Once you are clear with your reasons for investing and you have also determined your risk appetite, the next big question infront of you is, ‘What are the investment options available to me?’
The answer to this question will open several investment doors for you. However, you should decide on the investments you want to make, based on your financial plan, age, awareness and risk appetite. The various investment instruments available are
Fixed
Income Instruments
Mutual
Fund
IPOs
Direct
Equity
Equity
Derivatives
Gold
A brief study of each of these investment instruments will help you achieve the right investment mix in your financial plan.
Fixed Income Instruments
 What are Fixed Income Instruments?
Fixed
Income Instruments – Risk free – A Myth
Characteristics
of fixed income instruments
Characteristics
of Fixed Income Investing
Popular
Fixed Income Instruments
What are Fixed Income Instruments?
If you will ask a cross-section of the investor community, one characteristic
which an investment should offer, “safety” will top the list. By and large,
investors are willing to settle for “fixed” and resultantly lower returns as
long as their invested capital is safe. Fixed income investments attempt to
address this need of the investors.
Before the year 2000, fixed income instruments used to carry high
interest rates (in excess of 10 per cent) mainly due to scarcity of capital and
high inflation rates prevailing in India. With the opening up of the Indian
economy, flow of foreign funds in India, consistently high savings of Indian
investors, declining inflation and several other economic factors, interest
rates started declining from the year 2000 onwards from a high of approximately
12 per cent in late 1990’s they came down to approximately 6 per cent in 2005!
Further, several fixed income instruments earlier came with tax benefits. For
instance, interest earned on bank fixed deposits attracted the erstwhile
section 80L benefit, whereby if the interest income from such investments did
not exceed a certain amount, no tax was payable on it. However, coupled with
declining interest rates in this millennium, most such tax benefits have been
withdrawn, squeezing the returns for fixed income investors.
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FIXED INCOME INSTRUMENTS – RISK FREE – A MYTH
Though, fixed income instrument do offer an element of safety and stability of
returns, they are not risk free. The two primary risks associated with fixed
income investing are:
Interest Rate Risk: When interest
rates rise, fixed income investments lose value. This is because the investor
will continue to earn the same (lower) interest rate until the investment
matures while market interest rates have already gone up. In order to
compensate for a lower interest rate compared to the market rate, the fixed
income investment will thus have to be priced at a lower rate. For example, if
a Rs 100 bond is fetching 7 per cent interest and market rates have moved to 9
per cent, the bond will now be worth 77.8 per cent of its face value (coupon
rate of 7 per cent divided by market rate of 9 per cent multiplied by 100),
i.e. Rs 77.8 (77.8 per cent of the face value of Rs 100). Thus, if the bond is
sold at this price, the new investor will earn 9 per cent from this bond.
Credit Risk:This risk herein is
that the borrower may default on interest and/or principal repayment. For
example, a company borrowing fixed deposits from investors may default on
servicing its obligations (interest and/or principal repayment) in case it is
going through a bad patch.
Characteristics of fixed income
instruments
Some of the characteristics which fixed income instruments offerare:
Fixed interest rate:Fixed income
instruments offer a pre-determined rate of return which is applicable for the
term of the investment.
Fixed term:Fixed income
instruments come with a fixed investment term. Depending on the instrument you
may have the facility of undertaking a pre-mature withdrawal. Normally there is
a directly proportional relationship between interest rate and tenure, longer
the tenure higher the interest rate.
POPULAR FIXED INCOME INSTRUMENTS:
Fixed income instruments mainly include bank fixed deposits,
company fixed deposits, RBI Bonds and Post Office Small Savings Scheme (POSS).
Bank fixed deposits:
These are by far one of the core fixed income opportunities available
for the retail investor. Bank deposits can be placed for flexible time periods.
The minimum and maximum tenure of these deposits varies from bank to bank. Generally,
the minimum term of such deposits is 7 days and maximum is 10 years. A longer tenure
deposit attracts a higher rate of interest to compensate the deposit holder for the
interest rate risks arising on such deposits. Bank deposits are mainly of two types –
non-cumulative and cumulative deposits. Under the former, interest accumulated on
the deposit is paid out to the deposit holder after specified intervals whereas
in the case of the latter, interest accrued on the deposit is re-invested in the
deposit at the pre-determined rate of interest. The interest is then made available
to the deposit holder at the end of the term.
Bank deposits allow a great deal of liquidity since you can undertake
premature withdrawals. In case of a premature withdrawal, you will receive interest at
the rate applicable for the term for which the deposit is maintained.
Also, Section 80C allows you to avail of a deduction from
taxable income to the extent of your investment in certain specified avenues, up to
a maximum consolidated limit of Rs 1 lakh.
Company deposits:
Certain government companies, manufacturing companies and Non-banking Finance Companies (NBFCs) are authorised by the RBI to issue fixed deposits to the public. These deposits are raised by the companies in order to fund their business activities, expansion plans, to provide for capital expenditure etc. Like bank deposits, even these deposits can be placed for a fixed tenure and at a pre-determined rate of interest. Company deposits are normally placed for a period ranging from 6 months to 5 years. The Interest rates on these deposits are based on the term of the deposit and the credit rating given to the deposit scheme. This rating summarises the company’s ability to repay the principal and interest amounts of the deposit upon maturity to the deposit holder. Higher the rating, lower will be the interest rate.
These deposits offer higher returns as compared to bank deposits, but they are unsecured in nature. Hence, in case of a default on the part of the company, the deposit holder has no way of recovering his money back. The only recourse available is to approach the requisite grievance redressal agencies. Also, these deposits are highly illiquid as companies do not permit premature withdrawal. And, income earned on company deposits attracts tax at personal income tax rates, applicable to you.
RBI Bonds:
RBI Relief Bonds are issued by the Reserve Bank of India and are a popular tax-saving tool. These bonds are currently available under two options – an 8 per cent bond which is taxable and a 6.5 per cent tax-free bond. A number of banks such as the UTI, SBI etc. undertake the distribution of such bonds on behalf of the RBI. The maturity period of the 8 per cent RBI Bond is 6 years and for the 6.5 per cent RBI Bond is 5 years
Since these bonds are issued by the government, they carry zero risk with them.
Also, these are highly illiquid, as they cannot be encashed prior to their maturity. However, the 6.5 percent tax-free savings bond can be redeemed after a minimum lock-in period of 3 years from the date of issue. Also, these are non-tradable securities and therefore cannot be sold on the debt market..
For the 6.5 per cent bond, interest received is completely exempt from income tax. But, for the 8 percent RBI relief bond, interest is taxable according to the personal income tax rate applicable to you.
Small Saving Schemes:
The Post Office Savings Schemes (POSS) are a popular savings destination as they offer guaranteed returns and are risk-free as they are backed by the government. There are several Small Savings Schemes with varied tenures and rates of return. The liquidity however, is low in most of them. You can invest in them depending on your requirements.
Mutual Fund
What is a Mutual Fund?
Advantages of investing in Mutual Funds
Disadvantages
of mutual fund investing
Types
of mutual funds
How to choose a Mutual Fund Scheme?
Mutual
Fund Investing Strategies
Know Mutual Funds terminology
What is a Mutual Fund?
To benefit from investing in the stock or the debt market, you must have a
basic understanding of how these function and a good overview of what is on
offer. Beyond that, it requires continuous tracking of various stocks and/or
debt market products, in order to stay abreast with the trends in these
markets. For example, if you buy shares of ten companies, it means that you
will have to keep a close tab on these ten companies in terms of their
performance, financial results, future plans and so on. In the case of debt, to
invest gainfully, you must be aware of trends in inflation and interest rates,
amongst other factors, not only in the domestic market but in international
markets as well.
This may sound like a daunting task as it could take up a lot of
your time and effort. It would also require access to a considerable amount of
information, in addition to having suitable skills and expertise. The simple
alternative would be to invest in debt and equity through mutual funds.
A mutual fund is a vehicle through which an investor can
indirectly invest in equities or the debt instruments. It holds the
contributions of a large number of investors and the common pool of funds so
collected is invested by professional managers in equities and/or debt
instruments in accordance with the predefined objectives of the mutual fund.
Since the ownership of the corpus is joint, i.e., the fund belongs to all
investors, and its investment purpose is “mutual”, i.e., common for all
investors, it is called a mutual fund.
In proportion to their contributions, investors receive units of
the mutual fund. At the outset, the units issued have a face value of Rs 10
each. Later, as the corpus is invested and the value of the investments change
the value of each unit changes proportionately. The value of each unit is also
impacted when management fees and other expenses are deducted from the overall
pool of funds.
The value of each unit is called the Net Asset Value or NAV of the
scheme. It changes on a daily basis. As per the definition, the net assets mean
the current market price of all securities held plus cash and any accrued
income, minus liabilities.
More specifically,
NAV = (Market value of the fund's investments + Current assets + Accrued
income) - Current Liabilities - Accrued Expenses / (Total Number of units
outstanding)
Investors who wish to purchase or sell units of a mutual fund after the scheme
is fully functional must do so at a price that is linked to the NAV.
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Advantages Of Mutual Fund
1) Expert Decision making in your investments
The biggest advantage that mutual funds offer is greater expertise on the markets, be it the stock market or debt market. The AMC, with its well organized and structured pool of talent, tracks the stocks/economy at the micro as well as macro levels and takes investment decisions accordingly.
2) Flexibility of investments
Mutual Fund investments give you the flexibility yo pick and choose from various categories of schemes, i.e, equity, debt, etc, as per your risk appetite, return expectations and overall investment objective.
3) Diverse Portfolio
Mutual Funds give you exposure to a large variety of instruments, with only small investments from you. In fact, some instruments which form part of a mutual fund’s portfolio, especially in the debt segment, are totally out of the reach of a retail investor due to the high threshold investment limits.
4) Transparency and Safety
Mutual Funds are subject to stringent disclosure norms. SEBI regulates all mutual funds operating in India, setting uniform standards for all funds, thus guaranteeing transparency and safety of investors’ funds.
5) Tax Benefits
Income earned from Mutual Fund investments are subject to various tax exemptions, depending on the type of scheme and the period of holding.
Disadvantages of Mutual Funds investing.
Disadvantages Of Mutual Fund
Impact Cost
Operationally, mutual funds buy and sell in large volumes and voluminous buying or selling of shares often results in adverse price movements. Funds which buy in large volumes end up inflating the prices and when funds sell in large quantities, they tend to depress prices. This could result in high prices while buying and low prices while selling is called ‘impact cost’.
Lead Time
The mutual funds cannot remain fully invested all times due to various reasons. Firstly, they must maintain some part of their corpus in cash, in order to meet redemption pressures. Then there could be a time lag between identification of investment opportunities and actual investment. And finally, it is not possible for a fund house to deploy money in the market immediately after receiving it from investors. This lead time when cash is lying idle with mutual funds results in lower overall returns on the corpus.
Marketing and Fund management costs
In the case of most mutual funds, there is an exit load (fee) applicable while selling mutual of fund units. This load, which is a certain percentage of the value of units held, is applied to cover marketing and other costs. In addition to this, the AMC charges annual asset management fees and expenses, which are captured in the expense ratio.
