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The Mutual Fund Show: Best Alternatives To Equities

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With stocks taking a beating of late, where do mutual fund investors turn to?

Debt, suggested Vishal Kapoor, chief executive officer of IDFC Asset Management. “It’s the largest asset class that we should be focused on,” he said in BloombergQuint’s weekly series The Mutual Fund Show. According to Kapoor, this helps in diversification across asset classes. “The proportions can differ across objectives, time horizon.”

Explaining that everyone holds debt as in the form of fixed deposits and other long-term investments through pension and provident fund, Kapoor said, “We have various debt mutual funds and almost 4-5 categories that deal with just that… of under 1-year maturities.”

Amit Trivedi, a mutual fund expert, suggested gold funds for diversification. “You end up buying slightly cheaper than physical gold as it will have a mark-up,” he said. “Those who don’t have allocation to gold and want to accumulate gold for (their) children’s wedding, then by doing SIP (systematic investment plans) in gold for over a period of time, one can be able to accumulate that gold.”

Trivedi also suggested international equity funds for diversification. “When the Indian equity markets are down, FIIs (foreign institutional investors) are pulling out money and the dollar is appreciating against the rupee.” When Indian equity is going down, the currency appreciation in international portfolio itself becomes a good balancer, according to him.

Watch the entire episode here:

Edited transcripts from the show:

What are the options available on non-equity side in the Indian AMC industry?

Vishal Kapoor: In any portfolio, it always good to have diversification across asset classes. One very large asset class which is important is debt. It should be part of your allocation. The proportions can differ across objectives, time horizon. But it is very important component of asset class. Debt is the large asset class that we should be focused on. Other asset classes like real estate, gold, most investors are overweight through other products including physical holdings. So, debt is the one we should get deeper and understand. There area various ways to play in the debt asset class category. When we look at debt one way to think about it is what is the objective. Everyone holds debt as we hold some amount of cash, FD and other long-term investments through pension, provident fund. So, there is category of objectives where you are looking to park your money for the short term or even for near term for a few months or for an year. That is bucket of liquidity requirements which you have which is near term needs when it comes to cash. We have various debt mutual funds and almost 4-5 categories that deal with just that. There are 5 categories of debt funds of under 1 year maturities.

Look at the other bucket which is most popular product in financial market which is FD offered by banks. Debt funds offer a full range of products which are FD like. They do not guarantee a return. But the two variables which FD offer you is reasonable return with reasonable safety. So, a debt fund can try and manage for that which is to reduce the credit risk to the extent possible and reduce the volatility or duration risk to the extent possible. By reducing it to minimum level, you can make it as close to FD as possible. It is not an FD, but it is as close to FD as possible. There is full range of products available in that bucket too.

Then there is third bucket where the people want to earn more than an FD. Whenever you want to earn more, you are taking some more risk. In the debt fund category, you can either take credit risk which is you invest in lower rated paper and therefore earn high yield, or you can invest in duration risk where you play the interest rate curve and how it will move which is largely done by the fund manager. Based on the cycle you can earn slight capital appreciation over some period of time and earn more. It is important to understand that debt is not a small category but there are various segments to it and it is important to understand what you need it before you get in any of them.

Amit Trivedi: Gold fund is available, though it may not be popular. But if somebody wants to give a diversification to debt and equity, a small allocation to gold is good idea. Those who don’t have allocation to gold and want to accumulate gold for kids wedding, then by doing SIP in gold for over a period of time, one can be able to accumulate that gold. You end up buying slightly cheaper than physical gold as it will have a markup. Other than that, I don’t find reason to get into gold.

In hybrid, SEBI has categorized it and there are four versions of that. One is conservative hybrid which will have small allocation to equity but larger allocation to debt. For large number of people who want to get equity exposure, these kind of products can be good starting point. One also needs to understand that the expected returns should not be very high because allocation to equity is very small. The second category is moderate which will have roughly half money allocated between equity and debt. The third category is the aggressive hybrid category where 65 percent plus will be allocated to equity. That is as close to equity as possible but with lower risk.

A different category where the fund has the flexibility to modify allocation or dynamically manage allocation between equity and debt is the fourth category which are called dynamic asset allocation funds or balanced advantage funds. The beauty of the product is unlike the typical herd behavior that lot of people follow. Today people are looking at alternatives because the market has gone down. If the equity markets are up then that’s not the time to get in but when the they are down, then that’s the market to get in. The dynamic funds manage the allocations on their own and that adds stability to overall portfolio. That’s hybrid category.

The other is international equity fund which is equity. Today all the international funds available in Indian markets are only equity funds. The benefit of it is the currency diversification. A lot of time when the Indian equity markets are down, FII are pulling out money, dollar is appreciating against rupee. In such cases, when Indian equity is going down the currency appreciation in international portfolio itself becomes a good balancer. From a diversification perspective, it adds good value to overall portfolio. For somebody to send children abroad for education, you can start accumulating money.

How does one go on choosing the funds available? How does an investor decide which category is apt for them?

Vishal Kapoor: Tenure of investment as well as the risk-taking ability could be one of the ways to start. If your objective is near term parking of some extra cash like you have money in bank account and wondering why it is lying there, then you can look at any of these categories. The categories can be overnight and up to one year. Most of them less expense and they don’t have exit load. It is how much daily volatility in NAV you can take. There can be some volatility, you have to keep that in mind. If it is for few days, then cash or liquid funds are best. But if it is for few more months, then money market could be the other alternatives. The moment we are looking at one year plus horizon and also as part of allocation which is part of your investment bucket now, then you have to look at FD type or FD plus category. Between the two, the market plays an important part of what’s the right cycle for what type of returns.

