A Correction and some Observations about Mutual Funds and ETFs

About index funds and ETFs

This discussion is not about the correction that has been seen in global stock markets this week. In an article about two index funds, I had discussed about ICICI Pru Index Fund Retail and UTI Sunder. My broker pointed out that UTI Sunder is not an index fund but an index ETF. That means you require a demat account to purchase or sell units of the fund. The oversight is regretted.

Index ETFs are supposed to track the index closely. But due to the very low volume of transactions in the UTI Sunder ETF, unit prices move abnormally higher or lower even on small transactions. Investors may be better off with Nifty BeES, which tracks the Nifty more closely and has decent volume of transactions as well.

About SIPs

I often receive queries about SIP (Systematic Investment Plans) in mutual funds. My bias against SIP has been documented in this post. However, SIP works if used during sideways consolidation patterns - like the one we had in the Sensex for the past 6 months.

If you have the self-discipline, then keep the investment date flexible. Signing up for a SIP plan with a mutual fund every month or every quarter locks you into specific dates. You won't be able to take advantage if there are sharp market turns in between.

About Debt MFs

Some times investors ask me if they should put money into a debt mutual fund instead of a fixed deposit. I am old fashioned and have never invested in debt MFs. I like the assured return in a FD, even though the return is taxable. A quarterly interest payout from FDs provide a regular cash inflow - which a debt MF may not be able to match.

About Sector Funds

These are more risky and volatile than diversified equity funds. Unless you have a very good reason, avoid sector funds. There were a plethora of infrastructure fund offerings during the bull market. Many performed spectacularly. But their fall has been equally dramatic.

The only exception would be if you really know every thing about a sector, let's say the banking sector, that needs to be known but do not have sufficient cash to deploy in more than one stock. In that case, an investment in a banking sector fund may work for you.

About Gold ETFs

Buying and storing of gold - whether bars or coins or jewellery - has been a tradition with many Indian families. With the advent of gold ETFs, the hassle and risks in storing physical gold can be avoided.

According to some gold analysts, the bull period in gold has not ended. It is about to get even bigger and stronger. I've never bought gold or gold ETFs. But with the current uncertainty in the global economy, a small investment - not more than 5% of total investment portfolio - may not be such a bad idea. I'm looking at UTI's gold ETF for possible purchase.

If any reader has a better idea, I'd be more than happy to hear from you.

Two Index Funds that track the Nifty 50

In a post on Dec 8, '08, I had written briefly about the benefits of index funds and discussed about Nifty BeES, which is a ETF (Exchange Traded Fund). ETFs are traded like shares through brokers in a stock exchange, and just like for share trading, investors need to open a demat account.

In a subsequent post on Feb 22, '09, I had discussed about two balanced funds that may be more suitable for those investors who have less risk tolerance and don't have a demat account.

Index funds are ideal for the category of investors who are:

a) conservative but don't mind taking the risk associated with equity investments;

b) disinclined to track the performances of individual stocks;

c) not interested in opening a demat account

What are the specific benefits of index funds? They need very little management since they track the constituents of the respective indices. That means no dependence on the skills or whims of fund managers - leading to minimal management fees. Also, there is not much scope of out-performance or under-performance since an index fund tracks an index closely.

In the longer term, equities as an asset class tend to outperform all other assets. Regular investments in index funds provide long term wealth creation in a slow and steady fashion.

For more than 4 months, since the Sensex made a 52 week intra-day low on Oct 27, '08, there has been a rectangular sideways consolidation by the Sensex with no clearly discernible up or down trend. Such periods provide good opportunities for investments in index ETFs like Nifty BeES or index funds.

A couple of highly rated index funds that investors may want to consider are ICICI Pru Index Fund Retail and UTI Sunder, both of which track the Nifty 50 index. A brief summary of the funds are given below:-

1. ICICI Pru Index Fund Retail

Entry load - 1%, exit load - nil; Minimum lump sum investment: Rs 5000, subsequent investments: Rs 1000; Systematic Investment Plan (SIP) - available, minimum investments are Rs 1000 for monthly SIP and Rs 5000 for quarterly SIP; Systematic Withdrawal Plan (SWP) and Systematic Transfer Plan (STP) available; Dividend option available; top holding - Nifty Futures (65%).

2. UTI Sunder

Entry load - nil, exit load - nil; Minimum lump sum investment: Rs 10000, subsequent investments: Rs 2000; SIP, SWP, STP - NOT available; Dividend option available; top holding - Reliance Industries (11%).

Both index funds have marginally out-performed the Nifty 50 over all time periods. They have lost less during shorter time periods and gained more over longer time periods. This was possible because of some amount of tweaking of the weightage in the portfolio of the Nifty 50 stocks.

My personal preference is for an index ETF like Nifty BeES over an index fund because it is easier to buy and sell ETFs any time during the day at the prevailing price (whereas a mutual fund can be bought or sold up to 3 pm on the same day's NAV and after 3 pm on the following day's NAV).

A rectangular Sensex chart pattern

In a prior post on July 13, 2008 I had discussed about identifying stock market trends using moving averages. It is time to take a re-look at the current market trend.

After the prolonged bull market that started in May 2003 at about 2900 and took the Sensex all the way up to 21200 in Jan 2008, a  bear market reversal pulled the Sensex down to 7700 in Oct 2008.

