State of Indian Stock Markets – August 2018

This is the August 2018 update for the State of Indian Stock Markets and includes historical analysis and Heat Maps of Nifty50 as well as Nifty500‘s key ratios, namely P/E, P/BV ratios and Dividend Yield.

Please remember that these numbers are averages of P/E, P/BV and Dividend Yield in each month. Neither Nifty50 heat maps nor Nifty500 heat maps show the maximum or the minimum values for each month. Also, note that NSE publishes PE ratios based on standalone numbers and not consolidated numbers (Read why this may matter too).

Caution – Never make any investment decision based on just one or two ‘average’ indicators (Why?) At most, treat these heat maps as broad indicators of market sentiments and a reference of market’s historical mood swings.

So here are the Nifty 50 Heat Maps…

Historical P/E Ratios – Nifty 50 (Monthly Average)

Historical Nifty PE 2018 August

P/E Ratio (on last day of August 2018): 28.40
P/E Ratio (on last day of July 2018): 28.22

The 12-month trend of P/E has been as follows:

Nifty Average PE Trends August 2018

 

And here are the average figures of Nifty50’s PE for some recent periods:

Nifty 12 Month PE Trend August 2018

Historical P/BV Ratios – Nifty 50

Historical Nifty Book Value 2018 August

P/BV Ratio (on last day of August 2018): 3.76
P/BV Ratio (on last day of July 2018): 3.70

Historical Dividend Yield – Nifty 50

Historical Nifty Dividend Yield 2018 August

Dividend Yield (on last day of August 2018): 1.15%
Dividend Yield (on last day of July 2018): 1.18%

Now, to the historical analysis of Nifty500 companies…

As the name suggests, Nifty500 is made up of top 500 companies which represent about 95% of the free float market capitalization of the stocks listed on NSE (March 2017).

Nifty50 on other hand is an index of 50 of the largest and most frequently traded stocks on NSE. These represent about 63% of the free float market capitalization of the NSE listed stocks (March 2017).

So obviously, Nifty500 is comparatively a much broader index than Nifty50.

Historical P/E Ratios – Nifty 500

Historical Nifty 500 PE 2018 August

P/E Ratio (on last day of August 2018): 34.50
P/E Ratio (on last day of July 2018): 33.59

Historical P/BV Ratios – Nifty 500

Historical Nifty 500 Book Value 2018 August

P/BV Ratio (on last day of August 2018): 3.52
P/BV Ratio (on last day of July 2018): 3.45

Historical Dividend Yield – Nifty 500

Historical Nifty 500 Dividend Yield 2018 August

Dividend Yield (on last day of August 2018): 1.04%
Dividend Yield (on last day of July 2018): 1.08%

You can read the previous update here. The State of Markets section has also been updated with new Nifty heat maps (link).

For a detailed analysis of how much returns you can expect depending on when the investments have been made (at various P/E, P/BV and Dividend Yield levels), please have a look at these 3 posts:

Getting Rich without Going Into Unsafe Territories

Getting Rich without Going Into Unsafe Territories

Let’s get straight to the point.

You want to become rich and you want to become rich FAST!

That’s what we all want right?

Thankfully, most of us understand that it’s easier said than done. But unfortunately, far too many don’t get it and end up losing tons of money instead of making it.

And the internet does what it does best – adds to the noise – and is overcrowded with a lot of misleading information on how to become wealthy. To be fair, it’s quite possible to get rich quickly, more often than you’d think.

However, it comes with a high probability of losing whatever you put into such get-rich-quick ventures. And it involves taking high-risks, putting in hard work and ofcourse a lot of luck – or let’s say a ‘lucky’ combination of all the three.

Stock market investors who get greedy after noticing a good run in certain stocks for a couple of years start believing the stock market is a sneaky way to get rich very fast.

Sometimes this is true for the short run. But mostly it’s not. After a good run, mean reversions reframe the game and markets go down. And people aren’t ready for it.

As a result, people end up losing whole life investments or at best end up with a very bad experience with equities – and that can haunt them for years, make them stay away from equities (and it just translates into a big loss of wealth creation opportunities).

Another example can be the almost vertical rise in value of cryptocurrencies like Bitcoin in the very recent past.

Again what happened there was that people believed that this is a way to get rich overnight and so hoards of investors started joining the party. But the crash that happened after the all-time highs has left most people with a bad taste for currency investments. To be honest, cryptocurrency isn’t my field of expertise, but I have close friends in Silicon Valley who have actually got rich taking a cut of this modern-day currency market.

And I mean they became filthy rich way too fast. Some were lucky to cash out before the big fall and have literally achieved financial independence. Others weren’t so lucky. I would say that in the case of crypto-riches, luck played a really big part for many people’s good fortune – there can be no denying that.

Also, there is the foreign exchange or currency market also known as forex – which I’m not sure most people know is the biggest market in the world!

If you surf around enough online financial and trading sites, chances are that soon enough, our Lord Google will contextually throw in alluring Forex Trading advertisements which highlight the magical capabilities of currency trading offers.

I personally know someone abroad who does quite well dealing in forex trading. And he has been doing it for years so he knows his trade. If you were to ask him whether it’s possible to get rich in forex trading he’d say ‘Hell yes!’. But if you were to ask him whether it’s easy to get rich trading in the forex market, he would say right off the bat ‘No way!’.

In fact, he very clearly told me that Forex Trading is not a get-rich-quick method as many online advertisements make it out to be. That doesn’t happen. It’s a skill and takes time to learn and profit from. Being properly equipped with certain tools to trade in forex and having timely funds along with proper non-impulsive risk management skills are valuable assets when going the forex way.

I, being a participant in Indian stock markets for several years, could clearly see the similarities with it.

The insights about what works and what doesn’t work in stock markets come after years of trying out various strategies, taking hits on your portfolio and your ego and what not.

It might seem that it’s easy but I can vouch that there is no easy money-making here. It is simple but not easy.

Another close acquaintance of mine got really lucky sometime back. He piggybacked another friend’s VC and Angel around bets without any clue about what the startups were exactly doing. Lady luck shined and he made a killing with a couple of super bets.

You see the pattern?

Some people ‘get rich quick’ here and there. But they are the exception to the rule, not the norm.

You need to realize that for most people, the way to wealth is typically on the slow lane. It’s good to take your chance, but more often than not, what happens is that your capital gets lost and you need to start fresh. Which is hard stuff. After a while it adds up, less money is available for compounding and naturally, the amount of money you end up making is much lesser than what would have been possible if you’d have not run greedily towards a quick highly risky scheme.

Believe me, you can wait for years to accept the perennial truth that slow and steady wins the race and compounding is indeed the 8th wonder of the world. Or you can start with time-tested wealth creation strategies and begin your journey of being really wealthy.

It might not seem as glamorous as the get-rich-quick schemes but it works.

By starting early, you can be rich enough much before you retire – something that is desirable as you don’t want to be the richest man in the graveyard! Right?

