GOODBYE ELSS

Nobody ever did envisage the day when the tax saving schemes of mutual funds would become a thing of the past. After March 2012, this entire category of equity based tax saving schemes would be history. Frankly, this is a blow to investors. These schemes were the only tax saving instruments that combined tax saving with the higher return that is possible only through equity and the lowest lock-in period amongst all the other schemes. In fact, for many young investors, they were the gateway product through which they entered the stock market. It was after exploring this avenue that they began to get a taste for investing in diversified equity funds.

Fund managers certainly were fond of these products. The 3-year lock in period ensured that investors could not walk out anytime and so sudden or frequent redemptions were not a prime concern here. This enabled them to take a longer-term perspective on their portfolio.
Of all the routes available under Section 80C, the NPS is the only one that offers some sort of equity exposure; a maximum 50 per cent of an individual’s NPS corpus can be invested in equities.

Unlike the 3-year lock-in period of an ELSS, withdrawal from NPS can take place only at the time of retirement.

Imagine the plight of an affluent retired individual who currently relies on ELSS for tax savings.
Once DTC comes into force, what tax-saving options would he be left with? A PPF account? Not a wise option since it matures after 15 years and offers limited liquidity after five years. NPS? Not possible since it is only open to individuals between 18 and 55 years of age, and certainly not retired individuals. Term insurance? What is the point since it is only beneficial to your beneficiaries when you pass away. This senior citizen will have no viable option available but to pay his tax.

Sample portfolios of 3 different categories

This is an approach to portfolio planning that helps you build wealth without too much sweat while allowing some free play to your risk-taking instinct.
If one had to broadly look at three categories of investors, here’s how their Portfolios would shape up.

Aggressive investor
Core 60%
1) DSPBR Top 100 (Large Cap)
2) HDFC Top 200 (Large & Mid Cap)
3) Reliance Reg Savings Eq. (Multi Cap)
4) ICICI Prudential Dynamic (Multi Cap)
Tactical 25%
5) IDFC Premier Equity (Mid Cap)
6) Birla Sun Life Mid Cap (Mid Cap)
Debt 15%
7) JM Money Manager Super (Liquid Plus)

Conservative investor
Core 70%
1) DSPBR Balanced (Hybrid Equity)
2) Franklin India Bluechip (Large Cap)
3) ICICI Prudential Dynamic (Multi Cap)
Debt 30%
4) ICICI Pru. Income Opp. (Debt: Medium Term)
5) JM Money Manager Super (Liquid Plus)

Moderate investor
Core 70%
1) HDFC Prudence (Hybrid Equity)
2) DSPBR Top 100 (Large Cap)
3) Reliance Regular Savings Eq. (Multi Cap)
4) ICICI Prudential Dynamic (Multi Cap)
Debt 20%
5) ICICI Pru. Income Opp. (Debt: Medium Term)
6) JM Money Manager Super (Liquid Plus)
Tactical 10%
7) IDFC Premier Equity (Mid Cap)
The above can act as a general guideline and you can always mix and match to get to the portfolio that best suits your needs and keep you on track.
Conclusion
So an investor can have a portfolio of just seven funds and be very smartly diversified. It’s not a numbers game, it is quality picks that will make it for you.
Play it smart!

Note: THE IDEA BEHIND A CORE FUND IS THAT IT SHOULD BE ONE THAT IS ABLE TO
DELIVER RETURNS IN GOOD TIMES WITHOUT BEING TOO VOLATILE. THE TACTICAL FUND WILL GIVE YOU THAT EXTRA ZING IN YOUR RETURNS. THE DEBT PART IS FOR BALANCING YOUR PORTFOLIO BETWEEN EQUITY & DEBT.

Dangerous Advice For First Time Investors

New investors are bombarded with advice from everywhere. Financial television, magazines, websites, financial professionals, friends and family members all have advice on how to structure your investment portfolio. Beginning investors are much more likely to give credence to investment tips than experienced investors. While the advice is meant to be helpful, it may actually be detrimental to the investment newbie.
Here are five examples of the types of dangerous advice given to beginning investors:
1) "Buy Companies Whose Products You Love"
How many times has someone told you that when investing, you should buy companies that make products you love? This can be a risky and expensive proposition.
For example, let's say you want to buy shares of Bajaj Auto because you love your new bike. You buy shares of Bajaj Auto at its market price and wait to reap the rewards from all of the bike sales. The problem with this strategy is that it fails to take price into consideration. Bajaj Auto may be a great stock to buy at Rs.1500, but it could be a pricey investment at Rs. 2000.
New investors tend to overpay for companies that they really want to own. This buy-at-any-cost philosophy can leave you regretting your stock purchase at the end of the day.
2) "Invest In What You Know"
Investing in what you know is an old investment axiom. This works well for experienced investors who are familiar with lots of companies in different sectors of the economy. This is terrible advice for the investing novice, because it limits your investments to only businesses that you know a lot about.
What if the only companies you know about are in the hotel industry or retail industry? You may find yourself overinvesting in one or two sectors. Not to mention the fact that you would end up missing out on some great companies in the capital goods industry or technology sector.
3) "Diversify Your Stock Portfolio"
Diversification is supposed to help protect your portfolio from market drops and control risk. It's a great concept, but proper diversification can be difficult to achieve and expensive to do. New investors have difficulty building a properly diversified portfolio because of the costs. If not using an index fund to diversify, constructing a properly balanced portfolio in stocks requires thousands of Rupees and may require buying at least 20 individual stocks. It can also be difficult for new investors to maintain a balance between being diversified and not being overly diversified. If you aren't careful, you could end up owning 50 different stocks and 50 mutual funds. An investor could easily get overwhelmed trying to keep track of such a portfolio.
4) "Trade Your Brokerage Account"
Since the market crash of 2008, more investors are abandoning a buy-and-hold strategy and turning to short-term trading. Financial television shows and market experts have even been recommending that investors trade their accounts. Short-term trading may work for sophisticated investors, but it can crush the confidence of new investors.
Short-term trading requires the ability to time buy and sell decisions just right. It takes lots of available cash to hop in and out of positions. It can also decimate your entire portfolio because of trading fees and bad decision making. Daytrading stocks is a strategy best left to the experts.
5) "Buy Penny Stocks"
Emails, advertisements, friends and even family members often trumpet penny stock investing for new investors. The attraction of penny stock investing is that it seems like an easy way to get rich quick, since penny stocks are subject to extreme price volatility. If shares of ABC Company are selling for Rs.1.50 per share, you could buy 1,000 shares for Rs. 1,500. The hope is that the stock goes to Rs.3 or more so that you could double your money quickly.
It sounds great until you realize that penny stocks trade in the single digits for a reason. They are normally very flawed companies with large debt burdens and whose long-term viability is usually in doubt. Most penny stocks are much more likely to go to zero than to double your money.
The Bottom Line
As you can see, sometimes investment tips can do more harm to your portfolio than good. One size fits all may work for others, but it does not work when it comes to investment advice.

The Perfect Mutual Fund Portfolio

I probably don't need to convince many of you of the benefits of owning mutual funds. For investors that don't want to research, buy, sell, and keep track of dozens of individual stock holdings, funds are a great way to delegate the investment management function to a knowledgeable professional. All that time you otherwise would have spent building a stock-by-stock portfolio can be directed into other worthwhile pursuits, like gardening, stamp collecting, or building those little wooden ships inside of glass bottles.
But now the question remains -- exactly how many funds do you need to adequately diversify your portfolio?
Think outside the box
To help answer this question, the first place most investors can look at is a Style Box of “Value Research On Line” or “Morning Star India” website. For those of you not familiar with the Style Box methodology, this is a system of classifying funds according to three capitalization ranges (small, medium, or large), and also by style, or fundamental characteristics (growth, blend, or value). Thus, there are nine possible combinations of funds: small growth, small blend, small value, mid-growth, mid-blend, mid-value, large growth, large blend, and large value. Each of the nine Style Boxes represents one of these categories.
Too often, the prevailing wisdom is that investors need to own at least one fund in each style box, so as to ensure exposure to each and every corner of the market. Following this line of thought, many folks end up buying three different small-cap funds, three mid-cap funds, and three large-cap funds to cover each contrasting investment style. And that's not even taking into consideration international stocks, bonds, and alternative asset classes. So it's easy to see how, all too soon, many investors can find themselves up to their ears in a dozen or more different mutual funds. Hey, wasn't investing in funds supposed to simplify your life? Remember all those ships-in-bottles you wanted to build with your newfound time?
The problem with keeping a strict loyalty to the Style Box system is that doing so will cause your portfolio to become redundant. Having three different types of mid-cap funds will likely contribute to a decent number of overlapped holdings (different funds buying the same stocks), and in the end, probably won't add much, if anything, to your overall portfolio's returns. You want just enough mutual funds to get adequate diversification -- get rid of everything else that is not helping you reach that goal.
KISS: Keep it simple, sweetie
Investing, like so many other things in life, often works best when we remember to simplify. The truth is, most investors would be better served with a bare-bones fund structure. How bare? To start, pick one large-value fund and one large-growth fund. This will give you exposure to growth stocks and also to more value-oriented stocks. Probably the only place you will need two funds for the same market cap mandate will be in the large-cap space, considering this is where you will likely allocate the biggest share of your investment.

The Fundamental Mechanics Of Investing

The article demonstrates why stocks and bonds are created.

A Business Is Created
Amrut is a farmer, and he is interested in starting up an apple stand for the tourists who pass his place. Since Amrut has fairly good credit, he got a business loan to cover the costs of set up, and he now has the ideal land for apple growing. Unfortunately Amrut only set aside enough money for getting his land in shape. He forgot all about buying seeds. By a stroke of luck, he finds a store that will sell him a magic high-growth, high-yield seed for Rs.100, but Jack only has Rs.50 left.

