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Smart
Investing : Equity, debt or something else?
Investors have to decide their fund allocation based on their risk
appetite. But should you go with the market mood or stay steadfast?
The
Smart Investor Team
You may have heard
this a hundred times before, but here we go again: prudent and intelligent
asset allocation is indeed the crux of investing. The pros say it
doesn't quite matter what securities you choose. As long you stay
invested in an asset class which is appreciating, you'll make money.
In the last three years, debt funds had an exciting run on the back
of a sustained fall in interest rates. Result: even the worst performing
debt fund posted returns in excess of 10 per cent. To recall, in February
2000 when the Sensex touched a peak of 6150, all equity funds outperformed
the index with returns in excess of 40 per cent annualised . So it
did not really matter which fund you were into. You would have made
money by simply choosing the right type of fund.
So which asset class will outshine others this year? In the last three
years ending June 30, 2003, plain vanilla debt funds returned 13.29
per cent, outpacing equity diversified funds which actually lost 2.46
per cent in value. However, in the last three months, equities have
looked up with the Sensex touching 3750 levels. As a result, equity
funds posted returns of 26.31 per cent in the quarter ended June 30.
On the contrary, debt funds have been facing increasing volatility.
In the first quarter of the current fiscal, debt funds ended up losing
0.86 per cent on an average, wiping out a large part of the gains
made earlier. The yield on the benchmark 10-year government security
increased from 6.06 per cent in early January to 6.43 per cent by
the end of March. During the period, not a single debt fund reported
capital appreciation.
In the April-June quarter, however, debt funds made a comeback with
average gains of 4.15 per cent. But that's little reason to cheer.
Fund managers say that not only are bouts of volatility going to increase,
but also debt funds are unlikely to post double-digit returns. "Debt
funds will not be able to hand out returns of more than 6.5-7 per
cent (this year)," says Rajiv Anand, chief investment officer,
Standard Chartered Mutual Fund.
Overall, most fund managers think this year will belong to equities.
They say the recent rally in stocks is not temporary and will be sustained.
Does that mean you should put all your money in stock funds? No. Stocks
are extremely fickle and in the short-term, volatility is unavoidable.
"This year, investors should look at equity mutual funds more
favourably than debt funds, but putting all the money is equities
can be dangerous," says a financial planner. So some amount of
debt is essential to any portfolio. Here are some strategies to make
the best of both worlds.
Debt Fuds
The way debt funds are poised today, investors face two challenges:
how to preserve capital in case of a trend reversal in interest rates;
and how to enhance return given that returns in these funds will fall
in line with lower interest rates.
If preserving capital is paramount, then there are the floaters and
fixed-maturity plans, though the latter are aimed at big-ticket investors.
Floaters or floating rate funds can serve as a good means to hedge
interest rate risks and provide a stable income. The distinct feature
of a floating rate scheme is that it invests in securities whose interest
rates are reset at periodic intervals. This infuses the floating rate
scheme with the characteristics of a short-term plan, even though
the underlying bonds may mature a few years down the line. A constantly
resettable interest rate option effectively reduces the duration of
debt instruments.
How does this help? Prices of long-term bonds tend to be more volatile
than prices of short-term bonds, but a reset option effectively puts
a floor to the decrease in prices caused by rising interest rates.
There are two methods of deciding the level at which the interest
rate has to be adjusted. One is to use the average Mumbai inter-bank
offer rate (Mibor) over a certain period; and the other is to simply
take the Mibor as on the date of repricing the bonds.
Some trade experts say that an estimated 90 per cent of bonds are
repriced using the former method. Thus, the return investors will
get will be in line with prevailing short-term interest rates.
Again, there are many who question the wisdom of investing in a floating
rate bond when there are other alternatives such as bank deposits
or short-term mutual funds. However, in case of a sharp spike in interest
rates, banks don't pass on the benefit to customers.
On the other hand, under a floating rate scheme, since bonds get repriced
every month, it's easy to see why these instruments tend to adapt
less painfully to increasing rates. Floating rate bonds may have posted
lower returns in the last quarter but their performance in the last
six months definitely stands out.
During this period, Templeton Floating Rate Scheme posted returns
of 3.07 per cent in the long-term scheme and 2.98 per cent in the
short-term scheme. Similarly, HDFC Floating Rate Scheme posted returns
of 2.57 per cent.
Compared to this, the return on regular debt funds looks relatively
pale at 2.52 per cent. The six-month returns are better for floating
rate schemes because of the volatility and the rise in interest rates
witnessed in the first three months of the current calendar year.
Essentially in volatile times, floaters will tend to do better, while
in normal times, these will deliver returns close to those in short-term
debt funds.
Another way to contain risk in debt funds is to settle for fixed maturity
plans (FMPs), which almost all major mutual funds offer. But the caveat
here is that adopt a buy-and-hold strategy.
FMPs attempt to match their maturity with the tenor of securities
in the portfolio. You don't have the flexibility of withdrawing money
without being charged an early withdrawal penalty. You can't even
treat it as a fixed deposit which assures you a pre-determined rate
of return for a specified period.
But this newly designed product allows you to choose the maturity
period according to your requirement. The fund manager invests in
fixed-income securities in a manner which ensures that the fund's
holdings mature exactly when the fund is due for redemption.
The fund actually earns regular coupon on its debt and the principal
remains intact at the end of the tenure. This reduces, what the experts
call, the 'price risk' associated with debt.
This effectively means that investors can protect themselves from
any capital loss on maturity.
Enhanced returns
If you like to see better returns than the prevailing rates of interest,
the only option is to add a dash of equities to your portfolio. Balanced
funds and monthly income plans (MIPs) are good options.
Balanced funds contain just about everything an investor needs. They
invest in several asset classes, including stocks, bonds and cash,
and stay balanced over time to reflect changes in the economy. Balanced
funds aim to achieve a constant asset allocation between equities
and bonds over longer periods.
The fact that the fund invests in equity as well as debt means that
they will benefit in case either component booms. But not all balanced
funds are alike. While some have a strong equity flavour, amounting
to almost 60 per cent of their corpus, others such as Children's Benefit
Plan and asset allocation funds are skewed towards debt.
MIPs are similar to balanced funds as these also have both debt and
equity in their portfolios. However, the relative proportion differs.
MIPs have a smaller proportion of their corpus invested in equity,
than balanced funds. This is because of the objective of the schemes
are different.
MIPs serve the needs of individuals who need regular income. They
are ideal investment for persons looking for additional monthly income
to supplement their monthly salary, self employed individuals looking
for regular returns, or the retired wanting regular monthly income
from a one-time investment. To achieve this objective, these funds
invest primarily in debt.
A small portion is put in equities to perk up returns. But since these
funds have to pay dividends on a monthly basis, they cannot afford
to take on too much risk and, hence, even the most aggressive MIPs
cap their equity exposure at 20 per cent.
Another option is a dividend yield fund. Currently offered by the
Birla mutual fund, this fund actually invests only in stocks which
offer good dividend yields. Dividend yield is basically the dividend
income as a proportion of the acquisition price of the stock. Fund
managers say that a dividend yield should be viewed as a low-risk
equity fund. It may be strictly seen as an alternative to debt fund.
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