Frequently, getting rich quickly is either due to pure coincidence or extreme risk. But even hard work and willingness to take tons of risks cannot guarantee overnight riches.

So do yourself and your family a favor and assume calculated risk, invest in testing out the best strategies and work only with the best ones. Don’t ever take luck or hope into account! Both hope and luck are not strategies. 🙂

May the odds be in your favor!

State of Indian Stock Markets – June 2018

This is the June 2018 update for the State of Indian Stock Markets and includes historical analysis and Heat Maps of Nifty50 as well as Nifty500‘s key ratios, namely P/E, P/BV ratios and Dividend Yield.

Please remember that these numbers are averages of P/E, P/BV and Dividend Yield in each month. Neither Nifty50 heat maps nor Nifty500 heat maps show the maximum or the minimum values for each month. Also, note that NSE publishes PE ratios based on standalone numbers and not consolidated numbers (Read why this may matter too).

Caution – Never make any investment decision based on just one or two ‘average’ indicators (Why?) At most, treat these heat maps as broad indicators of market sentiments and a reference of market’s historical mood swings.

So here are the Nifty 50 Heat Maps…

Historical P/E Ratios – Nifty 50 (Monthly Average)

Historical Nifty PE 2018 June

P/E Ratio (on last day of June 2018): 25.90
P/E Ratio (on last day of May 2018): 27.19

The 12-month trend of P/E has been as follows:

Nifty 12 Month PE Trend June 2018

And here are the average figures of Nifty50’s PE for some recent periods:

Nifty Average PE Trends June 2018

Historical P/BV Ratios – Nifty 50 (Monthly Average)

Historical Nifty Book Value 2018 June

P/BV Ratio (on last day of June 2018): 3.61
P/BV Ratio (on last day of May 2018): 3.69

Historical Dividend Yield – Nifty 50 (Monthly Average)

Historical Nifty Dividend Yield 2018 June

Dividend Yield (on last day of June 2018): 1.22%
Dividend Yield (on last day of May 2018): 1.23%

Now, to the historical analysis of Nifty500 companies…

As the name suggests, Nifty500 is made up of top 500 companies which represent about 95% of the free float market capitalization of the stocks listed on NSE (March 2017).

Nifty50 on other hand is an index of 50 of the largest and most frequently traded stocks on NSE. These represent about 63% of the free float market capitalization of the NSE listed stocks (March 2017).

So obviously, Nifty500 is comparatively a much broader index than Nifty50.

Historical P/E Ratios – Nifty 500 (Monthly Average)

Historical Nifty 500 PE 2018 June

P/E Ratio (on last day of June 2018): 30.47
P/E Ratio (on last day of May 2018): 31.59

Historical P/BV Ratios – Nifty 500 (Monthly Average)

Historical Nifty 500 Book Value 2018 June

P/BV Ratio (on last day of June 2018): 3.37
P/BV Ratio (on last day of May 2018): 3.49

Historical Dividend Yield – Nifty 500 (Monthly Average)

Historical Nifty 500 Dividend Yield 2018 June

Dividend Yield (on last day of June 2018): 1.09%
Dividend Yield (on last day of May 2018): 1.08%

You can read the previous update here. The State of Markets section has also been updated with new Nifty heat maps (link).

For a detailed analysis of how much returns you can expect depending on when the investments have been made (at various P/E, P/BV and Dividend Yield levels), please have a look at these 3 posts:

State of Indian Stock Markets – April 2018

This is the April 2018 update for the State of Indian Stock Markets and includes historical analysis and Heat Maps of Nifty50 as well as Nifty500‘s key ratios, namely P/E, P/BV ratios and Dividend Yield.

Please remember that these numbers are averages of P/E, P/BV and Dividend Yield in each month. Neither Nifty50 heat maps nor Nifty500 heat maps show the maximum or the minimum values for each month. Also, note that NSE publishes PE ratios based on standalone numbers and not consolidated numbers (Read why this may matter too).

Caution – Never make any investment decision based on just one or two ‘average’ indicators (Why?) At most, treat these heat maps as broad indicators of market sentiments and a reference of market’s historical mood swings.

So here are the Nifty 50 Heat Maps…

Historical P/E Ratios – Nifty 50 (Monthly Average)

Historical Nifty PE 2018 April

P/E Ratio (on last day of April 2018): 26.66
P/E Ratio (on last day of March 2018): 24.66

The 12-month trend of P/E has been as follows:

Nifty 12 Month PE Trend April 2018

And here are the average figures of Nifty50’s PE for some recent periods:

Nifty Average PE Trends April 2018

Historical P/BV Ratios – Nifty 50 (Monthly Average)

Historical Nifty Book Value 2018 April

P/BV Ratio (on last day of April 2018): 3.69
P/BV Ratio (on last day of March 2018): 3.42

Historical Dividend Yield – Nifty 50 (Monthly Average)

Historical Nifty Dividend Yield 2018 April

Dividend Yield (on last day of April 2018): 1.19%
Dividend Yield (on last day of March 2018): 1.29%

Now, to the historical analysis of Nifty500 companies…

As the name suggests, Nifty500 is made up of top 500 companies which represent about 95% of the free float market capitalization of the stocks listed on NSE (March 2017).

Nifty50 on other hand is an index of 50 of the largest and most frequently traded stocks on NSE. These represent about 63% of the free float market capitalization of the NSE listed stocks (March 2017).

So obviously, Nifty500 is comparatively a much broader index than Nifty50.

Historical P/E Ratios – Nifty 500 (Monthly Average)

Historical Nifty 500 PE 2018 April

P/E Ratio (on last day of April 2018): 31.36
P/E Ratio (on last day of March 2018): 29.65

Historical P/BV Ratios – Nifty 500 (Monthly Average)

Historical Nifty 500 Book Value 2018 April

P/BV Ratio (on last day of April 2018): 3.56
P/BV Ratio (on last day of March 2018): 3.27

Historical Dividend Yield – Nifty 500 (Monthly Average)

Historical Nifty 500 Dividend Yield 2018 April

Dividend Yield (on last day of April 2018): 1.04%
Dividend Yield (on last day of March 2018): 1.12%

You can read the previous month’s update here. The State of Markets section has also been updated with new Nifty heat maps (link).

For a detailed analysis of how much returns you can expect depending on when the investments have been made (at various P/E, P/BV and Dividend Yield levels), please have a look at these 3 posts:

3 Big Changes that will impact Mutual Fund Investors

Big Changes in Mutual Fund

Last few months have been very dynamic and interesting for the mutual fund industry.

3 big changes have taken place that are going to impact all mutual fund investors and how they take their investment decisions in future.

If you are a little confused about what these changes are, then let me calm you down.

Maybe you have already heard about them but not understood their impact fully. Or it might have slipped off your mind as the impact may not be immediate or even short term. Nevertheless, I feel that these 3 changes need to be understood by you as long-term mutual fund investors.

So without wasting more time or making it a very long post, I will try to highlight what these changes are.

By the way, I have already written about two of these changes in super detail earlier. I will share the links two those articles shortly.

So what are these changes?

