs to be a part of a broader financial plan (like planning for retirement or child's future for instance) and should be targeted at achieving a predetermined objective.

A directionless SIP could well turn into a financial burden at a later stage and instances of the same being cancelled are not uncommon.

2. SIP in the wrong fund

An investment in a poorly managed fund remains just that irrespective of the investment mode i.e. lump sum or SIP. Hence it is imperative that investors first select a well-managed fund which has a track record to show for. Simply making an investment through an SIP will not eliminate the inadequacies of the underlying investment i.e. the mutual fund scheme.

Similarly, investing in a sector/thematic fund using the SIP route doesn't necessarily reduce the risk associated with that investment. Hence before joining the 'SIP band wagon', address the most pertinent question - 'what's the right mutual fund scheme for me?' The investment advisor should ideally aid investors at this stage.

3. SIP performance

In their fact sheets, fund houses are known to flaunt the performance of their schemes assuming that investments had been made using the SIP route. It is not uncommon to see 5-year or even longer time periods being considered for this purpose.

While per se, there is nothing wrong with the same, this is often used as a ploy by poor-performing funds to window-dress their performances. Over longer time frames when equity markets have been through more than one cycle (a bull run followed by a bear phase or vice-versa), the benefits of rupee-cost averaging become apparent.

For example, let's consider an open-ended diversified equity fund which has been in existence for over a 6-year period. Since inception, the fund (8.4% CAGR) trails its benchmark index (12.9% CAGR). However an SIP performance over the same time frame could show the fund (28.1% CAGR) outperforming its benchmark (26.4% CAGR).

Hence the SIP performance can actually be misleading. Of course, the fund house is unlikely to reveal that its fund looks better on the SIP performance front because it fell harder than the benchmark during the lows, which in turn aided the SIP calculation to lower the cost of purchase.

4. The investment advisor effect

While most fund houses now charge entry loads on lump sum and SIP investments at the same rate, some continue to subsidise investors by charging lower entry loads for SIPs.

Investment advisors are known to use this to their advantage by pushing schemes with lower entry loads. Sure, investors do benefit if the entry loads are lower, but that doesn't qualify as a good enough reason for getting invested. Instead, investors should aim for investing in schemes that fit into their portfolios and match their risk appetites.

Another reason for investment advisors' promoting SIPs is the cash incentives offered by fund houses. Schemes like 'garner SIPs worth a predetermined amount and get a cash incentive of Rs 100 to Rs 2,000 per SIP clocked' are routinely offered to distributors.

Although, there is nothing wrong with the distributor earning a cash incentive or the investor bearing a lower entry load, getting invested in a scheme only for the same is certainly out of place.

5. SIPs are not foolproof

As a mode of investing, SIPs aren't necessarily foolproof all the time. While over longer time frames (3 years and more) and across market cycles, an investment via the SIP mode is likely to prove more lucrative vis-�-vis a lump sum investment, the same may not necessarily hold true over shorter time periods.

6. Beware of banks

If individual distributors are peddling SIPs to win contests, can banks be far behind (remember banks are among the biggest distributors). And because banks have access to your account details, you need to be even more careful of them.

In one instance, we came across an insurance (yes insurance, not investment) consultant representing a leading private sector bank (that had access to the author's bank account details), who made a pitch for a Rs 2,000 monthly SIP.

On being told that the minimum SIP amount for that particular AMC (Asset Management Company) was Rs 1,000 and not Rs 2,000, he pleaded ignorance. On checking with that AMC, we learnt that indeed the minimum SIP amount was Rs 1,000, but the bank in question had internally raised the SIP limit to Rs 2,000 for its clients!

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Mutual Funds benifit through Derivatives

In the last few months a lot has been said and heard about the use of derivatives by mutual funds. A plethora of new fund offers (NFOs), which propose to invest in derivatives, has caught the attention of investors.

Derivatives have become a much-discussed topic in the investment community and investors are curios to learn more about it.

