Be aware of Income funds

Ever since the trend of rising interest rates started in mid-2003, income funds have moved out of investors' radar and have been replaced by short term, floating rate, fixed maturity and liquid funds.

The reason is obvious: income funds have been the worst performers over the last one and three years giving returns of just 4.24 and 3.14 per cent a year, respectively (Value Research).

Keeping them company at the bottom are medium and long-term gilts, which have given returns of 4.49 and 4.09 per cent over the same period. Liquid and short-term funds in comparison have given returns of nearly 6 per cent in the one-year period. Should investors ignore income funds and focus instead on short-term funds?

Investment options

Three months ago it would have made more sense to not invest in income funds, as interest rates were peaking.

However, yields on the ten-year benchmark government security have fallen, which has boosted the net asset values of income funds. But, with rates having come down, would investment in these be warranted?

There are votaries for both, short and long term funds, but in large parts it also depends on the investor's risk appetite, investment horizon and other investment options.

Asks Ritesh Jain, fund manager, Kotak Mutual Fund, "With fixed deposits offering 8 per cent over a one year period, would investors wish to take on an interest rate risk for a 50-basis point incremental return from income funds?  Moreover, if interest rates go up, investors in income funds would have to reconcile to lower returns. With fixed deposits, they score only when the tax adjusted returns are taken into consideration."

With a tightening of liquidity due to the festival season, a possible hike in rates and volatility, an investment in income funds does not seem to have many takers.

Horizon and returns

While there is a lack of clarity on which way interest rates would move, on the longer term they will average out over a longer period.

Says Devendra Nevgi, head of fixed income at Quantum Mutual Fund, "Interest rate cycles last for three to five years and you need this time frame to catch a rate rally."

Over the long term, income funds tend to generate better returns than short-term funds. Over a five-year period, category returns have been 7.11 per cent as compared to 5.73 per cent for shorter tenure funds.

"Over a five-year period you can expect a return of 8-12 per cent," says Sandeep Bagla, head, fixed income Principal PNB Asset Management.

And it is not just on the returns front that income funds score. "They not only give a better risk adjusted return as compared to other risky and volatile asset classes, but also serve as a partial hedge against inflation," says Nevgi.

Investments in these funds, suggests Nevgi, should be done at the peak of the interest rate cycle. While that is ideal, one is not sure of where the rates will move.

"Systematic investment plans are a good way of capturing growth instead of committing upfront. If rates move above 8.25 per cent, you could look at a larger one-time investment in these funds," says Bagla. If interest rates do not dramatically move up, do fund managers have the flexibility to make hefty gains?

Trading gains

Income funds are primarily invested in bonds, debentures, government securities and short-term instruments like commercial papers and repos. The regular income for these funds comes from coupon payments and the trading gains accrue from interest rate movements.

Typically, today, between 50-70 per cent is invested in CPs/CDs of a one-year maturity giving a return of 7 to 8 per cent (fixed component), while the rest is parked in government securities over varying tenures.

Kotak's Jain says, "The kicker for these funds comes from the 30 per cent cash component that is invested in gilts and gains from interest rate movements."

With volumes and liquidity in gilts showing a sudden jump, trading profits could start making an impact on returns. And with corporates likely to tap the debt market to finance expansion, opportunities in the bond market will only increase. Since AAA-rated paper are more risky than gilts, they offer higher yield than gilts.

Hike may happen

With RBI's goals of containing inflation, credit growth and money supply, it is likely that a hike may be in the offing.

With credit growth at 29 per cent year-on-year instead of 20 per cent as of September 2006 and showing no signs of slowing down, money supply growth at 19 per cent instead of RBI's 16 per cent target and consumer demand led inflation likely to be over 6 per cent, a hike might be around the corner.

Unless you can stomach volatility, do not mind a longer waiting period, you are better off parking your funds in shorter tenure funds.

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Investing in MFs then consider these points

Investors in mutual funds should, however, be aware that investing in mutual funds does have a few disadvantages too. They must, therefore, do adequate research to minimize the impact of such negative factors.

Over Diversification

The fund may become very popular and attract lot on investments. Therefore at some point the corpus size may become too large vis-�-vis the investment opportunities available. The fund manager would, then be forced to invest in average stocks also, as he would have already reached the prescribed limits for the quality stocks.

Or the fund manager may take a cautious route and invest in much larger number of stocks than what is actually warranted for the purposes of diversification.