The Initial Public Offering to Raise Capital for Growth
Our clever farmer goes to five of his closest friends (you're included) and asks if they'll each give him Rs.10 to help his business. However, Amrut doesn't know if he can take it in the form of a loan because he may not be able to pay it back if the seed doesn't turn a profit. No worries: Amrut promises everyone they'll receive a percentage of the tree's apples that is equal to the percentage they gave. In other words, Amrut has given his friends a share in his tree. They agree and the seed is in the ground.

The Distinction Between Being a Partner and Being a Shareholder
This tree, being magic and all, grows rapidly. In the first month, it is five feet tall and there are two apples. Amrut keeps one apple because he owns 50% of the business's product, which he paid for with the Rs.50 he put in for the seed. He cuts the other one into five pieces, each of which goes to each of his investors, who can sell or eat it. The investors have a quick meeting and decide they'd rather have him sell their portion of the product and give them a percentage of the profit. So Amrut makes up little papers saying, "Amrut's Apple Company: you have one share guaranteeing you 10% (10/100) of the profits."

Trading Occurs in Amrut's Undervalued Stock
So this tree really takes off now - the magic is coursing through the wood and it grows to 10 feet tall! There are 20 apples and he sells them all for Rs.10 a piece, keeping Rs.100 for himself and giving his friends Rs.20 each. He uses his Rs.100 to buy another seed and plants it. Pretty soon, he has two trees producing 40 apples and earning Rs.400 a month.

Some of his neighbors want in on the deal Amrut gave his friends, and Pravin, Jack's first investor, is interested in selling his 10% of Amrut's Apple Company. Jaya, Amrut's neighbor, wants to buy it and she offers Pravin the Rs.10 that he originally paid. However, Pravin is not stupid: he realizes that this share is producing Rs.40 a month and Amrut is about to buy another seed. So Pravin asks for Rs.40 and Jaya snaps up the share, which pays for itself immediately.

A Bit of a Bubble Forms
The other original shareholders see how much Pravin got and want to sell too, and the other neighbors notice how quickly Jaya's investment paid off so they really want to buy in. The offers steadily climb until Amrut's shares are being bought for over Rs.100 a piece - more than Amrut's trees are producing in a month. Only one original shareholder, Bharti, is still in there and holding out on offers like Rs.120 because she is still getting a regular payment that is pure profit for her. Suddenly, Amrut's trees (four in total) are ravaged by aphids (plant eating green flies). The entire month's production is ruined and several shareholders are wondering if they can pay rent since they used their savings to buy shares.

The Bubble Bursts
The shareholders that need the money sell to Bharti at a discount (Rs.40), and then the other shareholders notice, all of a sudden, that their Rs.100 shares are worth Rs.40. This is very disconcerting. The remaining shareholders offer their shares to Bharti, but she says she's quite content with three shares. The other shareholders are desperate now, so when you (one of the investor) offer them Rs.20 a piece for the shares, they take their losses and get out.

Meanwhile, the main drive of Amrut's business hasn't changed: people still want apples. He needs to get rid of these pesky aphids and he needs the money to buy insecticide.

Amrut Issues a Bond
Amrut is not too keen on issuing more stock after the fiasco with his neighbors, so he decides to go for a loan instead. Unfortunately, Amrut used up his credit with the land preparation so he is once again looking for divine inspiration. He's looking at his equipment to see what he can sell and what he can't, and then it hits him: he'll try to sell his apple crates without actually selling them. The crates are useless without aphid-free product to fill them, but as soon as the aphids are gone he'll need them back.

So Amrut calls up Jaya (in hopes of making amends) and offers her a deal, "Jaya, my good friend, I have an offer for you. I'll sell you my apple crates, which are worth Rs.100 total, for a mere Rs.60 and then buy them back next week for the full Rs.100." Jaya thinks about this and sees that in the worst case scenario, she can just sell the crates… sounds good. And a deal is made.

"But Jaya," Amrut adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."

"I don't know - can we call it a promissory note?" Jaya asks enthusiastically.

"Sure can, but I was thinking more of calling it a bond or a certificate," says Amrut.

And lo and behold, Amrut eliminates the aphids, pays Jaya back, and turns a healthy profit that month and every month thereafter.

What Did We Learn?
This story will not explain everything about investing in stocks, but it does highlight one very important point: the price of Amrut's stock followed investors' opinion of the stock's value rather than just the performance of Amrut's company. Because the stock market is an auction, there is no set price for a certain stock, there is a concept that derails most people's trains of thought: the price paid for a stock is what it's "worth" until a lower or higher price is offered.

This fluctuation of worth is good and bad for investors because it allows for profit (when you buy an undervalued stock) but also makes losses possible (when you pay too much for a stock)

How Fidelity Mutual Fund has fared

Fidelity Mutual Fund has great brand value and has become synonymous with research, but somehow that does not translate into outstanding returns.

Schemes from this fund house are not chart toppers. Opt for them if you are
looking for stability and consistency.

Fidelity India Special Situations (2007 - 2009) has never been a first quartile performer, but has occupied positions in all the other three quartiles during the 3-year period. However, it could be argued that the inherent nature of the fund will result in periodic underperformance.

Fidelity Equity (2006 - 2009) just about managed a 1st quartile performance in 2006. In 2007, it dropped to 3rd quartile, which was understandable when the market got overheated and the fund manager refused to chase fads,avoided Real Estate and stayed away from stocks whose valuations were ridiculous.
But in the downturn in 2008, the fund managed a 2nd quartile performance and
stayed in that bracket in 2009 too.

Fidelity India Growth (2008 - 2009) has always had top 2nd quartile annual performances in its short history.

Fidelity Tax Advantage (2007 - 2009) has either been a 1st quartile or 2nd quartile performer.
Over a 3-year period (February 28, 2010), the annual diversified equity
category average return has been 8.30%. Fidelity Equity (10.05%)
outperformed while Fidelity India Special Situations underperformed
(5.71%). Fidelity Tax Advantage outperformed its category average
(7.96%) with a return of 11.11%.

ACTIVE VS PASSIVE INVESTMENT

At first glance, it would seem that most equity mutual funds are sitting pretty well on profits—last year, 99.03 per cent of active funds gave positive returns. Dig deeper and you find one in three active funds underperformed the bellwether Sensex. As compared to the Sensex’s returns of 76 per cent, some actively managed equity funds returned just 41 per cent. As in any bull market, the rising tide lifted most stocks and so it was not that difficult for fund managers to chalk up a positive performance. Yet, over the long run, most fund managers find it difficult to beat the averages consistently every year, year on year. The funds that are leaders of today could be the laggards of tomorrow.

In the quest for market-beating performance, mutual fund investors could often chase the top performers and churn their fund portfolios, but just as often find that these funds did not perform well the next year. In such a scenario, it’s best to balance out your mutual fund portfolio by including index funds—funds that only track their benchmark index.

Index funds are passively-managed funds which invest in those securities that lie in their benchmark indices and in the same proportion. There are mainly two types of funds: one that holds all the stocks which are the constituents of the chosen index in the same proportion, and the other that follows the sample of benchmark index. In India we have two widely-tracked indices: the NSE-Nifty and the BSE-Sensex. Around 34 schemes track these two indices. Out of these schemes, six are Exchange Traded Funds (ETFs). Among the rest, 19 are Nifty-based index funds, while the remaining track the Sensex. A few of them track some sector-specific indices, such as the banking and PSE indices.

Active versus passive
Index funds are still not very popular in India as they are in most developed countries. That’s because there are valuation gaps in the stockmarket and pockets where the fund manager can use his acumen to pick outperforming stocks. In the US, there are not many valuation plays that fund managers can exploit as the market is more mature and well-researched. On the other hand, mutual fund distributors were selling more actively-managed funds than index funds. But with the new distribution structure, the onus will be on investors to select funds, if they don’t want to go through a distributor. However, you need to pay the distributor for his services. It is not a very easy task to choose the right fund among around 250 actively-managed funds on your own. If you are not that much investment-savvy, or do not have the time and the resources to track the hundreds of actively-managed MF schemes that are available, you can add an index fund to your portfolio. This should help you cover the broad market.

The beauty of an index fund is passive management and, because of this, its low cost structure. If you look at the returns, index funds have performed equally well vis-a-vis other actively-managed funds. The average return of index funds on a 5-year and 3-year basis is 18.19 per cent and 6.19 per cent respectively, whereas the average return of an actively-managed equity fund are 20.92 per cent and 8.52 respectively, for the same period, on the BSE. Among index funds, some have delivered as high as 23 per cent compared to benchmark returns of 20.79 percent. Some of the actively managed funds have given returns as low as 5 per cent on a 5-year basis, which is far lower than passively-managed index funds.

Lower expenses
Selection of the right index fund is not rocket science. It is far easier than the selection of an actively-managed equity fund. Here, you need to look at the two main parameters: expense ratio and the tracking error. The lower the expense ratio, the better is the fund. For instance, assume you invest Rs 50,000 each in ING Nifty Plus and Franklin India Index-Nifty, for a period of 20 years. Note that while ING Nifty charges 2.5 per cent towards expenses, Franklin India Index charges 1.5 per cent. Assuming that the market grows by 15 per cent for the next 20 years on a compounded basis, Franklin India Index will yield you Rs 6,29,342, while ING Nifty will yield you Rs 5,27,254. That is a clear difference of Rs 1,02,088, or 19 per cent.
The objective of index funds is to achieve the return of index they are tracking so, usually, the returns from index funds are almost the same. But, in many cases, you will find the return of index does not match the index fund you have invested in. There are plenty of reasons for this. The stocks that the fund has invested in may have declared a dividend. In other cases, the cash levels and expense ratios that the fund holds might be different. This leads to a mismatch between the net asset value of the index fund and the closing values of the index. This mismatch is also called a tracking error. The better-managed index funds are the ones that have the lowest tracking error.

