Mutual Funds: Diversified or Sector focused

Diversified mutual funds are any day better than sector focused ones. Here’s why.

There are myriad options when it comes to choosing mutual fund schemes. But most equity funds fall under two buckets: diversified and sector focused. Diversified equity funds invest in shares of companies across industries: manufacturing, services, infrastructure, technology, consumer products etc. Sector focused equity funds on the other hand invest only in shares of companies in select industries that are pre-defined as per the mandate of the fund. Examples of sector-focused funds are Power Fund, Infrastructure Fund, Energy Fund etc. The question is - which category is safer and better for the long term.

Before we pass a verdict, let’s first try to define what’s the principal reason for people to invest in an equity mutual fund, which for all practical purpose is merely a conduit for investing in stocks. If you ask me, I would say it is their indisposition towards investing directly in stocks. Why else would people give their money to a third party to invest on their behalf? There is tax benefit, but I don’t think it’s the sole reason. So, assuming that we invest in equity mutual funds primarily because we feel inadequate to invest directly in stocks, the logical question is why then do we want to unnecessarily stick our neck out and choose a particular sector?

Here’s another way to look at the matter. Once we have decided to give our money to a mutual fund to pick stocks for us, would we rather have the fund pick stocks from a universe of 10 sectors or only from 1 sector? If the objective is to invest in stocks of the best companies at the best price, the larger the universe of sectors the better. Right? Given that a typical equity fund holds a portfolio of 20 to 30 stocks, the more the sectors the more the degrees of freedom available to the fund manager to choose the best stocks out there. In all my years of experience in investing, I have been unable to find more than 3 to 4 good companies in a single sector. Restricting a mutual fund to one or two sectors (the case with sector funds) means the fund manager is literally forced to buy stocks of crappy companies just to meet his portfolio target of at least 20 stocks. This process can be considered as being equivalent to adding sludge to raisins. Irrespective of the number of raisins, the end product is going to be “sludge”.

Sector funds usually become popular when a particular sector is “hot” i.e. when a lot of action is happening in the sector. Although rationally, this could probably be the worst time to invest in the sector. Even a sector with terrible long-term economics can become “hot” for a short period. This is exactly what happened to the textile sector a few years back. Most of the time, when a sector is “hot”, it implies investors are exuberant about that sector and this could lead to a bubble (inevitably followed by a burst!). Take the power sector today, for example. Many private power companies are coming out with IPOs and the already listed companies are raising further capital for mega-expansion plans. A lot of money is flowing into the sector to cater to the power shortage in our country. Obviously mutual funds that plan to focus on power sector are quite popular these days. What people fail to understand is that because of the pent up demand for stocks in power sector, most of them trade at very high valuations. While some of the stocks may actually deserve high valuations (assuming their rosy growth projections come true), many will fall by the wayside because of their inability to scale up, execute projects as per plan and operate efficiently. Afterall not all IT companies could become an Infosys, Wipro or TCS, could they? Investing in a Power fund today is similar to investing in a Tech fund in the year 1999. Although most Tech funds held stocks of Infosys, Wipro and TCS, they also held stocks of dozen other IT companies, some of which have since disappeared. This translated to pathetic performance of Tech funds, and tremendous wealth erosion for investors – a direct consequence of my “sludge” theory, discussed earlier.

In the short term, when a particular sector is in fashion, sector funds focusing on that sector will perform as if they are on steroids. But they may fall off the cliff anytime, wrecking their long-term performance. What matters in long term investing is identifying good companies and not what is “in” or “out” of fashion. Diversified funds are safer and better suited to accomplish this long-term objective compared to sector focused ones.

Q&A: Real estate investment woes

I bought a flat six months back in an up-and-coming suburb on the IT corridor as an investment, hoping to make good returns in the form of rental yield and appreciation. But I have been unable to find a tenant so far. In fact only a third of the flats in the colony are occupied. Because of this situation, I am struggling to meet EMI commitment and this is taking a toll on my personal life. Suddenly what appeared to be a safe investment has turned into risky one. What should I do?

