Don't be fooled by mutual funds' dividends! Sep 04, 2009

Light up your Child's future this Diwali

Sep 4, 2009

Weekly Facts
	Close	Change	%Change
BSE Sensex	15,398.3	382.7	2.43%
Re/US$	48.9	0.0	0.06%
Gold Rs/10g	15,245.0	190.0	1.26%
Crude ($/barrel)	67.3	3.5	4.94%
FD Rates (1-Yr)	5.00%-6.65%

Weekly change as onSep 3, 2009

Don't be fooled by mutual funds' dividends!

Impact

Dividends have often been used as a tool to mis-sell mutual funds. Especially, after the banning of entry loads by SEBI, mutual funds have resorted to wooing investors by declaring attractive dividends.

However, what most investors fail to realize is that the term 'dividend' does not have the same significance with respect to mutual funds, as it does with stocks. When mutual funds declare dividends, they simply pay back a part of the principal invested, with no additional gains. This is illustrated in the example below:

Pre-Dividend
Investment	Rs 1,000,000
Net Asset Value	Rs 100
Units	10,000
Dividend Declared	50% of Rs 10 (face value)
Dividend Received	Rs 5*10,000 = Rs 50,000

Post-Dividend
Net Asset Value	Rs 95
Units	10,000
Value of holding	Rs 95*10,000 = Rs 950,000
Dividend Received	Rs 5*10,000 = Rs 50,000
Total Amount	Rs 950,000 + Rs 50,000 = Rs 1,000,000

After declaring a dividend, the value of your investment (NAV) falls by the amount of the dividend. Thus, the Value of Holding plus the Dividend Received will equal the Original Investment, in the example - Rs 1,000,000. By declaring a dividend, the mutual fund has simply transferred your own money back to you.

Therefore, dividends should not be the primary incentive behind investing in a particular fund. Instead investors should consider factors such as the performance and sustainability of the fund in question.

Is IRF meant for retail investors?

Impact

National Stock Exchange (NSE) launched Interest Rate Futures (IRF) on August 31, 2009. The underlying security is the 10-Yr Government Bond with a notional coupon of 7% p.a. payable half-yearly. One contract size of IRF is Rs 200,000 and it is open for both retail and institutional investors.

How is IRF helpful?

Interest Rate Futures are derivative instruments on an underlying security which is usually government securities/government bonds.

With Interest Rate Futures, investors can now easily express their view on the movement of 10 year G-Sec yields and use it to hedge their exposure in G-Sec.

For instance, if an investor holds a 10 year G-Sec at 7.5% and expects the yield to rise to 8.0%; he can sell the future at current levels to hedge the risk of capital losses on his cash bond holding. Price of bonds fall when interest rates (yield) rise and vice versa. Hence, by selling the futures now and buying it back later, when the yield has risen and the price has fallen, the investor realises a profit which can minimize the overall losses on his cash bond holding.

From a retail investor's perspective, IRF can be used to hedge the interest rate risk on home loans.

For instance, an individual has a home loan of Rs 20 lakhs at a floating rate of 8% p.a. for 10 years at an EMI of Rs 24,265. If interest rates rise in future to 9% p.a., then the EMI would also increase to Rs 25,335, an increase of Rs 12,835 per year.

To compensate for this rise in EMI, an individual can take a short position in IRF. Consider each IRF contract is trading at Rs 100; then one can sell futures at Rs 200,000 (this is the value of futures). The yield of the underlying security would rise due to the rising interest rate regime. A 1% rise in yield would lead to approximately 6.5% fall in the price of the bond. Consequently, the yield of the IRF will also rise which would lead to a fall in the price of IRF to Rs 93.5 = 100*(100% - 6.5%). The value of future will fall to Rs 187,000 = (93.5/100)*200,000. Thus, netting will lead to a gain of Rs 13,000 = (200,000-187,000) on buying back the future for Rs 187,000.

Interest Rate (%)	EMI (Rs)	Contract Price (Rs)	Value of Futures (Rs)	Savings (Rs)
8	24,265	100	200,000
9	25,335	93.5	187,000
	(12,840)		13,000	160

(Not included the impact of tax and transaction cost in this example.)

But the question remains - Is trading in IRF meant for retail investors?

To trade in IRF, retail investors need to consider the following:

They need to have a view on the interest rate movement. If the call goes wrong then it can lead to huge losses.

They should understand the pricing of futures as it is linked to the underlying security - the 10 year G-Sec.

They would need to understand the dynamics of the yield/price relationship as explained above and be able to price the underlying security.

There is a physical settlement. So one should know how to avoid taking delivery. If one takes delivery of the security then the question arises of what to do with that security and how to sell it without suffering losses.

Since every futures contract is for a 3 month period, to continue their investments for a period of one year, one will have to roll the futures transaction every 3 months. The cost of rolling over can be adverse at times.

Transaction charges and tax on gain are involved.

The interest rate future is thus a product more suitable for institutional investors with sophisticated knowledge of the bond markets and derivatives. We would not recommend that individuals try their hand on this product.

Retail investors would be better off investing in bond mutual funds to take exposure to the bond markets and leave the intricacies of managing interest rate risk on the fund manager.

New health insurance rule to benefit customers

Impact

The Insurance Regulatory and Development Authority (IRDA) has made it mandatory for all general insurers to offer a 15-day free-look period for health insurance products with a duration of 3 years or more. This is applicable to all policies issued or renewed from October 1st, 2009 onwards.

Now, all customers will have the liberty to meticulously read and understand the documents during this period, after which they can return the policy within 15 days if they are unsatisfied with any terms or conditions. If the customer does return the policy, he will receive a refund of the premium paid after a deduction of the expenses incurred by the insurer on his medical examination and stamp duty charges. In case the risk has already taken place during this period, a proportionate risk premium for the period on cover will also be deducted.

Currently, the 15-day free-look period is offered only by life insurance companies. From October 1st, health insurance companies failing to comply with this new rule will be subject to appropriate action under the IRDA Act, 1999 and the Insurance Act, 1938.

Policyholders should make the most of this new rule and ensure that they carefully read through the fine print of their health insurance policies before agreeing to it.

Deadline for banks: October 15, 2009

Impact

After approval from the Reserve Bank of India (RBI), the Indian Banks' Association has ordered its 150 member-banks to implement the Rs 10,000 cap per third-party ATM cash withdrawal from October 15th, 2009. In addition to this, customers will be limited to only 5 such free transactions per month. From the 6th transaction onwards, an interchange fee will be charged to the customer's account. With the recent escalation in third-party transactions, banks tried to persuade the RBI to impose a minimum limit of Rs 1,000 on third-party transactions. However, this suggestion was rejected as it would be detrimental to the small client.

Free withdrawals from third-party ATMs are beneficial for customers; however customers must be careful not to exceed the limit of 5 transactions per month. RBI's decision to decline a floor on third-party transactions is favourable for small withdrawals.