This can hurt the overall returns that the fund could have otherwise generated by limiting its exposure only to above-average stocks.

Higher concentration

Contrary to the above, it may also happen that the fund manager may take a much larger exposure to select industries, thereby exposing the fund to concentration risk.

If your risk appetite is low or possibly you have already invested in a few sector-specific stocks, then this particular fund may no longer be suitable to your overall investment pattern.

Idle Cash

All funds must keep some amount of the corpus in cash/cash equivalents to take care of the day-to-day redemptions. If this amount is large, it means that the fund is forgoing the opportunity to earn higher returns.

However, care must be taken to see whether this is a permanent feature of the fund or only a temporary phase. It is possible that the fund manager expects the markets to fall. Therefore, he might have booked profits by selling off a part the portfolio and is waiting for an opportune moment to re-enter the market at lower levels.

Fancy Names

Mutual funds have been marketing their funds under very fancy and catchy brand names. These could sometimes mislead the investor in understanding the real objective of the fund.

The investor, therefore, must read the prospectus to find out the exact nature of the fund and then decide whether it suits his investment objective or not.

Moreover, there could be a perception difference in what you believe the name stands for and what the fund's intention actually is.

Higher expenses

As compared to direct investing into equity, one has to generally pay a higher cost at the time of investing. Typically, brokerage for direct purchase could be about 1% maybe even less, whereas entry load in a mutual fund could be around 2.25%.

Second, in mutual funds one would have to pay on-going annual fund management charges of about 2.5%, which is nil if you have brought shares and these are lying in your demat account. Moreover, these fund-management expenses are payable even if the fund has failed to perform, which would further reduce your already below-normal profits or maybe even add to your losses.

Loss of control

When investing in a mutual fund, you are effectively handing over the charge of your money to a fund manager. You are, therefore, dependent on the fund manager's investment philosophy to generate returns for you. 

Some investors may not be comfortable with this kind of passive investing. They would rather like to be in full control of their investment decisions.

One must keep the above issues in mind, when investing in mutual funds. However, given the fact that the advantages of a mutual fund far outweigh these negatives, they are still the best alternative available.

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Midcap sector may rule the market in future

The focus will remain on quarterly earnings announcements, though volumes are expected to be lower because of the truncated trading week. The stock market will remain closed on Tuesday (October 24) on account of Diwali and on Wednesday (October 25) on account of Ramzan Id.
Brokers said the outlook continues to be bullish because of better than expected quarterly numbers from frontline companies and Tata Steel’s acquisition of Anglo-Dutch Company Corus, which has catapulted the latter to the number five slot among steel producers.
Key results for this week include those of ICICI Bank, Hero Honda Motor, India Cements, Mahindra & Mahindra, TVS Motor Company, Zee Telefilms, Maruti Udyog, Suzlon Energy, BHEL, Century Textiles, Dr Reddy’s Laboratories and Pantaloon Retail.
However, the action is now likely to shift to the mid-cap sector.
Most brokerages are advising their clients to book profits in frontline shares as these are beginning to look expensive at current levels, and buy into second line shares, which look reasonably priced.
Market watchers in the US are predicting that the Federal Reserve officials may leave interest rate unchanged at 5.25% when they meet this week, satisfied by signs of core inflation declining slowly.
Crude oil fell below $57 a barrel in New York — the lowest in nearly 11 months — as traders are betting on Opec members not cutting production by 1.2m barrels a day as planned earlier. Prices have plunged 28% from the record of $78.40 a barrel touched on July 14.
US crude oil inventories surged 5.02m barrels to 335.6m last week, the US Energy Department reported recently. It was the biggest increase since March and left stockpiles 14% higher than the five-year average for the week.
This is leading to increasing confidence among traders, even as Opec members threaten to cut oil production to boost oil prices. But any increase in crude oil price may prove to be a dampener. FII inflows for October ’06, till October 19, ’06, totalled a healthy Rs 2,155 crore.
Meanwhile, mutual funds were net sellers to the tune of Rs 303 crore in October ’06, till October 19, ’06. Brokers expect foreign fund flows to remain robust this week as quarterly numbers of most companies have been on track

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Leading open ended mutual funds

Unfortunately for investors, the festive season commenced on a sorry note with markets slumping sharply. After being poised to breach the 13,000 level (12,928 on October 16, 2006), markets corrected to settle at 12,737 points (BSE Sensex).