You just need to look at the expense ratio of the fund and the actual return from the fund versus its benchmark return. Always go for funds having the least expense ratio and less difference between the fund's return and the benchmark's return. Usually index-based ETFs have the least expanse ratio. On an average it is around 0.71 per cent, which is around 50 per cent less than non-ETF index funds. If you are a tech-savvy investor and looking for index funds, you may choose to go the ETF way. Alternately, you could opt for non-ETF index funds.

Diversification and Taxes

One investor diversifies his allocation in mutual funds by investing in 2 or 3 equity oriented balanced funds dividend payout option and another by selecting equity and debt funds dividend payout option.

What happens after one year of investing? If whenever dividends are declared, equity oriented balanced fund dividends are tax free in the hands of investor.

In effect even the debt portion of the fund (average 35%) also becomes tax free which otherwise is taxed in pure debt fund.

This makes a compelling reason to select good equity oriented balanced funds to diversify than to try and do it on your own by investing separately in equity and debt funds.

Understanding Triggers in MF

Trigger is an event on the occurrence of which the fund will automatically
redeem/switch the units on behalf of investors.
Once you invest in a fund, there are two basic transactions that you can execute;
redeem your units or transfer them to another fund. When these transactions are automated
based on an event taking place, it is referred to as a Trigger.
So once you decide on the Trigger, the execution of the transaction is automated.
Who sets the Trigger? The investor.
Who executes the Trigger? The fund house.
When is it executed? On the day the Trigger point has been reached, which is mostly
value specified.
Let’s say you bought 100 units of Fund A when the Net Asset Value (NAV) was Rs 12.
You want to redeem all your units when the NAV touches Rs 15 (Trigger point). You
can keep track of your investment on a daily basis and send a redemption request
when that happens, or you set a Trigger. If you opt for the latter, the fund house will take over and track your investment and sell the units when the NAV touches Rs 15.
It sounds like a winner. But this concept yet has to gain momentum.
Trigger-based plans enable investors to shift conveniently between
debt and equity. The investor determines the Trigger and the portfolio
gets rebalanced accordingly. Simple, specially if he wants to just sell his
units or shift them to another scheme from the same fund house. The
hindrance is if the investor wants to shift his investment to a scheme
from a different Asset Management Company (AMC). So he may exit
from an equity scheme from Fund House A but not want to put his
money in a debt scheme in Fund House A, but rather, in Fund House B.
The Trigger will just enable him to sell his units. He will have to make
the effort to buy the units of the scheme from the other fund house.

When It Works For You...

Automated: Investors need not track their investment
or the market. It is conveniently taken care of.

Discipline: There is no emotion involved, which often
works against the investor. If you get carried away
with the stock market, a Trigger will help you stay disciplined.

Goal Based Investing: It helps you to stick to your
goals of capital appreciation.

Loss Limitation: Since limits can be assigned to
upside and downside movement of investment value,
a market slide will not take away your gains.
When it works against you...
Disturbed Asset allocation: If gains are regularly booked in equity
investments as a bull run gains momentum, the portfolio may get
skewed towards debt and restrict gains from a market rally.

Revisiting The Trigger: One cannot be totally disconnected
from their investments. A lot of these Triggers
cease to exist after being executed the first time.
Investors may need to apply for another Trigger again.
Alternatively, if the Trigger is not executed within a
certain time, it may expire and would need to be reactivated.

Aimless Profit Booking: Profits may end up getting
booked even if there is no goal in sight. Hence the
money could remain un-utilised for years to come.

Load & Taxes: Redemptions could attract taxes. For
instance, redemption in equity funds within one year of
investment will attract capital gains tax. Not to mention
exit loads if the tenure of the investment is brief.

USEFULL CALCULATIONS

Personal finance is all about managing, investing and saving money. Other than these, one other thing needed is to know the exact value of your money because various external factors can have an impact on the value of your money. For instance, Rs 1,000 now would be worth less five years later.

Another reason is that gains and losses are not simple functions and can change under different circumstances. Therefore, it is important to know how to calculate certain figures to understand the actual worth of an investment.

Sometimes, calculations may be done in a different way or using a different formula. Even the same formula can be used differently to arrive at a certain result.

How to use

These calculations can be done manually also, but doing them in an MS excel sheet is much easier. The first step would be to open an excel sheet. Do remember to type ‘=’ in any box and then type out the formula. Without the ‘=’ sign, the formula will not work. Once you have inserted the values, hit the ‘enter’ key to view the result.

Section I

Maturity value on term deposits

Q:- I want to invest Rs 75,000 in a bank fixed deposit for 10 years at 9 per cent interest per annum. How much will I get on maturity?

When you invest in a fixed deposit for a certain period, the final maturity amount can be calculated using the compound interest formula. The interest earned is a fixed percentage per annum but banks usually compound it every quarter. Therefore, one gets more on quarterly compounding rather than from annual compounding.

Formula: Maturity value = P*(1+R%)^N

* Here, P is the amount invested (Rs 75,000)
* R is the rate of interest charged per annum (9 per cent)
* N is the time duration in years (10 years)

This formula is for annual compounding. But, since banks compound quarterly, the formula becomes:

=P*(1+R/4)^(4*N)

What you need to type is =75000*(1+9%/4)^(4*10)

When you hit enter the value 1,82,639 will show in the cell. This is the maturity value.

Maturity value on recurring deposit

Q:- My daughter is 10 years old. I want to start a recurring deposit in a bank of Rs 2,000 a month. The interest rate is 8 per cent per annum compounded quarterly. How much will I get when she turns 20?

The formula used is:

M =
P [(1+R)n–1] 1-(1+R)-1/3

Formula: Maturity value = P*((1+R)^N-1)/(1-(1+R)^(-1/3))

* P is the amount invested each month (Rs 2,000).
* R is the interest rate (8 per cent). However, as it is compounded quarterly the interest rate would be = 8 / 400 which gives 0.02
* N is the number of quarters over the duration, that is 40 quarters over 120 months.

So, you need to type in =2000*((1+0.02)^40-1)/(1-(1+0.02)^(-1/3))

When you hit enter, you will get Rs 3,67,233 as the maturity value.

Compounded annualised growth rate

Q:- I had invested Rs 1 lakh in mutual fund five years back at an NAV of Rs 20. Now, the NAV is Rs 70. How should I calculate my returns on an annual basis?

The gain of Rs 50 over five years on the initial NAV of Rs 20 is a simple return of 250 per cent (50/20*100). This, however, does not mean 50 per cent average return over five years. The compounded annualised growth rate (CAGR) needs to be calculated here to find out what the growth has been over a period of time.

Formula: Returns = (((M / I)^(1 / N))-1)*100

* Here, M is the maturity value (Rs 70),
* I is the initial value (Rs 20) and
* N is the time duration in years (5 years).

So, you need to type in =(((70/20)^(1/5))-1)*100

When you hit enter, the CAGR comes to 28.47 per cent.

Annualised yield

Q:- My fixed deposit of 10 per cent interest per annum is compounded quarterly. What is its actual yield? What if it has been compounded monthly? What if the deposit is of more than a year?

Here, 10 per cent is the nominal rate of interest. As interest is compounded every quarter, the effective interest amount, and thus the yield, increases. Higher the frequency compounding, more is the yield.

Formula: Yield = ((1+R/N)^n-1)*100

* Here, R is the rate of interest,
* N is the number of compounding periods per year and
* n is the number of quarters in the total period.

So, if compounding is quarterly: Yield = ((1+0.10/4)^4-1)*100= 10.38%

If compounding is monthly: Yield = ((1+0.10/12)^12-1)*100= 10.47%

A deposit of Rs 1 lakh at 10 per cent simple interest per annum would yield Rs 1,10,000. However, because of compounding it yields Rs 1,10,380. A longer period of deposit will enhance the yield.

However, if the deposit is for more than a year, say, for two years, then there will be eight quarters.

Formula: =(((1+R/4)^n-1)*100)/2

=(((1+10%/4)^8-1)*100)/2 = 10.92%

Discounted rate of interest

Q:- My bank is giving 5 per cent per annum interest rate. But, if I make a deposit asking for monthly income, the return is lesser. Why?

Under the monthly, quarterly or half-yearly option the amount received will be lesser than under the annual option because banks use discounted rate of interest for shorter periods of deposit. Here’s how to work it out.

Formula:
R/400 (1+R/1200)2 + (1+R/1200) + 1

* R is the interest rate per annum.

Formula for discounted rate per month: =(R/400)/((1+R/1200)^2+(1+R/1200)+1)

=(5/400)/((1+5/1200)^2+(1+5/1200)+1)= .00415

So, on a deposit of, say, Rs 1 lakh at 5 per cent, instead of receiving Rs 416.66 each month, the discounted income would be Rs 414.93.

Home loan EMI

Q:- I have a home loan of Rs 30 lakh for a period of 20 years at a floating interest rate of 9 per cent. I want to ensure that my bank is charging me the right EMI. How to calculate my EMI?

The loan being on floating interest rate, the EMI would keep changing as rates change. On a given date and on known parameters like rate of interest and the loan amount, you can calculate the EMI.

Formula: EMI =(A*R)*(1+R)^N / ((1+R)^N-1)

* Here, A is the loan amount and
* R is the rate of interest.
* Convert R into monthly rate (= 9%/12 or =9/1200). This will be 0.0075

The EMI using the formula will be:

= (3000000*0.0075)*(1+0.0075)^240 / ((1+0.0075)^240-1)= 26,992

So, your EMI is Rs 26,992.

