Calculating Annualised Returns

In a portfolio, how does one calculate Annualised returns? I would like to know the mathematical formula used, especially in a complex case such as:
1. SIP
2. Partially realized gains
Please try to explain each with an example.
- Kapil Khanna

At Value Research, we use two methods of computing fund returns over a period of time. Returns of fund's performance for a period of less than 1 year are Absolute Returns and that in excess of 1 year are Annualised Returns.

For Annualised returns, we use the CAGR formula i.e. Compound Annualised Growth Rate formula.
If an investment of Rs 5,000, made five years ago has grown to Rs 6,500 today, then the absolute gain would be Rs 1,500 - a 30 per cent growth on initial investment. A 30 per cent return on investment would normally qualify as good but for the fact that it was realized over five years. If you want to know how much the investment has grown on a yearly basis, you will have to take a look at the compounded Annualised growth rate (CAGR).

The CAGR tells you the return a fund turned in every year during the five-year period, provided the gains were re-invested every year. In this case, the CAGR works out to 5.38 per cent. So, in the first year the investment would have grown to Rs 5269. In the second year, it would have been Rs 5552.4 (by adding 5.38 per cent of Rs 5269) and so on. In India, mutual fund regulations require that all returns over one year should be stated in Annualised terms.

On our website, we calculate the returns for less than a year using the absolute method and those above a year as Annualised.

For calculations of SIP returns, the complex formula of XIRR is used. You can access this formula in a software like MS Excel. To calculate you should list your monthly SIPs as an outflow respective to a date and then write the final value on the respective date of calculation. The XIRR formula would give you the internal rate of return of your investment.

Date Cash Flow 01-Jan-06 -1000 01-Feb-06 -1000 01-Mar-06 -1000 01-Apr-06 -1000 01-May-06 -1000 01-Jun-06 -1000 01-Jul-06 -1000 01-Aug-06 -1000 01-Sep-06 -1000 01-Oct-06 -1000 01-Nov-06 -1000 01-Dec-06 -1000 10-Dec-06 13000 XIRR 0.177 Annualised Return 17.70%

In the above table you see a monthly SIP of Rs.1000 which is taken as outflow every month. On December 10, 2007 the value of the investment stands at Rs. 13000. The XIRR function helps you calculate your annualised return i.e 17.7 per cent.

(Source: Value Research)

Birla Sunlife on the Top

On the whole, of the total 467 rated funds, 39 funds have been upgraded and almost as many (43 funds) downgraded. 383 funds have maintained a status quo.

As on October 31, 2007, as many as seven funds gained the 5-star tag: DSPML Balanced, Birla Gilt Plus Liquid, Birla Sun Life Frontline Equity, HSBC MIP Saving, Grindlays GSF PF Regular, Templeton Floating Rate ST Inst and LICMF Floater MIP Plan A. The first six of these funds have been upgraded from 4-star rated to 5-star rated funds. LICMF Floater MIP Plan A, after fluctuating between 3 and 4 star rating, has moved up two steps to become a 5-star fund thanks to its improved returns. DSPML Balanced made a comeback to the 5-star club after being out of it for four months. Two funds, Tata Dividend Yield and Reliance NRI Equity, have been rated for the first time this month. Being rated for the first time, Reliance NRI Equity has begun its rating life in the elite club of the Value Research Fund Rating with a 5-star tag. Tata Dividend Yield has scored a 3-star tag. As many as ten funds lost their 5-star tag while ICICI Prudential Dynamic slipped to become a 2-star tag after enjoying the 4-star tag for the past six months. As far as the fund families are concerned, Birla Sun Life AMC tops the chart with six of its funds finding a place in the top-rated category and 14 funds with a four-star tag. Closely following it are the ICICI Prudential and SBI Mutual; lagging behind by just one step with five 5-star rated funds. Fund Families: How they Stack Up AMC Name « «« ««« «««« ««««« ABN AMRO 2 2 2 1 - Benchmark 2 - 2 - - Birla Sunlife 3 6 10 14 6 BoB 2 4 3 - - Canara Robeco 2 2 4 5 - DBS Chola 1 3 3 1 1 Deutsche 1 3 2 2 1 DSP ML 2 3 4 4 2 Escorts 1 4 3 - - Fidelity - - - 1 - Franklin Templeton - 7 19 8 2 HDFC 3 7 9 7 4 HSBC 1 1 6 4 1 ICICI Prudential - 5 18 10 5 ING - 6 5 4 - J M 3 6 3 1 - Kotak Mahindra 1 2 10 3 3 LIC 4 3 7 2 2 Principal 1 6 6 5 2 Quantum - - 1 - - Reliance 3 - 6 5 3 Sahara - 1 2 3 - SBI 4 5 8 5 5 Standard Chartered 2 5 4 3 1 Sundaram BNP Paribas 2 5 5 4 1 Tata 1 5 10 10 4 Taurus 3 1 2 - - UTI Mutual Fund 3 11 11 3 4 As on November 30, 2007