Cost of churn
Some schemes tend to churn their portfolio very often, in keeping with the investment philosophy of the fund manager, i.e., whether he/she believes in long term or short term returns. This means higher transaction costs (brokerage, custody fees etc) and consequently, lower returns.
TYPES OF MUTUAL FUNDS
1) Mutual funds based on structure
A. Open ended and close-ended schemes
Based on maturity there are two types of mutual fund schemes - open-ended and
close-ended schemes.
Open-ended schemes
These schemes do not have a defined or fixed maturity period. The investors can
buy or sell units on any business day at NAV based prices from the fund house.
Due to this flexibility offered to unit holders, the overall capital of
open-ended schemes can fluctuate on a daily basis.
Close-ended schemes
These schemes have a stipulated maturity period and the fund remains open for
subscription only during a specified period, at the time of launch of the
scheme. Investors can invest in the scheme at the time of the initial public
issue and thereafter, they can buy or sell the units of the scheme on the stock
exchanges where the units are listed.
To provide an exit route to the investors, a few close-ended funds give an
option of selling back the units to the fund house through periodic (usually
monthly or quarterly) repurchase at NAV related prices. SEBI regulations
stipulate that at least one of the two exit routes is provided to the investor
i.e., either repurchase facility or through listing on stock exchanges.
B. Load and No Load Funds
Some mutual funds charge entry or exit loads (fees) when an investor buys or
sells units. These are called “Load funds”. The load is based on the NAV and is
calculated as a certain percentage of the NAV. The load is applied to cover
expenses incurred on the scheme’s marketing, distribution, advertisements, etc.
Because of these charges, your purchase price is higher and your sale price is
lower than the prevailing NAV of the scheme. For instance, if the NAV of a
scheme is Rs 15, and the scheme levies an entry load of 2 per cent, then your
purchase price is 15.30 (NAV + (entry load * NAV)). The number of units that
you would hold is a function of your purchase price and not the NAV. Similarly,
if the NAV of a scheme is Rs 15, and the scheme levies an exit load of 2 per
cent, then your sale price is 14.70 (NAV - (exit load * NAV)). The sum of money
that you receive on redemption is a function of your sale price and not the
NAV. You should consider loads applicable to schemes while investing your money
as it directly impacts your actual returns from the investment.
A ‘no load’ fund does not charge any entry or exit fees.
C. Cumulative or growth schemes, dividend reinvestment
schemes and dividend payout schemes
Mutual funds usually give investors a choice of three ways in which they can
receive their profits from a scheme. These are called the dividend payout
option, the growth option and the dividend reinvestment option.
Dividend payout option - In the dividend
payout option, the profits of the scheme are distributed to the investors in
proportion to the number of units that they hold. This option is suitable for
investors who would like to receive a regular income and for those who would
like to use their profits elsewhere.
Growth option - In the growth option, the
profits are not distributed and accordingly, the value of each unit keeps
appreciating as the profits increase. This option is suitable for investors who
do not have any immediate need for cash and would prefer to reap better wealth
in the long run.
Dividend reinvestment option - Lastly, the
dividend reinvestment option is similar to the growth option, in that the
profits are not distributed. However, here the value of the units is not left
to simply appreciate. Instead, each investor’s profits are converted into more
units of the same scheme at the NAV of the scheme as on the day of conversion.
This option is for those investors who have a medium risk profile and would
prefer to see their capital base grow rather than allow their appreciation to
be eroded by any fall in the value of the scheme’s portfolio.
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Mutual funds based on the
Portfolio Allocation
Based on portfolio allocations, there are three broad categories of funds:
-
Equity Funds
-
Debt Funds
-
Balanced Funds
A. Equity Funds
Equity funds invest largely in the shares of companies which are listed on the
stock exchange. Equity funds are basically high risk, high return schemes.
Dividend and capital appreciation are the major revenue streams for equity
funds. The schemes are suitable for investors who are ready to take on some
amount of risk to receive good returns.
All those risks which are associated with equities are associated with these
funds. The NAV will generally move in tandem with the share prices of the
stocks that make up the fund’s portfolio. If the prices of the stocks in its
portfolio fall, the NAV of the schemes too will register a dip.
There are various types of equity funds, key among them include:
Diversified funds
The objective of diversified equity funds is to provide the investor with
capital appreciation over a medium to long term by investing in stocks from
various sectors and segments of the equity market.
These funds balance their
portfolios so as to prevent any adverse impact on returns due to a downturn in
one or two sectors. Hence, the returns change more or less in tandem with the
broad movement of the stock market.
Diversified funds are ideal for
investors who wish to invest in an instrument that delivers equity market
linked returns, without having to build up a large portfolio and monitor it
separately.
Sector funds
Sector funds invest only in companies belonging to specific sector mentioned in
the offer document. Normally, sectors that are in the limelight or are
witnessing robust growth are the ones targeted by the mutual fund industry in
order to launch sector funds. The sectoral equity funds dedicated to industries
like technology, bank, pharmaceuticals, infrastructure, etc are good examples
of such funds.
Sector funds invest only in companies belonging to the specific sector mentioned in the Offer Document. Normally, sectors that are in the limelight or are witnessing robust growth are the ones targeted by the mutual fund industry in order to launch sector funds. The sectoral equity funds dedicated to industries like technology, bank, pharmaceuticals, infrastructure, etc. are good examples of such funds.
Investments in these funds come with a higher risk attached, since the investment is spread only across a single sector and vice versa. This fund is suitable for investors who are convinced about the future prospects of a particular industry and wish to cash in on it.
Theme based funds
Theme based funds are fairly similar to sector funds. The differentiating factor is the level of diversification that they offer. Instead of concentrating on stocks belonging to a single sector/industry, their focus lies on a specific theme and they invest in companies which conform to that theme. For instance, some theme based schemes invest in only globally competitive Indian companies or multinational corporations operating in India, others invest in only those companies which offer a dividend yield above a certain pre-determined level, and so on.
Index funds
An index funds replicates a selected index, such as the Nifty 50 or the Sensex,
etc., by investing in the same stocks that comprise the index. There are two
types of index funds – Passive Index Funds and Active Index Funds. The former
align their portfolios as accurately as possible to the index and try to hold
index stocks in proportion to the weight-age they enjoy in the index. Active
index funds, on the other hand, aim to give a better return by changing the
weightages of individual stocks and even sectors, as per the fund manager’s
discretion. Such funds may also allocate a certain portion of their portfolio
to non-index stocks.
Exchange Traded Funds
Exchange Traded Funds (ETFs) are similar to index funds, in that they too
invest in stocks comprising a particular stock index like the NSE Nifty or the
BSE Sensex. The crucial difference is that an ETF is listed and traded on a
stock exchange while an index fund is bought and sold by the fund and its
distributors.
There is very little difference between these funds and index funds structurally, except for the fact that entry and exit in the case of ETF will attract brokerage while buying and selling index funds could attract exit loads. Investors who wish to regularly enter and exit index funds may prefer ETFs if they work out more cost effective.
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Equity Linked Savings Schemes
The Equity Linked Savings Schemes are popularly known as ELSS. ELSS is a variant of diversified equity funds; however, these schemes come along with income tax benefits under section 80 (C) of the Income Tax Act. However the income tax deduction comes with a lock-in-period of 3 years. Such schemes carry the same risk as equity diversified schemes. Yet they could deliver better returns since the lock in period gives the scheme’s fund manager the freedom to invest without fear of redemption pressures.
These schemes are suitable for investors who are looking for a tax break from their mutual fund investment and can safely lock away their funds for a period of three years.
Mid-cap, Large-cap, Small-cap, Multi-cap
Funds
Based on their market capitalisation, companies that are traded on the bourses
can be classified as large caps, mid caps or small caps. Market capitalisation
(also known as market cap) is equal to the total number of equity shares issued
by a company multiplied by the company’s current market price.
Market cap based equity funds invest in stocks that belong to either only one or two or all three of the stated segments. In other words, at the time of stock selection, the company's market capitalization is the basic criteria for selection. The level of risk that you are willing to accept and the returns that you expect, will be the criteria for determining which category of funds you choose to invest in.
Dividend Yield Funds
Dividend yield mutual funds invest in share of companies which have a high dividend yield ratio. The dividend yield ratio is calculated as the dividend paid divided by the current market price of the share and represented as a percentage.
Generally, high dividend yield stocks have a low beta value relative to benchmark (say the Sensex) and hence are stable. Besides, dividend yield stocks offer reasonably good returns over the medium to long term.
Such schemes are suitable for those who can invest their capital for a fairly long period of time.
Contra Funds
Contra funds are equity diversified schemes which follow a ‘value investing’ strategy. The fund manager of such schemes looks for stocks of companies which are fundamentally sound but their values are currently not recognised and invest before this value is acknowledged by the market. If you are ready to take on a fair amount of risk and are not necessarily keen on investing in stocks that are popular at present, you could consider such schemes.
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B. Debt Funds
Debt oriented schemes cater to more conservative investors as they invest all or a significant portion of their corpus in various debt instruments, such as company bonds and debentures, treasury bills, government securities, etc. The income of such funds comes from the interest that the debt instruments held in the portfolio deliver. In the case of debt instruments that are traded, income could be accrued in the form of capital appreciation on traded debt paper.
Interest rate movements are the biggest risk factor for debt funds. This is because the prices of debt instruments and therefore their value share an inverse relationship with interest rates. The longer the duration of the paper held by the fund, the higher this risk. Other risk factor is the intrinsic risk attached to the paper held in the portfolio; for instance government bonds are risk free but corporate bonds have some risk attached.
There are various types of debt funds, key among them include:
Short term debt funds -
Cash funds, liquid funds and money market funds can be classified as short-term
funds as their portfolios contain instruments that have a maturity of up to one
year such as treasury bills, certificates of deposit, commercial paper, reverse
repo, etc.. The main objective of these funds is to offer investors a liquid
investment avenue that also offers scope for good returns, unlike a bank fixed
deposit which offers low fixed returns.
The returns from these funds
are not subject to any great risk as the instruments in the corpus can be held
to maturity, unless there are better prospects.
They are ideal for corporates and individual investors who want to park their surplus funds in a safe but lucrative investment for short periods or until a more favourable investment alternative emerges.
Medium term debt funds
- Income funds fall into the category of medium term debt funds. These funds
have a time frame of 1-3 years. Income funds have the liberty to invest in
longer maturity instruments, like commercial papers, treasury bills, repos,
medium term bonds, debentures and government securities. These funds also have
some of their corpus invested in short term avenues like the money market and
treasury bills. In addition, if an income fund spots good opportunities in the
long-term maturity segment, it may even invest a small proportion of its funds
in fixed income instruments that have a maturity period of well over 5 years,
which usually offer better returns.
Income funds offer scope for better returns, and hence come with greater risks.
Investors with short to medium
term horizons who are comfortable with low to medium risk could choose to
invest in income funds.
Long term debt funds -
Bond funds and balanced funds have an investment horizon of three to five years
and therefore fall into the category of long term debt funds. These funds
invest in long term debt instruments which typically offer the highest returns
since the durations are long and there is a direct relationship between the
duration of a bond and its returns.