Internal Rate of Return

Q:- I paid Rs 27,300 every year on a money back insurance policy that I had bought 20 years back. After every five years I received Rs 50,000 back and Rs 7 lakh on maturity. What is my overall rate of return?

The internal rate of return (IRR) has to be calculated here. It is the interest rate accrued on an investment that has outflows as well as inflows at the same regular periods. Follow the steps mentioned below carefully.

In an excel sheet type 27300 as a negative figure (-27300), as it is an outflow, in the first cell as shown on the right. Paste the same figure till the twentieth cell. So, all 20 cells will have -27300 in them.

Now, as every fifth year has an inflow of Rs 50,000, type in 22700 (inflow-outflow or 50000-27300) in every fifth cell. However, in the twentieth cell, type in -27300. In the twenty first cell, type in 700000, which is the Rs 7 lakh maturity value of the policy.

Then click on the empty cell below 700000 and type = IRR(A1:A21) and hit enter. You will get 5.17%, which is the IRR or simply the overall rate of return on your money back insurance policy.

XIRR

Q:- I bought 1,000 shares on 18 May 2006 at a price of Rs 250. On 18 July, I bought another 500 shares of the same company at Rs 160. On 3 April 2007, I bought another 300 shares at Rs 120. On 12 December 2008, I sold off all the 1,800 shares at Rs 444 per share. What will be the return on my investment?

The XIRR function is used to determine the IRR when the outflows and inflows are made at different periods. It is calculated almost in the same fashion as IRR. The dates of the transaction are mentioned on the left side of the outflows and inflows before the calculation is made.

In an excel sheet, click on tools in the toolbar. Go to add-ins, check Analysis ToolPak and click ok. (You may have to re-install MS Office 2000 for this function to work). Type out the data from the top most cell as shown here. Outflow figures are in negative and inflows in positive. In the cell below the figure 800,000, type the formula

=XIRR(B1:B4,A1:A4)*100 and hit enter.

XIRR, or the overall return, will be 70.66%
A B
18 May 2006 -250000
8 July 2006 -80000
03 April 2007 -36000
12 Dec 2007 800000
70.66

Post-tax return

Q:- My father is looking to make a fixed deposit in a bank at 10 per cent annual return for five years. He is an income tax payee. How will his returns be impacted?

The post-tax return has to be calculated here. This formula is used for determining the return on income that is fully taxable. The interest income from a bank deposit is fully taxable as per your tax slab. Hence, the return comes down after factoring in the tax. For example, for someone who pays 30.9 per cent tax, the post-tax return on a bank FD of 10 per cent is 6.91 per cent.

Formula: ROI-(ROI*TR)

* Here, ROI is the rate of interest and TR is the tax rate.
* Hence, post-tax return =10-(10*30.9%)=6.91

So, post-tax yield will be 6.91 per cent.

Pre-tax yield

Q:- My brother says that Public Provident Fund (PPF), which gives 8 per cent return, is the best investment option. But, isn’t 8 per cent a low rate of return?

We need to see the pre-tax yield to understand if an investment’s return is high or low. PPF gives 8 per cent tax-free return. The pre-tax yield should be compared with a taxed instrument to estimate its worth.

Formula: Pre-tax yield =ROI/(100-TR)*100

Using this formula, you need to type in =8/(100-30.9)*100 =11.57%

For someone paying tax at 30.9 per cent, pre-tax yield from PPF would be 11.57 per cent.

In the current scenario, there is no fixed, safe and assured return instrument that could pay 11.57 per cent return and yield a post-tax return comparable to PPF’s 8 per cent.

Inflation

Q:- My family monthly expense is Rs 50,000. At an inflation rate of 5 per cent, how much will I need after 20 years with same expenses?

The required amount can be calculated using the standard future value formula. Prices of goods and services rise every year and over a period of time, you need more money to fund the same expenses.

Formula: = Present amount * (1+inflation rate)^ Number of years

= 50000*(1+5%)^20 = Rs 1,32,665

Purchasing power

Q:- My family’s monthly expense is Rs 50,000. At an inflation rate of 5 per cent, how much will be the purchasing power of this amount after 20 years (or how much will this buy in today’s money terms)?

Due to inflation, over the years, a certain sum of money is able to purchase a lesser amount that it used to in the past. Here, Rs 50,000 after 20 years at an inflation of 5 per cent is able to buy goods that Rs 18,844 can buy today. Here’s how.

Formula: Reduced amount =present amount/(1+inflation rate)^Number of years

= 50000/(1+5%)^20= Rs 18,844

Real Rate of Return

Q:- My father wants to make an FD in a bank at 9 per cent for a period of one year. On maturity, he says, his capital will be preserved and he would be getting assured return. What will be the real rate of return (or inflation-adjusted return) for him?

It is true that a fixed deposit is safe and gives a fixed and assured return. However, after adjusting for inflation, the real rate of return can be negative. Very simply, if the nominal rate of interest on a bank FD is 9 per cent and inflation is 11 per cent, the real rate of return is a negative 2 per cent. A more correct way, however, is to use the formula below.

Formula: Real rate of return =((1+ROR%)/(1+i%)-1)*100

ROR is rate of return per annum (9%) and i is rate of inflation (assuming it as 11%).
=((1+9%)/(1+11%)-1)*100

When you hit enter, you get -1.8%, which is the real rate of return.

Doubling of Money

Q:- I would be able to generate 12 per cent return on my investments in equity. In how many years can I see my investment double or even quadruple?

There is a simple thumb rule to calculate the number of years in which the investment will double. It is known as the rule of 72. To calculate it, simply divide 72 by the rate of return that you can generate.

No. of years= 72/12 = 6.

So, at 12 per cent return, you can double your money in six years.To find out the time needed to quadruple your money, divide 144 by your expected return. Hence, 144 / 12 will give 12 years.

What Will It Take to make up those losses?

The terrible market declines of the past year have investors everywhere licking their wounds and toting up their losses, even as they prepare for the possibility of more losses to come. Nearly every portfolio that holds stocks is down significantly since late 2007, with 40% declines not uncommon. Just about the only solace is the thought that the market is bound to turn around at some point, and then people can start making up some of the ground they've lost.
But what, exactly, will it take to make up those losses? Many people underestimate the gains needed to recover from big investment losses, and the extent to which additional losses put you deeper in the hole. Amid all the current market gloom, it's worth taking some time to understand what it might take to recover from the current market swoon.
Climbing Out of the Hole
Suppose you hold a stock or a fund that falls 50% in value. How much does that stock or fund have to gain before you're back where you started? Many people instinctively say 50%, but that's wrong. If the stock's price starts at Rs.10 and loses 50%, it's at Rs.5; from there, gaining 50% would put it only back up to Rs.7.50. To get back to Rs.10, the stock would have to gain 100%, twice as much as it lost in percentage terms.
Recouping losses always requires a larger percentage gain than the loss itself, and the difference between the two gets more dramatic as the losses get larger.
For example, a stock had lost 10.1% over the past year, meaning it will have to gain 11.2% to recoup that loss, and if another stock had lost 30% over the past year, but it will have to gain 43% to get back to where it was a year ago.
Once the losses exceed 50%, as they have for many stocks, the numbers get even uglier. For example, a stock has lost 68% of its value over the past year, meaning it would need to more than triple in price (gaining 214%) in order to make up for that loss.
Easing the Pain
All this may seem a bit depressing, and it is, but it highlights the importance of diversification. If you had your entire life's savings invested in one of the stocks that have completely imploded, your portfolio would be critically damaged and would be facing a long recovery. But, of course, very few investors have all their money tied up in a single stock, and with good reason; diversifying your holdings helps stabilize a portfolio and lessens the chance of one investment torpedoing returns. Even in a market where everything is down, like last year, moderating your losses can make it much easier to bounce back.
The best way of diversifying a portfolio is through asset-class diversification. In addition to making sure your portfolio is diversified by asset class, it's also important to ensure that its spread across different industries and individual securities.
One very basic rule of thumb for determining a good stock-bond allocation is to subtract your age from 100, which gives a rough estimate of the percentage you should have in stocks. Thus, if you're 50 years old, it's a good idea to have 50% of your portfolio in stocks; if you're 60, it makes sense to have 40% in stocks; and so on. Alternatively, tools like Asset Allocator available in www.moneycontrol.com or www.mutualfundsindia.com can help you arrive at a customized stock/bond split.

ARE GILT FUNDS SAFER

Indeed, Gilt Funds are safer than other classes of mutual funds,But it's important to recognise that higher safety does not mean elimination of all risks. These funds invest in government securities, or gilts, which can be considered default free since they carry sovereign risk. Yet, the net asset values (NAVs) of gilt funds can fluctuate, as the government securities market is extremely price sensitive.

Like most traded financial instruments, gilt prices too are a function of market sentiment, which, in turn, is affected by a host of factors. These include demand and supply of gilt paper, interest rates in the economy, foreign exchange movements, Reserve Bank of India (RBI) auctions and government borrowings, most of which are not constant over a sustained period of time. In fact, the government securities market is at times as volatile as the stock market, which is reflected in the changing NAVs of gilt funds.

Yet, for the small investor, gilt funds have opened a hitherto inaccessible investment avenue. The large size of individual transactions limits the gilts market to entities like banks, financial institutions, provident funds and insurance companies. Statutory requirements compel banks to invest 25 per cent of their funds in government securities, because of which the gilts market is highly developed and liquid. But what about the risk associated with such instruments?