Buying a home is not as easy a decision as it is made to sound. We Indians are by nature averse to take on excessive debt; at least our parents were. But today, with the proliferation of home loan schemes, homebuyers buy property by funding up to 85% of the purchase value with debt, without an iota of doubt about repayment. The fact is - home loan is just like any other loan and needs to be used with restraint, after fully comprehending that inability to repay will lead to forfeiture of property. You need to understand that although your bank would be willing to lend you what they ‘think’ is the maximum loan amount you are eligible, it is only you who is going to repay the loan every month. Therefore it is only you who has to finally decide the loan amount based on your risk appetite and accordingly pick the property that you can afford.

For the benefit of all readers, here are few basic tenets to keep in mind before buying property. The first rule is to not take more than 50% debt. Even companies hesitate to take loans worth more than 50% of their assets and I don’t think individuals should be any more confident. That is, avoid the temptation of buying a home, unless you have saved enough money to make down payment of at least 50% of the value of the home. By ensuring that you don’t fill up to your neck with debt, you can reduce the risk of drowning in debt! Secondly, make sure that there is a comfortable margin of safety (gap of atleast 50%) between your EMI amount and your monthly take home pay, even if your home loan interest rates were to increase. Third, remember that if you are going to depend on rentals to pay off your home loan, you need to have enough cash cushion to withstand atleast a year of ‘zero’ rentals, in the event that you do not find a tenant.

Now, coming to your issue of occupancy - the key reason for low occupancy in newly built apartments and townships that have sprung up in up and coming suburbs, is that majority of the owners have bought these apartments as second homes or ‘investments’ and very few buyers actually planned to live there. Everyone, like yourself, were convinced by the builders that it was a no-brainer investment that would pay for itself!! The rentals were projected to cover a significant portion of the EMI, and the value of the property was projected to double within a few years. What no one dared to ask was – what if neither happens?

Today many flats in these residential complexes are kept locked, awaiting ‘renters’ to live in them. Clearly, this is because of a yawning gap between demand for renting homes in these areas and the available supply of readymade homes. One reason for this gap is that many of the IT suburbs are still under nascent stages of development. Despite the proximity to office complexes, many of these areas are not very conducive to live in terms of availability of basic facilities and entertainment options. I am sure that few years down the lane, they will transform into holistic and comprehensive living communities, but at this point many IT suburbs have ‘work-in-progress’ written all over them. A renter prefers to spend some extra money on rent and extra time in commuting so that he can live in a better area instead of opting for an IT suburb that is still under development. The other reason is that the few renters who do want to live in these areas, see more rationale in buying rather than renting.

“Time” is the only healer for the current state of affairs. To address your immediate concerns, I suggest you reduce your expectations in terms of the amount of rent and see if that works. Try reducing the rent to such an extent that it becomes irresistible for prospective renters. In other words – “some rent is better than none”. You can always hike rentals when situation improves. Simultaneously, you can also speak to your banker and check if he/she can re-structure your loan by increasing the tenure and reducing the EMI. Although this option will result in higher interest outgo over the term of the loan, it will no doubt reduce your immediate EMI burden and protect you from defaulting. The last option is of course to sell your property. Now that the real estate market has started looking up, you may choose to trade-in for a smaller apartment that you can really afford. After all no investment is worth losing sleep over it!

Remember to adjust for inflation in your financial plan

Inflation is not merely a statistic. It is a reality that every household needs to plan for.

These days I see many ads of financial/ investment products brimming with optimism, telling you how easy it is to become a crorepati. While I am definitely a supporter of optimism, I am against the fact that the optimism fails to take an important truth into account – ‘Inflation’. Inflation is the rise in price of day-to-day ‘stuff’…be it food, good or services. High inflation is a reality in a developing economy such as ours. It is also a slow killer by gradually but continuously reducing the value of money and in-turn the value of your savings. Every one of us must have heard our parents/grandparents cribbing about how something that used to cost only a few annas in the not so distant past costs few hundred rupees today. That’s inflation at work.

