December 20, 2009

Analysing floating rate funds

I wrote in my last post on my views on inflation and one venue of investing or hedging against it – floating rate funds. Two key points to keep in mind, when reading my views on inflation or any other macro fundamentals. They are views and guesses, nothing more and nothing less. Even paid economists get it wrong more than 50% of the time and it is their job to get it correct.

The second point – I look at floating rate funds as temporary place holders for cash. If I don't find attractive ideas, I invest the surplus cash in a floating rate fund till I find something interesting. That way, the cash is earning more than the paltry 1% in a savings account and I can liquidate with complete ease and within 1-2 days if I want to move the cash to an attractive idea.

Due to the second point, I don't agonize on finding the most attractive fund as the difference would at best 1-1.5% per annum which is not worth the effort for me.

A caveat – I am not a typical investor (that does not mean I am a super smart investor). I spend far more time looking for attractive ideas and as a result my focus and effort is directed towards higher return opportunities such as equities or arbitrage. If you do not fall in this category - investing being an area of extreme interest – then my suggestions on personal finance may not be entirely valid for you. If you really want to invest in a debt fund for the long turn, it makes sense to do more homework and invest intelligently

Floating rate funds are basically debt funds which invest in floating rate securities. So if the interest rates rise, the return on these securities and hence the fund rises and vice versa.

This is not the same in case of fixed rate funds. A fund which invests in fixed rate securities faces a different risk. When the interest rates rise, these debt instruments with fixed rates fall in value and so does the mutual fund. As a result these fixed rate funds show a higher return in falling rate scenario and poor returns in an increasing rate scenario

My views on mutual funds can be found here and on debt funds here.

Selection criteria

I had written the following in terms of debt funds

- Mutual funds – fixed income: This is my favored avenue during a falling rate scenario and I tend to invest with well know mutual fund houses such as franklin templeton, DSP etc. At the time of investing in a debt mutual fund, I tend to look at the following factors
o Asset under management – avoid investing in funds with low level of asset as the expense ratios could be high.
o Fund expense – lower the better. Although the indian mutual fund industry typically gouges its customers and charges too high compared to the returns.
o Duration of fund – This is the average duration of the fund. A fund with longer duration will rise or fall more when interest rates change
o Fund rating – 80-90% of the fund holding should be in p1+ or AAA / AA+ securities.
o Long term performance of the fund versus the benchmark

- Mutual funds – floating rate funds : This is my favored approach in a rising rate scenario. In addition to all the factors for the fixed income mutual funds, I also tend to favor floaters with shorter duration.

So based on the above criteria and in view of the possible rise in interest rates, I was able to find the following funds

Some selections

Templeton Floating rate retail growth – The fund has been around for 5+ years, has beaten the index by around .5% and has 425 crs under management. Majority of the fund holding is in AAA securities. The major downside is that it charges 1% as management fees.

Birla sunlife floating rate LT retail growth – This fund has been around for 6 odd years, beaten the index by around 1% and invests in AAA securities. An additional point is that the fund charges .44% as management fees which allows the fund to deliver better returns to the investor compared to other floating rate funds. The downside is that the fund does not have as much asset under management (around 150 crs)

HDFC floating rate income LT – This fund has been around for 7 years, has beaten the index by around 1%, and invests in AAA securities. In addition the fund charges only .25% as management fees and has fairly high asset under management (around 850 Crs). This fund clearly seems to be better among the lot.

ICICI prudential LT floating rate B – The fund has been around for 6 years, has barely beaten the index and charges 0.85%. In addition the fund is fairly small, less than 100 crs in asset.

Kotak Floater LT G – This is one of the largest funds with around 18000 crs in asset. The fund has beaten the index by around 0.6%. In spite of its large size, it charges around 0.5% as management fees.

The above list clearly shows that the variance in the performance between the funds is low as expected. As a result, it is critical to choose a low cost fund which is difficult as all the funds clearly charge too much compared to the value provided. If one nets out the cost, the return is almost same as the index for most of the funds.

Conclusion

The conclusions are obvious

  • If you want flexibility and ease of transaction, select a low cost fund such as HDFC or kotak.
  • If you have the time and can put the effort of going to a bank and don't need the liquidity, then it makes sense to buy short duration fixed deposits with good banks and keep rolling them. As a result when the interest rates rise, you will be able to take advantage of the higher rates.

What am I doing ?

I am using option 1 for myself and option 2 for my parents.

21 comments:

Ameet Talwadker said...

Hello Rohit,

What abt the exit load for these funds? for eg, I see on valueresearchonline that the exit load for the HDFC fund is 3% if exited within 540 days. Do you look at this factor when parking ur funds?

Cheers,
Ameet

Mayank said...

Hi Rohit,

Could you also specify the benchmark that is considered in this case.

Since the fund management charges are anywhere between 0.5% - 1%, you must also have minimum time frame for which you are comfortable blocking till you find a good value stock. Could you specify whats the average such time interval.

Regards,
Mayank

Anonymous said...

Doesn't a typical savings account earn 3.5% - even after tax that should be more than the 1% you quote ?

amit said...

