Archive for November, 2006

Usually dividends are declared as Rs. per unit (like Rs. 1.5 per unit). So is it better to buy funds of a smaller NAV so that, for the same corpus, you can get a much larger number of units, and therefore, larger dividend?

See also: Dividend or Growth Option: The difference.

Dividend or units, they are both "your money". If you buy 5000 units for 10 rupees or 1000 units for 50 rupees, it's the same thing - dividends that come reduce your NAV to that extent so your net value is the same. Let me give you an example: Let's say you own 5000 Rs. of Fund A at 10 Rs., and 1000 units of Fund B at 50 Rs. each.

So your net worth is:
Fund A : 5000 x 10 = 50,000
Fund B : 1000 x 50 = 50,000
Cash : Zero (it's all in the funds)
Total: Rs. 100,000

Let's say both give a dividend of Rs. 2 per unit.

Now you will get Rs. 10,000 from Fund A, whose Nav will go down to Rs. 8 per unit.

And you will get Rs. 2,000 from Fund B, whose NAV will go down to Rs. 48 per unit.

So your net worth is:
Fund A: 5000 x 8 = 40,000
Fund B: 1000 x 48 = 48,000
Cash : 10,000 + 2,000 = 12,000
Net worth = 100,000

Both ways your net worth remains the same.

So if you wanted money from Fund B you could sell some units and get the money (as much as dividend falls short).

But there is a caveat: Dividends are totally tax free, and for equity funds, zero dividend distribution tax applies. All the money you get through dividends is exactly that value - no tax is paid and no charges are paid.

Selling fund units involves 2 charges: A 0.25% STT charge during the sale, and potentially, a 10.2% short term capital gains tax if you sell within a year. That's a fairly big hit on your money, if you need it in the short term (within a year of investment). Even after a year, the Higher-units-more-dividend strategy pays off to the extent of the STT (0.25%) - small, but could be significant when you consider 10 lakhs or more (STT will be Rs. 2,500 for that amount).

Having said that, this strategy will only work if the dividend given by a smaller NAV fund is as much as that of a higher NAV fund. That means you have to compare "dividend yields" i.e. dividend divided by NAV. This is usually much smaller than the "50% Dividend" type of announcements that funds make - such percentages are of the Par value (Rs. 10) and not the current NAV! A "50%" Dividend is equal to Rs. 5, but on a Rs. 50 NAV, the yield is only 10%.

Let's see some recent dividend announcements:

You'll notice that the LIC Index Fund has the best yield - 26% at a (predividend) NAV of 18.58, and that is even better than the Magnum Comma fund whose NAV is lesser (14.56) but yield is only 10.3%.

You should choose funds with the best dividend yield. (Remember of course that dividends are only past performance, and may not be repeated in future. You should choose good fund houses where you are confident of their dividend disbusements in future)

Such a dividend yield strategy should only be chosen if you want cash flow, i.e. money to be constantly returned from your investments. Most equity funds pay money twice a year, and if you use this strategy, you can ensure that you get money to pay off your annual payments, like insurance premiums, property tax or even income tax.

Also, you should choose funds with consistent dividend payments. LIC MF Index Fund (Sensex Plan) has announced dividends in Nov 06, Jan 06, Jan 04 and Nov 03; no dividends from Jan 2004 to 2006. This makes it a very erratic dividend payer. That would destroy your cash flow!

No mutual fund site in India provides historical dividend yields and analysis. Maybe I should start working on this as well. (I am in the process of defining a site that will help you figure out what works best)

Here's an introduction to mutual funds: http://theinvestorblog.blogspot.com/2006/06/introduction-to-mutual-funds.html

And here's my elevator explanation:

Shares: When companies look for money for their business, they can get it in two ways - either they borrow from a bank and pay interest ("debt") or they ask people like you and me to invest and give us shares ("equity"). A share is a part of a business.

Then let's say a friend named Sarath wants to buy a share of this business but the company has got all the money it needs. So Sarath asks us to sell our shares to him, at a higher value than we bought it. So he will own our share of the company, but he's willing to pay more because he thinks the company will do well. Now we make a profit and then Sarath perhaps sells it to someone else at even higher values etc. The company doesn't really get affected because it isn't seeing the money, but the share price goes up as the company starts doing better, and as more people begin to want the shares.

Why does the share price go up? The answer is: Perceived value. I may think the company is worth 1 crore, but someone else might think it's worth 2 crores. When my shares reach my valuation I sell, but someone else will think it's a good deal and buy.

