Sunday, December 05, 2004

Mutual Funds - Selecting a Mutual Fund

Mutual funds are an excellent way to grow one’s money. Not only do they diversify risk by investing in a large number of stocks, they also provide small investors like me the reassurance of having an expert fund manager.

Welcome to the Jungle

For better or for worse, there are loads of fund choices open to retail investors looking for mutual funds and sorting through the lot is quite a chore. It’s a bit like hacking through the Amazon jungles with a machete - and, just like in the jungle, it’s very easy to get lost without a map!

In an earlier post, I’ve stressed the importance of having clearly-defined financial goals when investing for the future. Your goals are like your map of the jungle and a good, clear map (as opposed to an illegible scrawl about a site marked X) is essential for investments, including those in funds.

Before I started looking for a fund, I made sure I was clear about the following:

  • The returns I was looking for (15%)
  • My investment timeframe (over 10 years)
  • My degree of comfort with short-term volatility (very comfortable, as long as overall trend is upwards)
  • My ability to make regular, monthly payments to purchase units (I settled upon a relatively small monthly amount that I would not miss normally)

Having drawn up the map, I was all set to go hunting. The only issue was the bewildering number of options open to me:

  • Debt (funds that invest mostly in debt instruments like bonds), Balanced (roughly equal mix of debt and equity) or Equity (funds that invest primarily in shares) funds.
  • Within equity, there’s a choice of index funds (funds that invest in Sensex / Nifty stocks in exactly the same proportion as the indices themselves in order to exactly mirror their movements), sectoral funds (investing in specific sectors like Pharma) or diversified equity funds (investing across companies in a variety of industries)
  • Within diversified funds one needs to choose between about 12-15 fund houses – Franklin Templeton, Reliance, HDFC, HSBC…. you name it! My choice was limited to the 7 fund houses that my online brokerage allows. The decision to go with one of them was mainly based on history and prior track record
  • Each fund house has a few diversified equity schemes as well as index funds to track the Sensex as well as Nifty
  • Within each scheme, there is a choice between dividend and growth options – the dividend option pays out regular dividends from profits whereas the growth option retains the profit and grows the investment at a compounded annual rate

Confused? Well, you should be. I know I was completely stumped till I found an excellent mutual funds site that made comparison-shopping extremely simple. You could try it out too – The site gives all kinds of filters for you to short-list funds based on your goals and it also provided detailed information about each fund in the form of an information-packed page on the past performance, sector and company exposure, entry / exit loads and much more.

Choosing An Ideal Fund

I followed the following method to choose my funds:

Step 1
Look for diversified equity funds that have returned an average of over 25% annually. You may want to note that mutual funds gains seem to be reported in simple interest terms rather than as compound interest, so a gain of 25% for the past 5 years would actually only be a CAGR of 15%, which is my target. I realized this quite late and was initially taken in by the promises of 40-50% ‘annualized’ gains that some funds claim.

Step 2
Select the funds that have the longest track records and come from well-known fund houses that you trust. I believe a track record of at least 5 years is necessary to judge a fund’s performance.

Step 3
Narrow down the list to funds that your broker / online brokerage will support

Step 4
Look for 2-3 funds with the best combination of entry and exit loads and performance. ‘Loads’ are commissions charged on your investments with entry loads being charged on purchasing mutual fund units while exit loads are charged on redemption. The better performing funds usually charge higher loads, which are liable to be increased at any time.

Step 5
Finally, make your decision based on the management fee (ranges between 0.5 to 2.5%), which is the cost of running the fund and hence gets deducted from your returns. Again, the better funds tend to have higher management fees. Since the final shortlist would have similar performing funds, it makes sense to go for the cheapest.

