Average Quartely Balance -- How is it calculated

To understand how AQB is calculated, here are some useful links:

http://www.hdfcbank.com/personal/accounts/aqb_pop_up.htm

Systematic Investment Plans aka SIP

Systematic Investment Plans (SIPs) are much misunderstood. For one, investors often mistake SIPs as an investment avenue rather than a mode of investing in mutual funds. Then there are investors who invest in SIPs expecting quick results without fully appreciating the need to invest via SIPs for the long-term.

In an earlier article, we discussed how SIPs are perceived incorrectly by many investors as standalone investments. This explains why one of the most common queries we receive on the website is – which is the best SIP? Unfortunately, these investors have not been educated by their investment advisors about SIPs i.e. SIPs are only a mode of investing and not an independent investment avenue.

Minimum tenure of an SIP
Another misconception investors have about SIPs is with regards to the minimum tenure. Most fund houses have a minimum SIP tenure of 6 months. This leads investors to believe that 6 months is the ideal time frame for investing via SIPs (just like a lot of investors invest Rs 5,000 in mutual funds simply because that is the minimum investment amount for several mutual fund schemes).

In our view, investors should ideally invest via SIPs over at least 2-3 years. This way they can exploit the most critical benefit of an SIP – rupee cost averaging. Let’s understand how this is possible.

For an SIP to deliver the goods, it must witness a falling market. This way the investor can average out his cost of purchase. If the investor does not witness a downturn, i.e. he is only exposed to a market rally, the average purchase cost of his SIP will rise over a period of time.

SIPs in a rising market

Month of investment	NAV (Rs)	No. of Units
January	11.00	45.45
February	12.00	41.67
March	12.50	40.00
April	12.90	38.76
May	13.25	37.74
June	13.40	37.31
Avg. purchase cost of 6 SIPs	Rs 12.45

In the above table the average purchase cost of the SIP is Rs 12.45. Clearly, the SIP has not worked in the investor’s favour. Why is that? Because if he had instead invested lumpsum in January, his purchase cost would have been Rs 11.00 as opposed to the average purchase cost of Rs 12.45 over a 6-month period.


SIPs in a falling market

Month of investment	NAV (Rs)	No. of units
January	11.00	45.45
February	12.00	41.67
March	12.50	40.00
April	12.90	38.76
May	13.25	37.74
June	13.40	37.31
July	12.10	41.32
August	11.20	44.64
September	10.30	48.54
October	10.10	49.50
November	10.50	47.62
December	10.20	49.02
Avg. purchase cost of 12 SIPs	Rs 11.50

However, if the investor had opted for a longer investment tenure of say 12 months, he could have benefited from greater fluctuations in the mutual fund’s NAV. These fluctuations which arise over a market cycle lower the average purchase cost of the SIP over the long-term.

This is apparent from the above illustration. As is evident from the table, if the investor had taken an SIP for 12 months (instead of 6 months) his average purchase cost would have declined to Rs 11.50. Compare this with the average purchase cost of Rs 12.45 for a 6-month SIP.

It can be argued that there is no way for the investor to know when there is likely to be a turnaround in the markets (in this case a downturn). That is exactly our point. Since the investor does not know when markets will fall (and lower his average purchase cost), he must opt for a longer SIP tenure. Or at least he must manage his investments in a manner so that when his existing SIP terminates without witnessing a dip in stock markets, he can extend it further. This way should the markets fall, his SIP can benefit from a dip in the mutual fund NAV which in turn will lower his average purchase cost.

Points to remember before opting for an SIP

1) Ironically, while SIPs are meant to eliminate market-timing, investors must opt for a long-enough SIP tenure so as to ‘time’ the market downturn.

2) SIPs are equally beneficial in a falling market. Most investors believe that lumpsum investments (as opposed to SIPs) prove more beneficial in a falling market. This is only partly true. Having an SIP in operation during a falling market can ensure that investors stand to benefit should markets fall even further.

