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Suresh Krishnamurthy

`As an asset class, MIP should be doing well. With a one-year perspective, if you have to choose between income and MIP, the latter will certainly deliver better returns.'

Investing and staying invested in income schemes have now come under a spell of considerable uncertainty. The prospect of capital loss looms over every income scheme. In this context, the thinking of fund managers could be useful to an ordinary investor. This interview with Head-Fixed Income, JM Mutual Fund, Mr M.Nandkumar Surti, could provide you with just such a perspective.

Excerpts from the interview:

What is your outlook for interest rates?

By and large, it is likely to remain stable going forward at least for the next six months. Only if the policies of the new Government are such that they will increase the non-performing assets of the banking sector, interest rates will rise. That is the only dampener.

Do you think the new Government prefers higher interest rates?

It is not a preference for higher interest rates. Structurally, the probable savings rate cut and the postal schemes rate cut will not happen.

Having said that, if they do not do anything, which disturbs the fundamental characteristics of the banking sector, then still interest rates will not rise.

This status quo cannot exist for more than six months. The prevailing market rate is about 6 per cent and the PF rate is about 9 per cent. It will be difficult to deliver on that promise. They will have to revisit the PF rate about six months to one year down the road.

If the Government follows a tax and spend policy, what will be the impact on interest rates and liquidity?

Tax and spend is not necessary as of now. The industry is doing very well and tax collection has been buoyant in spite of the tax rate cuts. In a booming economy, the shortfall that will arise out of the policy of no disinvestments can be taken care of. There is no need to increase the tax rate levels.

If, however, they were going to do anything to hurt the industry then there would be some problems.

You said that you expect interest rates to remain stable. Is that why the average maturity of your portfolio is quite high?

No. It was more a function of our expectation that the Government will continue.

We have, however, already reduced our duration. Our duration is going to be slightly higher than that of peers because of our preference for gilts.

The spreads that corporate securities give are not sufficient given the low liquidity.

Can we say that the higher returns generated by your fund is because you took higher risks?

We have done well across periods. Even during the periods in which interest rates rose, such as the Kargil War, in 2001 and the Iraq War, we have done well. If our performance is because of the higher risks that we take, then we should not have done well during periods of crises.

How do you read the large increase in inflow into floating rate products?

The increase in inflow into floating rate products is not a function of expectations of rise in interest rates. If interest rates remain constant, the amount of risk you are taking by investing in an income or gilt fund for those additional returns of 1 per cent is substantially higher compared to your investment in a short-term fund or floating rate fund.

This risk-return profile is leading to higher inflows into short-term funds, money market fund and floating rate funds. There is a consensus in the market that rates are remaining steady and the focus is on the shorter-end of the curve.

Are inflows into floating rate funds justified? Will not active management — represented by diversified income funds — not do well over a longer period compared to passive management, represented by floating rate funds?

Over a longer term, you are talking about a risk element. How much can active management deliver above passive management? It is going to be one per cent over the next year. Is the risk justified? Certainly not. That is why we are advocating short-term funds, money market fund and a floating rate fund more than an income or gilt fund. Tomorrow, if the return is going to be 2-3 per cent over a one-year period more then actively managed fund will be better.

So, if someone shifts to short-term or floating rate funds now, it is also incumbent on the investor to shift back to diversified income schemes at the right time...

That we keep advising. We always come out with weekly commentaries and fortnightly commentaries.

Who reads those commentaries...

Investors are supposed to read. The marketing and sales team also increases the pitch when the strategy needs to change either on the defensive or aggressive side.

For an average investor who is not skilled and unlikely to shift out of his funds and who generally holds for a longer-term, would you still say he should shift out of diversified income funds?

Yes. I would still say he should park a portion of his funds in floating rate funds and short-term funds. You are entering into a scenario when interest rates going down are ruled out and there is a lot of uncertainty. Allocation to floating rate or short-term funds is desirable.

What is the difference in expense ratio between a floating rate fund and a diversified income fund?

It would be at least about 0.5 per cent. This will also add to the fund's performance.

Given the lack of long-term floating rate instruments, will the rising inflows into floating rate funds create a problem?

Even if a long-term floating rate paper was available we will not buy it. Suppose you buy a five-year floating rate paper at 50 basis points and then interest rates rise, the spreads will rise to 75 basis points.

This means lower returns. We will never be able to explain this to our investor who expects higher returns. We will still buy the floating rate paper at the shorter end of the curve or invest in synthetic floating rate instruments such as a pass-through certificate with monthly maturities.

So you would advice investors to put the bulk of their funds in short-term and floating rate funds?

Definitely. Move to short-term funds where the expense ratios are lower with a clear vision that this is going to protect your capital.

Over the next three-six months, playing defensive appears better. With respect to investing in income funds and gilt funds, they will have to take advantage of some time-bound opportunities.

Apart from the rise in inflows into floating rate funds, there has been a sharp rise in inflows into the monthly income plans (MIP). How do you read this development?

As an asset class, it should be doing well. With a one-year perspective, if you have to choose between income and MIP, the latter will certainly deliver better returns.

Do you think a simple strategy of investing a small proportion in equity and a large proportion in debt will out perform an MIP?

If the markets are good then that will give better results. If the markets are bad then it will not be attractive.

The MIPs, by nature, will invest in some growth stocks but also invest a proportion in stocks that are slightly defensive in nature.

A diversified equity fund on the other hand will be aggressive. If you take a sustained three-four year rolling period analysis, then the simple strategy will do well because equity is anyway a better performing asset class.

If you are, however, going to look at investments made only in a downtrend, then you will lose much more.

The point, however, is the restriction imposed by regular dividend payments. Does it not pull down the performance of MIPs?

In the Indian context, the risk-reward ratio for income funds is not exciting and because equity as an asset class looks promising, a 90:10 asset allocation strategy is attractive.

Unfortunately, the moment you talk about that asset composition, you are talking about an MIP. A 90:10 product, which does not fall under the category of MIP, will be a better performer. We did try it with our MIP. Our MIP was initially not even named as an MIP.

After a month of marketing exercise, we realised retail investors are not even looking at 90:10 product that we marketed as a replacement for an income fund.

So, we decided, let us rather call it a MIP. The fund was initially named JM Income and Equity Fund. We had a lengthy discussion and finally renamed it. There will always be periods when the need for regular dividend payments will pull down returns.

What is the asset allocation that you would advise retail investors now?

About 15 per cent in monthly income plans, 15 per cent in income funds and 15 per cent in short-term income funds. The rest could be split between floating rate funds and money market funds.

Investments in MIP and income funds should be made with a very clear vision that they are not going to need those funds for the next one year.

Short-term funds with a three-month perspective while floating rate and money market can be have investment horizon of anything between a day and a month.

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