However, week on week (up 0.01%), markets were stagnant. On the same lines, the CNX Nifty appreciated marginally (0.22%) to close at 3,684 points. In a small reversal of sorts, the CNX Midcap (-0.19%) turned the other way to close at 4,767 points.

The results were no different from the other comparisons we have done in the past -- over a 3-5 year period, sector/thematic funds have failed to beat diversified equity funds lending credence to the view that it's best to be with diversified equity funds over the long-term.

Leading open-ended diversified equity funds

Diversified Equity Funds	NAV (Rs)	1-Wk	1-Mth	1-year	SD	SR
Ing Vysya Atm G	10.31	1.48%	6.40%	-	10.99%	0.03%
Pruicici Dynamic G	57.76	1.41%	5.90%	64.73%	7.36%	0.54%
Kotak Global India Scheme G	23.96	1.36%	6.03%	41.52%	6.29%	0.40%
Pruicici Emerging Star G	25.00	1.30%	6.79%	51.15%	7.99%	0.45%
Kotal Mid-Cap G	17.99	1.14%	5.22%	40.05%	7.91%	0.34%

(Source: Credence Analytics. NAV data as on Oct. 20, 2006. Growth over 1-year is compounded annualised)
(The Sharpe Ratio is a measure of the returns offered by the fund vis-�-vis those offered by a risk-free instrument) (Standard deviation highlights the element of risk associated with the fund.)

In a surprising development, we have ING Vysya ATM (a contrarian fund) at the top of the heap with 1.48% appreciation over last week. It was a particularly good week for equity funds from Kotak Mutual Fund and PruICICI Mutual Fund as they had two funds each in the top 5 rankings.

Leading open-ended long-term debt funds

Debt Funds (LT)	NAV (Rs)	1-Wk	1-Mth	1-year	3-year	SD	SR
Grindlays Super Saver G	16.59	0.34%	0.52%	3.94%	2.08%	0.36%	-0.55%
PruICICI Flexible Income	13.27	0.14%	0.59%	5.30%	3.66%	0.25%	-0.34%
Kotak Flexi Debt G	11.25	0.14%	0.59%	6.69%	-	0.07%	-0.42%
Principal Income G	17.2	0.14%	0.81%	6.25%	3.83%	0.38%	-0.15%
Birla Dynamic Bond Retail G	11.16	0.13%	0.74%	5.81%	-	0.17%	-0.59%

(Source: Credence Analytics. NAV data as on Oct. 20, 2006. Growth over 1-year is compounded annualised)

Grindlays Super Saver (0.34%) led the long-term debt fund rankings by a significant margin. Its closest competitors were -- PruICICI Flexible Income, Kotak Flexi Debt and Principal Income -- all at 0.14%.

The 10-year 7.59% GOI yield closed at 7.66% (October 20, 2006), 3 basis points above the previous weekly close. Bond yields and prices are inversely related with rising yields translating into lower bond prices and net asset value (NAV) for debt fund investors.

Leading open-ended balanced funds

Balanced Funds	NAV (Rs)	1-Wk	1-Mth	1-year	3-year	SD	SR
Kotak Balance	22.58	0.79%	3.66%	41.50%	38.83%	4.70%	0.56%
Birla Sun Life 95 G	165	0.73%	3.18%	34.17%	34.28%	4.54%	0.49%
FT India Balanced G	30.64	0.36%	4.11%	40.63%	31.78%	4.76%	0.43%
LIC Balance C G	42.42	0.30%	2.56%	40.56%	23.99%	5.21%	0.35%
DSP ML Bal G	35.98	0.28%	3.54%	41.65%	33.48%	4.49%	0.46%

(Source: Credence Analytics. NAV data as on Oct. 20, 2006. Growth over 1-year is compounded annualised)

With Kotak Balance (0.79%) heading the balanced fund rankings, this was a bumper week for Kotak Mutual Fund with its schemes featuring among the leaders across the three categories under review.

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Look Investing on Pharma funds

The most important benefit that mutual funds offer to investors is the opportunity to diversify across sectors and market segments.

They work on the principle that the fund stands a better chance of delivering by investing in stocks belonging to various sectors and market segments. As a result, the fund manager is at liberty to choose stocks from an unrestricted investment universe.

Sector funds on the contrary, deprive investors of the benefit of diversification, which is the mainstay of diversified equity funds. The intention is to clock growth by capitalising on attractive growth opportunities from the designated sector.