No credit risk. Government securities are the only asset class free from default risk. "There are two primary reasons why the government will not fail on its obligations. One, the government can print money to pay you back. Two, it can also tax you to pay you back."
In fact, the world over, governments are not expected to default. Gilt funds invest in purely government securities. Hence, there is no credit risk because the government guarantees it.
There have been a few exceptions like Russia, but they have either postponed their debt obligations or rolled it over. A sovereign default has far-reaching implications. If a country defaults, the value of the domestic currency falls dramatically. This sparks of chaos, and along with government securities, every other financial asset too falls in value.

only price risk. While there's no credit risk, it's the price risk that can actually hurt a gilt fund's NAV. Although the gilts market is largely liquid, it's also extremely volatile. Trading activity in the money market and the forex market has a huge impact on the gilts market.
The money market is extremely active, with the RBI holding regular auctions of short- and long-term paper. Moreover, various entities have to comply with statutory requirements regarding investments in government securities. On a day-to-day basis, the prices of sovereign paper varies, largely due to changes in the expectations of market players and the demand-supply position.

Even small changes in the forex market affect gilt prices. For example, if there's a run on the rupee, the RBI might tighten the call money market to reduce speculation on the rupee. If there is a shortage of liquidity, borrowing rates on the call money market move up. This leads to a drop in prices in the shorter end of the gilts market (paper with up to one-year tenure), and in some cases, even two-year paper. And when call money rates start coming down, the reverse happens. These are short-term swings that tend to even out over a period of time.
But a policy change usually has a longer-term impact on gilt prices. For instance, a cut in the Bank Rate (the rate at which the RBI lends money to banks) will see prices of longer duration government securities soar and that of shorter-duration paper increase marginally.
In fact, the liquid gilts market reacts sharply even to the smallest change in interest rates. For instance, when interest rates rise, gilt prices fall, with longer-duration gilts leading the decline.
Conversely, when interest rates fall, gilt prices rise. Reason: when rates fall, interest payments on existing gilts become more attractive, since new papers offer lower yields. In other words, the current yields adjust to the prevailing rate of interest.
At any given point of time, the risk associated with shorter-duration paper is lower than for higher-duration paper-the longer the duration of the security, the greater its sensitivity to interest rate movement, and vice-versa.
Managing the risk. With this kind of volatility, fund managers assume a great degree of importance. They fine tune their investment techniques and strategies to reduce the impact of this volatility on their fund's NAVs.
One of the best ways to reduce volatility is to hold shorter-duration paper. "Volatility depends on the kind of dated paper you hold. If your portfolio is leaning towards long-dated paper, there is too much of volatility, but in short-dated paper there is not much volatility."
However, there's a consolation: gilt prices move within a narrow band. In absolute terms, the annual volatility in gilts is estimated to be around 2 to 3 per cent. Hence, despite the volatility, NAVs of gilt funds wouldn't be hit significantly. Moreover, in a debt fund, the NAV accrues interest everyday. The NAV comprises of interest income and changes in security prices. So, even if prices dip for a short period, the interest accruals make up for the loss.
Investors should hold on to gilt funds for a reasonably long period of time and not be scared of falls in the NAV or a drop in yields. Ideally, investors should hold on for six months or more. Investors going in for shorter duration like 15 days will feel the pinch.
What most fund managers are confident about is the swift return to normalcy in gilt prices. If prices of gilts fall drastically, for reasons such as hardened call rates, they bounce back to original levels in a short span of time. It takes between a couple of days and about three months for gilt prices to restore, but they eventually come back to original levels."
In fact, fund managers like such short-term dips, as it gives them much-needed entry points.
A case for gilts. Why gilt funds make an attractive investment is the decent returns they give to an investor, without any credit risk at all.
Today, gilts have become attractive when one considers the risk-adjusted rate of return they offer.

SHOULD YOU INVEST IN NFO

Investing with experienced mutual fund managers is a time-tested strategy. These industry veterans have established track records, which enables an investor to more easily learn about the managers and establish a comfort level with their strategies and credibility. Research providers make the search for data even easier. But what about the rookies? New funds are launched all the time, and fund managers with new ideas sometimes deliver impressive growth right out of the box. How can you tell if a new fund will be a winner or a loser? How do you know if you should take a chance on a new fund? Read on to find out.
Look Before You Take a Chance
While investing in a new fund might seem like taking a shot in the dark and hoping for the best, first impressions can be deceiving. Although a specific fund might be new, it's possible that it is being run by an experienced fund manager with a long and distinguished track record. Likewise, the fund complex itself could have a strong history of launching successful new products. Nothing is certain, and even veteran managers can stumble, but there are many ways to research a new fund before you decide to add it to your portfolio.

Managers
Start by doing research about the fund manager. How long has the manager been in business? How much of that time was spent running a strategy that is similar to the new fund? Was the previous fund successful?

You'll also want to find out how long the manager has been with his or her current employer. If the manager has had a long tenure with the organization, what role did he or she play before taking over the fund? Has the manger been in the business long enough to have seen both bull and bear markets? Determining the answer to these questions will help you figure out whether an experienced manager is running the show, an experienced assistant manager is now taking the helm of his or her own fund, or if a true rookie is making a debut.
Fund Complexes
Next, thoroughly review information about the fund complex. Is the rookie fund the latest product from a reliable old fund complex? Does the organization have a long history with the type of strategy the new fund offers? Many firms specialize in small cap, growth, value, socially responsible and other strategies, and have strong track records of launching successful offerings. In many cases, a new fund is managed in a manner similar to an existing product. When a new fund is similar to an existing strategy, the name of the new fund sometimes provides insight into this type of scenario. Names, such as Large Cap Growth I and Large Cap Growth II generally denote situations where strategies are similar. You'll want to know if the fund complex has a good track record of launching funds that last and whether they have historically lowered fees as assets under management have risen.

The Fund
The fund itself is also a valuable source of information. To learn about the fund, read the prospectus and check the fund's track record - even if it's short. How did it fare against its benchmark in terms of returns, alpha, beta and turnover? Does the fund's history demonstrate a rigorous adherence to the stated investment strategy? Are the fees high or low when compared to similar, competing funds?
Take a Chance on a Rookie?
While time-tested strategies and tenured managers appeal to the risk-averse among us, the opportunity to take a chance on a rookie in the hope that you find the next all-star player can be a power draw. If you can resist the urge to take a chance, be sure to thoroughly research the fund before investing.

If you do all of the research that you can and still like what you see, it could be time to put down the money to invest in a few shares of the fund. Adding a rookie fund to your portfolio should, like all risky moves, be done in moderation. Put a small amount of your assets in the fund as part of a well-diversified portfolio. If the manger does well, you will enjoy the gains. If the manger doesn't do well, the bulk of your portfolio will not be exposed to the damage.

The Great Satyam Robbery

For sheer scale and audacity, the Rs 6,000 crore heist that Satyam promoter Ramalinga Raju attempted is breathtaking. Yesterday, the Satyam board of directors approved the acquisition of Maytas Properties and Maytas Infra for USD 1.6 billion. These two companies are promoted by Mr. Raju's son.

It's no secret that no one is willing to invest in real estate companies. Under the circumstances, this deal boils down to Mr. Raju just giving away a gigantic sum of money to his son.

Incidentally, independent directors on the board include Harvard management guru Krishna Palepu, International School of Business (ISB) dean Mendu Rammohan Rao, and former Cabinet Secretary to the Government of India T.R. Prasad. These distinguished luminaries owe some explanations to the non-promoter shareholders whose interests they were supposed to be guarding.

As things stand now, the company has pulled out of the deal. This is not surprising, given the strong reaction from investors. Overnight, the stock's US-listed ADRs lost 55 per cent of their value.

What will Mr. Raju do now? Well, if my understanding of the typical Indian promoter is correct, he will already be hard at work figuring out a smarter way of taking out the money. Let's face it; this type of theft is very much business-as-usual in India. Promoters have myriad ways of enriching themselves at other shareholders' expense. The only mistake the Rajus made was that they tried a method that is more suitable for smaller companies that don't have heavy institutional shareholding and foreign listings. I guess Maytas must be in deep trouble and they must have been desperate.

It is also logical to speculate that there could be some deeper reason for this desperation. Given what has happened to some other promoters recently, it wouldn't come as a surprise to anyone if it turns out that the Rajus' own stake in Satyam is under some sort of a threat.

Incidentally, the promoters' stake in Satyam is merely 8.6 per cent while institutions hold more than 60 percent. It is possible that Mr. Raju will now see institutions forcing changes in the board and possibly in the management. The 8.6 per cent that Mr. Raju controls was worth just Rs 1300 crore, even before the stock price crashed today.

My sense is that we'll be seeing more of such shenanigans now. For about five years, promoters could make enough money by exploiting the rampant capitalisation increase that was happening on the stock markets. Overvalued IPOs was the method of choice till January 2008. Now, that route has been shut off, Mr. Anil Ambani's Reliance Power having been the last successful exploit of that type.