Although these funds could offer greater returns than any other debt fund on the maturity spectrum, they are open to both credit risks and interest rate risks. These funds are suitable for people who wish to allocate some part of their assets to a variety of long term debt but may not have enough capital to get such an exposure without the help of a mutual fund.
Pension schemes –
are also allowed the same tax break that is applicable to ELSS, i.e., an investor can claim a deduction from taxable income for payments made to specified pension plans, up to a limit of Rs 1 lakh under Section 80C of the Income Tax Act. These funds aim to build up a corpus for investors that can be converted into an annuity on retirement. This annuity will ensure that the investor receives a regular stream of income post retirement.
These schemes invest most of their funds in conservative instruments since capital preservation is their prime objective.
Floating Rate Funds
– Some debt instruments are characterised by a floating rate of interest. This
means that the return on such instruments is derived from a particular market
determined interest rate that changes periodically. Debt funds that invest all
or a substantial part of their corpus in such funds are called floating rate
funds. Since the interest rates of the securities held in the portfolios
change, the return on floating rate funds also changes accordingly. Floating
rate funds offer investors the opportunity to receive market related returns.
Gilt Funds- The Gilt
Funds invest most of their corpus in sovereign securities, i.e. central and
state government securities. Such schemes can further be further categorized
into short term and long term gilt funds depending on the types of instruments
that they invest in.
Although these funds are almost risk free, they are subject to interest rate volatility.
These funds are suitable for
those who wish to play on the interest rate risk.
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Fixed Maturity Plans (FMPs)
The Fixed Maturity Plans are close-ended income schemes with a fixed maturity.
This fixed period of time could range from fifteen days to as long as two years or more. Moreover
similar to an income scheme, FMPs invest in fixed income instruments like bonds, government securities,
money market instruments and so on. The returns on such schemes are fairly predictable since the scheme
invests in instruments whose maturity date coincides with the duration of the plan and the fund manager
does not change the
composition of the portfolio unless there is a better opportunity available.
These schemes are somewhat comparable to fixed deposits and are ideal for investors who are looking for a
fixed return but other benefits of a mutual fund scheme.
C. Balanced Funds / Schemes
The Balanced Schemes invest in equities as well debt instruments. The key objective here is to blend advantages of equity and debt mutual funds – steady returns with moderate capital appreciation. Accordingly, the risk and return profile is somewhere between debt and equity funds. The various types of Balanced Funds/Schemes are mentioned below.
Monthly Income Plans (MIPs)
The Monthly Income Plans are basically debt schemes that invest small portion of the portfolio (about10-25% in equities) to boost the scheme’s returns. There is, however, no assured return in such schemes, unlike the Post Office Monthly Income Scheme or a Company Deposit.
These funds could offer slightly better returns than pure long-term debt schemes at marginally higher risk. They are ideal for investors who require a regular income and have a limited appetite for equity investment risk
Dynamic Asset Allocation Funds
These funds have the flexibility to invest partly/wholly in equity and/or debt, in line with the limits/parameters that are pre-determined by the fund house. The main objective of these schemes is to take advantage of the equity market by entering at lower levels, cashing out at high levels, investing the funds in debt/money market instruments and later re-entering equities when the markets undergo a correction.
Such schemes focus on preservation of capital but in case the fund management team gets their market timing wrong, it could lead to erosion of capital.
They are suitable for investors who would like an exposure to equity markets along with capital stability.
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Other Types of Funds
Fund of Funds
The Funds of Funds invest in other mutual funds. The significant benefit of
this scheme is diversification, not only across investments, but also across
Fund Managers.
Global Funds
Global funds Invest in the International equity markets. These types of funds
allow the investors to diversify their portfolio across countries thus reducing
country-specific risk.
Arbitrage funds
An Arbitrage Opportunities Fund is an open-ended equity scheme
that aims to provide capital appreciation and regular income to unit holders by
identifying profitable arbitrage opportunities between the spot and derivative market
segments as also through investment of surplus cash in debt and money market instruments.
Hedge Funds
A Hedge Funds deploys highly speculative trading strategies in order to protect
its portfolio and gain from short term speculation in the market. These funds
invest in all kinds of instruments including derivatives and their main
objective is to cash in on the arbitrage opportunities using advanced
investment strategies.
Gold Exchange Traded Funds (GETFs)
GETFs are like other Exchange Traded Funds, i.e., units of these funds can be
bought and sold on the exchange on which they are listed in the same manner as
units of equity ETFs. The difference is that the underlying investments in this
case are in gold and gold related instruments.
Realty Funds
This concept is new to the Indian markets and has recently been approved by
SEBI. These funds can invest in real estate properties and instruments related
to real estate. The core attraction of this product is that even individuals
with relatively small investment amounts have access to real estate investment,
which has been the privilege of big investors over the years.
How to choose a Mutual Fund Scheme?
Before you evaluate mutual funds on the basis of a comparison between schemes,
you must keep in mind that there are numerous types of mutual fund schemes in
the market. Besides, there are different ways in which the returns can be
disbursed to unit holders, such as regular dividend payouts, dividend
reinvestment and so on. So, you must be careful that you are not comparing
apples with oranges. Further, if you are trying to measure the performance of a
scheme in comparison to a benchmark, you must ensure that the benchmark is in
fact representative of the index or it could give you an inaccurate picture of
your fund’s performance.
Net Asset Value (NAV) – A basic tool
The first and the most important measure used for evaluating the performance
of a mutual fund scheme
is its NAV. The NAV of a mutual fund scheme, which is determined by dividing the net assets of the
scheme by the number of outstanding units as on particular date, fluctuates up or down
depending on the market value of its investments. The NAVs of open ended schemes are published
on a daily basis in newspapers and available on the web sites of mutual fund houses.
There are several methods of measuring the NAV, which in turn help you evaluate the performance
of a Fund.
I) Measuring Performance
vis-à-vis Benchmark
The method of evaluating performance of mutual funds on standalone basis as discussed above gives only a partial picture. To make the exercise meaningful, there has to be a benchmark against which the performance is measured. The stock indices are good benchmarks for relative comparisons. For instance, if you want to know whether the performance of any diversified equity mutual fund has been good or bad, what you can do is simply compare the returns from such funds with that of the BSE Sensex or the NSE Nifty. You also have broader indices such as the BSE 100 that would also help you to analyze the performance of diversified mutual funds. Several indices have been launched from time-to-time by several bodies/companies to benchmark the performance of Funds.
MUTUAL FUND INVESTING
STRATEGIES
In order to help you to simplify the decision of when to invest and disinvest
and make it as beneficial as possible, mutual funds now offer Systematic
Investment Plan (SIP), Systematic Withdrawal Plan (SWP) and Systematic Transfer
Plans (STP).
Systematic Investment Plans
SIPs involve making investments of fixed sums of money in a particular scheme
at predetermined periodical intervals of time (monthly, quarterly or annually).
As this technique results in buying more units when the price is low and less
units when the price is high, it has been found to lower the average cost per
unit purchased, irrespective of whether the market is climbing, falling or
generally volatile. Further, in addition to sparing you from the need to time
the market, it makes investing relatively simple as fund houses allow you to
invest using post dated cheques, ECS transfers, etc.
Systematic Withdrawal Plans
SWPs can be used to regularly disinvest either fixed amounts or some or all of
the appreciation that is generated from your investment in the scheme. This
allows you to receive a regular income from your investment in a scheme or
simply invest the gains from the scheme elsewhere. All you have to do to
utilize this facility is fill in a form that is available with the fund house,
intimating them about your preferences (fixed or appreciation withdrawal).
Systematic Transfer Plans
Through STPs you can transfer fixed amounts of money at regular intervals
(monthly or quarterly) from one scheme to another. You can activate this
facility by giving your fund house one-time standing instructions to execute
such transfers. These plans effectively automate both the processes of
investing and disinvesting.
Know Mutual Funds terminology
Account Statement - A statement issued by the mutual fund house, giving details of transactions and holdings of an investor. This is normally issued in lieu of a unit certificate.
Asset Allocation - When you divide your money
among various types of investments, such as stocks, bonds, and short-term
investments (also known as "instruments"), you are allocating your assets. The
way in which your money is divided is called your asset allocation.
Benchmark - A parameter against which the
performance of a scheme can be compared. For example, the performance of an
equity scheme can be benchmarked against the BSE Sensex. In this case, the BSE
Sensex will be known as the benchmark index.
Beta - It shows the sensitivity of the fund to
movements in the benchmark. A beta of more than 1 indicates an aggressive fund
and the value of the fund is likely to rise or fall more than the benchmark. A
beta of less than 1 implies a defensive fund that will rise or fall less than
the benchmark. A beta of 1 indicates that the fund and the benchmark will react
identically.
Cut-off time - In respect of all mutual funds
regulated by SEBI, fresh subscriptions and redemptions are processed at a
particular NAV. Every fund specifies a cut-off time in respect of fresh
subscriptions and redemption of units. All requests received before the cut-off
time are processed at that day's NAV and thereafter, at the next day's NAV.
Dividend - When companies pay part of their
profits to shareholders, those profits are called dividends. A mutual fund's
dividend is money paid to shareholders from investment income the fund has
earned. The amount of each share's dividend depends on how well the company has
performed.
Growth Fund - A mutual fund whose primary
investment objective is long-term growth of capital. It invests principally in
common stocks with significant growth potential.
Income Fund - A mutual fund that primarily
seeks current income rather than growth of capital. It will tend to invest in
stocks and bonds that normally pay high dividends and interest.
Load - A sales charge or commission charged by
certain mutual funds ("load funds") to cover their selling costs.
Portfolio Churning - Switching investments
between different stocks in the market, with a view to give unit holders a
better yield by taking advantage of market conditions.
Record Date - The date on which the fund
determines who its unitholders are; "unitholders of record" receive the fund's
income dividend and/or net capital gains distribution.
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Direct Equity
Why
Equities?
Investing
Risks involved
Valuation
approaches for picking stocks
How to monitor your stocks?
Investing
process
A word of caution
Key Terms
What is Equity?
Equity / stock (also referred to as equity share) represent a share of ownership in a corporation (company). There are 2 main types of stocks, namely Common Stock and Preferred Stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders. There are several other categories of stocks as well.
Investing in equity means, investing in shares of the company, which are listed in the stock market? The words equity, stocks and shares are synonymous and investing into equity also means as investing in stocks or shares of the company.
WHY EQUITIES?
Time and again, a calculated investment in equities has proved to be a rewarding option. A careful examination of stocks/sectors/economy gives a fair idea of the movement of the Stock Market at any point of time. The following points will tell you why it is a good decision to invest in the Indian Stock Market:
1.A robust economy, impressive corporate earnings growth, relatively stable interest rates and the rising recognition of domestic companies in the overseas markets have made India a favourite investment destination for overseas fund managers.
2.The increasing interest among domestic institutional and individual investors, alike, for availing themselves of investment opportunities in the fast emerging Indian financial market, have made it the most sought after investment option around the world.
3.Accordingly, the long-term prospects of the Indian stock market, which measures the pulse of the Indian economy, continue to be buoyant as almost all industrial sectors have been benefiting from the country's economic growth.