  1. Introduction of Long-Term Capital Gains Tax (LTCG) on equity
  2. Categorization & Rationalization of existing funds
  3. Use of TRI or Total Return Index for benchmarking of funds

If all three seem boring and too technical to you, then please hold on (and don’t close the window).

These are important changes. These are not just administrative changes that will have no impact on you. These three (yes…all three of them) will impact you and have a role to play in how much wealth you will create. So it makes sense to understand these changes.

Please. 🙂

Your money. Your responsibility.

I hope you are still reading.

Let’s get into these changes now…

1) Introduction of Long-Term Capital Gains Tax (LTCG) on equity

Unlike earlier years, your profits (capital gains) from equity after 1 year will now be taxed. So the actual money that you get in hand will be little lesser than what you would have got in a zero-LTCG regime.

But I won’t get into the details about LTCG tax here.

I have already addressed the impact of LTCG tax on long term investors in a super detailed post mentioned below:

Real impact of LTCG tax on long term equity investors

So I strongly recommend you read that post if you haven’t already.

It’s a little long but that should not stop you from reading it as its important. Bookmark it and read it when you have made time for it.

2) Categorization & Rationalization of existing funds

The regulator SEBI has ‘forced’ the fund houses to clean up their acts and make their fund offerings more logical, simpler to understand and more investor-friendly. This also forces the fund houses to be truthful to what they are offering.

This might seem just like a cosmetic change upfront to many. But it isn’t. This is one of the biggest change in Mutual fund space in recent years.

This will directly impact your investments as some of the funds will see big changes in their portfolio. And if you are MF star-rating lover, then please note that this will also impact how much returns some of the earlier 5-star rated and popular but now ‘rationalized’ funds will deliver.

So if you are an existing investor of any of these funds, then you will be impacted. So logically speaking, you should sit up and take notice of this change.

Want more details to understand it?

I have written a huge article on this.

Here is the link to that article:

Real impact of the NEW Categorization & Rationalization of existing mutual funds that YOU have Invested in

Please read it. Like the first one, this too is important even if you don’t feel it is right now.

That brings us to the last one…

3) Use of TRI (Total Return Index) for benchmarking of funds

(I haven’t written about this topic. So I will tackle it here itself in some detail)

This is another important development. It won’t put more money in your pocket directly. But it can help you take better decisions when picking right mutual funds – which in turn can put more money in your pocket eventually. 🙂

I will explain myself in a bit.

The respected regulator SEBI has asked all mutual fund houses to adopt the Total Return Index (TRI) to benchmark their schemes.

According to the regulator (and many others), this is a more appropriate way to measure the performance of such financial products. Here is a link to SEBI’s circular on TRI adoption for benchmarking fund mutual performance – Link

Till now, most equity mutual fund schemes have been benchmarked to the Price Return variant of the Index (PRI).

So what is the difference between this new animal TRI and the old PRI?

When you invest, there are 2 components of the total return you can make from your investments. First is ofcourse capital appreciation, And the second is the dividends from that investment.

If you only consider capital appreciation, then it means you are looking at PRI version. But if dividends are factored in too alongwith the capital appreciation, then that’s TRI – Total Returns.

Naturally, the returns of a total return index will always be higher than that of a price index.

Let’s now come back to the mutual funds.

The MFs receive dividends on the stocks they hold in their portfolios and this dividend is re-invested into the scheme. So ideally, they should compare their performance with Total Returns Index. That would be fair. But as I said earlier, they use PRI or Price-only Index.

How does it change the depiction of fund manager’s ability?

Suppose a Rs 100 invested in a fund becomes Rs 120.

The PRI index (which is generally used) to benchmark has grown itself from 100 to 112 in meantime. So in this case, the outperformance over and above the benchmark is Rs 8 = (Rs 120 – Rs 112).

On the other hand, TRI includes dividends and hence will be higher than PRI. Suppose it is 116. Obviously, the outperformance over and above the benchmark is now reduced to just Rs 4 = (Rs 120 – Rs 116).

Here is a simplistic summary:

Total Return benchmark Indian mutual funds

What has happened and why have fund managers been using PRI till now?

As returns appear lower in case of a PRI, it is easier for a fund to show higher out-performance against it. Read the previous statement again.

So when the fund compares itself with a PRI, it shows a much higher outperformance than it is actually doing (when compared with TRI). 🙂 🙂

PRI doesn’t capture the dividends which are available for the fund. TRI does that.

This gap between the price-only returns and Total-Returns in a way tells that by avoiding the recognition of dividends (in TRI), it actually helps the case of fund managers as they can set a lower bar on the returns that they need to make to ‘outperform’ the benchmark! 🙂

This might seem bad but luckily, SEBI has taken care of this by forcing fund houses to adopt TRI now. I am sure that if SEBI had not pushed the fund houses, most MFs would have continued to use PRI benchmarks. To be fair, few fund houses had already adopted the TRI for benchmarking even before the regulations came. Cheers to them!

I did some number crunching with Nifty50 data of last 10 years (Apr-2008 to Mar-2018).

The Nifty returned 7.87% over this 10-year period, while it’s TRI version returned 9.16% over the same duration.

Now suppose the fund you invested in gave a return of 10% in the same period. If you use PRI, then outperformance is 2.13% whereas if you use TRI, the outperformance over benchmark reduces to just 0.84%.

Nifty Total Return benchmark mutual funds

It is still outperforming the benchmark, but as you might have noticed, the outperformance (or what fund managers take credit for and become celebrities) can go down significantly due to change in benchmarks.

Hence, TRI is more appropriate as a benchmark to compare the performance of mutual fund schemes. And going forward, atleast some of the funds will have a tougher time beating this benchmark – something that they were able to do easily earlier. This pushes fund managers to work harder to generate real alpha (outperformance) and not rely on technical differences between TRI and PRI to artificially bloat their alphas.

But nothing is perfect.

Some people are saying that even the TRI is not perfect.

Why?

Because mutual funds have to keep some liquid cash aside too – for liquidity needs and in search of better opportunities. And the index – which is the benchmark does not have to keep this cash! So if this cash component of the fund is slightly large, then it can drag down the overall performance of the fund. And this reality is not captured by the TRI.

So it seems that the PRI was overstating performance while the TRI is ‘slightly’ understating it when compared to the index. 🙂

This is true to an extent. But I don’t buy the argument completely as cash was held even under the PRI regime. This is nothing new that is introduced in the TRI regime. Isn’t it?

As I said, nothing is perfect. So we really cannot ignore the investor-friendliness of using TRI over PRI for benchmarking.

But it is important to highlight something here:

The use of Total Returns version of the Index for benchmarking has absolutely no impact on the actual returns generated by the mutual funds. It is just done to ensure that fund performance is compared more accurately against a correctly chosen benchmark.

I know what you are thinking.

If this doesn’t impact the actual returns, why should we even be bothered?