From now on, poor promoters will have to rely on older, more direct methods like Mr. Raju attempted. But make no mistake, he has been thwarted only because his company was too big and the size of the heist was too big. I'm sure such methods must be working well in smaller companies.
By Dhirendra Kumar of VROL_________

Equity works, if we follow the rules

This is that time of the year when the knives are out for equity. While the Left makes political cakes out of ashes in the market, there is genuine confusion among lay readers and investors. Writes Dr Viraj Shah of Ahmedabad: “The Dow Jones was around 66 a century back and today it is around 8,500, giving a CAGR (compounded annual growth rate) of only 5 per cent. The Nikkei was 7,162 in 1982 and was at same level after 26 years a week back, which means negative returns taking inflation into account. Then why it is said that equity has given the best returns of around 12 per cent over long periods? I think that 100 years or 26 years are long enough investing periods. Is it true that equity as an asset class has given maximum returns over the long term? This is an utterly confusing situation.”
Valid question. But we need to look at point-to-point comparisons very carefully. By choosing dates I can either get the market to perform very well or very badly. Simply pick a year in which markets have done badly and compare to a year of stock boom to show performance or the reverse. One way out of this statistical bias is to use what are called ‘rolling returns’. Let’s see what you would have earned as return if you had bought the Sensex on any day from 3 April 1979 to 7 November 2008 and held that investment for a year. Across 29 years, your maximum return would have been a fantastic 265 per cent and worst loss 56 per cent. Now, what if you held on for two years? Or three? As the number of years that the investment is held goes up, the gap between the minimum and maximum return goes down, or, in jargon, the volatility reduces. After five years, the minimum return (or loss) is minus 8 per cent and the maximum return 56 per cent. After 10 years, you lose 3 per cent but gain 35 per cent. At a holding period of 14 years, the minimum return is 5 per cent, the maximum is 29 per cent. This means that if you held the Sensex over any 14-year period from 1979 till 2008, the minimum return would have been 5 per cent, or you would not have lost money. And over a 25-year period, the average return is 14 per cent.
But you cannot eat average return, you say. Sure, you cannot. Therefore, you have this wonderful tool called rebalancing your portfolio that allows you to book profits of the asset class that is rising and invest in the class that is not. In the research period, there have been years of super-normal returns. Those are the years in which to book profits and move money to the safer asset class of debt. Keeping your overall asset allocation in mind, the move should be from debt to equity when the reverse happens. Long-term investing will work only if you follow the rules, just as your car will move forward only if you learn how to drive. If you choose not to learn driving, it is best to hire a driver, or an asset-allocating lifecycle fund that will do the rebalancing for you automatically. So, yes, equity works, but we need to follow the rules.
Editor, Outlook Money____

ARE WE TAKEN FOR A RIDE

Pushed to the wall, several mutual fund (MF) houses have cut off-market deals with corporates and financial institutions to fight the cash crunch.

With redemption pressures mounting amid a liquidity squeeze, some fund houses have given “guaranteed” returns to big-ticket investors who were willing to bail them out by parking money in MF schemes for a few weeks. Under the arrangement, even if the net asset value (NAV) of the scheme dipped, these investors would be allowed to exit at a higher, pre-agreed NAV — something that other investors in the scheme would be clueless about.

This is just a variant of a mutual fund industry practice, where big investors are given cash incentives upfront to invest, as fund houses try to outwit each other in the numbers game. However, this time, the ‘extra’ return is handed over to the investor at the point of exit; and the intention is not to grow the fund’s assets under management, but to avert a serious crisis, or even a default.

As inflows dried up and the prices of securities plunged, several MFs found it difficult to meet redemptions, with investors pulling out money from fixed maturity and liquid funds. The deal with corporates was a sharp practice in desperate times.

This is how it works: say, the NAV of a scheme is Rs 10.10 when the corporate invests in it; the deal is that the money will lie with the fund for a fortnight, after which the corporate will exit at an NAV of 10.25. Even if the NAV slips to 10.05 after a fortnight, the investor still gets out at 10.25. The fund finds a way to pay this extra 20 paise (per unit) to the investor.

“Either the asset management company pays the extra return, or it can be shown as marketing expenses... However, some funds have charged this as expense in an existing scheme, where expenses can be amortised over the life of the scheme. It’s virtually impossible for investors and even auditors to get wind of this,” said an industry source familiar with such transactions.

The extra return could be handed over as an incentive to MF distributors who pass it on to clients. “At times, the investor collects the extra guaranteed money through a separate cheque, which is credited to the account of one of its investment subsidiaries. So, in its book, the investor may show that it has exited at the market NAV (i.e., Rs 10.05) just like any other retail investor, while he collects the extra money in a group subsidiary,” said a senior distributor.

There are fears that more fund houses will have to resort to such transactions if redemption pressures continue. Last week, the Reserve Bank of India used every monetary policy tool in the book to flood the market with liquidity. A slice of it may eventually trickle down to mutual funds. But it won’t be instant or easy.

RBI recently opened a liquidity window where banks can borrow from it and onlend to MFs. But not many mutual funds will benefit from this. First, such loan lines are expensive, costing MFs an interest rate of 12-13%; and second, few funds actually hold adequate certificates of deposits (CDs) — the instrument against which loans are available under the special window.

What has actually compounded the problem is the bag of illiquid securities that the fund houses are holding. This pile of papers of around Rs 40,000-45,000 crore, for which there are no takers, is possibly the toxic assets in the Indian financial market. It comprises pass-through certificates (PTCs) — securitised instruments against consumer durable and other loans, debentures floated by real estate companies and similar securities issued by non-banking finance companies. MFs can’t sell these papers, and have been forced to off-load good and more liquid investments like CDs.

One of the funds had to sell back some of the PTCs it was holding to the issuer of the instrument. PTCs are like bonds, and in this case, the PTC which had a coupon of 12% was sold back to the issuer — a Mumbai-based NBFC belonging to a large corporate — at 18%. It’s a situation where the lender of money requests the borrower to prepay the amount at a considerable discount.

According to a money market trader, it’s difficult for MFs to return to their earlier position, unless commercial banks resume investing in liquid funds — something that could take time. Besides, any upswing in the market could actually trigger fresh redemption pressures, since investors who find themselves currently trapped would try to exit. As things stand, mutual funds will have to continue firefighting till they find a way to get cheap money or get rid of their dud investments.
Economic Times----

MARKET CRASHES ARE YOUR FRIENDS

In the equity markets, one makes more money not despite the crashes but because of the crashes. Let us see how with an assunmption that post-tech crash of 2000-2001 never happened the way that crash actually happened. The Sensex reached a peak of about 5900 in Feb.2000. It then crahed and went as low as 2600 in Sept. 2001. It started rising and reached the previous peak of 6190 again only in Jan.2004.
Let`s assume that the crash never happened. The sensex reached 5600 in March 2000 and then stayed at that level till Oct. 2004. If that happened, then an investment of say Rs. 20000 a month in Sensex based index fund in early 1997 would be 55 lakh at 14% till today instead of 66 Lakh. that is right. for the long term investor, the crash of 2000 was worth a lot of money.
How did you make more money because of the market crash? The answer is obvious who understands the basic arithmetic of what is happening here. The crash unabled you to buy cheap and thus eventually raised your total returns. If you are steadily investing for the long term, then intermttent crashes help you make more money, not less.
And this is how you will make profit eventually from this great panic of 2008. THe longer and deeper this crash, more money you will eventually make.
Fo a long term investor, equity is good precisely because it crashes. Volatility is your friend, and volatility is what will make you reach.
Wishing all of you happy Diwali and a very prosperous new year.

Principal-protection notes

Asset prices have crashed globally due to the financial mess on Wall Street. It is in times such as these that asset management firms peddle products that allay investors’ fears and encourage them to regain exposure to the stock market.

One of our clients was recently offered such a product, similar in structure to the principal-protection notes (PPNs).

This article discusses the characteristics of PPNs, also called as capital-guarantee products, and shows why the plain-vanilla version may not be optimal for investors.

It also shows how asset management firms can custom-tailor products to enable investors fulfil their horizon objectives.

Principal-protection notes


The product plays on an important behavioural bias that Kahneman and Tversky called as the Prospect Theory.

These two psychologists found that people suffer more pain for losing money than they enjoy from gaining the same amount.

The PPNs moderate this bias by guaranteeing the return of capital. The guarantee, of course, comes at the cost of lower return.

Suppose an asset management firm offers a five-year plain-vanilla PPN for a minimum investment of Rs 25,000.

The portfolio manager will invest a proportion in zero-coupon (zeros) bonds and the balance in equity.

If the five5-year bond-equivalent yield is 10 per cent, Rs 15,400 will be invested in five-year zeros. This amount will grow to Rs 25,000 in five years to provide the capital protection.

The balance Rs 9,600 will be invested in an instrument that mirrors the Nifty index.

Some asset management firms provide a participation rate on the equity instrument. If the Nifty index moves up 10 per cent, a 75 per cent participation rate means that investor will receive only 7.5 per cent of Rs 9,600.

This plain-vanilla PPN is not an optimal investment. The reason is that the investor can replicate the payoffs at lower costs.

Of course, zeros are not available for retail investors. Such an investor can instead take 60 per cent exposure to a 10 per cent interest-bearing cumulative bank deposit and invest the rest in index funds. The exposure in term deposits will mature with a face value of Rs 25,000. The index funds provide a low-cost market exposure.

Replicating PPNs with cumulative deposits and index funds could generate a higher return for two reasons.

One, the investor gets 100 per cent participation on the Nifty index. And two, the cost of replicating the PPN structure (management fees) is lower.

Structured PPNs


Asset management firms can structure PPNs that carry exposure to select stocks or replicate payoffs custom-tailored to meet certain investment objectives.

Suppose a class of investors wants to buy a house five years hence. The primary risk is that house prices may go up in five years because of increase in real estate prices and/or hike in input costs such as cement and steel.

Assuming a five-year BEY of 10 per cent, the portfolio manager will invest Rs 15,400 for every Rs 25,000 in zeros.

The balance of Rs 9,600 can be used to take exposure in such stocks that help the investor hedge the risk of rising house prices.

This could mean exposure to the infrastructure sector. Specifically, the portfolio could contain stocks such as DLF, Tata Steel and ACC.

Of course, the assumption is that the rise in real estate, steel and cement prices would improve the revenue streams of these companies.

And that, in turn, will prompt the market to revise upward the asset prices of these companies.

As an alternative strategy, firms can also provide alpha returns on the equity exposure. Suppose the firm has an asset size of Rs 10 crore.

About 60 per cent would be invested in zeros at the five-year BEY of 10 per cent. The balance Rs 4 crore can be used to set-up a market-neutral equity portfolio.