A Couple of Suggestions

Once you have chosen your fund, I recommend Systematic Investment Plans (SIP) as the best fund investment method and an almost foolproof method to make good money in the long term. A SIP is essentially a standing instruction to invest a fixed amount in your chosen fund on a regular basis (usually monthly). It has the following advantages:

  • It is automatic and hassle-free. I’d suggest setting it up for 6 months to a year at a time and then forgetting about it
  • It removes the need to time the market because by making purchases at regular intervals, you essentially remain invested at all times, buying more units when the market is down and fewer when the market is up. This way, you broaden your base of units in lean times, enabling greater increases during bull runs. Your average cost of units also remains low.
  • It imparts discipline to your investing, which, along with goal setting, is a key ingredient in financial success

Having said that, an SIP is most effective over long periods of time so consider one only if your investment horizon is more than 3 years and you have the discipline and wherewithal to keep at it for the entire period.

Another recommendation is to seriously consider index funds, which are effectively diversified equity funds with very low loads and management fees (due to the fact that they only need to track the index and hence the stock choices are automatic and require little management). According to Warren Buffet, investors in index funds will likely outperform over 90% of ‘active’ investors over the long term!

My Choices

Being at a relatively early stage in my life and career, my primary goal is to grow my money as fast as possible and I’m quite prepared to live with short-term volatility. Hence, the choice was between diversified and sectoral equity funds.

I invest only in diversified equity funds / index funds with the growth option. Sectoral funds are extremely volatile and move up or down depending mainly on whether that particular industry is the ‘flavour of the month’. Hence there is a strong element of market timing involved, which is something I am not comfortable with – my targeted 15% returns do not warrant this much risk and effort anyway. Over a long period of 10 years or more, it seems better to take a wider basket of stocks, which could gain from upward movements in multiple sectors.

I have SIPs in a mid-cap fund, a large-cap fund and an index fund from the same fund house. After a few months of meddling with the amounts, I have managed to settle on investing in a ratio of 1:1:2 in these funds. Second-guessing and frequent changes to SIPs are not desirable, but its probably something that a rookie investor like me will have to live with for a while till I get a degree of comfort with the performance of my funds.

Over the course of nearly a year, my investments have yielded about 20% returns, this despite the fact that I made the mistake of committing large sums in purchasing over-priced units at the fag end of a bull run. My funds had to compensate for my poor initial judgment and weather a major market crash. That they have performed well despite these hurdles is testimony to the virtues of patience, discipline and the efficacy of SIPs.

Till next time, have fun(ds)! ;-)

Monday, November 29, 2004

Investing in Stalwarts

According to Peter Lynch, stalwarts are large and established companies that have the ability to grow at a steady annual rate of 10-12%. I’d say the equivalent companies in India would show returns of about 15-18%, especially if bought at the right price. These are a very special group of stocks due to their ideal blend of growth potential and predictability and hence these stocks form the backbone of my stock portfolio – after all a growth rate of 18% would have these investments doubling every 4 years!

I believe ‘stalwart’ companies should have shown consistent and significant EPS and book value growth over the past 10-15 years. My method for finding a good purchase price for such companies is to calculate anticipated share price using 3 approaches and then take the lowest. To do this, the following are necessary:

Step 1
Calculate the average share price, EPS and book value growth rates over the past 10 years at least and then extrapolate these over the next 10 years (my expected holding period for stocks of stalwarts). In this manner I can find the expected share price, EPS and BV after 10 years.

Step 2
One can easily derive the stock price from these:
- Expected stock price using EPS = future EPS * lowest historical PE
- Expected stock price using BV = future BV * lowest historical return on net worth * lowest historical PE

Step 3
Take the lowest expected value from among these three methods and then work backwards to find the price at which the share should be bought in order to achieve the targeted returns

Step 4
Have the patience to wait for the target price to be reached.

What does this achieve? Well, for one you are confident of having taken the most conservative estimates for growth and can be fairly sure of meeting your targets, barring extenuating circumstances. At least there is little need to monitor these stocks’ performance on a daily basis. Further, there is a bit of a bonus, as dividends have not been considered in the above calculations.