Hi Rohit,

An additional alternative could be a flexi-deposit linked to the savings account. Most banks offer this now. Any amount exceeding a certain minimum amount gets transferred in multiples of 5k or 10k to a 6m fixed deposit. It offers complete flexibility and there is no risk of capital loss. The best part is that you dont need to go to the bank or ask them to make an FD, so it requires no effort at all.

Regards,
Amit

Anonymous said...

I'm not entirely convinced by your argument - as you pointed out, high expense ratios eat into your returns. Further, the other expenses (hdfc floating rate has 3% exit load if redeemed within 18months plus the transaction charges that (may) apply, both on the purchase and redemption) would eat into your return..

Anonymous said...

I prefer option2 while I wait for my opportunities.
But would feel more secure with higher deposit insurance - something we all as customers should be rooting for..

Manshu said...

I am a bit concerned about the exit loads since they will eat in the return for sure. I hate keeping cash, but sometimes that is the safest option.

That's what I am doing right now because of the steep run up of the markets. Was looking for some bond funds, but interest rates can only go up from here, and that is not good for bond prices.

Anonymous said...

Hi rohit,

Have you analysed Panasonic carbon india. I found the idea at this link - http://capitalideasonline.com/articles/index.php?id=3187

Stock is trading below book value and roce is more than the inflation(at least for the time being).
So book value should stay more than ROCE.
I don't think company is going out of business anytime soon, but nevertheless it a commodity stock with almost no moat.

Let me know your views.

Amit

Rohit Chauhan said...

Hi ameet
i missed the 3% exit load on hdfc. that changes everything for me. this fund works only if one wants to hold for sometime, but not good for a short term holding

rgds
rohit

Rohit Chauhan said...

Hi mayank
I think the benchmark is MIBOR or some similar floating rate index. i found it in valueresearchonline.
i dont have a specific holding period ..these funds are just a placeholder for me. i will hold cash as long as i dont find a good idea. its diffcult to know when that will happen
rgds
rohit

Rohit Chauhan said...

Hi anon
you may be right ..but in the past i have seen that these rates dont go up as much in response to rising rates. also bank use some average balance calculation ..so the effective rate has turned out to be lower than the advertised rate
rgds
rohit

Rohit Chauhan said...

hi amit
you are right ..flex deposit also a good option ..how much is the return in these cases ? i think it is lower than what you can get from floating rate funds
rgds
rohit

Rohit Chauhan said...

hi anon1
i agree with your comment. i did not notice exit load in hdfc and hence that part of the comment is invalidated. however kotak floater does not have an exit load and hence the conclusion holds true
rgds
rohit

Rohit Chauhan said...

Hi manshu
Bank FD or floaters are better than keeping cash especially if inflation picks up. but if holding cash looks safer to you and gives you good sleep then that is what you should do
rgds
rohit

Rohit Chauhan said...

hi amit
i have not seen the company. will have look and let you know
rgds
rohit

karthik said...

Hi Rohit,

ICICI direct charges 100 rs as transaction fee. In thier T&C ...

"b) In case cumulative value of Mutual Fund holdings (other than liquid fund) with ICICDirect is less than Rs. 8 lakhs - Rs. 30/- or 1.50% of investment amount, whichever is lower, per transaction in case of SIPs and Rs. 100/- per transaction in case of lumpsum investments. No charges will be levied in case of investments made in liquid funds "

This makes the floater fund little expensive. You were not charged this fee? How did you manage it :)

Anonymous said...

Hi Rohit - How about short term debt funds?

Thanks
Prashant

Amit said...

Hi Rohit,

In case of flexi deposit, the interest rate applicable is the 6m deposit rate (currently 6% pre-tax for Axis, I reckon it would be similar for most banks). However, if the amt is withdrawn before 6 months, the interest rate applicable will be the rate for the actual period of deposit on the initial deposit period. So if the amt is withdrawn in say 3 months time, the rate on 3m deposit (as it was on the initial date) will be provided.

Don't know how it compares with floaters, but given that there is no entry-exit load, no risk of principal loss and the flexibility to exit with the click of a button, I think it is a very good option who doesn't want to think too much about short term deployment of excess cash.

Regards,
Amit

Rohit Chauhan said...

hi karthik
beats me. i checked my transaction statement and did not find the fee. maybe as my holdings are more than 8 lacs ?

rgds
rohit

Rohit Chauhan said...

Hi prashant
short term funds are good, but they will have a drop in returns in a rising rate sceanrio. best avoided if you expect inflation and interest rates to rise.

hi amit
i agree, flexible deposit are also a good option. but you dont benefit from rising rates and also i think there could be a 1-25 difference compared to floating rate

mkd said...

Hi Rohit,

The fee from ICICI Direct is applicable only from 1-Aug-09. Also it is applicable only if MF holding value is less than 8 lakhs.

Regarding HDFC Floater, I was wondering what would be the objective difference between HDFC Floater LT and HDFC Floater ST?

I noticed that HDFC Floater ST does not have an Exit Load. But it has minimum investment amount of 1 lakh compared to 5000 for LT.

mkd