4.At a more micro level, you must realize that irrespective of how much you earn and save, the returns that you receive on your savings should outpace inflation by a substantial margin, if you wish to be able to fulfil your dreams and aspirations and build up a corpus for your retirement years. Investing in stocks has time and again proved to be the best way to do so.
5.The Indian economy is showing so much promise, which in turn is reflected in the stock market.
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What is a Primary market and what is a Secondary Market?
Any company who wants to raise its capital for its business approaches the public at large with an offer to issue and allot certain number of shares at certain prices. This is called as an initial public offering by the company in the Primary market.
Once these shares are allotted they get listed in the recognized stock exchanges where trading in the value of the shares take place in free market place by large number of buyers and sellers. This market place is called as a Secondary market. Currently on a nationwide basis BSE and NSE provides an on line trading platform to trade in Secondary market.
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INVESTING RISKS INVOLVED
One of the basic principles of investing is, higher the returns, higher is the risk and vice versa. The same applies to equities as well. As an investor, you should be able to judge whether the perceived risk is worth taking in order to get the expected return and whether a higher return is possible for the same level of risk and vice versa. Following is a list of the more common risks that are attached to investing in equity.
Market/economy risks
This risk stems from factors related to the economy such as money supply, the level of government borrowing, the industrial policy, global economic conditions, etc. and are not unique to a any particular company. These are also known as non-diversifiable risks, since investors cannot avoid these risks, however diversified their portfolios may be.
Industry risk
This is the risk that applies to a specific industry and therefore, to stocks of companies belonging to that industry. A large scale shift in demand, a rise in input prices and regulatory changes are factors that augment such a risk.
Management risk
It is defined as the inability of the management to take decisions in the larger good of the company and its minority shareholders. Further, even a shareholder-friendly management can be a risk if it is unable to manage a company's growth in both good and bad times alike, and lacks the necessary dynamism to lead the company.
Business risk
Business risks mainly arise from the fact that a company's earnings before interest and taxes (EBIT) can vary, depending on various factors, like demand, absorption of costs, profitability, etc.
Financial risk
Financial risks arise when debt represents a high proportion of the company's capital structure (which comprises net worth and debt).
Exchange-rate risk
This risk arises out of variations in exchange rates of the rupee against the U.S. dollar and other major currencies. Profits of companies who import a relatively large part of their raw materials and those that export a large part of their goods or services are impacted due to such variations.
Inflation risk
Inflation can hit a company's profits badly if it is not able to pass on the effects to consumers. In some cases, even if inflation eases, wage hikes can rarely be rolled back.
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VALUATION APPROACHES FOR PICKING STOCKS
In order to take correct investment decisions, it is always important to know the parameters based on which you can shortlist the instruments/investments. Following are few of the parameters which will help you decide the stocks/sectors to invest in.
Top-down and bottom-up
approaches
Top-down investing involves analyzing the ‘big picture’. Investors using this approach look at the economy and try to forecast which industry will generate the best returns. They then look for individual companies within the chosen industry and add the stock to their portfolios. For example, suppose you believe there will be a drop in interest rates. Using the top-down approach, you might determine that the home-building industry would benefit the most from the macroeconomic changes and then limit your search to the top companies in that industry.
Conversely, a bottom-up investor overlooks broad sector and
economic conditions and instead focuses on selecting a stock based on the
individual attributes of a company. Advocates of the bottom-up approach simply
seek strong companies with good prospects, regardless of industry or
macroeconomic factors. What constitutes ‘good prospects’, however, is a matter
of opinion. Some investors look for earnings growth while others find companies
with low P/E ratios attractive. Bottom-up investors will compare companies
based on these fundamentals. They feel that as long as the firms are strong,
the business cycle or broader industry conditions are of no concern.
The P/E yardstick
The price to earnings (P/E) is one of the most popular valuation tools not only in India but across the globe. Conceptually, the P/E multiple represents the premium that the market is willing to pay on a company’s earnings, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E ratio is calculated by dividing a stock's current share price by its earnings per share (EPS) for a 12-month period (mostly the last reported full-year EPS). In effect, the ratio uses the company's earnings as a guide to value it.
The important thing is that when looking at P/E ratios as part of your stock analysis, consider what premium you are paying for a company's earnings today and determine if the expected growth warrants the premium. Also, compare it to its industry peers to see its relative valuation and try to determine whether the premium is worth the cost of the investment.
Discounted cash flow (DCF)
analysis
Discounted Cash Flow is used to work out the value of a company today, based on projections of how much money the firm is going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as ‘discounted’ cash flow because cash in the future is worth less than cash today.
DCF serves as a reality check to the fair value prices found in brokers' reports. DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All of this will help you understand what drives the value of a company’s stock. This will enable you to put a more realistic price tag on the company's stock.
Economic value added (EVA)-based investing
Economic value added (EVA) is a financial concept that cuts away market chaos
to focus on a single investment question: Is a company creating or destroying
wealth for shareholders? By trying to answer this question, you will take the
first step to pick stocks that outperform the market, which is the dream of
every long-term investor.
EVA is defined as the difference between a company's net operating profits
(NOPAT) and its total cost of invested capital over a given time period. This
capital charge is necessary to compensate the providers of debt and equity for
use of their capital investment at a rate adequate for the risk incurred.
EVA = net operating profits after tax - cost of invested capital
If the EVA is positive, the company has created value above the minimum return required by investors, and if it is negative, wealth has been destroyed.
With the full cost of capital deducted from NOPAT, EVA shows
whether capital is being used efficiently in the company, and with further
analysis, whether high-return businesses are subsidizing low-return businesses
or which geographical regions or business segments of a company's operations
add value or destroy value.
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How to monitor your stocks?
If you have invested in the equity markets your investment needs to be continuously monitored. Even if you buy into equity with a long-term view, you still need to assess the performance of your portfolio on a regular basis. To assess the stock performance you need to monitor the performance of the company as well as the industry. You also need to keep in mind the economical, political and global factors affecting the firm. Therefore, take a closer look at the following factors while glancing through quarterly results of a company and measuring the performance of its stock:
*Sales growth
Revenues reveal how much the company has sold over a given period. Sales are
the direct performance indicators for companies. The rate of growth of sales
over the previous years indicates the forward momentum of the firm, which will
have a positive impact on the stock's valuation.
*Net profit
The growth in net profit indicates the attractiveness of the stock. The
expected growth rate might differ from industry to industry. For instance, the
IT sector's growth in bottom-line could be as high as 65-70 per cent from the
previous years whereas for the old economy stocks the range could be anywhere
between 10 per cent and 15 per cent.
* ROI (return on investment)
ROI in layman terms is the return on capital invested in business. For
instance, if you invest Rs 1 crore in men, machines, land and material to
generate Rs 25 lakh of net profit, then the ROI is 25 per cent. Again, the
expected ROI by market analysts could differ form industry to industry. For the
software industry, it could be as high as 35-40 per cent, whereas for a
capital-intensive industry it could be just 10-15 per cent.
* PSR (price-to-sales ratio)
This measures a company's stock price against the sales per share. Studies have
shown that a PSR above 3 almost guarantees a loss while a PSR below 1 gives you
a much better chance of success.
* ROE (return on equity)
Supposedly Warren Buffet's favorite ‘number’, the ROE measures how much your
investment is actually earning. Around 20 per cent is considered a good level.
* Debt-to-equity ratio
This measures how much debt a company has compared to the equity. The
debt-to-equity ratio is arrived at by dividing the total debt of the company
with the equity capital. A D/E ratio of 2 or greater is risky. It means that
the company has a high interest burden, which will eventually affect its
bottom-line. If the firm is using only a small portion of its revenues to pay
off interest, then the company is better off by employing debt to enhance
growth. However, note that companies in capital intensive industries have
higher debt/equity ratios. Hence, this tool is not the right parameter to
assess such firms.
*Beta
The beta factor measures how volatile a stock is when compared with an index.
The higher the beta, the more volatile the stock is (a negative beta means that
the stock moves inversely to the market so when the index rises the stock goes
down and vice versa).
*EPS (earnings per share)
This ratio determines what the company is earning for every share. For many
investors, earnings are the most important tool. EPS is calculated by dividing
the earnings (net profit) by the total number of equity shares.
* P/E ratio (price/earnings ratio)
Earnings per share alone mean absolutely nothing. In order to get a sense of
how expensive or cheap a stock is, you have to look at earnings relative to the
stock price and hence employ the P/E ratio. The P/E ratio takes the stock price
and divides it by the last four quarters' worth of earnings. If AB Ltd. is
currently trading at Rs 20 a share with Rs 4 of earnings per share (EPS), it
would have a P/E of 5. A significant increase in earnings can enhance share
value. When a stock's P/E ratio is high, a majority of the investors consider
it as pricey or overvalued. Stocks with low P/Es are typically considered as
having good value. However, studies done and past market experience have proved
that the higher the P/E, the better the stock.
INVESTING PROCESS
After you have built a portfolio investment strategy on the basis of your
risk-return profile and a time horizon, you have to implement it. Stock trading
can be done through two ways, either offline broking or online broking.
Offline investing
Opening accounts
To begin trading, you must first find a broker to execute your trades. Nowadays, most transactions are carried out in the electronic form. For this, you have to open a ‘demat account’ with a depository who should be registered with the regulatory authority. A depository is an organization which holds securities of investors in the electronic form at the request of the investors through a registered depository participant. It also provides services related to transactions in securities. After opening the demat account you should open a trading account with your broker.
Pay Margin money and buy stocks
Let’s say you strongly feel that the price of a stock will go up and so much so
that you don't mind taking some extra risk. You can make money by buying the
stock now and selling it later when the price increases. But what if you don’t
have the money to buy? Well, you could ‘go long’ on that stock; that is, you
ask your broker to buy the stock without paying him the full amount now.
Instead, you can pay him a token amount called the margin money. When you buy
on margin you are actually buying stocks on credit. Your broker will lend you
the part money if you have enough collateral in the form of adequate stocks in
deposit with the broker. Since it’s a loan the broker is giving you, he will
also charge you interest. You could have also borrowed money from some other
sources to buy those stocks. But, usually brokers try to offer interest rates
lower than other sources. Buying long allows you to buy more shares than you
can afford. And, if your hunch about a stock's price rise turns out to be
correct, you stand to gain more than what you could have without a margin buy.
But, the longer it takes for the stock to rise to the price level you had
expected, the less will be your gain. To be safe, the stock price should rise
enough to pay off the loan amount, the interest incurred and the transaction
cost. Buying long becomes risky if your calculations go wrong. If it takes a
much longer time for the stock price to reach the level than what you had
estimated, your profits will reduce because by that time the interest cost on
the borrowed money would also have risen. And if your estimate completely goes
wrong and the stock's price falls, you immediately start making losses. You
break even when the stock price rises enough to pay off the loan amount, the
interest incurred and the transaction cost.
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Online trading
Opening Trading, Bank and Demat accounts
Electronic trading (e-trading) connects buyers and sellers in geographically
separate locations in a virtual trading platform. Now, you can use your
computer via the internet to e-trade. With reference to shares, e-trading means
the buying and selling of equity vielectronic means. In practical terms, you
must register as a client with an e-broker as you do with a broker and can
start trading.