The fund manager managing a sector fund is restricted in terms of selection of stocks, as he can invest in stocks only from the earmarked sector/theme.

Portfolio strategy

Because of the sectoral constraints, sector funds typically have a limited number of stocks to choose from. As a result, they show the tendency to hold concentrated portfolios; and pharma funds are no different.

Broadly, the number of stocks in their portfolios hovers around 15-20, with the top 10 stocks accounting for over 70% of the assets in most cases.

In the pharma funds segment, Magnum Pharma (76.8% in top 10 stock holdings) emerges as the most concentrated fund followed by Franklin Pharma (73.7%) and UTI Pharma & Healthcare (70.1%).

On the contrary, funds from the diversified equity funds category score much better in terms of diversification across stocks. HDFC Top 200, with a top 10 stock holding of 40.2% is the most concentrated fund among diversified equity funds, while DSP ML Opportunities (34.7%) fares the best on this parameter.

Performance

Pharma funds have failed to impress on the returns front as well. As is evident from table above, over the 1-year time frame, the performance of pharma funds has been poor. Not only have the funds been comfortably outperformed by diversified equity funds, Franklin Pharma (21.8%) and UTI Pharma & Healthcare (15.7%) have failed to match the benchmark index BSE Healthcare (23.5%).

The 3-year and 5-year rankings paint a similar picture. Over the 3-year period, the only saving grace for the pharma funds segment is Magnum Pharma (44.1%), which has pitched in a performance comparable to that of diversified equity funds. In fact, it even outscores Sundaram Growth (43.2%).

Over the 5-year period, the performance of pharma funds is dismal and they substantially lag their peers from the diversified equity funds segment.

Volatility and risk-adjusted return

Pharma funds have also faltered in controlling volatility, which is evident from their high Standard Deviation figures.

Even the worst performer in the diversified equity funds segment i.e. Sundaram Growth (Standard Deviation 6.53%) fares better than all the pharma funds. Magnum Pharma (7.21%) pitches in the worst performance across segments.

In terms of risk-adjusted returns (which is measured by the Sharpe Ratio), diversified equity funds have again delivered a markedly superior performance. Effectively, pharma funds have failed to deliver despite having exposed investors to higher levels of risk.

Expenses

In terms of expenses, pharma funds rank above their diversified equity fund counterparts. This is mainly because pharma funds have relatively lower net assets. SEBI guidelines for expenses are loaded in favour of larger funds, i.e. larger funds incur lower expenses and vice versa.

Therefore the larger diversified funds in our sample -- HDFC Top 200 (2.13%) and DSP ML Opportunities (2.10%) have proved to be relatively more cost effective.

Conclusion

Our advice for investors remains unchanged -- unless you possess the necessary "expertise" to invest in a pharma fund, steer clear of it and instead invest in a well-managed diversified equity fund with an established track record.

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Advice on mutual funds turns dangerous

Investors are now at the "receiving end" of advice from newer sources like magazines and banks. While the retail investor's access to advice has grown exponentially, the quality of advice has remained poor, and in some cases it has even deteriorated.

Recently, a money magazine carried an article authored by an expert. The article deals with how retail investors should deal with mutual fund distributors and beat them at their own game. Nothing wrong with that.

But during the course of the article, the expert goes on to teach investors how to make the most of new fund offers (NFOs), by investing and exiting from them on a continuous basis. Also investors are required to demand rebate from the distributor while getting invested. The expert relies on rising markets for his "modus operandi" to succeed.

Now we aren't questioning the expert's intentions or even his credentials. But the bit about rebates and churning the portfolio is something we find hard to digest.

Firstly, the practice of 'rebating' or 'passing commission' is explicitly prohibited. Secondly, equity-oriented investments should be made from a long-term perspective (at least 3 years), since it is over such a period that equities are best equipped to deliver.

Advising investors to continuously churn their portfolios and maintain an investment horizon of 3-4 weeks is inappropriate. Effectively retail investors have been prompted to violate a regulation and act against the very fundamentals of investing in an endeavour to make easy money.

The second instance occurred when the author of this article visited a private sector bank. Although the author was there to make enquiries about his fixed deposit investments with the bank, the bank employee was more keen on getting the author invested in a mutual fund NFO.

The rationale for investing in the NFO was -- it is from a reputed financial institution (the bank employee was perhaps not aware of the difference between a fund house and its sponsor) and that there is no entry/exit load.