Can you believe that pulses have generated better returns than your fixed deposit over the last few years? That’s right - your fixed deposit returns didn’t even compensate for food price inflation. Meaning - money in a fixed deposit account that matures today would buy you less food than it did a few years back, when you initiated the FD. So despite the appearance of safe and sound returns of 8% p.a., the reality is that your money has earned negative return and reduced in “real value”!

Welcome to the world of “real returns”. Most investment products highlight what is called as “nominal returns” i.e. the rate at which your money will grow as a number. But just because your money is growing in “number” doesn’t mean that it is growing in “real value”. To know what is the growth in “real value” of your money, you need to adjust for inflation.

But how do you measure inflation? Well, the government seems to believe that the Wholesale Price Index (WPI), which computes the change in wholesale price of a set of commodities, is the right measure of inflation. But commodities are not the only “stuff” we consume and secondly we don’t buy them at wholesale prices. What’s more relevant to urban residents is another inflation index called the Consumer Price Index (CPI) for industrial workers, an index that is least publicized. The CPI calculates the change in consumer price of a set of goods and services such as food, clothing, fuel, housing, medical, transport, education etc. According to the most recent CPI data, the inflation is around 11.5% p.a.!! That’s how much more expensive things have become. In other words, that’s approximately the amount of value that your money has lost over the last one year, if you are an urban resident - a figure that is stark but nonetheless real.

Sample calculation for including inflation in your financial plan

Let’s say you have estimated that you need Rs 1 crore in today’s money value to retire, 20 years from now. Let’s assume that for this purpose you plan to invest fixed amount every month in a balanced equity mutual fund with a long-term track record. Being a conservative mutual fund scheme, you expect it to deliver approx 15% p.a. over the next 20 years, in line with the long-term average of stock market returns. How much money do you need to save and invest every month to attain your goal? Keeping inflation aside, the amount of money that you need to save works out to be very pleasant - just Rs 6700 per month! I am sure you are surprised at how low the number is.

But wait till you fast forward twenty years from now, and you will be in for a rude shock. Although you may have 1 crore in savings, you’ll realize that it’s no longer enough compared to the much higher cost of living prevalent then, thanks to inflation over the twenty year period. In fact if the amount of inflation over the next twenty years is going to be similar to what has happened over the last twenty years, you can reasonably expect around 6% annual CPI inflation. This would mean that twenty years from now your Rs 1 crore would be only as good as having Rs 31 lakhs today! i.e the value of money would have shrunk 3.2 times. If you don’t think Rs 31 lks is sufficient for you to retire today, Rs 1 crore will not be sufficient for you to retire after 20 yrs. Here’s how you can calculate the “real value” of future money:

Real value (in today’s money value) of Rs X, which will be available Y years from now =
X / (1+ annual inflation)^Y

Real value (in today’s money value) of Rs 1 crore, which will be available 20 years from now = 1 crore/ (1+6%)^20 = 1 crore/ 3.2 = 31 lks = shrinkage of 3.2 times

So, if your objective is to have Rs 1 crore in today’s money value, 20 years from now, you need to aim for total savings of Rs 3.2 crores and not just Rs 1 crore (to accommodate for shrinkage in money value by 3.2 times as a result of inflation). This means you need to invest approximately Rs 21,440 every month and not just Rs 6700 per month!! Do you see the difference of adjusting for inflation?

Ideally, you need to incorporate inflation in calculating how much you need to save for all the major financial commitments that you foresee in the near future – be it kids’ education, college, marriage etc. The only way to beat inflation is to prepare for it, well ahead. It’s therefore imperative that we adjust for inflation in setting our financial goals and planning for the same. Not accommodating for inflation leads to chronic under-saving - the impact of which is usually realized only when it’s time to use the savings.