There is a need to understand this difference between total return and price return. And it is because when you are picking good mutual funds to invest in, one of the many important criteria is to see how is the fund’s consistency with respect to its benchmark. As since beating the benchmark will be slightly tougher now, this factor will play its role in the proper selection of good mutual funds to invest in for the long term.

Let me remind that beating benchmarks is not the only factor in fund selection. There are several others which are important enough.

Another thing to note here is that changeover to TRI in no way means that fund managers will not beat their benchmarks. It only means that the number of funds beating the same benchmarks will be reduced in years to come. This fact will get a further push as SEBI’s directive to rationalize mutual funds has asked fund houses to just have one fund per category.

On a related note, some people are of the view that since beating benchmarks will be tougher, its best to go for index funds. There is no clear-cut answer here, to be honest.

Index fund is a beautiful product. More so now. But still, good fund managers will continue to do better than those index funds.

But the margin of their outperformance will get reduced to some extent. And as the years progress, the difference (or outperformance) will get reduced on a category basis. I will still not write off active equity funds as I believe that proper fund selection can increase the probability of finding index-beating and proper-benchmark beating funds.

But I agree, that the time for index funds will come soon.

And now more than ever, it’s true that an Index fund may not beat a good fund manager. But it will surely beat a bad one. 🙂

Why is SEBI pushing for so many changes in the Mutual Fund industry?

Many followers of the MF industry (me included) can vouch for the fact that the last few months have been quite eventful for the industry as a whole.

Implementation of LTCG on equity gains by the government, rationalization of schemes and forcing adoption of TRI by SEBI – these are not small developments.

And as far as I can make out, the future will see more announcements of such regulatory measures.

As you might have guessed by now, these are being done to ensure that the industry remains investor-friendly and curb misselling to some extent.

The industry is growing by leaps and bounds and as more and more people are joining the mutual fund bandwagon believing that #MutualFundSahiHai, it is only rightful that the regulator is doing its bit to nudge the industry to clean up and take a moral high ground.

I hope this article that focuses on use of Total Returns Index for benchmarking by mutual funds and other two focusing on tax on LTCG from equity and Categorization & Rationalization of Mutual Funds were able to give you the clarity that you need to have regarding these changes.

For common people, the Mutual funds are the best investment option to create wealth in the long run. And with new changes, it is expected that industry will be better regulated and investors will have the right information to ask the right questions from their fund managers.

Inspite of these 3 changes, nothing changes in how you should go about managing your money. Know yourself and your financial goals. Get yourself a good financial plan that gives you a roadmap to invest properly. And then, stick to the plan and continue monitoring your investments properly. That’s all that is needed.

So happy investing.

If you have any questions pertaining to these developments or want to take professional help in creating a solid financial plan (details here), please contact me.

SEBI Mutual Fund Categorization & Rationalization – Making Sense of it for Long Term Investors

SEBI Mutual Fund Categorisation Rationalisation Investor

If you are an existing mutual fund investor, you would already be aware that a lot of mutual funds schemes are being renamed, recategorised, merged or getting their mandates (investment objectives) changed.

Technically, this is being referred to as ‘Categorization and Rationalization of Mutual Fund Schemes‘ in India.

Before you write this off as something irrelevant for people like us, let me tell you upfront that this is important. This is a big change that is taking place in mutual funds in India.

Make some effort to try and understand this rationalization exercise that all mutual funds are going through. This understanding will help you in the long run when your portfolio will be much bigger than what it is today. 🙂

I am no expert but let me try and make sense of this in as simple terms as possible.

Since long, the mutual fund industry has been accused (and in a way rightly) of starting an unnecessarily large number of similar schemes. This has created a lot of confusion for investors who are unable to understand what their mutual fund schemes really stand for. For example – a fund house can have two differently named schemes but which both focus on large caps with significant overlap of strategy and portfolio. This is unnecessary.

Another issue was that many funds deviated from what their mandate was. For example – a large cap fund is expected to invest primarily in large cap companies. But in search for higher returns, many large cap funds took unnecessary exposure to smaller caps. This works well to boost returns when markets are rising. But can be disastrous when markets take a turn. Investors at their end, practically are not getting what they are promised. A large cap fund having more money invested in small and mid caps is not fair to the investors. Ofcourse they don’t complain when returns are higher. 😉 But they will when things don’t turn out as they are made to believe they will.

I hope you get the drift of what I am pointing to.

The industry regulator had been asking the AMCs (those who run mutual funds) to rationalize and simplify the big menu of hundreds of mutual fund schemes that were offered and also stay true to what their mandates were.

But that ‘asking’ did not help much.

So SEBI was forced to put out a circular on ‘Categorization and Rationalization of Mutual Fund Schemes‘ in October 2017 to ensure that the clean-up of mutual funds is done by force now. If interested in these new SEBI guidelines for mutual funds 2017 2018, you can read about them in detail in SEBI’s circular here and here.

At the time of writing of this article, the fund houses have either already recategorised and rationalized the fund schemes or are in process of doing it after getting SEBI’s approval. These changes will take effect beginning from early 2018 to about mid-2018.

Is this move by SEBI justified?

I think it is.

We cannot deny that the number of mutual fund schemes on offer had become unnecessarily large. Most investors are extremely confused by the sheer number of schemes on offer and what actually is the difference between them. To be honest, even I have had my own share of wtf moments on finding such unnecessary large overlaps between different schemes.

So the new system aims to bring uniformity to the schemes and ensures that there is a specific and clear categorization of schemes. Now, comparisons will be among the right things and hopefully, using the right and relevant numbers.

This simplification exercise is a step in the right direction and enables the right comparisons.

New Mutual Fund Categories & Sub Categories

Let’s see in some detail what the categorization is all about. Don’t worry. It’s not very complicated and you will have a clear understanding in next few minutes.

The first thing that has been done is to define 5 very clear groups to classify all the schemes. These 5 mutual fund categories are:

  1. Equity Schemes – will invest in equity and equity related instruments
  2. Debt Schemes – will invest in debt instruments
  3. Hybrid Schemes – will invest in a mix of equity, debt and other assets related instruments
  4. Solution Oriented Schemes – will have schemes like retirement schemes or children savings scheme
  5. Other Schemes – will have index funds, Fund-of-Funds and ETFs

Now each of these 5 categories has its own sub-categories or ‘type of schemes’:

Equity Fund Types & Sub-Categories

  • Large Caps
  • Large & Mid Caps
  • Mid Caps
  • Small Caps
  • Multi Caps
  • Dividend yield,
  • Value
  • Contra
  • Focused
  • Sectoral/thematic
  • ELSS (Equity Linked Savings Scheme)

Earlier, the definition of what is a Large Cap and what is mid cap and what is small cap was not defined by SEBI. So fund houses used to pick and chose whatever they wished depending on the in-house definition of market caps or their convenience!

But this has been standardized too in this exercise.

There is clear classification as to what is a large cap, mid cap or a small cap company:

  • Large Cap Company: 1st to 100th company in terms of full market capitalization
  • Mid Cap Company: 101st to 250th company in terms of full market capitalization
  • Small Cap Company: companies beyond 250th company in terms of full market capitalization

Fund houses will be required to rebalance their scheme portfolios within a short period based on the updated list of market caps put out by AMFI. Here is the latest AMFI list of Indian companies by market cap.

