Global Financial Services

Prelude:

Bank fixed deposits and Government small savings schemes have been the traditional investment choice of average Indian households. As per Reserve Bank of India’s Quarterly Estimates of Household Financial Assets and Liabilities, Rs. 4,753 billion was invested in bank FDs in FY 2018 (the latest year for which data is available from RBI). On the other hand, despite its growing popularity, the share of mutual funds in household fixed income assets is still relatively quite small. As per AMFI data (February 2020), retail and HNI net investment in debt mutual funds in the last year (ending Feb 2020) was Rs. 260 billion.

Bank FD interest rates have generally been declining over the last 20 years, from 10 – 11% in 1999 to just around 6% in 2020.

Source: Advisorkhoj Research based on historical SBI interest rates (quarterly rates are averaged)

Similarly, Government (Post Office) small savings schemes’ interest rates are also on a declining trend over the last 20 years from 12% to around 7% in 2020.

Source: Advisorkhoj Research (quarterly rates are averaged)

The Government has already announced a cut in interest rates of small savings schemes. In the long term also, we may see a further decline in interest rates as inflation goes down in our economy.

Factors to consider before investing in Debt Mutual Funds

Debt funds offer a greater variety of products across the risk/return spectrum. It is, therefore, important for investors to select the right product according to their specific investment needs, risk appetite, and investment tenure. Before we discuss how to choose the right debt fund, we should understand the two main risk factors in debt funds:

Interest rate risk:

Prices of fixed income securities are inversely related to interest rate changes. If the interest rate goes up, the price decreases and vice versa. Different fixed income instruments have varying price sensitivities to interest rate changes. Price sensitivity to interest rate change is also known as duration. The longer the duration of an instrument higher is the sensitivity to interest rate changes.

Credit risk:

This refers to the risk of default i.e. failure to pay interest and/or the principal by the issuer of the fixed income instrument. Rating agencies assess the credit risk of fixed income instruments based on the financial strength of their issuer and assign a credit rating to instruments. If the credit rating of an instrument gets downgraded, the price of an instrument will fall. Likewise, if the credit rating gets upgraded, the price will rise.

Selecting funds based on risk appetite

Investors should understand that risk and return are directly related. Your return expectation should be equivalent to the risk profile of your investment. Investors should be aware of the linkage between investment tenure and risk capacity (especially interest rate risk). Shorter the investment tenure, lower the interest rate risk capacity, and vice versa.

Very short duration funds like overnight and liquid funds have very low-interest rate risk but their average returns are likely to be lower than debt funds with longer duration profiles. Similarly, short duration and medium duration funds have moderately low to moderate interest rate risk, but their average returns are usually higher than liquid funds over a sufficiently long tenure. Dynamic bond funds and Gilt funds have the potential of giving high returns but they can be quite volatile in the short term. So one should select funds according to your risk appetite.

Selecting funds based on investment tenure

As mentioned earlier investment tenure influences your risk capacity. You should try to match the duration profiles of your investment with your investment tenure.

• For very short investment tenures (few days/weeks/months), you should invest in overnight funds or liquid funds.

• For 1 – 3 year investment tenures, you can invest in short duration funds or similar funds whose duration profile is less than 3 years.

• For 3 years plus investment tenures, you can invest in dynamic bond funds and Gilt funds.

Debt funds can give higher returns

Debt funds invest in debt and money market instruments like commercial papers (CP’s), certificate of deposits (CD’s), Corporate Bond, T-Bills, G-Secs, etc. These instruments pay interest (coupon) at pre-defined intervals and the face value (principal) upon maturity.

The yields of many of these instruments are usually higher than bank FD interest rates of similar maturities. Yields of AAA-rated corporate bonds can be 150 – 200 bps higher than FD interest rates. In addition to higher yields, since these instruments are traded in the market, you can benefit from price appreciation.

The chart below shows the trailing returns of different debt fund categories over different tenures. Based on historical data, you can see that across different product categories (risk profiles) and investment tenures, debt funds have the potential to give better returns than bank FDs.

Source: Advisorkhoj Research, Data as of 1st April 2020, returns are average for each category, returns over 1 year periods are annualized.

Past performance may or may not sustain in the future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.

Fixed income can outperform even in the long term

Extreme market conditions often challenge popularly held views. One view is that equity always outperforms in the long term. This is largely correct because historical data shows that, equity has been the best performing asset class in the long term. However, conventional thinking about what constitutes long term is now being challenged. The chart below shows the annualized average returns of some equity and fixed income categories over the last 3, 5, and 10 years. You can see that in certain market conditions, fixed-income funds can outperform equity even over fairly long tenures.