Simply put, derivatives are financial instruments whose value is derived from the value of underlying assets. These underlying assets can be equities, commodities, currency, and bonds among others. Derivatives like futures & options are used by mutual funds for hedging their portfolio to manage the risk, for speculation to clock profits and for arbitrage to earn risk-free profits.

Although, derivatives trading in India has been in existence for more than five years, their use by mutual funds is of a relatively recent origin. Previously mutual funds could use derivatives only for hedging purposes; also, they could deploy no more than 50% of their assets towards hedging.

Now as per new guidelines released by Sebi (Securities and Exchange Board of India), mutual funds can increase their net assets exposure up to 80% in the futures and options segment. This amendment in the regulation has cleared the path for mutual funds to use derivatives in their portfolio more effectively.

Hedging

The only thing that is certain about stock markets is the uncertainty. In recent months, we have witnessed volatility at its best. This has impacted mutual funds and other investors alike. In such a scenario, the two most likely alternatives for mutual funds are:

1. Sell the stocks immediately (i.e. distress selling). If the stocks have been purchased at higher prices, such an action could prove to be detrimental for the fund and its investors.
2. Remain invested and continue to bear the brunt of volatility. This could lead to interim losses (although notional) till the stock market recovers. But with derivatives, there is a third and smarter alternative:
3. Over shorter time frames, index futures can be used to reduce or eliminate stock market fluctuations.

Every portfolio has a market-linked risk associated with it. As a result, the portfolio reacts to market volatility. To insulate the fund from the same, the fund manager can hedge his portfolio by taking a contrary position in the futures market.

For example, if the fund manager foresees a downturn in the stocks held in his portfolio, he can hedge the same by selling (stock/index futures) in the derivatives segment.

Hedging should not be considered as a vehicle for making money. The best it can achieve is minimising the risk. Also the hedged position will typically make lower profit than the unhedged position. Alternatively there might even be instances where the hedged position incurs a loss, but this loss will be much lower than what an unhedged portfolio would have incurred.

Speculation

Speculation is a strategy in which a position is taken on the future movement in the prices of the shares. Previously mutual funds were not permitted to speculate in the derivatives market. They were allowed to use derivatives only for the purpose of hedging. But with the recent amendment in the regulations by Sebi, mutual funds can also use the opportunity of speculating in derivatives.

A fund manger may have a view that markets are going to rise and that he can benefit by taking a position on the index. Based on his view, he can buy Nifty futures and hold on to that position until the price rises to his expected level. If the fund manager's view about the market proves to be correct (i.e. the market rises), the fund will make a profit on its Nifty future position.

On the contrary, if his view proves incorrect then the fund will end up making a loss. Conversely, if a fund manager feels bearish about the market, he will sell Nifty futures and will hold on to it until the markets moved southwards. Similarly, the fund manager can also speculate in individual stocks by buying or selling stock futures/options.

Arbitrage

Arbitrage is a strategy, which involves simultaneous purchase and sale of identical or equivalent instruments in two or more markets in order to benefit from a discrepancy in pricing. This strategy normally acts as a shield against market volatility as the buying and selling transactions offset each other.

Recently UTI Mutual Fund and JM Mutual Fund have launched arbitrage funds, which will employ the arbitrage strategy of buying in cash and simultaneously selling in futures market.

In an arbitrage transaction, returns are calculated as the difference between the futures price and cash price at the time of the transaction. Ideally the positions are held till the expiry of the futures contract when the offsetting positions cancel each other and initial price difference is realised.

This arbitrage strategy makes the fund immune to market volatility i.e. the fund will not be affected by market fluctuations. Since the portfolio of arbitrage funds is completely hedged at all times to lower the risk of loss/erosion of gains, it also in turn caps the returns that the fund could have clocked if the portfolio was unhedged i.e. these funds have a limited upside.

Despite the fact that arbitrage funds offer investors the opportunity to benefit from investments in equities by making use of derivatives, the fund cannot be compared to conventional diversified equity funds, especially on the returns parameter.

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