To ensure strict adherence, the individual characteristics of each of these scheme types has been clearly defined now by SEBI. For example:

  • Large Caps – to invest atleast 80% in large caps
  • Large & Mid Caps – atleast 35% each in large caps and mid caps
  • Mid Caps – atleast 65% in mid caps
  • Small Caps – atleast 65% in small caps
  • Multi Caps – atleast 65% in equities & no market-cap wise restriction
  • Dividend yield – atleast 65% in equities but in dividend yielding stocks
  • Value / Contra – atleast 65% in equities but a fund house can either offer a value fund or a contra fund but not both
  • Focused – atleast 65% in equities but can have a maximum of 30 stocks
  • Sectoral / Thematic – atleast 80% in chosen sector stocks
  • ELSS (Equity Linked Savings Scheme)

If these percentages seem a little too tight to you from fund manager’s perspective, please understand that enough relaxation is provided for decent portfolio flexibility.

So if a fund house is running a mid-cap fund, then atleast 65% of the portfolio has to be in stocks ranked between 101st and 250th by market cap. But the remaining 35% or lower (if higher than 65% allocated to mid caps) is available to have some large and small caps, which may be on their way up or way down to enter into the definition of mid-cap in near future.

So enough leeway has been given to include ideas other than pure sub-category demanded allocations as well. And this is fairly decent in my view and will still allow smart mutual fund managers enough flexibility to build a solid portfolio of stocks in-line with their fund’s investment objective.

And here is the best part.

To ensure that the number of funds is rationalized, a fund house is allowed to have only 1 type of scheme in each sub-categories mentioned above. Only exceptions that are allowed are in case of:

  • Index Funds – can have as many schemes as there are indices
  • Fund of Funds
  • Sectoral / Thematic funds – can have as many schemes as there are sectors

Debt Fund Types & Sub-Categories

The earlier categorization of debt funds was found to be very broad and hence, more clear definitions have been drafted.

Now, the new types specify more targeted categories around the level of interest rate risk and credit risk taken by the funds. As a result, now the debt funds have quite a large number of sub-categories or types:

  • Overnight funds
  • Liquid funds
  • Ultra-Short Duration funds
  • Low duration funds
  • Money market funds
  • Short duration funds
  • Medium duration funds
  • Medium to long duration funds
  • Long duration funds
  • Dynamic bond funds
  • Corporate bond funds
  • Credit risk fund funds
  • Banking and PSU funds
  • Gilt funds
  • Gilt funds with 10-year constant duration
  • Floater funds

And here is the real difference between these funds:

  • Overnight funds – holding portfolio with maturity of upto 1 day
  • Liquid funds – holding portfolio with maturity of upto 91 day
  • Ultra-Short Duration – holding portfolio with maturity 3-6 months
  • Low duration – holding portfolio with maturity 6-12 months
  • Money market – holding portfolio of money market instruments with maturity of upto 1 year
  • Short duration – holding portfolio with maturity 1-3 years
  • Medium duration – holding portfolio with maturity 3-4 years
  • Medium to long duration – holding portfolio with maturity 4-7 years
  • Long duration – holding portfolio with maturity more than 7 years
  • Dynamic bond – can invest across durations
  • Corporate bond – atleast 80% in corporate bonds (AA+ & above)
  • Credit risk fund – atleast 65% in corporate bonds below AA
  • Banking and PSU – atleast 80% in instruments issued by banks, PSU undertakings, municipal corporations, etc.
  • Gilt – atleast 80% in instruments issued by government across periods
  • Gilt with 10-year constant duration – atleast 80% in instruments issued by government across periods such that average maturity is 10 years
  • Floater – atleast 65% in floating rate instruments

Then there are other categories too:

Hybrid Fund sub-categories

  • Conservative hybrid funds – 10 to 25% equity allocation
  • Balanced hybrid funds – 40 to 65% equity allocation
  • Aggressive hybrid funds – 65 to 80% equity allocation
  • Dynamic Asset Allocation – can vary without restrictions
  • Multi-Asset funds – invest in atleast 3 assets with minimum of 10% in each

Solutions oriented Schemes

Other Schemes

  • Index funds
  • ETFs (Exchange Traded Funds)
  • Fund of Funds (FoF)

If you have made it this far, congratulations.

And I know what you are thinking.

Aren’t these a little too much for cleaning up (simplification) exercise and rationalization of mutual funds?

🙂 🙂

Some feel that since the intention was to reduce the complexity bogging down the mutual fund industry, the new classification system has far too many schemes to be called ‘simple’.

I agree to an extent.

But this level of detailed categorization was needed. And I am not joking.

This was needed to ensure that fund houses did not take investors for a ride and offer them the same wine in a different bottle without changing much on the label too!

Debt funds are far more complex animals than equity funds. So due their inherent structural complexity and the fact that they are designed to cater to a wide variety of investor categories, a high number of fund types is reasonably justified. Things might change more in future. But as it’s just a start, it seems to be fine for time being.

You already knew that Mutual Fund investments are subject to market risks, read all scheme related documents carefully. But atleast for sometime now, Mutual Fund investments will be additionally subject to category-wise understanding too. So please (re)read the new scheme related documents (very) carefully. 🙂

Let’s move on to another important aspect that many investors use as the criteria for mutual fund selection – Past Performance of Funds.

Past Performance May Not Matter that much Now!

Yes. This is very important to understand.

Atleast for some mutual fund schemes, the past performance may not matter that much now!

If the fund is changing its mandate or its portfolio strategy, to accommodate categorization and rationalization, then its obvious that earlier strategy that resulted in past performance is no longer valid.

A new strategy has taken over. So you cannot expect past returns going forward as you don’t know how the new strategy will play out!

And that is why I feel that now, the problem of comparison based on past performance will begin. And mind you, this will not end until the time the funds accumulate a reasonable period of performance data post these changes. And this ideally means years.

This point is important and hence, I suggest you read last two paragraphs again if you didn’t get its importance.

If the fund has changed its nature, it means that whatever pattern it had set in past (with respect to return, risk, volatility, alpha, beta, whatever) is not valid going forward. It’s like a new fund has begun a semi-new life. 🙂

This also means that if you depend on Star Ratings to pick funds, then that won’t work. Even earlier depending only on Mutual Fund Star Ratings was stupid. Now, it would be more so.

Also understand that even though rating agencies will come up with some or the other mathematical adjustments, the fact is that it will really take few years to have enough real data to correctly compare the funds in the category and (ofcourse rated by rating agencies).

Since the nature of fund is changing, its performance may be impacted as well. The ability of fund managers to generate alpha will be restricted in new regime as the choices they have will be limited due to category wise restrictions that will be applicable to them. So if slowly the fund you loved for its great performance starts reporting poor numbers, you would know what one of the causes might be.