Source: Advisorkhoj Research, 31st March 2020

Past performance may or may not sustain in the future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.

Debt Mutual Funds – Myth versus Reality

1. Myth: Debt mutual funds are as risky as equity

The risk of fixed income instruments is usually lesser than equity because the issuer of fixed income instruments is contractually obliged to pay a certain rate of interest and principal on the maturity of the instrument. The management of a company has no such obligations to pay the Dividend to the shareholders, i.e. only when there is profit and the Management decides to share the profits among their shareholders.

Dividends are distributed only after paying interest and taxes first. In debt instruments, there is a possibility of issuers not being able to meet their debt obligations. If a company goes into bankruptcy and its assets liquidated, bondholders are paid before shareholders.

Further, usually, most of the underlying instruments in longer duration debt funds are G-Secs, which have probably no credit risk because they have a sovereign guarantee. Purely from the point of view of underlying instruments, fixed-income funds are less risky than equity. Even if you take interest rate risk into account, longer duration fixed-income funds are less risky than equity. The chart below shows the annual returns of Nifty 50 versus Nifty 10-year G-Sec Index over the last 20 years.

Past performance may or may not sustain in the future.

2. Myth: Fixed deposit usually give higher returns

The reality is that on average and over a period of time, well-managed debt funds have been able to outperform fixed deposits. Fixed deposits are seen as risk-free investments. Investors should understand that risk-free investments usually give the lowest returns. The yields of many fixed income instruments are higher than bank FD interest rates of similar maturities. Yields of AAA-rated corporate bonds can be 150 – 200 bps higher than FD interest rates. The chart below shows bank FD returns versus top-performing (top quartile) fixed income fund returns across different categories and periods. You can see that the top-performing debt funds were able to outperform FDs on average (across different categories) over time.

Source: Advisorkhoj Research, * Average 1-year SBI FD interest rates, † Top quartile (top 25%) of fixed income funds in each category.

Past performance may or may not sustain in the future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.

3. Myth: Invest in the debt funds aiming highest returns

Different types of debt funds have different risk characteristics. There are two main risk factors in debt funds – interest rate risk and credit risk. The longer the duration of a fund, the higher is its price sensitivity to interest rates, e.g. Gilt and dynamic bond funds are highly sensitive to interest rate changes while liquid and overnight funds have very little sensitivity to interest rate changes. Similarly, funds that invest predominantly in Government and highly rated papers have much less credit risk than funds that invest in lower-rated papers to capture higher yields.

Point to point returns in debt funds is driven largely by the interest rate and credit environment. For example, you should not select debt funds purely on the basis of recent returns. You should always invest according to risk appetite and investment needs and if need be consult your financial advisor before investing.

4. Myth: Liquid funds seek positive return

Historically, liquid funds have sought potential returns. These funds invest in money market instruments like CPs, CDs, and Treasury Bills, etc. CPs and CDs are unsecured money market instruments and only issuers with strong financial standing are able to get investors investing in such money market instruments. However, events over the past 30 months or so have shown that some liquid funds can give negative returns over certain periods. This has opened the eyes of many investors who were earlier blissfully unaware of credit risks in liquid funds. Investors should check the credit quality profile and investment track record of liquid funds before investing among other factors to be considered while investing.

5. Myth: Debt funds are meant for corporate and institutions, isn’t it?

While corporate and institutions account for a very large percentage of debt fund assets under management (AUM), these funds offer excellent investment solutions to retail investors for a variety of investment needs and risk appetites. You do not need huge sums of money to invest in debt funds – you can start with just Rs 5,000. You can also invest in debt funds through SIP. Apart from investing for your short-term, medium-term and long-term investment goals, debt funds are also useful for asset class diversification and reducing the risk profile of your investment portfolio.

Debt funds are tax-efficient

Bank FD interest is taxed as per the income tax rate of the investor. Capital gains in debt funds held for over three years are taxed at 20% after allowing for indexation benefits. Indexation benefits can reduce tax obligations substantially for investors in higher tax brackets. Incidence of taxation in fixed income funds arises only if you redeem (sell) your mutual fund units or if you receive dividends. Capital gains on your redemption proceeds and dividends are taxed differently.

