If you just started thinking about investing and trying to learn about the stock market, technical analysis is all you hear the most – support, resistance, trends, etc. For many people who did not have any formal training in investing, technical analysis may feel synonymous to stock market trading which is a faulty assumption. One of the reasons for popularity of technical analysis is that it does not take much time and training to start trading- but becoming successful is a different story. That is why you need to understand the basics of technical analysis, though the assumptions and theories behind it.
DIFFERENCE BETWEEN FUNDAMENTAL ANALYSIS AND TECHNICAL ANALYSIS
The basic difference between fundamental and technical analysis is that the fundamental analysis is dealing with Value and the technical analysis is based on Price. Allow me to elaborate.
Consider you are thinking about buying/selling shares of a particular company. If you are doing fundamental analysis the question you are dealing with is what is the intrinsic value of the stock. For that you can do a top-down or bottom-up analysis. In a top-down approach you start with the economic conditions, industry and at last consider the company specific factors. In a bottom-up approach you start with the company specific factors. In both ways, the goal is to determine the true or intrinsic value of the company and the stock. Then you compare whether the market is undervaluing or overvaluing the stock and make a buy/sell decision. The analysis is mainly based on value.
The approach in technical analysis is completely different. A technical analyst does not care about the value – the only thing matters to her is the trends in the price and volume of the stock. It is the timing that matters. If she considers that the prices will go up, she buys and if she considers that the prices will go down she sells/shorts the shares.
With this, let us delve into basics of technical analysis.
BASIC ASSUMPTIONS IN TECHNICAL ANALYSIS
1. Efficient Market Hypothesis : This hypothesis postulates that the securities prices reflect all the publicly available information. Here information includes the fundamental factors and market psychology.
2. Price depends only on demand and supply : All other factors are reflected in the demand for a security.
3. Markets tend to repeat itself and prices follow trends. These trends are primarily due to cycles of greed and fear.
THEORIES GUIDING TECHNICAL ANALYSIS
1. Dow Theory:
This theory was developed by Charles Dow, who co-founded the Dow Jones and Company. According to this theory, the stock price movement is governed by three cyclical trends-
a. Primary Trend: Long term trend, ranging 1-3 years.
b. Secondary Trend: Medium term trend running few weeks to a few months.
c. Minor Trend: Short term ranging to a few days to weeks.
2. Elliott Wave Theory:
According to this theory the market moves in waves that follows a Fibonacci Sequence (1, 2, 3, 5, 8, 13, 21, 34, 55 .....). According to this theory the market moves in five distinct waves on the upside and three distinct waves on the downside.
3. Kondratev Wave Theory
This is an economic theory which postulates that growth in economic sectors behave in long-term waves of 40-60 years, which consists of interval of high and low growths.
Before we get into the cryptocurrencies, let us understand the basic concepts.
WHAT IS A CURRENCY?
There are different facets of currency – it is the unit of money, medium of exchange and can be an asset class for investment.
Currency can be of different types based on how value is assigned to it.
1. Fiat Currency – The government and the free market determine the value. Most currencies are Fiat currencies now.
2. Asset Backed Currency – These currencies are guaranteed by some asset, such as Gold or Silver.
3. Commodity Backed Currency – These currencies used to be backed by commodities such as tobacco.
4. Digital Currency – The most modern one, digital currencies derive their value from the scarcity imposed on them by the difficult process of mining them by solving difficult equations.
WHAT IS A CRYPTOCURRENCY?
Cryptocurrencies are a special type of digital currency, which uses cryptographic techniques to Secure and verify transactions. The most known cryptocurrency is Bitcoin. Apart from that there is Bit Coin Cash, Litecoin, Dogecoin, Ethereum etc.
Most prominent technology for a cryptocurrency is blockchain. Blockchain is based on the concept of distributed ledger which can ensure secure transactions without any third party like banks or other financial institutions.
CRYPTOCURRENCY AS A MEDIUM OF EXCHANGE
What can act as a medium of exchange – when the other party recognises the value of it. For example, currency notes are simply printed paper, but the government guarantees the value assigned to it. A currency note does not have any intrinsic value associated with it.