Most banks offer online trading facilities and these are
three-in-one accounts – that is, bank, demat and trading accounts. The expenses
incurred here are the minimum balance one has to maintain with the bank, and
the demat and the trading account opening charges. Normally the following
charges are levied.
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A word of caution
Every person who invests in the market has his individual experiences to share; nevertheless there are few common misconceptions. To become a successful market player one must be well aware of the truth behind these. To give you a better understanding, let us go through the widely prevalent myths in the market that one must be beware of.
Myth 1: The market is always right
Most people believe the market is all-knowing and that the current price of a stock reflects all material information about the company, its history and its prospects. This does not hold true always. There are times when the market paints a new picture every day so it will be far more useful to consider the market as extremely prone to swinging to extremes, rather than as an all-knowing and all-powerful force that many market watchers assume it to be.
Myth 2: Price is not an issue while
investing in good companies
A large number of investors propound that one cannot go wrong if you buy into good companies, no matter what their share prices are. This philosophy is often ascribed to Warren Buffett, and his so-called followers swear by it. The truth is that, though Buffett believes in buying the best businesses, he acknowledges that if your entry price is unrealistically high, you might have to wait an eternity before you make decent returns from the stock. Usually, in such cases, your patience runs out on you, and you exit at an inappropriate time.
Myth 3: When a stock hits its 52-week low,
it’s time to buy
Bottom fishing is a popular investor pastime, but it’s usually the fisherman who gets the fish. The 52-week high/low is one of the most widely used parameters by many investors to buy or sell a stock. The logic: all stocks have a 52-week low and 52-week high, and that range is usually at least 100 per cent. So, if you can buy a stock near its low and sell it near its high, you should be able to earn good returns but grabbing a rapidly falling stock results in a lot of surprises, because inevitably you grab it in the wrong place
Myth 4: Rupee cost averaging is always a
good defensive stock strategy
Rupee cost averaging advocates buying more of a stock if its price falls in
order to average out the purchase price. Say, you bought 100 shares of a
company at Rs 100 (total consideration: Rs 10,000), after which it falls to Rs
50. At this price, you should buy 200 more shares (total amount invested
remains Rs 10,000) so as to bring down your purchase price.
Sure, you bring down your purchase price, but is it worth it? If
you buy something whose intrinsic value is only Rs 10, first at Rs 100 and then
at Rs 50, no matter how much you average down, you will still be buying onions
at the price of orchids, and sooner or later, either your money will run out or
you may be the only investor left in the company!
So, the more important thing to look at is the true worth of your investment.
Myth 5: Penny stocks are great buys, as they
have little downside
Is a stock priced at Rs 10 cheaper than another priced at Rs 1,000? Well, some
people will tell you it is. Their reasoning: how much lower can the stock
priced at Rs 10 go? Chances of price going to zero are more in favour of a
penny stock rather than in case of Wipro or Infosys. However, some people may
say that all the upside is already factored in the Rs 1,000 stock. The story is
already recognised and there is no more to be gained from buying this stock.
But, the truth is that the absolute price of a stock has
absolutely nothing to do with its future prospects, and hence, its valuation. A
stock issued at Rs 10 (maybe 10 years ago) and now quoting at Rs 1,000 suggests
that the company has done well over these last 10 years in terms of earnings
and profitability while on the other hand, stocks trading at or below par
suggest something drastically wrong with the company and/or its management.
Don’t take any company for granted – whether it is Infosys or just
a penny stock. Put their annual reports under the lens every year before taking
any investment decision. The price of a stock must be viewed in relation to its
earnings, its book value, the dividend per share and revenues per share, rather
than on an absolute basis. More importantly, you must also analyze qualitative
factors relating to the company’s business, its longevity, profitability and
sustainability of those profits.
Myth 6: P/E ratio tells you whether stocks
are cheap or expensive
P/E ratios are easy to find. Every newspaper, magazine and stock report publishes P/E ratios. As an investor if you were told that ABC Ltd had a P/E of 7 and XYZ Ltd had a P/E of 14, would you buy ABC Ltd instead of XYZ Ltd? You might, but you wouldn’t be comfortable making that decision because one needs more information. You’d like to know a whole lot of things before you decide which stock to buy. One of the most important things you’d like to know is the worth of each stock based upon its earnings, profitability and other key financial data. In other words, you would like to have a sense of the stock’s intrinsic value. P/E ratios don’t say anything about a stock’s value!
Key Terms
Taking a position.
When you act upon a stock and buy into it, you are taking a position. A
position is an amount of money committed to an investment in anticipation of
favorable price movements.
There are two kinds of positions:
-
Long positions
are what most people do. When you buy long, that means you are anticipating an
upward movement in the price, and that is how you profit. People usually buy
stocks expecting to sell them later at higher prices and hence make profits.
-
Short positions are the tricky ones. When you
buy short, you are anticipating a fall in the price and the fall is the source
of your profit. The shares will be sold and when the price falls they will be
repurchased and the difference is where the investor profits. Of course, the
investor who borrowed the shares carries the risk of not having the price move
as anticipated, in which case he may lose money while repurchasing the stocks.
Market orders, Limit orders and Stop orders
There are several types of orders that you can dictate to a broker. The most common type, which is a regular buy or sell order, is called a market order. Another type of order is a limit order wherein you ask the broker to trade only if the price reaches a specific level. In a stop order, you tell the broker to sell your shares if the price drops to a certain level to prevent significant losses because if it drops to that level it is likely to drop further and your losses are likely to increase.
Bullish and Bearish trends
When the market goes up it is called a bullish trend and when the market goes down it is called a bearish trend.
Contract note
It is a statement of confirmation of trade(s) done on a particular day for and
on behalf of a client. A contract note is issued in the prescribed format and
manner, establishing a legally enforceable relationship between the member and
client in respect to the trades stated in that contract note. Contract notes
are made in duplicate, where the member and client both keep one copy each.
Stocks often drop excessively on just a
little bit of bad news. Why?
If one piece of bad news gets out, investors begin to fear that more bad news
is lurking around the corner. Similarly, if one stock in a sector gets into
trouble (especially if it is an event that could easily happen to any other
company in the same business), there is a suspicion that others, too, will
suffer. For instance, investor confidence in Internet companies took a beating
after March 2000, when popular Web-based companies in the U.S. faced
bankruptcy.
Is it advisable to buy stocks on the basis
of information published in newspapers?
You will probably end up being the last in the queue. Everyone reads that news,
and the stock price has probably already reflects that news. In fact, stock
prices tend to drop on a major news announcements following the old jungle
saying: "Buy on rumours, sell on news."
If one invests for the long term, can he/she
simply ignore the short term?
If one invests for the long term, can he/she simply ignore the short term? It
is true that a 'buy and hold' strategy is superior to one that is based on
market timing. But, that does not mean you wait for all negative developments
to emerge before reacting. Hence, you need to look for positive or negative
signals in the short term. If these continue for some time they may have
long-term implications. However, avoid the temptation to profit from short-term
price swings. It may happen that you decide to sell stock ABC at a price hoping
to cover it later at a lower price. But then if the up-move is happening for
some sound fundamental reason, you will end up losing. Similarly, it may also
happen that you cover up your position at a lower price only to see the stock
price falls further as the share may have been downgraded for a genuine reason.
It is important that you do not miss the big picture.
How can one take advantage of general
fluctuations in stock prices?
If you think the market is ‘too high’, you might give a stop-loss to preserve
profits, liquidate some of your positions to capture profits and reduce your
exposure or delay any new purchases. If you think the market is ‘too low’, then
you might keep some money aside for fresh purchases or cover your position, if
you have sold the stock short before.
What are the four things that a trader fears
most?
The four fears are:
-
Fear of being wrong
-
Fear of losing money
-
Fear of missing out
-
Fear of leaving money on the table
An opportunity comes every now and then, but these fears do not let us take
full advantage of it. For instance, we enter the trade too soon - before the
market generates a signal, or too late - long after the market generated the
signal.
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Equity Derivatives
What are Equity Derivatives?
Benefits
of trading in derivatives
Forward
Contracts
Futures
Contracts
 Types
of Futures
Trading
in futures
Initial
margin
Marking-to-market
the contract
Settling
a futures contract
Before
expiry of the contract
Options
Types
of Futures
Types
of Options
Index
and stock options
American
and European options
Call
and Put Options
Covered
and Naked Options
Options
can get traded
Valuing
an Option
Futures
versus options
Trading
in Derivatives
Offline
Online
Myth
Buster
What are Equity Derivatives?
Derivatives, as the name suggests, are financial instruments that derive their value from an underlying security or asset. Any security or asset that varies in value from time to time could be used as the underlying asset. The underlying asset could therefore be securities, bullion, commodities, bonds, etc. With variation in value comes risk – the risk that the value of an asset that you wish to buy may rise, when you hoped that it will remain steady or still better fall; or the value of an asset that you wish to sell may fall when you hoped that it will remain steady or at best rise. Derivatives essentially enable the transfer of this risk from one individual who is risk averse to another who welcomes the risk in the hope of making returns. In Equity Derivatives, the underlying instruments are securities/stocks.
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BENEFITS OF TRADING IN
DERIVATIVES
1. Comparatively low capital investment required –
When you trade in the cash market, if you have undertaken a ‘buy’ trade, then
you need to deposit the total value of the trade with the broker within two
working days. However, in case of derivatives, you need to deposit only a
fraction of the value of the trade – termed as the ‘margin’ amount. As a
result, with a limited amount of capital, you can gain exposure to relatively
high value transactions.
2. Cap potential losses: Derivatives are
efficient risk management tools, which allow you to cap your potential losses
in the underlying asset.
3. Allow you to speculate – By buying and selling
derivative instruments you can book profits (which can be limited or unlimited)
on the basis of your view on how the price of the underlying will move.
However, keep in mind that you can also incur losses, which can once again be
limited or unlimited.
4. Offers opportunities for arbitrage - You can
profit from the price differential of the underlying asset in the cash market
and the derivatives market.
What are FORWARD CONTRACTS?
Forwards are derivative contracts wherein you agree to sell or buy the
underlying asset at an agreed price, on a predetermined date in the future. The
quantity and quality specifications of the underlying and the place of delivery
are mutually decided while entering into the agreement.
Essentially, the agreement takes place on a one-to-one level, between you and
the buyer/seller (as the case may be) and hence, is more or less tailor-made to
meet the specific needs of both the parties involved. The duration of the
contract, the quality and quantity of the underlying, etc. are decided upon
after mutual negotiation.
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FUTURES CONTRACTS
Futures contracts are derivative contracts wherein you agree to buy or sell a
specified quantity of the underlying asset on a specified particular date in
the future, at the price agreed upon at the time of entering into contract. In
Indian equity futures market, this price is the spot price (i.e. the price of
the underlying asset in the cash market) prevailing on the date of the expiry
of the contract.
