TESTON - Online Testing Engine

How mutual funds can be used for financial planning

This time, like all other times, is a very good time, if we but know what to do with it." - Ralph Waldo Emerson

Financial Planning couldn’t have been summed up better; to put it simply it allows an investor to know today what is required for achieving financial goals tomorrow.

A financial plan helps an investor in the following ways:

• Enabling investors to identify his goals and investment needs.


• Understand the various financial products with respect to their risk, return, liquidity and maturity profile.


• Combine the features of financial products with the investor’s financial needs and determine appropriate mix of investments, technically referred to as asset allocation.


• Suggest suitable instruments as part of asset allocation Mutual fund allows a financial planner (read investor) to enhance the effectiveness of his financial plan in the following fashion:

Diversification as practiced in financial planning can be done at three levels by assets, investment style and management style.

• Diversification of assets – Assets can be diversified on many levels for example holding a mix of stocks, bonds and cash. Possibly then by geographic sector taking advantage of global opportunities and the fact that if one economy is weak, another is strong. And then by economic sector, to include a variety of industries, because when one industry is slowing down, another is picking up. Each of these diversifications will serve to increase returns and reduce risk.


• Diversification of styles - Each asset class is then diversified into multiple investment styles - such as growth, value, and opportunities. c. Diversification of managers - Portfolio returns can be enhanced by using multiple managers with complementary investment styles who react in their own ways to varying market conditions.
  However, we opine investors not to provide primacy to the fund managers in the diversification criteria.

Except for the most conservative portfolios which do not hold equities, every portfolio should be
diversified to hold all major assets classes:

• Cash for security and liquidity, so that one can take advantage of opportunities as they arise


• Bonds, to help preserve capital and provide a steady income


• Stocks, for growth to help you beat inflation and counter the impact of taxes


• Real estate, because of their low correlation with stocks and bonds


• Gold, for its ability to be a hedge against uncertainties

An important inference could be, that one should spend considerable amount of time and energy in choosing a tailor made or customized asset allocation strategy. Once the strategy is in place, then the next important action point would be the instruments to fulfil the role of respective asset classes.

Most portfolios are structured with 5 financial objectives in mind:

• Growth


• Income


• Inflation protection


• Peace of mind and preservation of capital


• Minimize taxes

A financial planner has to balance the importance of each of these, and keep them in mind as he goes about structuring a portfolio. There is no such thing as an optimal balance that’s right for everyone. The balance is a personal choice depending on the relative importance of these factors for a given investor. While doing financial planning through mutual funds, one must try to answer the following questions.

Knowing the objective of investing enables the investor to select the right options offered by a mutual fund house. For example, if an individual has a long term objective, then he may go in for a long term equity fund and for investors with short term objectives or needing intermediate returns, a liquid fund is the right option.

Time horizon refers to, when does the investor want to enjoy the fruit of investment? This ascertainment is critical because both, the risk and the reward of investments can vary according to the time horizon. Generally, a longer horizon allows for more aggression in investment. The less time, the more one needs to avoid risk.

There is a risk-reward continuum running from cash to bonds to stocks. Returns are commensurate with the risk someone is willing to tolerate. Risk has other dimensions investor to replace capital. If not earning any income, replacing lost capital will be difficult, which means a more conservative approach. Other considerations could be the present financial situation, estate planning and level of taxation. One other important factor is age. As a general rule, the younger one is, the more aggressive someone can afford to be with their investment portfolio. This is because the investor has more time to recover from any possible setbacks in the value of the portfolio.

Rebalancing is the action of bringing a portfolio of investments that has deviated away from target asset allocation. The goal of rebalancing is to move the current asset allocation back in line to the originally planned asset allocation. Rebalancing is primarily warranted under conditions where the returns have significantly deviated than expected or to stay in line with market conditions. For example, an equity heavy portfolio needs to be restructured in contraction phases where company profits are hit harder and interest rates move up. It could be done by moving a portion of equity holdings to debt instruments. Mutual funds probably allow the easiest window to rebalancing due to their diversity of offerings. A case would be help to understand better on rebalancing. Mr X has planned for his son’s marriage in 2020, for which the estimated cost in 2020 would be Rs 1.7 crores. In 2010 he is advised to invest Rs 70,000 in equity and Rs 30,000 in Debt assuming an average return of 12% for equity and 5% for debt the expected value of investments at year end would be 78,400 for equity and 31,500 for debt. At year end, at 8%, the equity markets performed worse than expected and at 14% the debt markets performed better than expected. Hence, the portfolio value, instead of the planned Rs 109,900 ended up as Rs 109,800. Consequently, the ratio of debt to equity changed from the original 70:30 to 69:31. To rebalance the portfolio, Mr X has to liquidate his debt holdings by Rs 2,700 and invest in equity and also add Rs 100 cash from his own personal reserves.