I feel for new investors in mutual funds that will join in next few years. I hope they don’t take the wrong decision of judging old (be newly changed) funds only on basis of their past performance.

There is some hope for investor protection as to its credit, SEBI has directed fund houses to follow uniform rules to disclose past performance of their schemes post-merger.

This is how the past performance of the schemes would look post-merger:

  • If two schemes have similar features, fund house will have to disclose the weighted average performance of both the schemes.
  • If two schemes have different features, fund houses can highlight the weightage average performance of the surviving or retained scheme. However, fund houses can also disclose the past performance of scheme which was not retained post merger on request of investors.
  • If two schemes merged to form a different scheme altogether, fund houses need not disclose any past performance.

(Source – recent SEBI circular)

There are and will be cases where a fund house has two similar looking schemes and both have a good track record to boast of. Now it will be difficult for Fund houses or AMCs to tweak them as shutting them down or merging will create a fund with assets that may be too large to manage within the scope of new restrictions and revised investment objective.

How does all this help Investors?

Earlier, for most investors it was difficult to gauge which is large cap and which isn’t. So with all funds having their own definitions, it was difficult to carry out comparisons correctly. A large-cap fund could easily have stocks that would be counted as mid-cap for a different fund. So this definition-setting will help eliminate cap-related confusion to some extent.

Another benefit is that over the years, just too many schemes had come into existence without a real need for. So this cleanup will reduce the unnecessary clutter.

Some of the scheme names were very misleading. And at times and to the uninitiated, it gave the wrong impressions of some kind of guarantees. With the restriction on the choice of name that the funds can have, the regulator has done its part to ensure that investors do not misunderstand the product and end up taking higher risk than they should.

This is something that used to happen a lot. A balanced fund ideally should be balanced. Right? That is what it is meant for. It was not to beat full-equity schemes. But unfortunately, many balanced schemes were unbalanced as they were stuffed with a lot more equity than was needed. So it was difficult to compare the two balanced fund simply on basis of returns when one was actually balanced and other was unbalanced.

The biggest advantage of this classification is that it will make mutual fund schemes comparable in a much better way. That is to say that comparison within their category and also provide decent relative comparison across category which would make sense.

One Thing That No one is Discussing

I may be wrong in my apprehension here but somehow, I feel that the style drift that will be curbed going forward (due to restrictions due to this new regulation), may seriously dent some fund managers ability to manage the funds like they used to.

See… every investor (even a fund manager) has a style. There are as many ways of picking stocks as there are investors.

1 plus 5 can be 6. So can be 3 plus 3.

Isn’t it?

So given a Market Scenario A, a fund manager may choose a different strategy than what he may choose in a different Scenario B. This strategy might be to go overweight on large caps in Scenario A and underweight on large caps in scenario B. This may be…and I repeat may be one of his sources of alpha generation and fund’s good performance. But now, this will be curbed as you understand.

How this will play is something that I don’t know.

It will be interesting to see. But I don’t see this being discussed in various forums. It’s like a known-unknown which we need to be aware of as an investor and as an advisor.

I agree that style drift is a risk which may not be worth everybody. But it is also not that no class of investors is willing to take that risk.

I am not sure but somewhere I have a feeling that by forcing only 1 fund per category per fund house, the regulator SEBI is perhaps not letting fund houses to innovate and experiment with various strategies. I may be wrong in this thinking but this is what I currently have in mind.

Finally…

It has been a long post. But I wanted to write it in detail as it is an important development for investors.

Please understand here that no classification scheme is perfect.

There will always be new ways to improve the classification in each iteration. But as I said, this is a good start and a step in the right direction.

There are few blind spots like restriction on the ability of some fund managers to generate outperformance using their existing styles. But that I guess will be compensated by other means. I am not sure which or when but I presume good fund managers will do good in any regulatory environment.

To be fair, this is a new development and that too a big one.

So AMCs will take some time to stabilize their portfolios, reclassify their schemes, etc., etc. They have already started sending emails (which you too would be getting from them in your inboxes).

So without mincing words, let me say that this is a period of uncertainty for existing investors. But do not worry. Things are changing for the good.

Having said that, it is very clear that even after the new categorization, the number of mutual fund scheme categories is still very large. More than 30-35 I guess. So it would require some bit of understanding and effort to make proper mutual fund selections. For some, this will be easy. For others, it won’t be. If you have doubts, then it’s best to take help of professional advice.

So what is the best course of action?

Take this as an opportunity to clean up your portfolio, realign it in line with actual requirements and in line with your correct risk profile and investment horizon. Also now you can better compare the actual risk-reward scenario among similar schemes.

What will happen to the funds you have invested in?

It is possible that your fund may continue as it is with no changes. It is also possible that the scheme may get merged with another scheme in the same category. It is also possible that the investment objective of your fund may change.

But remember that just because a mutual fund scheme is changing to adjust to the new SEBI-proposed amendments, doesn’t mean that it should be thrown out of your portfolio. As long term investors, you must remain calm and have a relook at the funds in line with your goals (free financial goals excel download). If the amended scheme still fits into the suitability criteria, then there is no need to make unnecessary changes.

So do not be in a hurry to exit and re-enter funds at this stage. More so just on basis of returns or change in fund attributes.

Give the AMC or fund houses some time to allow their funds to settle into their new categories or new mandates. Remember, that depending only on mutual fund ratings even earlier was not a great idea. Now, it is more useless if the comparison is done with new category peers based on the past data.

Mutual funds still remain the best way for common investors to benefit from various assets (more so from equity). That too for common people who need a simple yet powerful method to invest systematically.

These changes might seem a bit too much in near term but will set the base for better industry structure in long term. Do not hesitate in contacting an advisor if you lack clarity.

These recent changes alongwith the impact of LTCG tax on equity are big changes that we face. It’s best to understand the realities without blindly believing in what others are saying.

It’s your money and your responsibility. Make the effort to protect it and grow it.

So take your time. Understand the whole impact of Categorization and Rationalization of Mutual Fund Schemes in India. And also about the impact of LTCG tax on equity investors.

There is no hurry to act now.

More so if you are long-term investor investing for your real personal financial goals. But as time progresses, a knowledge of these changes will help you better manage your investment portfolio.

Happy investing!

State of Indian Stock Markets – March 2018

This is the March  2018 update for the State of Indian Stock Markets and includes historical analysis and Heat Maps of Nifty50 as well as Nifty500‘s key ratios, namely P/E, P/BV ratios and Dividend Yield.

Please remember that these numbers are averages of P/E, P/BV and Dividend Yield in each month. Neither Nifty50 heat maps nor Nifty500 heat maps show the maximum or the minimum values for each month. Also, note that NSE publishes PE ratios based on standalone numbers and not consolidated numbers (Read why this may matter too).

Caution – Never make any investment decision based on just one or two ‘average’ indicators (Why?) At most, treat these heat maps as broad indicators of market sentiments and a reference of market’s historical mood swings.