To organise such buying and selling, there are commercial "stock exchanges". BSE and NSE are some of them, though there are a number of other, smaller exchanges in India. An exchange provides a common place for people to buy or sell shares, with sales happening on an auction basis - buyers bid for shares at a price they are willing to pay, and sellers "ask" for a price from buyers. Exchanges match these prices and share exchanges happen along with payments. "Brokers" facilitate these exchanges, and you pay them a fee as brokerage, part of which goes to the stock exchange as well.

Mutual funds: When a lot of shares are available on stock exchanges, you and me don't know which companies to invest in. But let us say a guy named Sandip Subherwal knows, and keeps track of the market daily. So we give him our money and he buys and sells stocks for us. This is a mutual fund - it's our money (mutual), and Sandip is a Fund Manager. There is a structure to this in India, so a fund manager is part of an "asset management company (AMC)". To protect Sandip from running away with our money, SEBI has some rules in place, and there are "trustees" for every fund. With this structure the AMC issues "units" to us for the money we have invested, and tells us how much our units are worth daily (NAV). We can then choose to exit by selling our units back to the AMC ("redemption").

Mutual funds are not just restricted to shares. They are mutual investments, therefore they can be anywhere. The common ones are equity (stocks and shares) and Debt. Debt markets are where companies borrow money, but they want to borrow huge sums of money that you and I don't have. Therefore, we pool in our money (mutual fund) and give the big whole lot to the company at an interest. Even the government borrows, but again, only large sums of money. Mutual funds can invest there too. Debt is traditionally "safer" than equity since there is a fixed valuation and good rating mechanisms to curb risk; and in the same vein, the profits (and losses) are usually much lesser than equity.

Mutual funds can also invest in other investment avenues, like Gold, Real Estate, Commodities and even in Windmills! Of course, in India only a few of these are available.

Shares are a part of a business, mutual funds are cumulative investment. I hope this helps.

Type: Closed ended Equity fund (3 years) after which is converted to open ended.
Issue Opens: Nov 14, 2006
Issue Closes: Dec 11, 2006.
Entry Load: nil
Exit load: 2% to 4% (explained later)

This is a closed ended equity fund that will invest in small caps and midcaps, primarily and in derivatives as well. Debt is restricted to 20%.

Features:
1) No Entry load.
2) This being a closed end fund, can amortise initial issue expenses upto 6% and they intend to. This charge will be amortised over three years.
3) There's a three year lock in, but if you do want to exit early, you can exit in the first five days after a calendar half-year (meaning Jan 1 to 5, or July 1 to 5) upto three years. An exit load or charge applies if you exit in the first 12 months (4%), 12 to 24 months (3%), 24-36 months (2%). Apart from that you will pay the amortised initial issue expense charge which can be another 2-4%!
4) As a zero load scheme, AMC can charge a further 1% as management fees (apart from the 1.25% it is allowed to charge)
5) The fund focusses on small cap (<250 cr market cap) and mid cap (<1500 cr. market cap) stocks.

My view: Don't buy. Why?
a) The exit expenses can be upto 8% and this is quite high. If you want to exit this fund if it doesn't perform, then you take a big loss.
b) There is a three year lock in but no ELSS tax savings. It's not worth that expense.
c) Reliance has four other equity funds - Vision Fund, Growth Fund, Equity Opportunities fund, and Equity fund, apart from a Reliance Taxsaver fund. This fund is a small+midcap fund which is exactly like the Growth Fund, so there is nothing really special about this fund (other than the lock-in, which is a negative). If you like the AMC (it has done well), invest in Reliance Growth fund instead. For another fund that has the same investment objective (but no exit loads etc.) Sundaram Select Midcap is a good bet.
d) The risk is extremely high - small and midcaps are inherently risky, and more likely to collapse. The risk is not a problem, but combined with a very high exit load, it hurts you much more if this fund's primary investments fail and then you can't even leave without paying a huge sum.

It's important to invest long term so the three year lock in makes sense. Even more so perhaps for small and mid-caps, some of which will take time to blossom. But if there are other funds giving you the same advantages (Reliance Growth, Sundaram Select Midcap) without the high exit loads, why should you choose this fund?

Overall, my suggestion is to wait and watch. Give this fund the three years it needs, let it run through its amortised expenses etc. and if it has done well, you can enter when it moves to an open ended nature.
(Comments from Personalfn . and Moneycontrol)

Here's what I think.