Using these methods I was able to identify companies like Infosys and ITC as candidates for my portfolio and then had a bit of luck when the market crashed immediately after the elections and allowed me to buy both these companies at prices below my target price. These investments are currently doing well.

Monday, November 08, 2004

Setting a Goal

One of the most memorable things I learnt from reading about Buffet is that your returns are not determined by the price at which is you sell but instead at the purchase price of a share. In other words, every share (even a blue chip) has a ceiling price above which it is no longer a good investment.

A good investor must learn to determine the price at which to buy a share in order to make the kind of returns which he / she expects.

There's more to this sentence than meets the eye. Look at the implications - to make money, an investor:

  • must have a well defined target percentage return in mind. The higher the target, the smaller the universe of stocks (or, for that matter, the universe of investments in general)
  • must identify promising candidates and research them to get an idea of their long term prospects. The time horizon must necessarily be long (5 years or more) because short term fluctuations in price are difficult, if not impossible, to predict
  • must be willing to wait for share prices to reach a level at which buying them makes it possible to achieve the target returns
Of these, the first is the one which people are likely to gloss over. Much has been said and written about research and the importance of patience in value investing but little is ever said about setting a target. But then, what use is all the research if you don't even know what your goal is?

Your goal should be a function of your own requirements and circumstances. Some people might expect 50% returns from their investments year after year whereas others would be happy with 15%. Most mutual funds in India would struggle to generate more than 15-17% on a consistent basis, desipite the high level of inflation and market volatility; Buffet apparently has a track record of growing money at a blistering rate of 23% per annum. (Note that Indian mutual fund returns seem to be usually stated in 'simple interest' terms whereas what we're looking for is compounded growth rate). Hence the purchase price ceiling for the same share would vary between individuals depending on what they're looking for.

I personally would like to see returns of 22-23% on my investments. What this implies is doubling of my investments every three years or, in other words, retirement in 15 years!! ;-)

Ambitious? Maybe, but I have great hope on the Indian markets. We're powering forth in the 21st century - India Inc. as a whole is going great guns and markets have enough pep to keep the right stocks going at rates possibly even a lot better than this. The trick is to finding these growth stocks. And my search has just started...

Tuesday, November 02, 2004

A New Beginning

It came as quite a shock when I found that my laptop was stolen. Not only did that have my office documents and a lot of personal information, it also contained a year's worth of research into shares and real estate investing. And while the former were backed up in the form of mails and soft copies, my investment research was gone forever. I'd have to start all over again.

Somehow, however, I feel that's not such a bad thing. Sure, I'd lost a lot of work but then there was also a fair amount of baggage there, wrong conclusions, poor assumptions etc. that I was willy-nilly carrying around. Perhaps these were even colouring my perceptions of the value of my investments. And then there were also some 'pet' stocks that I refused to give up on even though there were all indications that they were - or were about to become - lemons.

The value of research in not in documents and records. Research is best applied when it is internalized and over a year I'm sure I've learnt something. It will definitely not take a year to make up the lost ground and perhaps I'll gain some more insight in the process. Yes, there are worse things than losing a laptop.

Having said that, I think I'll blog everything just to be on the safe side!

These postings are mainly notes to myself and as such are not expert comments on investing. I'm no expert. However, I am a keen student with a strong desire to create wealth and achieve my financial goals at the earliest. As a result, this commentary is necessarily serious, practical and much of it would be applied on my own finances. That might make some of these notes interesting reading.

The research will focus on my home country - India - though the applications would perhaps be generic across markets. Being a private investor with no particular axe to grind, I would be touching upon all forms of investment that might intrigue me - stocks, bonds, art, real estate, business et al. There are many roads to wealth creation and this journey would probably take me through all - even the bad ones! It's only the beginning.

A final point - I would be grateful for comments from wiser fellow investors who may wish to save me from bankruptcy and point me in the right direction from time to time. Your experience and knowledge would greatly enrich (no pun intended!) the contents of this page and also add value way beyond my personal, fumbling efforts at prosperity.

So, who wants to be a millionaire?