(Source: Value Research)

The Ideal Plan

Which plan is ideal for me- growth, dividend payout or reinvestment?
- Anonymous

The treatment of gains and taxes are the two essential features that differentiate these plans. If evaluating the returns from an investment at a point of time, there is no difference among the three options. The difference emerges in an implicit form with respect to the applicable taxes.

Gains: In case of a growth plan, gains made are reflected in the higher NAV of the fund. The capital appreciates and investors can cash in on this by redeeming units. Under this option, the decision of booking profits is that of the investor. In case of dividend plans, the fund manager takes a call and distributes gains amongst investors in the form of dividends. Under the dividend payout option, the dividend is paid to you and the NAV falls by the extent of such a payout. It is up to you to reinvest that money as you deem fit. In case of dividend reinvestment, the dividend is paid out by issuing additional units. Hence the dilemma of reinvesting your dividends is taken care of. The biggest benefit here is that the discretion of booking profits is left to the fund manager.

Taxation of Equity Funds: As far as the growth option is concerned, one needs to pay taxes on capital gains. If the units are sold within a year, a short-term capital gains tax of 10 per cent is levied. There is no tax payable on long-term capital gains which comprise of units held for more than a year.

Dividends are tax free in the hands of the investor. When a fund house distributes dividends, it is required to pay a dividend distribution tax (DDT). There is no DDT applicable on dividends declared by equity and balanced funds.

So if you intend redeeming units within one year of investing in a fund, you would be better off under the dividend option. But such a strategy is not foolproof for investors will be at the mercy of the fund house to distribute dividends. Not to mention the fact that an investment time horizon of less than a year is not advisable for investing in equities.

Taxation of Debt Funds: The treatment of debt funds is slightly complicated. Dividends distributed are liable to DDT which implicitly eats into the corpus that could be potentially in your hands. In case of money market or liquid funds, the DDT (inclusive of surcharge and cess) amounts to as much as 28.33 per cent. For all other type of debt funds, the DDT (inclusive of surcharge and cess) amounts to 14.16 per cent for individuals and Hindu Undivided Families. The tax for all other assessees stands at 22.66 per cent.

In case of debt funds, a short-term capital gains tax depending on your income bracket is levied for units redeemed within a year of investment. Long-term capital gains tax is 10 per cent (plus surcharge) without indexation and 20 per cent with indexation. Therefore, purely in terms of tax efficiency, one ought to stick to the growth option in case of money market and liquid funds.

For all other debt funds, if you are in the middle or higher tax slab paying 20 per cent or more as income tax, then the dividend option will make more sense over the short term. For the long-term debt investor, growth would be the way to go.

Making the right choice: Some people prefer using the dividend payout option as a source of regular income. The glitch with this is that funds are not obligated to declare dividends even under a monthly dividend plan. Moreover, the quantum of the payout will not be consistent. Our advice is not to opt for the dividend option as a monthly source of income. You would be better off instituting a Systematic Withdrawal Plan for this.

The dividend option is suitable for those who would like to book profits regularly and redirect such money to other financial instruments such as a fixed deposit. For all other purposes, the growth option offers more flexibility in decision making.

There is an exception though. In case of ELSS or tax planning funds the dividend payout plan is superior. This is because the dividends paid out are not subject to a three-year lock in. And while you cannot redeem your principal units for three years, under the dividend payout option you can at least avail of the profits made here. However, one should absolutely steer clear of the dividend reinvestment plan under this category because the additional units received are subject to the three year lock in.