1) It's an NFO with nothing special, just tax saving diversified equity. You can get this from other, more established funds like HDFC Taxsaver, or Magnum Taxgain.

2) There is no real track record (HSBC Equity fund has underperformed all the major performing funds over the last two years). No other equity based offering from HSBC Investments (the AMC) has shown a stellar record.

3) There is no drop in the entry load (2.25%), and the recurring expense is estimated at 2.5% (greater than most funds) meaning that there is no benefit in investing in this fund as compared to other, existing, performing taxsaver funds.

Luckily there is no problem with initial expenses this time, they will be managed through the entry load only. Even so, some of the marketing expenses will probably need to be accounted for, as I feel they will cross the 2.25% limit (remember, this limit includes distributor commissions, which will likely be around the 2.25% limit). It'll be interesting to see how the NAV performs, since the AMC will want to recover these extra expenses through the fund (perhaps by front loading these expenses?).

My view: You are better off buying a presently available fund with a good track record, like HDFC Taxsaver or Magnum Taxgain. They have generated very good returns in the past. Let the HSBC Taxsaver fund run through a year and we'll re-evaluate it to see how it has performed. Perhaps it will be an outperformer, but now is too early to say.

But should you just buy?

Firstly a new fund is very risky. You don't know how it will perform. If you have similar funds with a good track record, of greater than five years, you might want to invest in those instead.

NAV at Rs. 10 makes no difference really. Mutual fund units are a function of "percentage" gains only - that means if the stock market goes up 5%, a mutual fund with NAV of Rs. 10 will go up to Rs. 10.5 and one with NAV of Rs. 100 will go up to Rs. 105. Gains are the same for you - your investment grows 5%.

And there's the question of commission.

Fund houses will offer distributors upto 6% commissions for selling NFOs. If you buy a fund anytime after the NFO, the distributor gets only upto 2.5%. No wonder distributors want to sell the NFOs. So who pays for this commission?

If you buy a fund after the NFO, this is usually an "entry load", meaning you get charged upto 2.5% of your money upfront to pay the distributor.

In an NFO, it's a "hidden" cost. Though many NFOs come with zero entry load, SEBI allows fund houses to charge upto 6% "NFO marketing" fees, part of which goes to the distributor and a part to the ads etc. that they put. This is 6% of all the money collected; for instance, Reliance Equity fund collected more than 5000 crores, and the 6% marketing fees is about 300 crores. That is a lot of money for advertisements and commissions!

This amount is (usually) taken out from the net assets of the fund, so the NAV goes down, sometimes below the issue price.

In some NFOs, fund houses like Templeton have decided to bear the marketing charges themselves so that the NAV remains at Rs. 10 or above after listing.

Earlier (before July 2006) Fund houses were allowed to amortize expenses over five years, meaning they remove only 1/6th part of the expenses in the first year and so on. (They usually do it quarterly or monthly) Basically, if you buy those funds even four years after the NFO, you are still paying the NFO expenses. Also, a similar fund, more than five years old, will give you better returns!

Those rules have changed but such funds like Reliance Equity can continue to amortise over the next four years, since the rules came after their issue. Be aware that investing in such funds even now (till 2010) will involve your NAV suffering to the extent of the remaining NFO charge.

The other problem with the old rules (which still apply to funds that had an NFO before July 2006) is that usually big investors take out their money immediately after the NFO. Why does that affect you? Because you pay more of the marketing costs. Let me give you an example.

Let's say you invest in an NFO that collects Rs. 1000 crore. Of that, Rs. 60 crore is marketing cost (6%), amortized over five years, so 12 crores per year, which is about 1.2% per year. Now big investors take out Rs. 600 crore in the first year. So the 12 crores has to be taken from the remaining corpus of Rs. 400 crores, which is 3% per year. If you invest for five years, your NAV suffers 15%! That simply means, another fund that has been around for more than 5 years, will make 3% per year more than your fund. This applies even if you invest in the fund AFTER the NFO, since this is amortized.

(New NFOs though do not have this problem, since the cost must be charged initially itself and no further amortization is allowed)

This is true for closed ended funds also. In fact for recent closed ended fund NFOs, if you try to get out of a closed ended fund before the end date, you are charged part of the amortised portion of the marketing charges. Closed ended funds are allowed to amortize the initial charges for five years (open ended funds are not).

In simple language: unless the AMC is bearing the marketing charges, Don't invest in NFOs. Don't invest blindly in funds that have had an NFO before July 2006, within five years of the NFO; they have a hidden cost that is applicable to you.