The long and short of money

COVERY STORY

Mutual funds continue to be the best place to park your money for the short, medium and long term, considering the benefits of diversifications and tax-efficiency.

The Budget has hardly changed anything to warrent a re-look at your personal investment strategy. But there are other reasons to do so. Stock markets have run up to dizzy levels and yet showing no signs of fatigue.

Thanks to buoyant markets, mutual funds are launching new schemes, each claiming to be different from the crowd, making them as difficult to pick as stocks. Then, the real estate prices have skyrocketed all across the country right from the rural hinterlands to downtown Mumbai.

The debt markets remain turbulent, but the scarcity of money is presenting investors with an opportunity to lock funds into high yielding deposits or bonds at levels one could not think of a year ago.

Against this backdrop, the finance minister has been generous in the sense that he has now transferred the power to choose where to invest to the investor by putting investment avenues on par as far as tax breaks are concerned. So, where do you put your money to earn the best you can out of every penny? Here are a few for your takes.

Fixed options
As far as taxability goes, mutual funds still have a favourable tax structure. Currently, debt-based mutual funds are required to pay an effective dividend distribution tax of 14.025 per cent (including the 10 per cent surcharge and 2 per cent cess). This income is tax-free in the hands of the investor.

Besides, units sold within one year qualify as short-term capital gains and are subject to tax at the marginal income-tax rate. Units sold after one year attract long-term capital gains of 20 per cent plus a surcharge of 10 per cent and 2 per cent cess after availing of indexation benefits or a flat 10 per cent plus a surcharge of 10 per cent and 2 per cent cess.

Indexation is a relief provided by adjusting the return on which tax is calculated downward, to allow for reduced buying power of the saved amount due to inflation during the period of saving.

If you are looking for a fixed income product with a holding period of less than one year, dividend plans of debt mutual funds score over fixed deposits, especially if you are in the highest tax slab. Here, the tax incidence is half that in other deposits.

However, most people fear mutual funds because of the volatility in their returns. How does one avoid volatility in mutual funds? Rather, how do you ensure that you do not incur a capital loss and also a basic minimum return?

The answer lies in fixed maturity plans (FMPs) of mutual funds. These mutual funds work exactly like fixed deposits. You get a pre-determined return based on current market yields "� of course, after deducting fund management expenses, which are lower than regular debt funds as there is less churning.

Since the fund manager holds the instruments till maturity, the returns are predictable. Besides, as there is no regular churning of the portfolio, the overall cost of transactions is reduced significantly.

Investors with a time horizon of more than one year may actually end up paying zero tax by using a trick called double indexation. Double indexation gives the investor the advantage of indexing his investment to inflation for two years, while remaining invested for a period of slightly more than an year.

This can be done if the investor puts in his money just before the end of a financial year and withdraws it immediately after the end of the next financial year. Now is the right time!

Every other mutual fund is launching FMPs these days and most of them indicate post-tax returns of about 7.5 per cent. But mind you, these are indicative returns that are most likely to be achieved. But not exactly assured. All the FMPs launched in the past one month have indicated post-tax yields of over 7.5 per cent.

These look really attractive given that the best one year deposit rates are still in the range of 6.5 to 7.5 per cent. Your post-tax returns thus will be a third lower if you happen to fall in the highest tax bracket.

You can invest in FMPs only during the initial offer period. Moreover, these schemes usually open for subscription for only a couple of days or so. Thus, you need to tell your fund distributor to alert you whenever a scheme is launched.

Another option for investors looking for stable returns is monthly income plans (MIPs), if they are willing to take a bit of equity exposure. MIPs usually have an exposure to equities in the range of 15-20 per cent on an average. With equity markets still having potential for steady returns, MIPs can deliver better appreciation than plain vanilla debt funds. The average MIP return for the past one-year period is around 10 per cent.

If you have a time horizon of five years or more, the conventional post-office schemes are the best option, apart from equity or equity-oriented mutual funds.

For the time being, income funds and gilt funds are eminently avoidable since these are most vulnerable to interest rate jitters. For those looking to park money for the short term, the best avenue is cash funds or liquid funds.

These funds currently deliver returns in the range of 5-5.5 per cent. Since cash funds are open-ended, you can redeem your units at any time. So, money is really available on call!

While choosing a cash fund, make sure that you choose a fund with low expense ratio. Since returns in cash funds are anyway in single digits funds with more than 1 per cent ongoing expenses are avoidable.

See table 'Cash In' for a listing of funds that have delivered over 5 per cent returns over the past one year and have expenses of less than 0.55 per cent. 
 