Capital Gains Tax

There are two kinds of capital gains in fixed income funds:-

Short term capital gains:-

If units of fixed income funds are sold within 36 months from the date of purchase then capital gains arising out sale of units will be treated as short-term capital gains for tax purposes. Short term capital gains are added to your income and taxed according to your income tax slab rate.

Long term capital gains:-

If units of fixed income funds are sold after 36 months from the date of purchase then capital gains arising out of the sale of units will be treated as long-term capital gains for tax purposes. Long term capital gains are taxed at 20% after allowing for indexation benefits.

If you received the same maturity amount from a bank FD, then your tax outgo would have been Rs 8,280 if you were in the 30% tax bracket (plus surcharge & cess). The long term capital gains tax in the example above is nearly 60% less.

Dividend Tax

Prior to this financial year, mutual fund dividends were tax-free in the hands of the investors but the scheme (AMC) had to pay dividend distribution tax (DDT) at the rate of 29.12% for debt funds before paying dividends to investors. In this Union Budget, the Government has abolished DDT.

Dividends will now be added to your income and taxed as per your income tax slab. If you are in the 30% tax bracket, your post-tax dividend will now be lower (assuming the same dividend payout rate per unit), but if you are in the lower tax brackets your post-tax dividends will be higher. You should decide whether to invest in growth or dividend re-investment option depending on your individual tax situations.

 

People make investments to gain safety and liquidity. Investments give returns which are of two forms one being “Regular Income” another being “Compounding called as Growth”. Risk-taking ability is universal, Risks should be present in investments. It can be controlled through a mechanism called “Asset Allocation”.

We invest to earn returns on our money. It’s an interesting fact that no single asset performs better than other assets. Concretely, in the last 10 years, different assets have been ahead at different points in time. We can comprehend that no single asset can always give you maximum returns consistently.

In the Year 2010 & 2011, Asset class Gold was the topmost with returns clocked around 24% & 29% respectively but in subsequent years the Gold as an asset class was displaced from top-notch, hence in a nutshell Winners Rotate.

If you follow a strategy of chasing the winners & invest in the last year’s best asset class, the CAGR returns for almost 25 years are as below.

However, if you had followed a contrarian strategy & had invested in the last year’s worst-performing asset class, the CAGR returns for almost 25 years has outperformed the above strategy.

However, the best strategy is the asset allocation strategy which has outperformed on returns, in both the strategies, as discussed above.

Asset Allocation strategy from conservative to aggressive investment spectrum is as below

The risk-adjusted return with 30% in Debt & 70% Equity is better off than 100% Equity. Hence look for an Asset Allocation strategy.

Benefits of Asset Allocation Strategy

• Provides a disciplined approach to diversification.
• Encouraging long-term investing.
• Eliminating the need to time investment decisions.
• Reducing the risk in your portfolio.
• Adjusting your portfolio’s risk over time.

Focusing on the big picture.

A small exercise of noting every smallest investment made and its purpose can help us understand the quantum of asset we hold. Every penny needs to have an end goal. Allocation of money starting from a few pennies to dollars will help to create wealth. After the creation of wealth different set of goals will emerge.

This process is cyclical which will help an individual to attain “Nirvana”. Money that will not be used for a long period should be invested in equities to participate in the economic growth of India. This will help to judge oneself by keeping track of wealth creation. This concept is known as “Asset Allocation”.

Asset Allocation in simple terms can be understood as where should we invest money and in what proportion. No single asset class can fulfill four basic requirements of investment which are – “Returns, Liquidity, Safety, and Minimal Tax”.  As different food items help to keep a balanced diet similarly, Different class of asset collectively helps us to achieve four objectives of investments. Asset allocation provides the right balance to your investments. Several researchers have proved that without asset allocation, we cannot become a successful investor.

Thank You!

One of the key aspects to become a successful investor is to understand “Volatility and Risk in Equity Investments.  While volatility is observed in the bond market, gold market, real estate, or equity market however, the high volatility which is been observed in the equity market is often misunderstood.  While uncertainty is the rule of this world, the most common reason for people not investing in equity markets is this uncertainty – the daily fluctuations in the equity markets which are the result of the choices made by the investors as a collective group, which are themselves the result of their collective emotions.  This means that, in a way, each investor is responsible for the fluctuations in the market.