So here are the Nifty 50 Heat Maps…

Historical P/E Ratios – Nifty 50 (Monthly Average)

P/E Ratio (on last day of March 2018): 24.66
P/E Ratio (on last day of February 2018): 25.68

The 12-month trend of P/E has been as follows:

And here are the average figures of Nifty50’s PE for some recent periods:

Historical P/BV Ratios – Nifty 50 (Monthly Average)

P/BV Ratio (on last day of March 2018): 3.42
P/BV Ratio (on last day of February 2018): 3.54

Historical Dividend Yield – Nifty 50 (Monthly Average)

Dividend Yield (on last day of March 2018): 1.29%
Dividend Yield (on last day of February 2018): 1.13%

Now, to the historical analysis of Nifty500 companies…

As the name suggests, Nifty500 is made up of top 500 companies which represent about 95% of the free float market capitalization of the stocks listed on NSE (March 2017).

Nifty50 on other hand is an index of 50 of the largest and most frequently traded stocks on NSE. These represent about 63% of the free float market capitalization of the NSE listed stocks (March 2017).

So obviously, Nifty500 is comparatively a much broader index than Nifty50.

Historical P/E Ratios – Nifty 500 (Monthly Average)

P/E Ratio (on last day of March 2018): 29.65
P/E Ratio (on last day of February 2018): 30.75

Historical P/BV Ratios – Nifty 500 (Monthly Average)

P/BV Ratio (on last day of March 2018): 3.27
P/BV Ratio (on last day of February 2018): 3.39

Historical Dividend Yield – Nifty 500 (Monthly Average)

Dividend Yield (on last day of March 2018): 1.12%
Dividend Yield (on last day of February 2018): 0.97%

You can read the previous month’s update here. The State of Markets section has also been updated with new Nifty heat maps (link).

For a detailed analysis of how much returns you can expect depending on when the investments have been made (at various P/E, P/BV and Dividend Yield levels), please have a look at these 3 posts:

Life after LTCG Tax & You – the Long Term Equity Investor

They brought it back.

And you already know what I am referring to.

Ending almost one-and-a-half decade long tax holiday, investors now face a non-zero tax environment as far as long term capital gains from equity is concerned.

Long Term Capital Gains (or LTCG) arising from the sale of equity shares and equity mutual funds will be taxed at 10%, if total capital gains in a year exceed Rs 1 lakh.

I know you have already got your dose of LTCG and its impact and this and that via newspapers, experts debating on television channels all day long for weeks and various online publications. So in all probability, I have nothing new to add here. But I will voice my thoughts here without getting into too much technicalities… but will nevertheless have to resort to some numbers & tables.

So… where do I begin 🙂

To be honest, the investors who were until just a few weeks back accustomed to earning tax-free long term capital gains would be affected. They will have to prepare themselves to accept the ‘new’ reality of paying tax on equity related long term capital gains at a rate of 10%.

For me personally, zero was always better than 10 percent. 😉

I don’t want to add more and say anything about how I feel as I know that you know what I want to say. 😉

But the fact of the matter is that the reality has changed for all of us. And from a personal finance and investment perspective, the restoration of LTCG tax on equity is not a small change.

Some people I know are really unhappy and calling it unfortunate. I feel that there are very few things we can control. And tax environment is something that we can’t. There is no point getting into theoretical arguments about whether LTCG was justified or not. We simply need to adapt and move forward. That’s the only way forward.

But I must say, that the grandfathering clause was pleasantly innovative. So many things that could have gone wrong were smartly avoided via that clause. So… thank your grandfathers first!

Generally speaking, keeping something tax free for very long can be detrimental. And tax-free profits was never a fundamental right. So it had to happen eventually.

Infact, the return of taxation of LTCG from equities was expected for many years and hence, cannot be called as a very big surprise. But not many expected this to happen immediately. But this government is known for taking such steps. It was a bold step (though not as bold as demonetization which impacted investors, non-investors and everyone in between). I don’t know how much revenue would the government actually collect from it as of today. But as our economy grows and markets are poised to rise further in years to come, the LTCG tax collection would trend upwards with time. And that is something which the government wants to milk slowly and steadily.

Let’s talk a bit about SIP flows that have been hogging the limelight for last few years first.

I don’t think that a favourable tax regime (zero LTCG tax) was the major reason for the surge in domestic flows into the equities market. But its possible that the removal of the tax advantage may affect sentiment and flows, more so if markets don’t continue their upmove as many new investors expect is their birthright! Maybe it’s too early to say anything. I don’t know. I hope that the recent trend of more and more household savings going into financial assets is not curbed.

But I must clarify one thing…

With or without taxation, equity is the best bet for retail investors in the long run. There is no denying that.

Although LTCG may have a near-term sentimental impact it won’t wreak havoc in long term.

People were perfectly fine paying much higher taxes on much lower returns from FD and other assets. So this move may have made equity a bit less attractive for time being. But for long-term inflation-beating returns, equities has to form a major part of any sensible investor’s core portfolio.

All that has changed is that from now on, investors need to factor in an additional 10% tax burden on equity investments. And this alters the risk-reward equation for equities somewhat.

Pardon me but to move further, I need to do some number crunching…

So have a look at the tables below:

LTCG impact equity tax 1

As is evident from the table above, in long term the impact of a 10% tax will be limited on the CAGR (after taxes).

So for example, if you invest Rs 1 lac (assuming 12% constant return) for 20 years, the value of your investment would be Rs 9.64 lac before taxes.

But since you will need to pay 10% on your LTCG (above Rs 1 lac), the amount you receive will reduce to Rs 8.88 lac. That is, you pay a LTCG tax of Rs 0.76 lac – which is an impact of 8.84% of your original capital gains had LTCG not being taxed.

So due to LTCG tax of 10%, your CAGR is reduced from 12.00% to 11.54%.

This reduction is marginal in percentage terms. And to be fair, this should not stop anyone from investing in equities. Isn’t it?

But as I said, the marginal-ness is in percentage terms. This may not seem much but let’s remember that we began with just Rs 1 lac in above example.

Let’s run the numbers with a bigger Rs 50 lac investment and you will see what I am trying to say

LTCG impact equity tax 2

Focus on the last row (25th year).

Your investment of Rs 50 lac has become Rs 8.5 Cr after 25 years of 12% returns.

But welcome LTCG taxation and the amount you will get in hand will be Rs 7.7 Cr.

The impact?

A small reduction of CAGR from 12% to 11.56%.

But actually, it means Rs 79.9 lac less in your hand!

That’s not a small amount for most readers of Stable Investor. 😉

Hold on…

Let me show you something else…

In both the above examples, we assumed 12% ‘constant annual’ returns. That’s fine as a CAGR but in reality, we will see ups and downs which on an average will result in 12% returns.