CASH IN (Cash fund returns for the period ending March 4)
	1-year return (%)	Expense ratio
Birla Sun Life Cash Manager	5.33	0.43
Grindlays Cash	5.17	0.54
DSP ML Liquidity	5.65	0.45
HDFC Cash Mang Savings	5.55	0.45
Tata Liquid	5.31	0.37

SIP on mutuals
For the past three years in a row, equity funds have fared exceeding well driven by high power stock returns. In 2003, equity diversified funds managed a whopping 110 per cent. Then in 2004, despite the May 17 mayhem, equity funds delivered a decent 26 per cent return.

For 2005 again, equity funds delivered 47 per cent return. The best performing FMCG category gave a return of 63.42 per cent on an average, followed by technology funds at 49.91 per cent and tax planning funds at 49.11 per cent. Even the least impressive category -- petroleum sector fund -- returns amounted to 17.77 per cent in 2005.

Fund managers are prompt to point out that, going forward, things are unlikely to be as good as in the past two years. Still the good news is that equities should continue to give returns which are better than any other asset class, stray cases apart. Clearly investor expectations are high.

In the next three to four years, one can expect equity returns of 15 per cent or thereabouts pretty much in line with the market. But then, as the going gets tougher not all fund managers will perform equally well. If anything, the difference between the good and the bad will only become more apparent. That means it is better to go with fund managers who have proved their worth over a longer time period.

Would it be wiser to invest in index funds? May be not. Since India is still a growing market, there is tremendous value fund managers can add by identifying potential winners at an early stage. Such a strategy can deliver better returns over the long term, though it goes without saying that one has to bet on the right manager.

How investors approach their equity investments will depend on their risk appetite. If one is looking for safety, then it is better to go in for large caps. However, even at the current market levels, growth is likely to come from the mid-cap segment, though the risk is definitely higher there.

The best (and most peaceful) way is to get invested in a diversified equity fund managed by a fund manager with a good track record through a systematic investment plan (SIP). Besides, equity linked savings schemes are the best bets in today's market as it is almost like buying stocks at a 33 per cent discount, thanks to the tax deduction. 
 

STOCK IT (Top equity funds for five year ending March 4)
	5-year return (%)
Reliance Growth	55.88
Reliance Vision	53.81
Franklin Prima	52.94
Magnum Contra	52.34
HDFC Equity	45.28

Long or short, equity is the best?
While there is no question that stocks look a lot more expensive than in the past few years, valuations do not look to be at unsustainably high levels. The government thrust on infrastructure and the rural economy is likely to be a key demand catalyst and will help the economy keep up or outpace the past year's growth rate.

Since the beginning of the rally in May 2003, the Sensex has more than tripled, buoyed by phenomenal foreign fund flows which have been backed by solid corporate performance. Earnings have grown over 25 per cent per annum over the past four years, but now expectations are that growth will slow down though the long-term story still remains intact.

Though topline growth would be strong, companies will find it difficult to keep up their bottomline growth. Savings on interest costs and salaries are already at rock bottom and may be set to rise marginally while depreciation expenses will begin to rise with plant expansions underway.

Analysts predict that earnings growth for the year would be around 15 per cent. So, stocks which already seem to be trading at a notch above what earnings can justify, market returns for them can at best mimic earnings growth. There could be surprises on the upside if the economic growth rate continues to be strong and that drives corporate performance beyond what is expected.

More significantly, retail investors have largely been spectators in the current rally and the retail hysteria, which accompanies every market boom, is yet to materialise. In all likelihood, even as foreign investors continue to pour more money, domestic investors could join the bandwagon and drive the market to even higher levels.

But as proponents of Warren Buffet would say, the margin of safety in stock today is very thin. This means two things: One, it would be safer to venture in stocks with a long-term view as intermediate corrections could be a distinct reality. Two, there is a strong case for investing in established companies with a track record than those that are driven by hope and faith since in several sectors, the valuation gap between large and small companies has narrowed considerably.

While consumption and infrastructure will continue to do well this year too, it may be time to take some contrarion bets on FMCG and technology as these sectors are still under-owned.

Since the secondary markets are still going strong, there are a large number of companies approaching the markets to raise capital. Most IPOs that have beat the market this year have listed at substantial premiums, even if the valuations were a bit on the expensive side.

Investors often have the temptation to increase allocations to IPOs that yield quick gains. This strategy may land one in trouble if the market mood changes suddenly. So, while applying for IPOs for listing gains is fine, it is better to be discerning about the company one is investing in and stock valuations at all times.