Where mutual funds score head and shoulder over other instruments in a financial planner’s eyes is when it comes to tax efficiency and reduction in transaction charges. Imagine a scenario where a person holds the individual stocks BSE-Sensex in the same proportion as it is meant to be and another person holds a unit of an index fund. The chances are that the Mutual Fund unit holder

would be a happier person for the fact that:

• The mutual fund unit holder is safe from transaction fees the stockholder might have to pay for using his DEMAT account for equity trading


• The incidence of capital gains tax would be zero for a mutual fund holder as it is the fund which is involved in equity trading and that equity trading is considered primary business and hence is exempt


• Dividends declared by equity-oriented funds (i.e. mutual funds with more than 65% of assets in equities) are tax-free in the hands of investor. There is also no dividend distribution tax applicable on these funds under section 115R. Diversified equity funds, sector funds, balanced funds are examples of equity-oriented funds.

Thus, mutual funds allow the financial planner to align the investment goals on the mantra of DIVERSIFICATION + PATIENCE = SUCCESS To invest prudently in a mutual fund, one can taking into the account the following 10 pointers for the concluding quick read.

While investing in mutual funds, an investor must primarily broadly look at the following 10 points, which enable them to select the right one:

• A fund sponsor with integrity
  
  Investors must check the sponsor's (promoter) record in the financial services arena. Apart from a consistent and clean record in financial services, sponsor(s) should have requisite experience and background in managing mutual funds be it in India or overseas.


• An experienced fund manager The fund manager must be experienced, which is best reflected in the returns he has generated on funds previously/currently managed by him.


• A suitable investment philosophy Every fund manager has his own individual style and investment philosophy. While some managers are aggressive, others are passive. Investors must choose the fund that best reflects and matches his own investment philosophy.


• The correct fund by nature Funds are either open-ended or close-ended.

An open-end fund is available for subscription throughout the year. Investors have the flexibility to buy or sell any part of their investment at any time at a price linked to the funds NAV.
www.Personal FN.com 55

A close-end fund begins with a fixed corpus and operates for a fixed duration. The fund is open for subscription only during a specified period. When the period terminates, investors can redeem their units. Close-ended funds may be listed on the stock exchanges to impart liquidity to the investment.

 

Mutual funds offer different categories. These can be classified as:

They seek to provide a regular source of income by investing in fixed income securities like debentures and bonds.

They aim to grow money over time (i.e. capital appreciation). Here, the investment focus is mainly on stocks/shares. Historically, stocks have outperformed other asset classes like bonds, fixed deposits, gold, and real estate over the long term - 10 years.

The fund attempts to maintain a balance between fixed income securities and equities in a pre-determined ratio like 60:40 equity - debt for instance. The investor must invest in mutual fund categories, which meet his criteria in terms of need for regular income, capital appreciation, and safety of principal.

Asset management companies (AMC) charge a fee for managing investor monies. In other words, your mutual fund deducts charges and fees from the net asset value (NAV) of the fund. As an investor you must be aware of the fees and charges of the AMC. Two schemes with more or less similar performances would generate different returns if one of the two schemes charges higher fees.

An investor may be required to pay a load either at the time of selling the units. Again, the returns of two similar performing schemes may vary depending on the load charged by the scheme to the investor.

The investor needs to understand the tax implications before investing in mutual fund schemes. Currently, if an investors exits (sells) his equity oriented fund prior to the completion of 12 months of his holding period, he will be liable to pay a short-term capital gains tax @ 15% + 3% education cess. However where an investor exits (sells) his equity oriented fund after the completion of 12 months of is holding period, he will not be liable to the payment of long-term capital gains tax. The dividend earned on a equity oriented is also exempt from tax. Tax-saving funds (commonly known as Equity Linked Saving Schemes (ELSS)) offer a tax benefit to the investors under section 80C of the Income Tax Act 1961, where an investor is eligible for a deduction for sum upto Rs 100,000.

Services offered by mutual funds (MFs) may vary across funds. Some MFs are more investor friendly than others, and offer information at regular intervals. For instance, some funds disclose the expense ratios, an important criterion for fund selection, once a year, some disclose it once every 3 months, while a few disclose it every month.

Every fund is benchmarked against an index like the BSE Sensex, Nifty, BSE 100, BSE 200, CNX 500, etc. The investor must track the fund's performance against the benchmark index. He must also compare its performance with other funds from the same category. He should also see the fund's calendar year performances over the years.