Assume that the portfolio manager is positive on certain stocks in the mid-cap space.

The objective would be to take exposure to the excess returns that these stocks provide over the mid-cap index. An exposure to the select mid-cap stocks gives the portfolio manager two returns — mid-cap index returns (beta exposure) and the excess returns (alpha returns).

Buying select mid-cap stocks and shorting a certain number of mid-cap futures subtracts the beta exposure from these stocks. The residual returns will be the alpha returns- the objective of this strategy.

Conclusion


The sharp decline in asset prices in recent times encourages asset management firms to offer PPNs to investors fearful of regaining exposure to the stock market. This article shows that plain-vanilla PPN is not an optimal investment choice, as investors can replicate the payoffs at a lower cost.

It also shows how asset management firms could custom-tailor exposure to suit investors’ needs. Such products may carry high management fees but could enable investors achieve their horizon objectives.

What is Credit Default Swap(CDS)

He called them “the financial weapons of mass destruction”. ‘He’ was ‘Warren Buffet’ and ‘them’ was ‘Derivatives’. Boy, the world’s smartest investor could not have been more right.

For proof, look no further. First, the world’s fourth largest investment bank, Lehman Brothers, went belly up and then the world’s largest insurance company, AIG, needed a bailout in the land of market economy. A principal reason: Losses due to extensive exposure to Credit Default Swaps (CDS).

What is a CDS?


We explain with a simple example.

Stripped of jargon, a CDS is an insurance contract. Okay, the high priests of finance would call it a derivative but that is a piece of minor detail. Now, suppose, Bank X has lent money to various entities which are non-A grade (read sub-prime) accounts.

To cover the risk that these accounts may default, the Bank sells the risk to someone willing to buy the risk. Suppose this buyer is AIG. In effect, the bank is swapping the risk of default (hence the word credit swap) for cash. If the borrowers fail to pay, AIG settles. Of course, for buying the risk (a k a swap), AIG takes a fee.

Some numbers will help us understand this better. Suppose Bank X wanted to de-risk loans aggregating Rs 200 crore. Suppose AIG charges Bank X Rs 5 crore to guarantee the Rs 200 crore exposures. Suppose AIG assumes that there is a 3 per cent probability that Rs 100 crore of the Rs 200 crore would devolve, that is, go bad — it provides 3 per cent of Rs 100 crore, namely Rs 3 crore in its books for estimated liabilities. That leaves it with a profit of Rs 2 crore on the transaction.

So far, so good. But competition does strange things to organisations. Someone like Lehman to out gun AIG may assume a 2 per cent risk of default and, hence, it may do the deal with Bank X for a lower price of, say, Rs 4 crore. At 2 per cent risk, it would provide Rs 2 crore (Rs 100 cr x 2 per cent) only and, hence, report a profit of Rs 2 crore. As undercutting turns rampant, assumptions relating to the underlying credit going bad becomes more aggressive, at some point becoming zero!

Now, if in the end, 7 per cent of the debt goes bad it would lead to a liability of Rs 14 crore (Rs 200 cr x 8 per cent) on Lehman who sold the CDS, whereas Lehman would have provided only Rs 2 crore in the books. Phew.

The growing chain


The story doesn’t end there. It is quite possible that Lehman Brothers to de-risk itself may buy a swap from someone else on the same loans.

This someone is willing to guarantee it for an even lesser fee because he makes more aggressive assumptions as to the outstanding going bad.

The result: a growing chain of CDSs on the same asset, with each one guaranteeing the previous one. And when the debt goes bad, the firm that holds the parcel pays through the nose.

AIG reportedly sold around $440 billion worth of CDS, which ended up in losses far greater than it had assumed. The ease with which banks could sell the risk clearly fuelled lending to bad accounts.

After all, you could do a crazy loan and the cover it with a CDS so long as there would be a greater fool to sell the cover. What got missed out in the race was that the CDS seller itself could, under the weight of CDSs, go turtle. And that was exactly what happened in the US.

A useful tool, through its blatant misuse, has shaken our confidence in the global financial architecture. Imagine what would have happened if these instruments had been further parcelled and sold to retail investors. Small mercies.

EQUITY INVESTING IS FOR LONG-TERM

Notwithstanding the day-to-day noise around stock markets, equity continues to be a favourite choice for long-term investments. Before plunging in, remember that by design, definition and style equity is a volatile asset class. However, a longer investment horizon can reduce risk substantially. For instance, the 29-year history of the Sensex shows that annual returns on the Sensex for a 1-year holding period has moved in the wild range between –52% and +265%. But with a 5-year holding period, the average annual return range is far superior, between –5% and +55%. This proves that for a short-term investor, equity is a very risky asset.
Diversified equity funds, for their inherent diversification tend to reduce your risk of losing money sharply. Simply put, these funds build a portfolio of stocks, chosen from various sectors and reduce the risk associated with a particular industry. A sector fund targeting a specific industry is susceptible to wider price-swings than its conservative counterpart - the equity diversified funds. The trade-off for balancing risk and return in a diversified portfolio is that your overall return might be lesser than what you could get in a concentrated portfolio. In the long run though a diversified portfolio helps you post steady returns and comprehensively beat the returns raked in by all other asset classes such as bonds, gold, etc. Though that diversification doesn't guarantee positive returns every year, it definitely reduces the risk on your investments. The point to remember is that risk is reduced not eliminated. The rules of sound investing are diversification, balance, and a long-term orientation. These should always be kept in mind when investing in equity funds.
Diversified equity funds will serve your purpose provided your investment span is at least 5 years and more. So, first consider your objective and the timeframe. Then evaluate the fund's return consistency and investment strategy. A look at the sector allocation will tell you about the fund's strategy. After that, decide which of the funds (in the category) will you put your money into. Pick up a truly diversified, yet actively managed equity fund. An actively managed fund will also ride the opportunities thrown up by a particular sector while being prudent with its exposure limits. And if the fund changes its investment strategy during your stay, do reconsider if the realigned strategy agrees with your comfort level. But most importantly, invest regularly.

WHY MUTUAL FUNDS HAVE EXIT LOADS?

Timing is the practice whereby traders try to profit from the short-term differences between daily closing prices. This is done with all types of securities. Whenever investors see the possibility of making a quick profit by buying low and selling high (or vice versa), they can do so.

Now, mutual fund timing is bad for investors in mutual funds because most often, investors are in it for the long term. But, by buying and selling the mutual fund in the short term, traders are increasing the associate costs of the mutual fund and passing these costs onto the long-term fund holders. Trading increases the costs for the long-term mutual fund investor because every time an investor buys or sells units of a mutual fund, the fund company must buy and sell the equal portion of the actual securities within the fund. With each transaction, there is a service charge (i.e. commission). These service charges eat into the returns of the people who are holding the fund for the long term.

Mutual fund companies are aware of the effects of timing and try to prevent it by adding on early-redemption penalties for those investors who redeem their investments before a minimum amount of time. These penalties transfer the costs of the transactions onto the short-term investor. These are known as exit loads.

GOLD AS HEDGE AGAINST RISING INFLATION

Gold as a Hedge Against a Declining U.S. Dollar and Rising Inflation
The idea that gold preserves wealth is even more important in an economic environment where investors are faced with a declining U.S. dollar and rising inflation (due to rising commodity prices). Historically, gold has served as a hedge against both of these scenarios. With rising inflation, gold typically appreciates. When investors realize that their money is losing value, they will start positioning their investments in a hard asset that has traditionally maintained its value. The 1970s present a prime example of rising gold prices in the midst of rising inflation.

The reason gold benefits from a declining U.S. dollar are because gold is priced in U.S. dollars globally. There are two reasons for this relationship. First, investors who are looking at buying gold (like central banks) must sell their U.S. dollars to make this transaction. This ultimately drives the U.S. dollar lower as global investors seek to diversify out of the dollar. The second reason has to do with the fact that a weakening dollar makes gold cheaper for investors who hold other currencies. This results in greater demand from investors who hold currencies that have appreciated relative to the U.S. dollar.

Gold as a Safe Haven
Whether it is the tensions in the Middle East, Africa or elsewhere, it is becoming increasingly obvious that political and economic uncertainty is another reality of our modern economic environment. For this reason, investors typically look at gold as a safe haven during times of political and economic uncertainty. Why is this? Well, history is full of collapsing empires, political coups, and the collapse of currencies. During such times, investors who held onto gold were able to successfully protect their wealth and, in some cases, even use gold to escape from all of the turmoil. Consequently, whenever there are news events that hint at some type of uncertainty, investors will often buy gold as a safe haven.


Gold as a Diversifying Investment
The sum of all the above reasons to own gold is that gold is a diversifying investment. Regardless of whether you are worried about inflation, a declining U.S. dollar, or even protecting your wealth, it is clear that gold has historically served as an investment that can add a diversifying component to your portfolio. At the end of the day, if your focus is simply diversification, gold is not correlated to stocks, bonds and real estate.

Different Ways of Owning Gold
One of the main differences between investing in gold several hundred years ago and investing in gold today is that there are many more options to participating in the intrinsic qualities that gold offers. Today, investors can invest in gold by buying:
• Gold Futures
• Gold Coins
• Gold Companies
• Gold ETFs
• Gold Mutual Funds
• Gold Bullion
• Gold jewelry
Conclusion
There are advantages to every investment. If you are more concerned with holding the physical gold, buying shares in a gold mining company might not be the answer. Instead, you might want to consider investing in gold coins, gold bullion, or jewelry. If your primary interest is in using leverage to profit from rising gold prices, the futures market might be your answer.