(Source: Value Research)

Patience Is The Key

I am 22 years old and started earning this April. I earn around Rs 2 lakh per annum. I have already managed to save Rs 30,000. Now I want to invest in mutual funds as well as do some tax planning. I also want a life cover of Rs 5 lakh. Would appreciate some guidance.
-Anonymous

It is commendable that you wish to begin investing at such a young age. In fact, this is the ideal age to make a start.

Get Started
Since financial responsibilities are minimum at your age, you should focus on wealth building. Being just 22, equity is an excellent vehicle for you. But the watchword here is patience. If you are willing to ride the ups and downs of the stock market without getting flustered, consider an equity fund.

The key is to invest regularly and stay in for the long haul. If you set aside just Rs 5,000 every month over the next 30 years at a rate of 11 per cent per annum, you will have Rs 1 crore by the time you are 52. That is the magic of getting time to work for you.

But you need to save every single month and learn the discipline of not being perturbed by market prices. The best way to do this is by starting with a Systematic Investment Plan (SIP) in a mutual fund where a fixed amount every month goes into a fund of your choice. (Refer to Buy Sell Hold to see benefits of SIP.)

A balanced fund would be the ideal way to kick start. These funds have considerable investments in debt and, hence, are less aggressive than pure equity oriented mutual funds. You can expect decent returns in the long run with no lock-in period whatsoever. Choose any top performing mutual fund like HDFC Prudence, DSPML Balanced or Tata Balanced. Once you are comfortable with the risks associated with mutual fund investing, you can venture into pure equity mutual funds.

Do You Need It?
Since insurance is not an investment, one has to evaluate the insurance needs on a case-to-case basis. If you don't have any dependents at this time, what are you buying insurance for? But if you are still keen on it, opt for a pure term policy. This is the most simple and purest form of life insurance. A term insurance cover of Rs 5 lakh for 25 years would cost you a meager Rs 1,200 per annum. Another plus point about term insurance; it is also the cheapest form of life insurance available.

The Inevitable
Think taxes. Think Section 80C.
This section of the Income Tax Act offers a deduction from taxable income. If you invest up to Rs 1 lakh in the relevant instruments specified under this section, you save tax up to that amount.

First you need to check if your employer offers a provident fund. If yes, a percentage of your basic salary will be deducted by your employer towards the Employee Provident Fund (EPF). Since you are considering a life insurance policy, the premium you pay is also eligible for deduction under Section 80C.

So total these two figures and see by how much you fall short of the Rs 1 lakh limit. If you still want to invest to save tax, then you can consider five-year bank fixed deposits, the National Savings Certificate (NSC) or the Public Provident Fund (PPF). All these are fixed return instruments with maturities of five, six and 15 years respectively. Tax saving bonds of different maturities are also brought out by financial institutions from time to time.

At your age, consider Equity Linked Savings Schemes (ELSS). These are diversified equity funds that offer a tax benefit under Section 80C. They have the lowest lock-in period (three years) and the capability to generate the highest return amongst other tax saving instruments. Also, you pay no tax on maturity unlike the other options. The PPF is an exception, but that could change in the future.

If you wish to select an ELSS, choose from Value Research's five- or four-star rated funds like SBI Magnum Tax Gain, HDFC Tax Saver, Sundaram Tax Saver or Franklin India Tax Shield.

Emergency Planning
Don't forget to create a contingency fund to meet immediate cash requirements in case of an emergency. For this, you can keep two to three months of your salary in a savings account, as it gives you accessibility 24x7. In fact, your savings of Rs 30,000 can be set aside and you can initiate SIPs with you regular salary from now on.
All the best!

(Source: Value Research)

Dividend Announced under Two Schemes of HDFC Mutual

HDFC Mutual Fund has announced December 12, 2007 as the record date for declaration of dividend under the dividend option of HDFC Multiple Yield Fund and HDFC Multiple Yield Fund - Plan 2005. The quantum of dividend will be 10 per cent for both the schemes.

(Source: Value Research)