In the current market, the AAA category of corporate bonds are offering very attractive years. You have repo rate at 6.5 percent. Overnight rates which are 7-7.25 and triple A bonds which are almost at 8.8 percent. So, you are getting 2.3 percent extra for just taking a bit more tenure and going to AAA corporate bond. If you have a one year plus time horizon, then it looks like attractive return. That is attractive bucket right now in current situation to look at.

The passively managed fund which is IDFC’s Banking and PSU Debt Fund. There we build portfolio with maturity of over 4-4.5 years and roll it down. So, the maturity keeps coming down over the next few years which means that the interest rate risk that investor takes is coming down which is the normal corollary of taking longer tenure products. But the credit quality is the best possible. That’s the advantage of locking in at very high yields today and benefitting from it over the next 2-4 years. That could be based on time horizon. If you are not sure about 3 years and want to keep for 1-2 years which is normal time horizon to look at FD then a short term fund which as per the category can be between the category can be 1-3 years.

Our IDFC Short Term Bond Fund is for 2 years. It doesn’t mean that you have to keep money for two years. It is just maturity and risk profile of product. It is triple A product. It holds average maturity of about two years means the interest rate risk is not very high and you can look tenure of 1-3 years and not being sure that you want to keep it for 3 years or not. Those 2 become attractive because your benefitting from current high yield in the market. In a different market cycle, something other can offer more value which is when you go back to advisor to see what’s the right market. Not all products are best for all time. For different cycles, there is different types of categories which can be more appropriate.

What are the other mutual funds options when I don’t want to park money in equity linked funds?

Amit Trivedi: Time horizon is important to understand in case of debt mutual funds. FD has fixed time periods decided by the issuer of the deposits whereas the investor’s time horizon may not catch with that. Once you fixed it, then you can’t change it. In debt funds, the NAV volatility comes into picture. Because you have the flexibility to get out earlier than the predefined date or continue to hold longer than debt, that’s where you do take volatility. FD, you lock your money for whatever period you started with. In this case, you don’t lock your money and flexibility available and that’s where the volatility comes in. Because of that choosing the product becomes critical depending on time horizon and risk profile.

Which debt funds are better for parking money for over an year?

Amit Trivedi: The moment you look at over one-year category then there is short term bond fund category. If you are slightly more conservative, then look at ultra-short-term bond fund category for over one year also. The difference would be, the typical short-term bond fund would have underlying papers maturing between 1-3 years, ultra-short term would have papers maturing below 1.5-2 years. That way the papers will mature faster. To that extent, the maturity coming earlier would reduce the risk when interest rates fluctuate in economy. If you are conservative, then ultra-short term. If you are not so conservative, then short term bond fund is good choice for one year plus.

Vishal Kapoor: If you have not decided whether to keep it for one year then keep it for three years and short-term fund is good option. Less than one-year, ultra-short term is also a good option. Maturity has to be between 6-12 months. Our funds run at slightly more than 6 months. Interest rates risk is not a lot. But the yield pickup is reasonable. It depends on how much risk you can take. If you don’t want any risk, then liquid fund. Some risk, some volatility and you don’t need money in a hurry then ultra-short-term fund is also a good option.

Is there a way to simplify the jargon for accrual funds and how can an investor use it?

Vishal Kapoor: Accrual means that you are looking primarily the interest rate payment of primary means of earning a return. Duration means that you are also looking for some capital appreciation arising out of change in interest rates which is reduction in interest rates which adds to returns. Depending on the cycle, one or the other may be more can be attractive. In the industry, rather than heavy terms like accrual and duration, I will go back to framework which I explain the tenure or investment period and how much risk you can take. If you cannot take risk, then don’t go to FD plus category which is either credit risk or duration risk. Because there will be more fluctuation and possibility of risk which we have seen in recent past. That mismatch causes a lot of anxiety. So, people may come into accrual saying it is steady and it is only interest rate but there is credit risk embedded in it. That credit risk may show up and when it shows up it means some amount of NAV fluctuation. If you did not anticipate it, then it hurts.

One has to look at type of investment returns or what is the proxy you are looking for. FD plus by definition means you are looking for higher returns and taking higher risk. If you don’t want that risk, stick to an FD type of product which is managed for highest quality and lowest interest rate risk which is come down on duration and go up on the credit quality to best possible. That is the category of funds which I explained in banking and PSU debt fund or short-term fund or medium-term fund. So, you should look at credit profile of the fund and what is the duration of that fund. These are available through fact sheet or ask an advisor.

What are arbitrage funds and what kind of investors are suitable for it?

Vishal Kapoor: Arbitrage is very interesting category. Although its an underlying equity which is the product that plays in equity as well as equity linked in equity options in futures market, the return characteristic is similar to fixed income. So, the asset is equity, but returns is similar to fixed income product. It is in cash futures arbitrage. It doesn’t take a position in underlying equity. It doesn’t care about the price movement. It is fully hedged position. But in the equity market there is intrinsic rate of interest that you can earn between cash and futures and that is the return the investor is getting. Based on market movements and volatility and other factors, that rate can be very attractive. Because it is fully equity linked product, it qualifies for equity taxation. Mostly investors who understand this difference who have at least a one month if not longer period of time in mind and equity taxation for the tax status. It becomes very attractive as a category. So for HNIs and family office, this is very popular product. Returns tend to be slightly volatile month on month based on where the cash futures market is. But as an example of late, last month or so the returns have been very attractive, slightly more than even a liquid fund. On a tax adjusted basis, you can see the difference there.

Amit Trivedi: It is important for someone to understand the category before getting into it. A lot of people don’t understand what it is all about. Some of them pursue it as equity product because it gets categorized for the purpose of taxation. The characteristics of the product is not equity like. So, the returns can be liquid kind of returns and the risks are low. So, this is not an equity product and only categorized as equity in terms of taxation.

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