Futures are standardised contracts in terms of quantity, quality, delivery
time, delivery place and date of delivery. Further, futures are legally binding
and both parties are bound to uphold the agreement. As a result of these
additional features, futures are easily tradable on exchanges and therefore
offer better liquidity than forwards Contracts.
Types of Futures
The Indian markets offer trading opportunities in both stock and index futures.
A stock future is one, where the underlying asset is shares of companies that
are traded on the bourses. An index future is one, where the underlying asset
is units of the index.
Trading in futures
Initial margin
In order to trade in futures, irrespective of whether you buy or sell
contracts, you are required to deposit a ‘margin’ with your broker. This amount
is a fixed percentage of the value of your trade and varies from scrip to
scrip. As the value of your outstanding position changes the amount that you
need to maintain as the ‘initial margin’ also changes accordingly on a daily
basis. The margin percent is dictated by the exchange and acts as a surety
against any default in payment on your part (if the need arises).
Marking-to-market the contract
Additionally, at the end of each day, the value of your outstanding position as
per the previous day’s closing price of the futures is compared to the value as
per the current day’s closing price of the futures that you hold. If you have
made a gain, your account is credited with the difference and if you have made
a loss, you will have to make good the difference by depositing the requisite
amount in your account. The net inflow/outflow that takes place from your
account is after factoring in the margin that needs to be maintained that day.
Settling a futures contract
Futures traded on Indian bourses do not result in actual delivery of the
underlying, i.e., if you purchase a futures contract which comprises of 100
shares of Company ABC, then, it does not mean that on expiry of the contract,
100 shares of Company ABC will be transferred to your demat account. In the
case of index futures, there is no question of giving or taking delivery.
Before expiry of the contract:
If you wish to close your futures position before expiry, you have the
option to sell the future that you have purchased or buy back the futures that
you have sold, as the case may be, at the price prevailing in the futures
market.
Similarly, if you have sold a contract, you can purchase it at the price
prevailing in the market. You will receive the difference between the sale
price and the purchase price, if the price has fallen and you will have to pay
the difference if the price has risen.
Your net profit/loss will be after factoring the margin deposited and the
brokerage charges.
What are OPTIONS?
An option is a derivatives contract that gives you the right (but not the
obligation or the liability) to buy or sell a specified quantity of the
underlying asset at an agreed price (strike/exercise price) on or before the
specified future date (expiration date). To acquire this right, you pay a price
(option premium) to the seller of the option. In technical parlance, the buyer
of the option is known as an ‘option holder’ and the seller of the option
‘option writer’.
The potential loss for the option seller is unlimited, while, his upside or
profit is limited to the premium that he receives. On the other hand, the
maximum loss that the buyer could face is the option premium that he pays, but
his potential profit is unlimited.
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Types of Options
I. Index and stock options
If you wish to trade in options, the underlying asset can either be shares of
companies that are traded on the bourses or stock indices. The former is termed
as ‘stock options’ and the latter ‘index options’. However, remember, that you
can undertake option trading in only those companies that are listed and meet
certain criteria as defined by Securities Exchange Board of India (SEBI). In
the case of index options, you can undertake option trading in the S&P
Nifty CNX 50 index, CNX IT index and the Bank Nifty index on the NSE and the
Sensex on the BSE.
II. American and European
options
Options can also be classified on the basis of their validity period as
‘American’ and ‘European’.
American style options – This type of an
option can be exercised anytime by the option buyer during the validity period
of the contract. Stock options traded in India are of this type.
European style options - This type of an
option can be exercised only on the expiry date of the contract by the option
buyer. Index options traded in India are of this type.
III. Covered and Naked Options
Depending on whether or not the option seller holds the underlying stock at the
time of selling the call option, the option can be categorised as ‘covered’ and
‘naked’
Covered Options: These are options wherein the
option writer holds the underlying asset at the time of selling the call option
to the option buyer.
Covered options allow you to mitigate the loss in case the call option buyer
exercises his option. Since, the option will be exercised only if the spot
price of the underlying asset rises beyond the strike price plus the premium
paid by the option buyer, if you already hold the underlying shares wherein the
cost price is higher than the current spot price, your loss will be less. This
is because you will not have to buy the underlying asset from the cash market
to fulfil the contract.
Naked Options: These are options wherein the
option writer does not hold the underlying asset at the time of selling the
call option to the option buyer.
IV. Call and Put Options
Call Option: When you buy a call option, you
hold the right to buy a specified quantity of the underlying asset at the
strike price on or before the expiry date.
Put Option: When you buy a put option, you
hold the right to sell a specified quantity of the underlying asset at the
strike price on or before the expiry date.
Buying a call option: If you are bullish about
a stock, you could purchase a call option at a pre-determined price (the strike
price). You will benefit if the price moves beyond the strike price and results
in an appreciation.
If all goes well and the stock price in the cash market does rise beyond the
strike price plus the premium you have paid, on or before the expiry date of
the contract, you can exercise your option. Your profit would be the difference
between the strike price and the spot price after deducting the premium and the
brokerage paid by you.
If, on the other hand, the price of the stock in the cash market does not rise
beyond the strike price plus the premium you have paid, you can let the option
contract lapse. Your loss in such a case would be limited to the premium and
the brokerage that you have paid.
Buying a put option: If you are bearish about
a stock, you could purchase a put option at a pre-determined price (the strike
price). Here, you will benefit if the price moves below the strike price.
If all goes well and the stock price in the cash market does fall beyond the
strike price plus the premium you have paid, on or before the expiry date of
the contract, you can exercise your put option. Your profit will be the
difference between the strike price and the spot price after deducting the
premium and the brokerage paid by you.
If, on the other hand, the price of the stock in the cash market does not fall
below the strike price, you can let the option contract lapse. Your loss in
such a case would be limited to the premium and the brokerage that you have
paid.
Selling Call and Put options: You buy options
from the seller i.e. the option writer. The option writer is obliged to comply
with your decision for which he receives a fee (i.e. the premium you pay to buy
an option).
A put option seller begins to make losses when the spot price of the underlying
stock in the cash market falls below the strike price, unlike a call option
seller who begins to make losses once the spot price of the underlying stock in
the cash market rises above the strike price.
If you exercise your option (call or put), the option writer bears a loss. The
loss would be the difference between the spot price prevailing of the
underlying asset in the cash market and the strike price. The loss stands
reduced by the premium that he has received at the time of selling the option.
In case you let the option lapse, i.e. you do not exercise the option, then,
the premium received is the profit earned by the option writer. In other words,
the option writer’s return is limited and risk is unlimited.
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Options can get traded
It is not mandatory that if you have purchased/sold options you need to hold
onto this position till the expiry date. You can settle off your position in
the market at the then prevailing premium.
This premium is not a static figure and changes from moment to moment. Factors
which have an impact on its movement include the demand/supply for the option,
the current market price of the underlying stock and the time left to expiry of
the option (with decrease in time, the premium falls).
TRADING IN DERIVATIVES
Offline
Step 1: You will have to register with a broker who is a
member of the exchange on which you wish to trade.
Step 2: You will be required to fill in a “client registration
form” in which you must provide details such as your name, address, approximate
income level, etc. As proof of identity and residence, you will be required to
submit copies of your passport, driver’s licence or ration card. In addition,
you are required to submit a copy of your Permanent Account Number (PAN) card
and details of your bank account.
Step 3: Your broker will guide you about the amount of margin
that you must deposit with him after understanding your trading needs. This
margin can be in the form of cash or stocks from the approved securities list.
In case the margin is in the form of stocks, you will have to pledge the shares
to the broker or transfer the shares to his collateral account. The value of
shares available for margin will be the value as reduced by the “haircut”. The
“haircut” is a fixed percentage, determined by the exchange and is equivalent
to the normal margin of safety. For instance, for every share of Company ABC
(which is presently traded at Rs 1,000 per share on the bourses) pledged as
collateral, the margin available could be 85 per cent of Rs 1000 i.e. Rs 850.
Step 4: Then, just like you would buy and sell equity shares,
you can place an order with your broker who, in turn, forwards your orders to
the stock exchange. The exchange will monitor your trade and debit or credit
your broker’s margin account depending on your trade.
Step 5: Your account is debited/credited daily, based on price
movements. At the time of expiry/squaring off of the contract, you will
actually have to make good all losses or book profits, as the case may be.
These profits/losses are settled by the exchange, through your broker.
Online
The steps to be followed for online trading in derivatives are the same as that mentioned in Offline above. However, you need to have an Online Trading account for the same.
MYTH BUSTER
Myth 1: Derivative trading is only for those who have an
appetite for risk. Trading in derivatives holds scope for both the risk-averse
and for those who have an appetite for risk. In fact, it provides risk averse
investors with products which help them to transfer their risks to those who
are more amenable to risks and therefore, it provides them a means of
protecting the value of their portfolio.
Myth 2:Futures and options culminate in transfer of shares. In
India, both futures and options are settled in cash.
Myth 3: In the case of options, the risks involved are
limited. While buying options results in limiting your risks, selling options
leaves you open to unlimited risks.
Myth 4: In case you purchase an option contract, you break
even when the spot price in the cash market of the underlying asset crosses the
strike price. You break even only when the spot price of the underlying asset
in the cash market exceeds the sum total of the strike price and the premium
per share that you have paid to purchase the contract.
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Initial Public Offerings
When a company raises capital by issuing shares to general investors, the process is called a public issue of shares or a primary market issue. If the company is approaching the capital market with an issue of shares for the first time, the issue is called an ‘Initial Public Offering’ or an IPO. This process paves the way for listing and trading of the issuer’s securities on the bourses. If the public issue is from a company whose shares are already listed on a stock exchange, it is also called a ‘follow-on public issue’, though sometimes the term IPO is used generically to describe such issues as well.
One of the foremost reasons as to why companies go public is to raise capital to support their future growth. Once a company gets listed on the bourses, it has to comply with several regulations making it more accountable, efficient, etc. At the same time, it comes in the eye of the investor community at large which raises its chance of being acquired or merged in the future, which could be valuable for its shareholders. Additionally, the shares of a listed company also act as a currency for the company and could potentially be a medium of payment for future acquisitions or amalgamations.
KEY DOCUMENTS INVOLVED IN THE PUBLIC ISSUE PROCESS
Draft Offer Document
Any company coming out with a public issue is required to file its preliminary
prospectus with SEBI, the market regulator. This preliminary prospectus is
termed as the ‘Draft Offer Document’. It contains all the information that you
may want to know about the company before subscribing to its issue - its
management, business model, future plans, financials, risk factors involved,
etc.
SEBI does not approve or vet the draft offer document. SEBI's role is to ensure
that the disclosures made in this document are generally adequate to enable the
investors to make an informed decision regarding the offer. SEBI conveys its
comments, if any, on the draft document, which results in the issuing company
making the suggested additional disclosures in it before it is dispatched to
the investors.
Red Herring Prospectus
Once SEBI passes the draft offer document, it gets converted into the Red
Herring prospectus. This contains all the information that you need to know
about the company before subscribing to its issue - its management, business
model, future plans, financials, risk factors involved, etc.
In addition, the red herring prospectus contains the issue details – i.e. the
size of the issue, the number of shares on offer, the offer price band and the
duration of the issue.