In case of cryptocurencies there is no central guaranteeing authority. So, the effectiveness of the cryptocurrencies as a medium of exchange depends on the number of people and authorities consider them as a valid medium of exchange.
Another issue is the rapid change in purchasing power due to high volatility in the cryptocurrencies.
CRYPTOCURRENCIES AS AN ASSET CLASS
Are currencies an asset class ? This is a much debated question. Some may argue that because there are no benchmark, currencies should not be considered as an asset class. But, people do put their money on foreign exchange market. Even if we consider the currency an asset class -we have to agree that this is highly speculative. But, there is some understanding on the factors such as interest rate, demand for exports of the country etc., on the direction of a fiat currency.
On the other hand, the direction of cryptocurrencies is much less understood and can be completely arbitrary. The behavior of cryptocurrencies, at least now, is more comparable to speculative bubbles such as the Tulip Mania.
CRYPTOCURRENCIES IN INDIA
The cryptocurrency ecosystem is struggling in India due to regulatory issues. Given the decentralized nature of cryptocurrencies, it is a threat to the Anti Money Laundering measures taken by the regulators. In 2017, the Income Tax department sent notices to around five lakh people dealing in cryptocurrencies. In April 2018, RBI prohibited all regulated entities (means all financial institutions) providing services to persons and entities involved in virtual currencies. The services include “maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer / receipt of money in accounts relating to purchase/ sale of Vcs”. Earlier, the Finance Minister stated that India does not recognise virtual currencies as legal tenders.
This effectively segregated the financial system from the virtual currency ecosystem. The crypto exchanges, including Zebpay, WazirX and Unocoin etc. approached the Supreme Court but SC did not remove the ban. In September 2018 Zebpay, which was the largest Crypto Exchange in India, closed operations.
Business Standard reported in September that the Indian Government is considering launching a cryptocurrency similar to Bitcoin.
The basic steps of Financial Planning – either simple Goal Based Planning or Comprehensive Planning are -
a. Determining the current financial situation.
b. Developing and financial goals – Necessary Goals and Aspirational Goals.
c. Creating a plan to achieve those goals.
d. Create and evaluate alternative paths to achieve those goals.
e. Implementing the financial plan
f. Review and Revise the plan.
One component of evaluating financial situation is assessment of assets. Asset is a simple language means something which can create future cash-inflows or save cash-outflows . For example, if you own a car – it saves your transportation cost (hopefully) and also if you sell it in the future, you can get some cash in return. Similarly, if you own some Mutual Fund units – you can earn some dividends and get some cash at redemption.
But, most of the time our financial planning ignores the biggest asset a young person owns – the present value of his lifelong earnings which is also called Human Capital. Does your financial plan, consider Human Capital?
WHAT IS HUMAN CAPITAL ?
Human Capital represents the expected present value of lifetime earnings. Most of the time while creating our financial plan, we consider that our income will grow at a constant rate. While it can true in some cases, in most cases the uncertainty associated with our income can be much higher and vary person to person. As the concept of Human Capital represents our future earnings as an asset, we can include this to our current assets and manage it as part of a portfolio.
Every asset is represented by two factors – Value and Risk or Uncertainty. For example, if you own a share – there is a current market price of the share and uncertainty about the future value represented as volatility.
Likewise, we can always estimate the value of Human Capital based on certain assumption, but we should not forget that this value can be changed.
VALUE OF HUMAN CAPITAL ?
The Human Capital can be estimated is Discounted Cash-Flow method. We can project the future income till our retirement from current income and an assumed growth rate and then discount them with a proper discounting factor. The discounting factor is the sum of risk free rate and risk premium based on the uncertainty of the future earnings. For example, a person who earns through commissions has higher uncertainty about future income than a person with a secured regular income. So, even though the person earning in commission may have higher earnings currenty, the Human Capital value can be lesser than the person with secured income.
HOW TO INCREASE HUMAN CAPITAL VALUE ?
In simple language Human Capital represents our long-term earning ability. People often look for ways to increase income, but often do not take the consideration of the uncertainty associated with such increased income. For example, contract jobs may offer higher earnings, but also has an inherent uncertainty. Increase income does not necessarily mean increased Human Capital.