Technical Risk Ratios for Portfolio Planning

There are five ratios referred to while creating and maintaining efficient portfolios.

1. Alpha,
2. Beta,
3. Standard deviation,
   
4. R-squared, and
   
5. The Sharpe ratio.

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Alpha
A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

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Beta
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.

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Standard Deviation

Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns.

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R-squared

R-squared values range from 0 to 100. An R-squared of 100 means that all movements of a security are completely explained by movements in the index. A high R-squared (between 85 and 100) indicates the fund's performance patterns have been in line with the index. A fund with a low R-squared (70 or less) doesn't act much like the index.

A higher R-squared value will indicate a more useful beta figure. For example, if a fund has an R-squared value of close to 100 but has a beta below 1, it is most likely offering higher risk-adjusted returns. A low R-squared means you should ignore the beta.

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Sharpe Ratio

The Sharpe ratio tells us whether a portfolio's returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been.

A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.

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Financial health of a company: some tips

We started off by eliminating all those companies that had recorded less than 15% growth in net sales and PAT in any of the past three years.

Further, we filtered companies on the basis of debt-to-equity ratio and return on capital employed (RoCE). While a high debt-to-equity ratio indicates that a company may not be able to generate enough cash to satisfy its debt obligations, a low leverage ratio increases a company’s potential to raise funds.

Hence, we selected companies which had a debtto-equity ratio of less than 1.5. In order to carry sustainable operations, it is necessary for a company to operate at an RoCE which is well above its cost of capital. Only those companies with an RoCE of more than 15% could make it to the next stage.

The final criterion was to do away with all companies whose three-year average net cash flows from operating activities was less than 50% of their reported cash profit.

SIP + Insurance but Not ULIP

A number of mutual fund companies have tied up with insurance companies to offer long-term investment plans that offer you an insurance cover for the residual part of your entire investment plan. If you die part of the way through the plan, then your survivors will get not just the principal and returns of the amount that you have invested, but also the amount that you had not yet invested, but intended to.

Because this product is so unusual, it's probably not quite clear how this works, so let me explain through a detailed example. Let's say that a forty-year old person decides to invest Rs 20,000 a month till he is fifty-five years old. This amounts to investing Rs 2.4 lakh a year, or Rs 36 lakh over the entire fifteen year period. He decides to invest this money in a Systematic Investment Plan of an equity fund. Based on past experience, he expects to earn an average of perhaps 15 per cent a year on the investments he makes.

He starts investing and for five years, everything is fine. His has invested Rs 20,000 a month for five years, which comes to a total of Rs 12 lakh. His investments have yielded an average of about 15 per cent a year and are now worth a total of Rs 17 lakh. At this point, an unfortunate mishap occurs and he passes away. Normally, that would be the end of the investment plan. Of the Rs 36 lakh he originally intended to invest, he could invest only Rs 12 lakh before he died.

However, if this person had invested in the insured investment products that I'm talking about, then this would not be the end of the story. The 24 lakh that he couldn't invest because he died will be paid to his family by the insurance company. So his family gets the Rs 41 lakh which is Rs 17 lakh (the current value of the 12 lakh that he was able to invest), plus the 24 lakh that he intended to invest but couldn't because he died. His family could then invest the money and thus make sure that the financial plan is not disrupted. This isn't like a normal insurance where the amount you are insured for stays constant. Instead, the amount insured keeps decreasing. At any point, this amount is equal to what remains out of the original investment plan that the investor signed up for.

The obvious question is who pays for the insurance. After all, if the insurance company is covering the risk of the investor's death, then the investor must be paying the premium somehow. The answer is that this premium is paid in the form of an extra one per cent load that is deducted out of the money that is invested. Normally, fund companies charge a load of 2.25 per cent out of the investment you make. In the case of this product, this load is one per cent more. For Rs 20,000 a month, that comes to an extra Rs 200, which would strike most of us as a fair price to pay for the peace of mind that this product offers.