HOW TO EARN 9% TAX FREE RETURN

Ever since the bulls and bears began slugging it out over the past few months, equity fund managers are trying hard to make sense of the market and manage volatility. In the midst of all this humdrum, there has been one category of mutual funds that has quietly gone about its business without too much of a noise. Those are the arbitrage funds which are sometimes more lucidly referred to as equity-and-derivative funds. While these terms tend to convey a risky and aggressive investment, the reverse is actually true.

These funds are an ideal way to earn a reasonable income with a moderate amount of risk. In fact, this puts them at par with income funds on the risk-return profile. So the equity-and-derivatives funds are actually a good alternative to income funds.

The concept

All the arbitrage funds have an identical objective: to capitalise on the price difference between the spot market (cash segment) and the derivatives market (futures and options segment - F&O). So they generate income by taking advantage of the arbitrage opportunity emerging out of the mis-pricing between the spot and derivatives market.

Let’s say that the shares of company XYZ are trading at Rs 500 (cash segment). Simultaneously, they are also being traded in the derivatives market, where the stock futures is priced at Rs 510.

So what the arbitrage fund manager will do is sell a contract of XYZ stock futures at Rs 510 and buy an equivalent number of shares at Rs 500. This number of shares will be equal to the number in one contract of a stock future. The result: a risk-less profit of Rs 10 (less transaction costs like brokerage). Just by buying in the spot market and selling in the futures market, the fund manager has made a profit, irrespective of the overall market movement.

All these transactions in futures get settled on the settlement day. On this day, the price of the stocks in the spot and futures market tends to coincide. Since he already bought shares at Rs 500 and sold stock futures at Rs 510, he will just have to reverse the transaction, i.e., buy back a contract in the futures market and sell off the holding of equity shares in the spot Markets.

In this way, irrespective of which direction the market moves, the fund earns its share of profit (i.e., the spread between the initial purchase price of equity shares and sale price of futures contract).

Let’s create two scenarios to understand. Say the fund manager bought the shares of company XYZ at Rs 500 and sold stock futures at Rs 510.

Now let’s look at two different price scenarios on settlement day. Remember, on this day, the price will be the same in the cash and derivatives segment.

Situation I: He bought the shares in the cash segment at Rs 500 and now sells them at Rs 600, earning a profit of Rs 100. Now he will purchase the stock future at a loss of Rs 90 (because he had sold it at Rs 510). Both the transactions net up to a profit of Rs 10.

Situation II: The stock price plummets to Rs 400. He makes a loss of Rs 100 in the cash segment (he bought the shares at Rs 500). But he sold the futures contract at Rs 510 and now buys it at Rs 400, making a profit of Rs 110. Once again, both transactions net up to a profit of Rs 10.

So whichever way the market moves, the arbitrage has worked. The investment strategy of arbitrage funds is such that they earn moderate returns by taking low to moderate risk.

Even though the underlying securities in which they invest in are risky, since the portfolio is always completely hedged it is market neutral, i.e., the returns do not get affected by the Markets moving up or down.

The performance

The concept presents a wonderful proposition on paper. But the test lies in whether these funds have been able to translate it into substantial gains. The returns certainly suggest so.

Arbitrage funds have outperformed the major categories of debt funds across time periods. The category average returns of 8.9% over the last one year are definitely appealing when compared with the income funds’ average of 6.10%. And what adds to the glitter is the fact that the returns of an arbitrage fund become tax-free after a holding period of one year, since they are treated as equity-oriented funds from taxation point of view.

Moreover, these returns have come at a low risk. Barring one fund, none of them have delivered negative returns over any one month period.

This means that if you invested in these funds for a month, you would not have incurred a loss. Ditto is the case over three-month and one-year periods. And remember, this includes the periods of market correction (May-June 2006 and July-August 2007) as well. The market neutrality factor that we talked about earlier has ensured that wherever the Markets go, these funds remain unscathed.

The concerns

Though not the case now, a bloating asset size can be a real drag on the performance of an arbitrage fund, which will face the challenge of identifying that many more mis-pricing opportunities to keep up the performance. ICICI Prudential Equity & Derivative Income Optimiser, the biggest of the lot, manages Rs 1,400 crore and also happens to be the best performer. However, it has to be kept in mind that this fund has the option to invest up to 5% in equities without taking an off-setting position in the derivatives market. This enhances its return potential while adding slightly to its risk profile as well.

Going forward, a concern does arise on the availability of adequate arbitrage opportunities to generate reasonable amount of returns.

This category of funds is managing a modest amount of assets. But going forward, should there be a surge in the assets of such funds, they might find it difficult to identify enough arbitrage opportunities to keep up their performance records achieved thus far. Moreover, arbitrage is a self-cannibalising activity. As more and more money chases the limited amount of mis-pricing opportunities, the occurrence of such situations tends to diminish. In such a scenario, the assets can remain parked in the money market instruments for want of arbitrage opportunities, turning such a fund into nothing more than a liquid fund.

However, we seem to be far from such a situation as of now. More and more stocks are being introduced in the derivatives Markets, broadening the investment universe for these funds. For example, 14 stocks were added to the derivative segment from September 6, 2007, taking the total number of stocks traded in the F&O segment to 207. Therefore, there is little to worry about the future potential of these funds as of now.

The decision

Should you decide to opt for such a fund, there are 10 such offerings in the market, up from just one at the start of 2005. Their ability to generate reasonable returns by taking moderate risk, coupled with their tax efficiency, makes them a strong contender to be part of income fund investors’ portfolios.

These funds generally thrive on volatility. The reason being that higher the volatility in the Markets, higher the potential of mis-pricing between the spot and futures Markets which leads to arbitrage opportunities. So don’t shirk them when you find the market volatile. That’s the time you should seriously look at them.

MUTUAL FUND OFFER DOCUMENT

As a mutual fund investor, you've probably heard it said more than once that you should always consult a mutual fund's offer document before handing over your money. It's no secret, however, that the size of this document and the type of information inside can be hard to tackle. But don't be too overwhelmed. Here is a guide to what an offer document is, why it is important and what items should be central to your considerations.

What Is a Mutual Fund offer document?
A mutual fund offer document is a document detailing the investment objectives and strategies of a particular fund or group of funds, as well as the finer points of the fund's past performance, managers and financial information. You can obtain these documents directly from fund companies through mail, email or phone. You can also get them from a financial planner or advisor. Many fund companies also provide PDF versions of their prospectuses on their websites.

Knowing What to Look For
An offer document is a legally binding contract between the fund itself and the investor. It's easy to get lost in all the legal jargon and miss the information that matters most to you, so here is an outline of sections to which you should pay special attention. Note that the way in which a fund's offer document information is organized may vary from fund to fund; however, by law, all offer documents must contain the following important sections:

Investment Objectives
These are the fund's financial goals, which are reflected in the types of securities chosen to achieve those goals. Types of investment objectives include long-term capital growth, stable income, high total return, etc. Fund companies cannot change these objectives unless investors of the fund consent to the changes through a vote.

It is important to determine whether the fund's goals match your own investment goals. For example, a fund with an above-average capital growth objective would probably not be a good fit for an 89-year-old widow who needs regular income from investments to cover day-to-day expenses.

Investment Strategies
This part of the offer document explains the way in which a fund allocates and manages its resources to achieve its investment objectives. Aspects considered when designing such a strategy include setting goals for net asset value, determining asset allocation, investment restrictions (such as only investing in a certain industry) and deciding whether (and how) derivatives may be used.

A fund's investment strategy, like its goals, should be in sync with your investment style. For example, although a small cap fund and a large cap equity fund are both aiming for long-term capital appreciation, they are both using very different strategies to reach this goal. Before choosing one type of fund over another, make sure you consider why investing in any one of these asset types is right for you. Otherwise, you might be in for some surprises!

Risks of Investing in the Fund
Because investors have varying degrees of risk tolerance, the risk section of an offer document is very important. It details the risks associated with a particular fund, such as credit risk, interest rate risk, market risk, etc.

To get the most out of this section, you should be familiar with what distinguishes the different kinds of risk, why they are associated with particular funds, and how they fit into the balance of risk in your overall portfolio. For example, if a fund invests a large portion of its assets into foreign securities, you need to understand that this may pose significant foreign-exchange and country risk - but you also need to determine whether this kind of risk works with other types of risk in your portfolio in satisfying your tolerance.

Past Performance
This section shows you the fund's track record, but do remember the common disclaimer that "past performance is not an indication of future performance". Read the historical performance of the fund critically and make sure to take into account both long- and short-term performance. Also, make sure the benchmark chosen by the fund is appropriate. For example, using the performance of a bond market as a benchmark for an equity fund is useless. In addition, keep in mind that many of the returns presented in historical data don't account for tax, or some funds calculate an after-tax return with a rate that may be higher or lower than your own. Be sure to look at any fine print in these sections, as they should say whether or not taxes have been taken into account.

Distribution Policy
The dividends a fund pays its investors come from realized capital gains, dividends, interest or other income stemming from the securities and investing activities of the fund. The distribution policy tells you how these payments are made.


Fees and Expenses
This section is extremely important to consider because fees and expenses will eat into your total investment return from the fund. Here you will find information on any back or front-end loads and the management expense ratio. Because these compromise your return regardless of the fund's performance.

Fund Management
Here you can discover how long your fund manager has been managing your fund. Watch out for the fund that has been in operation significantly longer than the fund manager has been managing it. The performance of such a fund can be credited not to the present manager, but to the previous ones. If the current manager has been managing the fund for only a short period of time, look into his or her past performance with other funds with similar investment goals and strategies. You can then get a better gauge of his or her talent and investment style.

Conclusion
After reading the sections of the prospectus outlined above, you will have a good idea of how the fund functions and what risks it may pose. Most importantly, you'll be able to determine whether it is right for you. If you need more information beyond what the prospectus provides, you can consult the fund's annual report, which is available directly from the fund company or through a financial professional.