Two factors influence the value of Human Capital – Income and Risk Associated with your income. To increase the value of Human Capital you can either increase your Income, lower the risk associated with your income or do both.
Concept of Human Capital as an asset enables us to think our income ability as malleable and not fixed. Consider you have a property and you are renting it out. The rent is lower compared to similar properties because of shabby condition. You can increase the rent income from this property by investing some amount one time. Likewise, investing in your Human Capital may increase the long term income ability. Investing in Human Capital can take the form of higher education, immigration to a different country or investing in social skills.
Risk associated with Human Capital can be reduced by opting for a secured job over commission based or contract jobs. Developing a diverse skill set is also one way of reducing the risk of Human Capital – this increases the predictability of cash-flows.
The financial system works on trust. Trust is formed mainly through familiarity. Let me explain this with an example. Consider you have some surplus money which you are willing to lend out to earn some interest. Now, who would you lend to? – most will limit lending to the people they personally know. This limits the availability of credit to many people.
Another issue is – how much interest should you charge? Logically, you should charge more interest on loans which are riskier than the less risky ones. But, how do you determine the borrowing behaviour of the borrower – which partially determines the risk of the loan. Even if you personally know this person, you may not have all the information about their finances and you have to depend on the information they provide to you – this is called information asymmetry i.e. difference between information available between the borrower and lender. One way to deal with this situation is to take a blanket approach and base the lending rate on the overall default rate and charge everyone the same interest rate. But, this encourages bad credit behaviour because people who managed their finances well carries the burden of people did not.
So, what is the solution of this problem. What if there is a central database of all borrowers from which a lender can know their past borrowing habit and base the lending decision and interest rates on that – this is the rational behind creation of Credit Bureaus and Credit Information Companies (CIC).
A Credit Bureau collects the information from lenders and provides the information to a Credit Information Company (CIC( who stores the information and provides the information to lenders. There are four CICs in India – CIBIL, Equifax, Experian and High Mark Credit Information Services.
WHAT IS A CREDIT SCORE?
A Credit Score is summary of credit history represented in three digits ranging between 300-900. It is derived from past credit behaviour of the borrower as represented in Credit Information Report (CIR) and indicates the “probability of default” based on credit history.
Your credit score is calculated based on your credit history, credit utilisation, length of credit history, recently reported balances and new credit accounts etc.
HOW BANKS USE THE CREDIT SCORE?
Credit Score is one of the first checks for a loan application. So, a good Credit Score increases the chances of getting a loan. Generally a Credit Score of 750 and higher is considered good. Apart of Credit Score, banks also check current loans and behaviour which is reflected on the Credit Information Report (CIR).
A good Credit History is the necessary but not sufficient criteria to get a loan. The lenders also want to evaluate your ability to pay back in the future. One of the way to do is calculate the ratio of your current EMIs and your current income. The lender can decide how much EMI you will be able to pay comfortably in addition to current EMIs.
ARE CREDIT SCORES FROM DIFFERENT CICs EQUIVALENT ?
It may not be. As different CICs use different methodologies to calculate the scores and source of their information may also vary. That is why if you are thinking about taking a loan, you should check your Credit Score from all the CICs – not just one.
ARE CREDIT REPORTS ALWAYS CORRECT ?
Not necessarily. The correctness of the Credit Report depend on how updated the data is with the CIC. The lenders from which you took loans before may fail to report information on your repayment. The Credit Card which you requested to close – may show up as active. This is why CICs allow you to raise disputes on the reports.
Given how important the Credit Reports are – you should check Credit Reports from all CICs considerable time before your are planning to apply for a loan. This will give you time to raise and close a dispute and contact the past creditors for reports on your repayment.
Consider a very common situation, you have invested your savings in a mutual fund scheme and now you need money for an emergency. One option is to just sell some mutual fund units and use the money. But, you may face certain difficulties. For example, redemption of mutual fund units may result in short term capital gains tax, a capital loss due to market situations, exit loads due to redemption before a specified period etc.
One way you can still fetch some cash without selling mutual fund is taking a loan against mutual fund units from a Bank or NBFC. It works like any other loan against an asset (secured loan) but in this case the lender takes lien of the mutual fund units.