What is interesting is that there is no lock-in and there's no obligation. If you want to pull out of the scheme at any point then you can just stop investing and withdraw your money. Such product, with minor variations, are offered by a number of fund companies including Kotak, DSPML and Reliance.

The obvious downside is that this product ties one to a particular fund company for a long period of time. I think that's where one should spread the risk a bit by splitting one's investment across funds from different companies.

Few things to know before you decide your SIP + Insure

1. Is there a minimum amount that has to be invested in the SIP?

2. Must the SIP be of a certain tenure?

3. Are all equity schemes of AMC, eligible or is it offered only on certain schemes?

4. Will the insured amount be given to the nominee or be used to continue with the SIP so that the investment plan continues?

5. Will all the insurance expenses be borne by the AMC?

6. Is there any age limit to avail of this scheme?

Smart tax-saving strategies without spending a penny

Shuffle strategy

As per tax rules, ELSS schemes are subject to a lock-in period of three years from the day of investing. And since there are no long-term capital gains tax for equity funds sold after a year of purchase, shuffling ELSS schemes practically entails zero costs. How does the shuffle strategy work? Say, for instance, investor A had been investing Rs 50,000 in ELSS every year for the past six years. Since there is a lock-in of three years for ELSS, his/her investment of last two years would not be redeemable. But those investments made more than three years ago could be redeemed and invested back into the fund to gain fresh tax benefits. Section 80 C of the Income Tax Act, allows tax deductions up to Rs 1 lakh of ELSS investment made in any financial year for an individual. “Earlier Section 88 had a condition for claiming rebate that the investment should be made out of the income chargeable to tax. This was subsequently removed to provide relief to the individual tax payers. Current provisions for claiming deduction under Section 80C do not contain this restriction. Therefore, investments could be made out of the current year’s taxable income or even the past accumulated savings/investments to claim the deduction from taxable income by an individual tax payer,” says KPMG executive director Vikas Vasal. While previously, such reinvestments attracted entry loads, the new Sebi rule has done away with such costs for direct investing. In this investment process though, there is a possibility that the investor might make small profit or losses since the NAV might move up or down during the shuffle process. Such shuffles while helping get tax benefits also gives a chance to have a relook at MF portfolio and prune investments if necessary.

Switching Strategy

There is one more quicker method and that is of switching out proceeds to a liquid fund of the same fund house and switching it back into the fund. Switching refers to the process of transfer of money from one scheme of a fund house to another scheme. While for taxation purposes, such switching is considered as redemption and taxed accordingly, the advantage for investors is in terms of getting NAV of the same day. So for instance, if an investor switches from an equity scheme to a liquid scheme, the same day NAV is applicable. How does it work ? Say for instance, an investor with previous ELSS investments doesn’t have money to make further investment in the current financial year 2008. He could consider switching it to a liquid fund and back into the ELSS fund. There are no loads applicable for doing it if done within a short period (say 10 days or lesser). The call centre officials of Franklin Templeton MF and ICICI Pru MF confirmed the same for their respective schemes. The recent Sebi rules also state that waiver of loads would be applicable for “additional purchases done directly by the investor under the same folio and switch-in to a scheme from other schemes if such a transaction is done directly by the investor.”

Short Term Capital Loss

According to Section 74 of the Income Tax Act, 1961, you can offset your losses and even carry forward them for eight assessment years immediately succeeding the year in which the loss was first computed.
As per the act, any loss related to a short-term capital asset (like the sale of equity funds/shares within one year), can be set off against income under capital gains in respect of any other capital asset (be it short-term or long-term). This means, you can even offset this loss against any long-term capital gain. For instance, let's say you invested in a debt fund. After a year, you sell the units and book a profit (long term capital gains). You can offset this gain with your short-term mutual fund investment loss.