But why do the fluctuations in the equity market scare people?  The fluctuations in the equity markets create a fear of loss, and because the fear of loss is accompanied with a hope that it will be avoided.  It is due to this reason why psychological research shows that the intensity of the fear of going to jail demoralizes more than the amount of sadness one feels when one is actually going to jail because the former is accompanied by the hope that one will not be caught.  It is also this logic which is in place when the amount of the feeling of desperation one has when you are headed to a meeting and suffer from a flat car tyre on a deserted road is much lesser than the feeling of helplessness one feels when one leaves for the meeting well in advance but is stuck in a massive traffic jam because the latter is accompanied with the hope that the traffic jam will ease soon.

It is this fear of loss due to the ups and downs in the market that leads investors to stay away from the market.  However, it is important to understand that quite similar to the ups and downs on the roller coaster that we hop on for pleasure, the ups, and downs in the market are not dangerous in themselves.  Because while investors who have stayed put in the market in the past have gained tremendously in the market, those who have quit prematurely out of the fear of losing have been the ones who have failed to truly gauge volatility and have suffered a permanent loss.

One who is afraid of volatility, for him the temporary loss is converted into a permanent loss. Many investors want to invest in equities only when the volatility reduces. Volatility is omnipresent. It is a normal and necessary piece of investing. It is an integral part of any investing.

There is an old story of “The Saint and the Scorpion” wherein a saint continues to help a scorpion drowning in the river despite the scorpion biting the saint every time he picks it up. The saint remarks about how biting is the inherent nature of the scorpion while helping others is the inherent nature of the saint. In the same vein, it is important to understand that volatility is the inherent nature of the stock market and it is not necessarily bad because volatility leads to uncertainty which helps generate returns for investors to reward them for investing in the company in times of uncertainty. Lower volatility would lead to lower returns because as soon as investors realize the situation of zero volatility, they would participate in equities, leading to a lower movement in the share price.

Those who understand equity always want volatility in the market as it is this volatility that provides returns.  If stocks become stable, people will forget the risk and feel safe.  Many people invest only in instruments where there is certainty.  However, what they fail to understand is that while certain instruments may provide certainty about the rate of return, the fact that return on equities will be uncertain is itself a certainty.

The volatility in the market and the resultant fluctuations in the market are also a result of the way we perceive news and react to it.  While it is important to check the news periodically to stay updated, it is equally important to not overreact.  While there will always be fluctuations, volatility, and uncertainty in the markets, it is advisable to accept them and ensure that one is well diversified with well-researched proper asset allocation and a relaxed mindset.  While no one can gauge the short term trend of the market, one can look at the development parameters of a country to assess the long term investment opportunities on offer.  It is important to accept, face, and conquer volatility as it is the primary reason that equities have delivered 14% returns over the past 20 years, irrespective of the fact that most investors earn below-average returns.  The reason for this paradox that equities deliver the highest returns while investors earn some of the lowest returns is anyone’s guess.

The sequence of returns risk refers to the risk of experiencing a bear market early in the life of a portfolio, rather than later, and how that can impact the longevity of a portfolio (rate of depletion of accumulated retirement funds). This risk is typically mostly associated with a retirement (or distribution) portfolio where the investor is withdrawing money on a regular basis to fund a lifestyle.

The sequence of returns can be explained with the following example.

Following 5 people had invested Rs.10000/- each and individually got the following returns as per the table.

Year	Person 1	Person 2	Person 3	Person 4	Person 5
1	42%	6%	4%	2%	40%
2	53%	-31%	-60%	-42%	-36%
3	-5%	56%	74%	70%	48%
4	-33%	45%	56%	80%	42%
5	-16%	64%	-36%	-48%	43%
6	-37%	99%	-40%	65%	90%
7	-30%	84%	65%	-18%	8%
8	98%	-3%	47%	63%	46%
9	40%	-73%	50%	79%	-38%
10	84%	0%	65%	-30%	-48%
GeoMean	2.61	2.60	2.60	2.60	2.60
(GeoMean)^(1/10)	1.10	1.10	1.10	1.10	1.10
Sequence of Returns (SoR)	10%	10%	10%	10%	10%

The returns are different for different people so is the journey to reach the destination, so the valuation of Rs. 10000/- after 10 years has grown to ~ Rs. 26000/- following the above sequence of returns year on year, the same can be depicted pictorially as below,

Now from the accumulated corpus if every person withdraws 10% year on year and undergoes a sequence of returns in reverse order the graph of withdrawal would be as below.

The graph depicts that few persons have lost their accumulated corpus from 5th years onwards while some persons were able to sail through the respective sequence of return risk. Hence in short every individual has to manage their individual asset allocation to sail through this tide of a sequence of return risk which is ignored most of the time.