WHAT IS A LIEN AND HOW TO GET A LIEN MARKED?
A lien is a document which gives the lender right to hold and sell the mutual fund units as collateral for the loan. To get a lien marked, the unit holder needs to write to the mutual fund, specifying his folio number, scheme name, number of units to be charged, and the person in whose favor the charge is to be created. According to that the RTA makes the lien on their records.
The implication of a lien is that the unit holder will not be able to sell the units or offer them for re-purchase but will be receiving the dividends. After the loan is paid back in full the lien is removed and the unit holder gets full control over the units.
HOW MUCH LOAN YOU CAN GET?
Depending on the type of mutual fund, the bank keeps a margin – a loan of lower amount than the current market value of the mutual fund units. For equity mutual fund units or ETFs, you can get a loan of around 50% of the current market value of the units. In case of debt or FMPs the margin is lower say 15% and you can get 85% of the value as a loan.
WHAT IS THE INTEREST RATE ON THESE LOANS?
The rates differ from bank to bank, but lower than the rates on unsecured personal loans. For example, currently SBI offers 2 year personal loans at a rate of 12% - 14%, but charges a 10.95% interest on loans against mutual fund units. The rate is actually lower than loans against NSC.
Banks may charge any other fees such as annual maintenance charge, loan processing fee, stamp duties, prepayment charges, etc. The borrower should review all the applicable fees before taking the loan.
CAN YOU USE ALL MUTUAL FUNDS TO GET A LOAN?
No, each bank has a list of approved schemes they can take a collateral. Many banks do not take ELSS units which are still in 3-year lock in period as collateral.
WHEN YOU SHOULD NOT DO THIS?
Taking a loan against Mutual Fund units makes sense in the situation mentioned above. There are some situations when this is not advisable.
When the mutual fund is performing well – the loan will cost you interest and selling the units may be more cost effective than taking a lien against them.
When you are unsure whether you can pay back the loan – the lender keeps a margin and if you fail to pay back, the lender can sell the units to get their money back. In the process you actually lose more than you get through the loan.
Consider that you have a lower risk tolerance and want to protect your capital rather than grow it. May be you are a retired individual or a freelancer with a unreliable income flow. You want some equity exposure but only with the protection of your capital.
The opposite situation is also possible – maybe you have a high risk tolerance and want to invest solely for growth but also want a small debt exposure.
Dividend Transfer Plan (DTP) enables you to do that.
HOW DOES DTP WORK?
In a dividend reinvestment option the dividend is reinvested in the same scheme increasing the unit holding. In case of DTP the dividend is invested in another scheme of the same mutual fund. So, basically units of the second scheme are bought when a dividend is declared for the first scheme. For DTP, the investor has to hold a dividend option of the mutual fund scheme.
HOW TO OPT FOR DIVIDEND TRANSFER PLAN (DTP)?
Mutual Funds decide on the source schemes, plans and option from which dividends can be transferred and target schemes. There may be limitations on what kind of dividend plans can be used as the source scheme (for example, plans paying daily and weekly dividends may not be eligible).
The investors need to fill up a DTP form mentioning details of the source and target schemes. The existing choices such as dividend redistribution, etc. will automatically and cancel and DTP will take hold.
DIVIDEND TRANSFER PLAN (DTP) TAX IMPLICATIONS
In case of a Systematic Transfer Plan (STP), capital gains taxes are applicable in the hands of the investor. In case of DTP, tax is not payable by the investor for the transfer, but the scheme pays a dividend distribution tax on the distributed income. According to the last budget, a 10% (plus surcharges and cess) dividend distribution tax is applicable to the equity funds and 25% (plus surcharges and cess) on non-equity schemes including surcharges and cess. In case of a dividend plan, this tax is payable anyways.
Let us compare the DDT with a capital gains tax on a growth (i.e. non-dividend) option. In case of equity funds, the short term capital gains is 15%, which is higher than the DDT by 10% (plus surcharges and cess) on equity schemes. In case of long term holding (more than a year) the capital gains tax of 10% is only payable on gains over Rs. 1 lakh. So, only in case of long term holdings the dividend option has a negative effect in case of equity funds.