So let’s do a more realistic assessment:

  • Assume you invest Rs 10 lac at the start.
  • The money is to be invested for 25 years.
  • At the end of every year, you liquidate all your investments and pay taxes if need be (if you are in profits).
  • This approach is seemingly unrealistic. But lets remember that in reality, you will exit some of your bad investments every few years to change funds, rebalance you allocations, etc. So you will exit and enter every now and then. If not every year, then atleast every few years. This particular scenario gives you a perspective of what happens with several exits between 1st and 25th
  • Within the above framework, we will test two scenarios
  • Scenario 1 – The CAGR of this 25-year period is 12% (for zero LTCG tax). But the actual annual returns are fluctuating (shamefully similar to Sensex annual return figures)
  • Scenario 2 – A ‘different’ series of 25-year annual returns that would also have delivered 12% CAGR (for zero LTCG tax).

Here is Scenario 1:

LTCG impact equity tax 3

And here is Scenario 2:

LTCG impact equity tax 4

Spend some time on both these tables. Notice the difference in sequence and quantum of annual returns. In a zero-LTCG-tax scenario, ideally both would have ended up with similar corpus.

A 12% CAGR for 25 years on an initial investment means a corpus of Rs 1.7 Cr. Now compare this will the corpus you get in above two scenarios ~ Rs 1.2-1.3 Cr. The difference is much more than 10%. Depending on the actual numbers and various other factors, the LTCG tax could cost much more than just 10% (for some cases, it might cost lesser). And this is something that people need to realize. Not easy but necessary to revise our expectations.

To be fair, the detrimental impact of LTCG tax will be negated ‘somewhat’ due to the availability of the set-off clause for Long Term Capital Loss.

As per clarification provided by the CBDT, long-term capital loss arising from sale or redemption on or after April 1st, 2018, will be allowed to be set-off against long term gains and any unabsorbed loss can be carried forward to subsequent eight years for set-off against long-term capital gains.

So this practically means, that returns will be slightly better than what the table highlights but still less than zero-LTCG scenarios.

And I am not even counting the possibility that the investor might throw in the towel at the wrong time and exit his long term investments due to lack of patience. 🙂

We can continue exploring more scenarios. But that won’t help any further. So without delving any deeper into the numbers, the point to realize is that the actual return that you get in hand will depend on a lot of factors now – like whether you sell fully or partly, after every year or after every few years, return % in years you sell, return % in years when don’t sell, quantum of set-off for gains vs losses, taxes you pay in years you sell, etc…etc…etc.

It always was a moving target.

Now the target is moving a lot more. 😉

In theory, one can put money in lumpsum at the start and remain invested till the end of 25-30 years to see a small reduction in CAGR (as highlighted in first two tables previously). But in reality, investors will sell some of their holdings and buy something else. And each such switch will have tax implications, leading to less capital being available for compounding subsequently.

As I said, the actual and eventual impact would differ for each investor depending on their buying and selling decisions. But the impact of the tax on long term capital gains on returns at times may be much larger than just 10%.

Let’s move on…

I have another small concern.

The difference between short-term and long term capital gains tax was 15% earlier. Now its just 5% (i.e. 15% tax for short term and 10% for long term). Will this reduction in difference push people towards ‘shorter’ term investing? It is possible to an extent. Probably, it’s a side effect that market will willingly digest.

But on the other side, it is also possible that people will avoid exiting investments in a hurry to defer paying taxes – so in a way, it may bring in a sense of long term’ness’ in the investments being made.

Earlier, long term investors had the luxury to switch from one investment to other every year (if need be). But now, this luxury will cost them 10% of their returns. And over time and depending on the number of such switches, the tax-related costs will add up. So ideally, this should make investors much more disciplined and avoid unnecessary exits.

So what’s the way forward?

From government’s perspective, they are back in the business of taxing capital gains from equity. Who knows what they might think of in future? Will they increase the tax to 20% with or without indexation? We don’t know but its possible. Will they change the definition of long term from currently 1 year to lets say 3 years? We don’t know but its possible. There is a non-zero probability that change will happen. More so if we are talking about decades, like remaining invested for periods of 20 or 30 years. Change will be gradual in small doses. Due to political and psychological reasons, governments and those in power will avoid making too many changes in one go. So we need to remain open to the thought that things might change again in near future.

And I haven’t addressed the concept of utilizing the exemption of Rs 1 lac capital gains which remain tax-free every year, if booked.

Mathematically speaking, it can save about Rs 10,000 a year which again atleast theoretically will be available for compounding. That’s fine. But this will be useful for small portfolio size and may not remain of much use as time progresses and your portfolio size increases (and puts you in rich and HNI category).

So should you book profits each year to lower equity LTCG tax? You can do it. But for it to make sense, your portfolio size should not be very large.

LTCG & your Financial Goals

If you invest according to your long term financial goals, LTCG will definitely impact you and your portfolio eventually if not immediately. That’s a no brainer.

Many investors and me included, run SIPs to meet their life goals – retirement (or early retirement), children’s education, travels, house purchase, etc.

Till now, it was fairly simple and most considered reaching some of these long term goals without much of a tax-impact. However, now that an LTCG tax of 10% has been introduced for equity, its possible that the investors will need to save more to meet their real financial goals, as money left in hand after paying LTCG tax will be lesser.

As a first thing, and I may be repeating – people need to keep their expectations in check and recalibrate it to the new and future tax environments. We cannot predict what will happen tomorrow. But having some buffer is fine and advisable.

Depending on various factors, chances are that the increase that investors need to make in their regular investments may not be a very big amount. The exact calculated additional amount that they need to invest to make up for the fall in equity portfolio return will depend on the investment horizon, return expectations and few other factors. For simplicity, assume that it may increase by about 10% or more too. Your financial adviser can help you create a goal-based financial plan that will have adequate tax-buffers.

Having said that, if the financial plan has made use of reasonable assumptions (like 11-12% equity returns), then there are decent chances that higher returns from the market will take care of your needs (even post tax ones too). But if the plan assumes 19-20% kind of returns from equity, then you need to put up your hand and revise your expectations first and ask your advisor to not fool you! And ofcourse increase your on-going investments.

That brings me to the important point of rebalancing the portfolio.

This includes buying-&-selling to preserve strategic asset allocation as well as existing dud investments and entering better ones.

All this will now cost 10% of the profits being booked.

So people need to avoid churning their portfolios unnecessarily and frequently to avoid this ‘new cost’. This also means that it makes sense to choose funds which have a good record of doing well in long term and which require least churns.

This is something that those focusing on asset allocation framework need to be careful about.

But avoiding taxes should not be a reason to remain put in bad investments. The notional loss by not being in the better funds will be much more than your tax savings.

Finally…

I think I have already added to the noise surrounding LTCG and its impact on long term returns from equity. 🙂

My apologies for that.

To summarize, LTCG is the new reality which no doubt is a negative for investors. But my advice is to accept, adapt and move on.

Equity still offers best inflation-beating returns, even after all the taxes and has the potential to outperform returns from most other savings and investment options.

Good, sensible and disciplined investing will take care of all such similar issues that come up every now and then.

Being an advisor, I can confidently say that instead of worrying and getting confused about things that cannot be controlled, investors should simply concentrate on their financial goals and keep investing (now a little more) in a disciplined manner through systematic investment plans (SIPs) and for the long term.