Investors on their part need to be careful about the advisors they are associating themselves with and the kind of advice they are acting on.

It was a 'record' week for investors with markets soaring to all-time highs. The BSE Sensex rose by 2.93% to close at 12,736 points, while the S&P CNX Nifty ended the week at 3,676 points (up by 2.97%). The CNX Midcap rose marginally (0.02%) and closed at 4,776 points.

Leading open-ended diversified equity funds

Diversified Equity Funds	NAV (Rs)	1-Wk	1-Mth	1-Yr	3-Yr	SD	SR
UTI - India Adv. Equity	7.35	4.11%	6.21%	14.31%	28.30%	8.49%	0.24%
HDFC Core & Satellite	24.64	3.64%	7.61%	47.75%	-	8.49%	0.41%
Birla India Opportunities	47.48	3.60%	7.40%	41.48%	37.91%	7.92%	0.33%
UTI Mastergrowth	41.53	3.41%	6.13%	38.02%	37.95%	7.74%	0.34%
Franklin Prima Plus	123.92	3.27%	7.23%	52.86%	47.43%	8.74%	0.39%

(Source: Credence Analytics. NAV data as on Oct. 13, 2006. Growth over 1-Yr is compounded annualised)
(The Sharpe Ratio is a measure of the returns offered by the fund vis-�-vis those offered by a risk-free instrument)
(Standard deviation highlights the element of risk associated with the fund.)

UTI � India Advantage Equity (4.11%) surfaced as the top performer in the diversified equity funds segment. HDFC Core & Satellite (3.64%) and Birla India Opportunities (3.60%) occupied second and third positions respectively.

Leading open-ended long-term debt funds

Debt Funds	NAV (Rs)	1-Wk	1-Mth	6-Mth	1-Yr	SD	SR
Tata Income	24.55	0.23%	0.77%	2.55%	8.41%	1.38%	0.02%
Deutsche Prem.Bond	12.03	0.20%	1.17%	2.69%	2.69%	0.65%	-0.25%
Templeton Inc. Builder	24.61	0.19%	0.94%	2.50%	2.83%	0.45%	-0.58%
Tata Income Plus	12.28	0.18%	0.98%	2.74%	4.73%	0.32%	-0.35%
Birla Income Plus	29.98	0.18%	0.74%	3.44%	5.01%	0.29%	-0.78%

(Source: Credence Analytics. NAV data as on Oct 13, 2006. Growth over 1-Yr is compounded annualised)

The 10-Yr 7.59% GOI yield closed at 7.63% (October 13, 2006), 4 basis points above the previous weekly close. Bond yields and prices are inversely related with rising yields translating into lower bond prices and net asset value (NAV) for debt fund investors.

Tata Income (0.23%) topped the debt funds segment, followed by Deutsche Premier Bond (0.20%). Templeton Income Builder (0.19%) and Tata Income Plus (0.18%) also featured in the top performers' list.

Leading open-ended balanced funds

Balanced Funds	NAV (Rs)	1-Wk	1-Mth	1-Yr	3-Yr	SD	SR
HDFC Balanced	30.81	2.82%	5.51%	28.57%	27.45%	5.46%	0.34%
ING Balanced	17.39	2.54%	5.59%	20.51%	26.90%	6.97%	0.30%
Sundaram Balanced	30.60	2.26%	5.47%	29.82%	27.52%	5.87%	0.30%
PruICICI Balanced	32.25	2.15%	4.74%	30.88%	31.82%	6.20%	0.38%
FT India Balanced	30.53	1.82%	4.14%	33.91%	31.49%	6.24%	0.34%

(Source: Credence Analytics. NAV data as on Oct 13, 2006. Growth over 1-Yr is compounded annualised)

Balanced funds drew from the rising equity markets. HDFC Balanced (2.82%) led the pack; ING Balanced (2.54%) and Sundaram Balanced (2.26%) occupied second and third positions respectively.

Now that we have discussed the topic of advice in great depth, we have some advice of our own for investors � "5 things to do with your money". While most of us would find this hard to digest, there are many individuals out there, who have a lot of wealth at their disposal but don't know what to do with it. Conversely, there are some who don't own a great deal of money, but are in complete control of their finances.

For those in the first category, conducting the tax-planning exercise, planning for retirement and getting insured are some of the most important objectives. While it's nice to have wealth, it is equally relevant to know what to do with it and to put it to good use.

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