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PLAYERS INVOLVED IN THE PUBLIC ISSUE PROCESS
Underwriter
Each and every issue has an underwriter. An underwriter could be a bank, a
brokerage house, a merchant banker or a financial institution. An underwriter
gives the issuer a commitment that it will buy all the public issue shares
which are not subscribed to during the offer period.
For instance, the issue of Company ABC Ltd. consists of 1 crore shares. If at
the end of the issue, subscription from all investors amounts to only 80 lakh
shares, then, the underwriter is under obligation to buy the balance shares.
An issue can have more than one underwriter.
Lead Manager
As in the case of the underwriter, lead managers could be banks, brokerage
houses, merchant bankers or financial institutions. It is the responsibility of
the lead managers to ensure that the issue is in accordance with SEBI’s
regulations, proper disclosures have been made and the facts in the red herring
prospectus are correct. Further, they act as intermediaries between the issuing
company and the investors. The responsibility of creating the draft offer
document and the red herring prospectus lies with them. Further, the
responsibility of marketing the issue lies with them. Post-issue activities
such as intimating the subscribers about the number of shares that have been
allotted to them and ensuring that the refunds reach investors who do not
receive allotments also fall under their domain.
Registrar
The actual work of drawing up the list of investors who will receive allotment,
crediting shares to their demat accounts and ensuring that the refunds are
disbursed, lies with the registrar to the issue. A registrar is a financial
institution appointed by the issuing company to keep a record of the issue and
the ownership of the company’s equity.
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SUBSCRIBERS TO AN ISSUE
The investors who subscribe to shares issued by a company are divided into 3
categories
Retail Investors:
This category consists of investors (including NRIs and HUFs) whose individual
application size does not exceed Rs 1 lakh.
Non-institutional bidders:
These are resident Indian individuals, HUFs, companies, corporate bodies, NRIs,
trusts, etc. whose application size exceeds Rs 1 lakh.
Qualified Institutional Bidders:
Public financial institutions, FIIs registered with SEBI, commercial banks,
mutual funds, etc. fall under this category.
Depending on the type of methodology used for pricing the issue, each of the
above-mentioned categories must be allocated a certain proportion of the issue.
READING THE RED HERRING PROSPECTUS
As mentioned earlier, the red herring prospectus contains all the information
that you need to know about the company before subscribing to its issue - its
management, business model, future plans, financials, risk factors involved,
issue details, etc. Hence, it is imperative that before deciding whether to
subscribe to the issue or not, you read this document carefully. However, the
sheer size of the prospectus is daunting, as it runs into a couple of hundred
pages. The key is to undertake a quick perusal of some of the sections listed
below:
Risk factors
This section will provide detailed information on:
-
All the risks that the company and the issue are exposed to.
-
Any legal cases filed against the company or its directors.
-
Whether any of the company's associate-companies are losing money.
-
Factors that could adversely impact the company's business in the future.
Capital Structure
You must go through the contents of this section as it will provide you
information on:
-
The pre-issue capital structure of the company.
-
The price at which shares have been issued to the promoters.
-
The number of new shares that are being issued.
-
The post-issue capital structure of the company.
With information on the pre and post issue capital structure, you will be able
to judge the extent to which the promoters of the company are liquidating their
holdings. While a low post-issue holding could indicate a ‘sell-out’, a high
post-issue holding could indicate that the number of shares available for
trading could be low. In such cases, there is the possibility of price-rigging.
Objective of the issue
This section will basically tell you why the company is raising funds. If the
company has specific investment plans, then it’s a positive sign. Also analyse
the total cost of the project for which it is raising funds. If a significant
amount of the funds raised, is slated for expenditure on non-productive assets
(such as corporate offices, cars, etc.) then the overall returns on equity are
likely to suffer.
Beware of plans of diversion of the funds raised to subsidiaries and to vague
expense heads such as international acquisitions, marketing branches or brand
building. Also, if the funds mobilised are to be used to meet the company’s
‘working capital requirements’, then there is really no way to check on where
the money is headed.
Business
This section will tell you all about the company's business and its strategy.
An understanding of the company’s business will give you an idea about the
uniqueness and viability of the venture that it plans to raise funds for. Also,
check on the competitive pressures that the company faces and how the company
has fared in the past.
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Basis for Issue Price
In this section you will find the reasoning behind the identified offer price
or price band and why it is fair. This section will provide you with numbers
and a basis for comparison with peer companies. The figures that you need to
take a look at include:
-
The Earnings Per Share (i.e. the post tax profits of the company divided by the
number of shares issued by the company). While analysing the financials of the
company, the EPS for each year should be rising.
-
The P/E ratio (i.e. the issue price divided by the most recent EPS). This ratio
tells you if the issue is under-priced or over-priced vis-à-vis the industry
P/E. All other things being equal, if the P/E of the company is less than the
industry P/E then the issue is under-priced. If the P/E of the company is
higher, then the issue is over-priced.
Financials
Finally, don't forget to check out the financials of the company, including the
auditor's comments. Take a look at the previous three years’ financial records.
Ideally, the operating and net profit margins should be stable, if not rising.
This should imply lower costs and a low debt burden, sales targets being
realised and no large inventory levels. The total income, net profit before tax
and net profit after tax figures recorded by the company should be growing at a
healthy pace. This implies that the company has been able to consistently run
its business efficiently and is poised for future growth.
APPLYING FOR A PUBLIC ISSUE
Applying for a public issue is ever so simple. It can be done offline or
online.
Online application
If you have an online investment account like
www.IDBIpaisabuilder.in, your Bank, Demat and Trading accounts are
integrated. This spares you of the hassles of managing different accounts,
writing cheques, and tracking your investments. Funds get transferred
automatically and shares get credited to your account automatically.
You don’t have to rely upon any external source for information on on-going
IPOs. You can access all of them on the investment portal. So you’d never miss
out on any IPO. Online application can be done virtually at the click of a
button so you do not have to waste time in filling up lengthy forms.
Some investment portals even provide research and recommendation on IPOs. This
spares you of taking the risk of investing merely on rumours.
In addition, you have the convenience of investing from anywhere, at virtually
anytime.
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Offline Application
STEP 1: Get an application form
You can pick up application forms at any broker's office. They are even
available on some street kiosks in your city's financial area. Agents who give
you mutual fund application forms or fixed deposit forms of companies are
another source from where you can procure a form. No fees are payable for these
forms.
STEP 2: Filling up the form
Detailed instructions on how you can fill up the forms are provided overleaf,
to ensure that your application does not get rejected for want of proper
information. Details that you need to mention include your full name and
address, your Permanent Account Number (PAN) (if required), your bank account
and demat account details, the number of shares that you wish to subscribe for
and the price at which you are willing to buy them (in the case of book built
issues) etc.
STEP 3: Submission of the form
Once you have filled-up the form correctly, submit it along with the cheque to
the collecting bankers or to the collecting agents. Details of their office
addresses are mentioned in the form.
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MYTHS THAT GOVERN INVESTING IN PUBLIC ISSUES
Myth 1:
Public issues are recommended by SEBI - Though it is mandatory for any company coming out with a public issue to file its preliminary prospectus (i.e. the Draft Red Herring Prospectus (DRHP)) with SEBI, SEBI does not approve or vet the DRHP. SEBI's role is to ensure that the disclosures made in this document are adequate to enable the investors to make an informed decision regarding the offer.
Myth 2:
Public issue investing is less risky than trading in shares via the secondary market - This a popular misconception associated with public issue investing. Investing in public issues and trading in shares in the secondary market involve the same amount of risk, as they both entail investments in equities and are hence subject to all the risks that are associated with equity investing.
Myth 3:
Investing in public issues is only good for making a quick buck - Usually most public issues that hit the capital market during bull runs are listed at a premium to the allotment price (the price at which the shares are allotted to subscribers). The listing premium in some cases has been in excess of 50 per cent. This gives the mis-conception that investors can invest in public issues to make a quick buck. However, at the same time, there have been issues, which have got listed at par (listing price is equivalent to the allotment price) or even below par (listing price is below the allotment price).
FAQs ON PUBLIC ISSUE INVESTING
-
Can I undertake multiple bid applications, wherein the applicant/(s) are
the same?
No. As per the rules governing investing in public issues, each applicant can
make only one application. In other words, if you make an application in your
individual name, you cannot make a second application, wherein you are the
first holder, irrespective of who the second holder is.
-
Is quoting of PAN mandatory?
If the total application size (i.e. the number of shares bid for multiplied by
the bid price per share) exceeds Rs 50,000, then quoting of PAN is mandatory,
not only for the first holder but also in case of a second and third holder.
-
Is there a minimum number of shares that an investor must bid for?
Yes. Every issue has a minimum number of shares which must be bid for, which
would be specified in the application form. You cannot apply for fewer shares
than this number. If you wish to apply for shares in excess of the minimum
number stipulated, then you can do so in multiples of a pre-determined number,
for e.g. 15, 20, etc.
-
What happens if the bid price I have quoted is Rs 100 per share, and the
price that gets fixed for allotment is Rs 125?
If the bid price that you have quoted is lower than the allotment price, you
will not be eligible to receive any shares.
-
What happens if the bid price that I have quoted is Rs 125 per share, and
the price that gets fixed for allotment is Rs 100?
If your bid price quoted is higher than the allotment price, then you will be
eligible to receive shares at the allotment price and receive a refund of
anything in excess. In your example, you will be allotted shares at Rs 100 per
share and receive a refund of Rs 25 per share.
-
If the number of shares allotted is less than the number of shares applied
for, what happens to the application amount already deposited?
In case of an allotment of a lesser number of shares than the number of shares
bid for, you will receive a refund. The refund amount is equal to total
application value (number of shares bid for multiplied by the bid price) less
the total allotment value (number of shares allotted multiplied by the
allotment price).
-
Within how many days is the refund made available?
The refund is made available within 15 - 30 days. The refund would be either
directly credited to your bank account via ECS or a cheque would be couriered
to the communication address mentioned in the application form. The mode of
receipt is your choice.
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Gold
Introduction
Gold
in your Investment Portfolio
Factors
influencing Gold Prices
Different
ways of investing in gold
Trading
in gold on the commodity futures exchanges
Accounts
to be maintained
Trading
in Gold Contracts
Settling
the Gold Contract
INTRODUCTION
For thousands of years, gold has been used as a global currency for
international trade. Besides, it is virtually indestructible and also highly
liquid, thus, making it a “safe haven” investment.
The lure of this precious metal has not dissipated over the years. In fact, in
our country, majority of the households invest in gold in its physical form. To
say that ‘Indians love gold’ is an understatement. In fact, according to a
report published by the World Gold Council, India, at present accounts for the
highest consumption of gold in the world. That itself speaks volumes for the
popularity of gold in our country.
GOLD IN YOUR INVESTMENT PORTFOLIO
An old saying preaches, “Gold shines when everything else falls apart”. True,
the glitter of the yellow metal makes it an attractive and popular choice as an
investment option.