In case of non-equity funds, the short term capital gains are added to the income of the taxpayer. So, the capital gains are taxed at the marginal tax rate. So, whether the dividend option has any negative effect depends on the marginal tax rate of the person. If the marginal tax rate is lower than the DDT of 25% (plus surcharges and cess) , then there is a negative effect. In case of long term holdings (more than three years in case of non-equity funds), the capital gains tax is 20% with indexation benefits which is lower than the dividend distribution tax of 25% (plus surcharges and cess).
So, we can see that a growth option is preferred to a dividend option from a tax point of view mostly in case of long term holding. This makes Dividen Transfer Plan (DTP) more beneficial for short-term holdings as well.
Planning for distribution of wealth after death is an important part of financial planning. People often hesitate to think about this part because it reminds us about our mortality, but that does not mean we should avoid it. In this article we will discuss about transmission of mutual fund units in the case of the death of the unit holders.
The transmission of units depends on the folio conditions and nominations. In case of a joint holding if the first holder passes away, the second holder becomes the first holder even if there is a nominee. In a sole-holding with the nomination, the units are transferred to the nominee. In there is no nominee, the units are transferred to the legal successors.
Let us discuss the procedure for transmission in case of various situations.
Note: Nomination by itself does not transfer ownership. The nomination of some asset just gives the right to hold assets till a decision is made about the legal ownership.
DEALTH OF AN UNIT HOLDER IN A JOINT HOLDING
In this case, if the first holder passes away the second holders becomes the first holder. The following documents are required:
1. Letter from surviving unit holder(s) requesting the transmission.
2. Notarised/ Attested death certificate.
3. Details of the bank account of the first unit-holder attested by the bank manager with cancelled cheque or bank statement.
4. KYC of the surviving holders if not already submitted.
DEATH OF THE SOLE UNIT HOLDER OR DEATH OF ALL HOLDERS – FOLIO WITH NOMINATION
In this case the units are transferred to the nominee. The following documents are required:
1. Letter from the claimant(s) requesting the transmission.
2. Notarised/ Attested death certificate.
3. Details of the bank account of the new first unit-holder attested by the bank manager with cancelled cheque or bank statement.
4. KYC of the claimant(s).
5. If the transmission value is more than Rs. 200,000, an indemnity bond in prescribed format should be attached to the application.
If the nominee is a minor, then the documents of the legal guardian are required.
DEATH OF THE SOLE UNIT HOLDER OR DEATH OF ALL HOLDERS WITHOUT NOMINATION
In this case, the units are transferred to the legal successor(s). The following documents are required:
1. Letter from the claimant(s) requesting the transmission.
2. Notarised/ Attested death certificate.
3. Details of the bank account of the new first unit-holder attested by the bank manager with cancelled cheque or bank statement.
4. KYC of the claimant(s).
5. Indemnity bond from legal heirs in specified format.
6. Individual affidavits from legal heirs in specified format.
7. In the transmission amount is more than Rs. 200,000, then one of the following documents are required -
a. Notarised copy of probated will.
b. Legal heir certificate or Succession certificate or Claimant’s certificate issued by a competent court.
c. Letter of administration in case of intestate succession.
DEATH OF KARTA OF AN HINDU UNDIVIDED FAMILY
1. Letter requesting change of Karta.
2. Notarised/ Attested death certificate.
3. Certified Bank Certificate stating that the signature and details of the new Karta has been appended to the account of the HUF.
4. KYC of the new Karta.
5. If there are no claims or objections from any other surviving member of the HUF, then the transmission will be done on the basis of following documents :
a. Notarized copy of settlement deed
b. Notarized copy of deed of partition
c. Notarized copy of the decree of the relevant competent court
If the mutual fund folio is in ELSS which did not complete the mandatory three year lock-in, the nominee or legal heirs can withdraw only after one year from the date of allotment to the now deceased investor.
So, for some reason you had to sell Mutual Fund units at a lower NAV than the NAV at which you have purchased. Depending on the type of the fund and the holding period, you either realise a short-term or long-term capital loss. The Income Tax Act provides you the option to set-off capital gains (i.e. reduce the capital gains by the amount of capital loss) and carry forward the loss the successive assessment years. In this article, we will discuss the specifics of set-off and carry forwards with the limitations associated with them.