We had a clear up trend for close to 5 years - interspersed with several bull market reactions, followed by a sharp down trend for 10 months - with a few bear market rallies.

After the Oct 2008 low of 7700, a swift rally took the Sensex to 10950. Thereafter, the Sensex seems to be meandering sideways with apparently no clearly visible up or down trend.

Let us take a look at the Sensex chart of the past 3 months.

The 200 day EMA is still moving down. The 50 day EMA and the Sensex are well below the 200 day EMA. So we are still firmly in a bear market.

But the Sensex is bouncing along sideways within a rectangular band between 7700 and 10950. Volume of transactions - given in the lower chart - are low. What does this indicate?

A rectangular chart pattern is a period of consolidation before the market makes up its mind where it wants to go. Such indecision amongst bulls and bears typically happens after a sharp move up or down.

A market consolidation - represented by a sideways rectangular chart pattern - can be of three types: accumulation, distribution or continuation.

At market tops the 'smart money', i.e. institutional and high net worth investors, sell. The 'weaker hands', i.e. retail investors and funds, buy. Shares are 'distributed' from stronger to weaker players.

At market bottoms, the opposite happens. The stronger hands 'accumulate' the shares from the weaker investors, who get tired of waiting for the market to move up.

In the middle of a clear up (or down) trend, a consolidation period is called a 'continuation', as the market pauses for breath before continuing the up ward (or down ward) journey.

Since we are not at a market top, this is not a distribution pattern. Is it then a period of accumulation at a market bottom or continuation for a further fall? There lies the conundrum.

The short answer is: we don't know. When and how will we know? Only when the market makes up its mind and decides to either move above 10950 or break below 7700.

Fundamentally, the macro economic situation is showing improvement. Inflation, as indicated by the WPI (Wholesale Price Index) is moving down. Oil prices have fallen drastically in the international market. Interest rates are also coming down.

We are now in the midst of the results season with companies declaring their Q3 or Q4 results for the period Sep to Dec 2008. Consensus amongst the experts is that most companies will declare awful results.

But the market is already expecting (i.e. 'discounting') that and unless there are more Satyam-like skeletons, it is unlikely that there will be a big fall below 7700.

On the day the Satyam scam broke, the volumes were very high and the market dropped 750 points but remained well within the rectangular pattern. The following two trading days also saw high volumes but much smaller falls. These are positives.

So, the scales look slightly tipped towards this pattern being an accumulation rather than a continuation. Why slightly? Because on some of the recent up days, the volume of transactions has been less than on down days. This goes against conventional wisdom of higher volume on up days and lower volume on down days.

If you are a patient investor, wait out this consolidation period. Such patterns can continue for a very long time - months, may be even years.

If you are itching for some action, start putting in small amounts of money in Nifty BeES or any good index fund. I would not rely on stock-picking skills at such a time.

If you must SIP, sip good Darjeeling tea

Edward Luce, the Financial Times correspondent who was stationed in Delhi and is now at Washington DC, has written an eminently readable book on the challenges faced by the growth story of modern India. Called "In Spite of the Gods", the book postulates that the reason for the success of a vibrant democracy is India's diversity.

This diversity can be exemplified by how tea is prepared in different parts of India. In the west, tea leaves, water, sugar and milk are brought to a boil in a pan. In the north, spices like cardamom or ginger or both are mixed with the tea to make 'masala chai'. In the south, coffee is the preferred drink, though a large quantity of tea is grown in the Nilgiris.

In the east, there is Assam tea - a strong rich brew prepared with milk and sugar. And then there is the queen of teas - Darjeeling - whose beautiful bouquet and light taste emerges only if it is brewed in a pre-warmed porcelain tea pot and sipped without adding milk.

That brings us to another SIP, or a Systematic Investment Plan (another of those investment myths!). A disciplined and conscientious investor should have no problems with saving a fixed amount of money every month or every quarter. But is it necessary to invest that sum every month or every quarter on a particular date?

The fund managers of most Mutual Funds will say a resounding "Yes".  They even provide examples on offer documents or on business channels to prove their point that investing a fixed amount on a particular day every month or every quarter is the way to untold riches.

Like a dummy, I listened to their collective advice and started a 12 months SIP in a well known diversified equity fund in the middle of 2004. By the time my 12 monthly installments were complete, I found to my horror that my average price per unit had continuously climbed up - along with the stock market. For my last monthly installment, units cost as much as 40% more than the units bought with the first monthly installment!

One lives and learns. The only people who get rich from your SIP is the fund manager. SIPs provide a steady monthly (or quarterly) revenue to the fund without the fund manager spending any time or effort in selling the fund.

In a trending market - whether it is moving up or down - a SIP will always make your average cost per unit much higher than the cost you will incur at the beginning of an up trend or the end of a down trend.

Is a SIP completely worthless? No, it works if a market is moving sideways - some times up and some times down within a range - without a clearly discernible up trend or down trend. How often do such sideways movements happen?

Not very often, and even when they do, they last for a short period of 3 weeks to 3 months - not long enough to benefit from the price averaging that a SIP will provide.

So heed a word of advice. Buy some good Darjeeling tea and learn how to prepare a proper brew. Savour the taste and flavour by taking small sips. And avoid SIPs.

(Note: No, I haven't joined a tea company. But I have alluded to another investment myth: Timing the market vs. Time in the market. That myth will get debunked in a future post.)