Throughout the world, gold is considered as a ‘must-have’ in your investment
portfolio. Experts recommend an exposure of anything between 5 to 15 per cent
of your total assets in gold. The following factors justify the reasons behind
this:
Store of Value
The preference for gold stems from the fact that it is virtually indestructible
and over the long term, gold generally gains in value. It is a veritable hedge
against inflation too. While the value of most financial investments depreciate
due to inflation, the price of gold keeps up with inflation in the long run.
For Diversification
Gold, as an asset is negatively correlated with other asset classes. Therefore,
its price generally moves in the opposite direction from other asset classes
such as stocks, bonds, etc. Hence, allocating a certain percentage of your
total wealth towards gold can greatly reduce your portfolio volatility or risk.
The more negative the correlation between this asset and your other
investments, the lower will be the overall level of volatility in your
investment portfolio.
Liquidity
Gold is one of the most liquid assets since it is a universally accepted store
of value and hence, you can convert your gold holdings into cash as and when
you require to. Gold is transacted 24-hours a day in markets around the world.
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FACTORS INFLUENCING GOLD PRICES
Some of the factors that affect gold prices are:
Demand versus Supply
The annual global demand for gold is approximately 3,000 tonnes, though supply
remains more or less constant at around 2,500 tonnes. This has a direct bearing
on prices. There has been a growing demand for gold as an investment avenue in
the domestic as well as the international markets. However, gold is a metal
whose supply cannot be substantially increased since it is an expensive and
cumbersome process. Therefore, the supply is subdued in comparison to the
demand, causing a rise in gold prices.
Changes in Sentiments
In times of crisis such as a war, geopolitical instability, terrorist attacks,
etc., the demand for gold increases. This is because people fear that they may
be unable to en-cash other paper securities. Gold, being a solid, tangible
asset, can be used to buy their bread and butter till the crisis tides over.
Thus, in times of uncertainty, the demand for gold steps up leading to an
upswing in prices.
DIFFERENT WAYS OF INVESTING IN GOLD
Investments in gold can be made either directly through the purchase of
physical gold (in the form of jewellery, bars, coins, etc.) or indirectly
through trading in gold futures and gold Exchange Traded Funds (ETFs).
In the form of Jewellery
Indian households predominantly purchase gold in the form of jewellery. Gold
jewellery has aesthetic appeal and is widely used for ornamentation. Gold
jewellery is not only looked upon as a status symbol but is also considered by
most as an asset that can be used in a distress situation. This is one of the
reasons why gold always forms a part of the “Stree Dhan” that is given to Hindu
daughters by their parents at the time of marriage.
In the form of bars and coins
Another way of holding gold in the physical form is through gold coins and
bars. Typically, they are priced according to their weight, at a premium of
around 5 per cent above the prevailing price of gold. They can be purchased
from your jeweller as well as from several banks and are available in various
denominations ranging from 1 gram to 1 kilogram. An advantage that this form of
gold carries is that it is 24-karat pure gold and comes with an international
quality certification, which indicates its purity level.
In the form of “i-gold”
The costs of storage associated with physical gold such as jewellery, can be
avoided by trading in gold in the dematerialised form. To enable this, the
World Gold Council along with the Multi Commodity Exchange (MCX) has launched a
gold demat product called “i-gold”. “i-gold” can be traded on the MCX through
weekly future contracts that begin every Wednesday and are settled on the
following Tuesday evening and the delivery is received by Thursday. The price
of these contracts is initiated by the MCX on the basis of the prevailing spot
price (i.e. the price prevailing in the cash market) of gold. Once these
contracts start getting traded, their prices fluctuate based on the demand and
supply. The contracts are in two denominations - 100 grams and 1 kilogram.
You can place an order through a commodity broker either at the prevailing
price or submit a bid price (i.e. a price at which you are willing to purchase
the contract) and wait for a seller to offer the same price. When you place an
order, you have to pay only a margin amount which is equal to 5 per cent of the
value of the order.
Settlement of an “i-gold” contract is possible in three ways – (1) you could
square-off the contract (i.e., sell a contract if you have purchased one and
vice versa), (2) you could settle in cash or (3) you can accept/offer delivery
of gold.
If you want to receive gold on purchase, you can choose to receive it in the
physical form or have it transferred to your commodity demat account by paying
the balance amount (i.e. value of the order less the margin deposited). A
commodity demat account can be created exactly in the same manner as an equity
demat account. This account helps you to keep track of how much gold you have
bought, sold and hold. The physical gold however lies in a vault. As and when
you require the physical gold you can collect it from this account by
requesting the depository with whom you hold the commodity demat account to
have it re-materialised (i.e. collected from the vault on your behalf).
In the form of Gold futures
When you buy a gold future, the contract entitles you to take delivery of a
specified quantity of gold (which is of 99.5 per cent purity) on a prescribed
date, at an agreed price. These contracts can be bought and sold via a
commodity broker on commodity exchanges such as the Multi Commodity Exchange of
India (MCX), The National Commodity and Derivative Exchange (NCDEX) or the
National Multi Commodity Exchange of India (NMCE). See section ‘Trading in Gold
on the Commodity Futures Exchanges’.
In the form of Gold Exchange Traded Funds (GETFs)
GETFs are open-ended mutual fund schemes that invest in certified gold in its
physical form. They are called ‘exchange traded funds’ because after the New
Fund Offer (NFO) period closes, these funds are listed on an exchange and
traded in much the same way as stocks. You can buy units of GETFs either from
the fund house during the NFO period or through the stock exchange after it
gets listed. In case of the former, you will be liable to pay an entry load. In
case of the latter, though you will not be levied any entry load, you will have
to bear brokerage charges. Post-listing, you can continue to buy even 1 unit of
a GETF whose value would be equivalent to approximately one gram of gold.
However, in order to do so, you will need to open and maintain a trading
account, demat account and a savings bank account.
TRADING IN GOLD ON THE COMMODITY
FUTURES EXCHANGES
Gold is traded on commodity exchanges in the form of gold futures contracts. A
gold futures contract is an agreement between a buyer and a seller that the
seller will deliver a certain amount of gold (equivalent to one lot size) to
the buyer at a predetermined price, at a particular date in the future.
Alternatively, if gold is not delivered, the contract must be settled in cash
on the date of expiry. These contracts are traded on the Multi Commodity
Exchange of India (MCX), The National Commodity and Derivative Exchange (NCDEX)
or the National Multi Commodity Exchange of India (NMCE).
Following is the procedural aspect of investing in gold derivatives:
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I - ACCOUNTS TO BE MAINTAINED
To trade in gold derivatives on the commodity exchange, you need to open and
maintain the following accounts with a commodity trading broker:
-
Commodity Trading Account
– The procedural aspects involved in commodity trading are on the same lines as
those in equity trading. Just like you need to have an equity trading account
before you can invest in the stock market, similarly, you need to maintain a
commodity trading account before investing your money in gold futures
contracts. This account needs to be opened with the brokerage firm through
which you wish to trade in gold futures. To open this account, you will need to
fill an application form and submit supporting documents. Once this account is
opened you are ready to start trading.
-
Commodity Demat Account – If you hold on to
the contract until its expiry, you have an option to either take delivery of
gold or settle off your position in cash. If you wish to take delivery of gold
on the expiry date of the contract (in the physical or the dematerialised form)
you need to open and maintain a commodity demat account. This account helps you
to keep track of how much gold you have bought, sold and hold. The physical
gold however lies in a warehouse. As and when you require the physical gold you
can collect it from this account by requesting the depository with whom you
hold the commodity demat account to have it re-materialised (i.e. collected
from the warehouse on your behalf)
II – TRADING IN GOLD CONTRACTS
While trading in gold contracts, you have to pay only a certain proportion of the
total value of the contract that you purchase or sell, known as the margin amount.
Generally, gold futures have an initial margin of 3.5 to 5 per cent of the contract
value. This margin amount varies between exchanges.
Once the necessary accounts are opened and you place the requisite margin money
with the broker, you can go ahead and place an order for gold futures. These contracts
are standardised in terms of quantity, price and duration.
- Gold futures contracts are traded in predetermined lot
sizes - Both MCX and NCDEX have two types of gold contracts — KG gold (1
kg) and 100 gms gold with KG gold being the more widely-traded contract.
- Settlement price is fixed by the exchange – The
price at which contracts can be purchased is determined by the market. In case you
do not plan to actually purchase gold, you can settle off your contract by paying
or receiving the difference between the settlement price and the price at which
you have initially purchased or sold the contracts.
- The expiry dates of all contracts are standardised
- The expiry periods for gold futures are typically 3 months for the contract with
a lot size of 100 gram and 1 year for the 1kg contract. Of course, you can sell
the contract before it expires.
Once you put in a purchase order, specifying the lot size, price and duration of
the contract that you wish to purchase, your broker forwards your order to the commodity
exchange. At the exchange, it is matched with a corresponding sale order placed
by a seller, completing your purchase transaction.
Maintaining your margin: As the value of your outstanding position changes, the
amount that you need to maintain as the ‘margin’ also changes accordingly, on a
daily basis. So, let’s say that the value of your contract moves from Rs 1,00,000
to Rs 1,05,000 the next day. If you are required to maintain a margin of 5 per cent,
your margin amount will increase from Rs 5,000 to Rs 5,250. In effect, you will
be required to increase your margin amount by Rs 250.
Your position is marked-to-market – At the same time, at the end of each day, the
value of your outstanding position is compared to that of the previous day. If you
have made a gain, your account is credited with the difference while if you have
made a loss, you will have to make good the difference by depositing the requisite
amount in your account. Getting back to our example, if the value of your position
has moved from Rs 1,00,000 to Rs 1,05,000, your account will be credited with Rs
5,000. This is called marking-to-market.
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III – SETTLING THE GOLD CONTRACT
1) Before expiry of the contract: If you wish to
close your futures position before expiry, you have the option to sell the future
that you have purchased or buy back the futures that you have sold, as the case
may be, at the price prevailing in the futures market. You will receive or have
to pay the difference between your sale price and the purchase price. The amount
that you pay or receive is net of brokerage and other charges.
2) On expiry of the contract: If, you hold on to
your contract until the expiry date, then you settle the contract at the settlement
price stipulated by the exchange. Here too, you will receive or have to pay the
difference between your sale/purchase price and the settlement price. Again, the
amount that you pay or receive is net of brokerage and other charges.
Mode of Settlement of a gold futures contract upon its maturity
There are two methods of settling a gold futures contract - one is in cash and the
other is by taking delivery of the underlying gold (either in the physical form
or in the dematerialised form).
Settling in cash
If the settlement is to be undertaken in cash, your profit or loss would be the
difference between the ‘settlement price’ (i.e. a price determined by the exchange)
and your purchase (if you have purchased gold futures) or the sale price (if you
have short sold), after adjusting for the brokerage charges, other charges and the
margin money deposited by you. These contracts are typically settled a day after
the expiry date of the contract.
Taking delivery of gold
In case you wish to undertake delivery of the underlying gold, then, the gold will
be credited to your commodity demat account in the electronic (demat) form. The
physical gold however lies in an accredited warehouse of the exchange. As and when
you require the physical gold you can collect it from this account by requesting
the depository with whom you hold the commodity demat account to have it re-materialised
(i.e. collected from the warehouse on your behalf).
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