ADJUSTMENT OF LOSSES UNDER THE HEAD “CAPITAL GAINS”
Section 74 of the Income Tax Act 1961 provides the options to set-off the capital losses.
1. Short-term capital lossess can be set-off against both long-term and short-term capital gain.
2. Long-term capital lossess can only be set-off against long-term capital gains.
3. Any capital loss cannot be set-off against any other head of income apart from capital gains.
4. Any capital loss which cannot be set-off can be carried forward for a maximum of eight assessment years.
“DIVIDEND STIPPING” AND RELATED LIMITATION ON SET-OFF
Consider, an investor buys unit of a dividend paying mutual fund just before the dividend distribution for Rs. 10 per unit . Now, the fund declares a dividend of Rs. 1 per unit. The NAV is expected to go down by Rs. 1.1165 (11.648% Dividend Distribution Tax with surcharge and Cess assuming equity fund). So, the NAV is now Rs. 8.8835 and he sells the units realising a capital loss of Rs. 1.1165 per unit. As per section 10(34) of the Income Tax Act dividends are not taxable in the hands of the investor. So, the investor in this case gets a tax set-off benefit without actually experiencing a loss (except to the extent of the Dividend Distribution Tax). This is called Dividend Stripping.
Section 94(7) of the Income Tax Act puts restriction on the set-off and carry forward to discourage Dividend Stripping.
According to this section, if the units are bought within 3 months of the dividend record date and sold within 9 months of the record date, the capital loss arising out of these transactions will not be eligible for set-off against other capital gains upto the amount of the dividend gained. In the above example, the amount eligible for set-off against capital loss is Rs. 0.1165 (Rs. 1.1165 capital loss– Rs. 1 dividend).
LIMIT TO SET-OFF IN CASE OF BONUS UNITS
Consider another situation where an investor bought mutual fund units at NAV Rs. 1 just before a 1:1 bonus declaration. Now, logically the NAV should reduce to Rs. 0.5. If the investor sells the units, he on paper realised a capital loss of Rs. 0.5 per unit which can be used for set-off capital gains.
The above 3 month – 9 month rule also applies here. So, this capital loss is not eligible for set-off if the units were purchased within 3 months before the bonus record date and sold within 9 months after the record date.
One of the fears that hold back investors from investing in the stock market is “what if the company I invested in is a fake company and just disappear?” It may sound ridiculous to some, but this is a real phenomenon – many companies in the past did “disappear” after raising money from investors.
THE “VANISHING COMPANY” PHENOMENON
The first thing we need to understand that only listed companies can be “vanishing company”. A joint committee of the Department of Corporate Affais (DCA) and SEBI known as Co-ordination and Monitoring Committee (CMC) defines a vanishing company as below:
1. The company failed to file statutory returns with the Registrar of Companies (RoC) for 2 years.
2. The company failed to file returns with stock exchange for 2 years, provided it remains a listed company.
3. The company not traceable at its registered office location.
4. None of the directors of the company are traceable.
The CMC identified 238 companies as “vanishing company”. Out of which 77 companies remain in the list as of December 2017.
Before we get into more details, let us understand the structure of a Mutual Funds.
MUTUAL FUNDS STRUCTURE
As per SEBI guidelines, Mutual Funds in India need to be structured as trusts. A trust is a legal structure which holds assets on behalf of some other beneficiaries. The people who transfer the assets to the trust are called the sponsors. The people who are responsible to manage the assets are called Trustees. People who actually benefit from the assets are called the beneficiaries.
Note: Consider Mr. Roy wants to transfer assets to his grandchildren. Because of some tax considerations or some other reason, he creates a trust and appoints some trustees to manage the assets till the grandchildren become majors. Mr. Roy here is the sponsor and the grandchildren are beneficiaries.
In case of Mutual Funds, the unit holders are the beneficiaries. A financial institution such as a bank is the sponsor who creates a trust and appoints trustees. The trustees then appoint an Asset Management Company (AMC) by executing an Investment Management Agreement.
Although, the AMC manages the assets, they do not hold the assets. The trustees appoint a Custodian who holds the assets such as securities.
WHY MUTUAL FUNDS CANNOT “VANISH” ?
As mentioned before, the mutual fund is not a single entity. There are many different entities, namely Sponsors, Trustees or Trustee Company, AMC, Custodians etc. are involved. SEBI needs to be informed in appointment of most of these entities and SEBI has set some minimum qualification for these entities. The system of checks and balances protects the investors from fraud or misappropriation.
SEBI guidelines require that the Sponsors, Trustees, AMC and Custodians are sufficiently independent to avoid collusion. Assets are held by the Custodians who are independent from the AMC and both of these entities operate the overall control of the Trustees. The trustees hold fiduciary responsibility towards the MF unit holders.
For most retail investors SIP removes many headaches such as selecting the fund or timing the market. SIP benefits from the volatility of the NAV and lowers the purchase cost due to Rupee Cost Averaging. As an SIP automates the investing process, it may give the impression that the investor does not have to bother about them anymore. While SIP is very good at dealing with the market risk, it does not automatically adapt itself to the changes to investors' financial requirements and life situations. In this article, I am going to discuss why even SIP investors need to understand rebalancing. But, before we do that, let us introduce some basic concepts useful for this article.
WHAT IS PORTFOLIO REBALANCING?
Portfolio rebalancing is used in Strategic Asset Allocation (SAA) which is long term asset allocation in the portfolio based on the long term investment priorities of the investor. Now, we make a lot of assumptions while devising the SAA such as financial situation and priorities, economic variables such as long term inflation expectations, risk free rate etc. and expected return from different asset classes. The keyword here is assumptions.
As time passes the financial priorities of the investors change. Not only due to unforeseen events, but also due to decreasing investment horizon with age and thus decreasing risk tolerance. We also may need to change the economic assumptions and our expectations about the returns. So, to make sure the SAA is meaningful we have to reevaluate the asset allocation and change the portfolio so that it reflects our current set of assumptions.
Another reason for rebalacing is changes in the weightage of different asset classes in the portfolio simply because of difference in performance. For example, consider you have three asset classes A, B and C in your portfolio. You have created a portfolio with 20% A, 30% B and 50% C. Now, in one year A returns 18%, B returns -5% and C returns 10%. Now, you have 22.04% of A, 26.61% of B and 51.35% of C in the portfolio. Now, if you want to maintain the SAA you have sold 2.04% of A with 1.35% of C and by 3.39% of the B asset class.
WHAT IS AN SIP?
Systematic Investment Plan or SIP is a well known vehicle to invest in Mutual Funds. It enables the MF investors to invest a fixed amount monthly in a MF plan instead of investing a lump sum at once. Apart from helping the investor cultivate an investment habit, it helps to use the volatility of the NAV to reduce the purchase price of the mutual fund units.
REBALANCING WITH SIP
Now, consider you are a smart investor who started investing in your twenties after comprehensive risk assessment and financial goal planning. At that time you opted for a mix of ELSS, small-cap and mid cap equity investments as an aggressive investor and to get 80C tax benefits. Now, a few years down the road you start a family, you have accumulated a large amount of risky equity funds in your portfolio, but your risk tolerance is lower because of the shorter investment horizon, increased number of dependents etc. Not only you need to change your portfolio to suit current realities, but also it may take a drastic shift because you have 100% of high risk equity funds. This shift is likely to involve a lot of redemption which has both market and tax implications. The market situation may not be suitable and you might have to realise a loss.
A better option for this plannable change in asset allocation is to define what kind of asset allocation you need to have at different stages of your life and accordingly start SIPs of lower risk funds as you get older while stopping some of the high risk SIPs if needed. But, this may not be enough because it does not account for the unforeseen changes in financial situation as well as changes in the economic and return assumptions.
So, a periodic evaluation and rebalancing of the portfolio cannot be avoided even if you are investing through SIP. Periodic evaluation does not mean drastic execution of the rebalanced portfolio. The investor may use Systematic Transfer Plan for short term adjustments while using new SIPs of lower risk for long term changes.