Tuesday, February 7, 2012

Lost faith in your SIP? Don’t give it up

Lost faith in your SIP? Don’t give it up

Lump sum investment outperforms an SIP in the long run, but the latter eliminates short-term volatility

If you checked the performance of your equity systematic investment plan (SIP) in the last one year, you’ve watched the value of your money go down, down, down. In fact, if you look at one- or three-year returns in SIPs in top 10 (by assets under management) equity diversified schemes, you’ve lost out to lump sum investments and in some cases underperformed benchmark returns as well. Data from Computer Age Management Services (CAMS), a registrar and transfer agent to a number of mutual funds, shows that spooked investors are voting with their money and the number of ceased SIPs has almost doubled over the calender year 2011. Ceased SIPs are those which are discontinued before their mandated time. For example, if you start an SIP mandate for 12 months but discontinue after five months then that qualifies as a ceased SIP. CAMS records 58-59% of the industry’s business. Says Sushil Jain, head-financial planning, Bajaj Capital Ltd, “No doubt people are discontinuing SIPs. But we try to educate them about the benefits of SIPs by showing past performance in market corrections.” Question investors are asking is this: should they discontinue their SIPs?

Though the disillusionment with SIP returns is understandable given the market sentiment and volatility in the past two-three years, we will need to look deeper to answer this question. First, a look at why we use an SIP.

Understanding your SIP

As the name suggests, SIPs are meant for making regular, systematic investments. For the vast number of investors who earn through monthly salaries, it makes sense to decant the surplus and funnel it into an investment vehicle each month. Investors find it difficult to time the market—it is impossible to know the right time to enter the market, the best index level and the best (or worst) day. You may get it right or close to it a few times but are more than likely to get the timing wrong an equal number of times. Says Suresh Sadagopan, a Mumbai-based financial planner, “We can’t know when markets move higher or lower, so why take a chance simply because there is a possibility of higher returns in the short term?” That is where an SIP comes in—it gives the investor a regular investing vehicle.

Equity investors must understand that if markets rise over the long term, the value of the lump sum will be higher than an SIP. Let’s also understand that an SIP is a facility that calls for a different way of calculating returns. Typically, fund fact sheets give out performances for lump sum investments. If here’s where your fund has outperformed benchmark indices, it’s on the right track. Look at SIP returns over a slightly longer time frame since money gets deployed gradually, and not all at once. Whether an investor chooses an SIP or a lump sum won’t impact performance against benchmark.

Says Sundeep Sikka, chief investment officer, Reliance Capital Asset Management Ltd, “SIP returns in the last two-three years have been disappointing but that is because markets haven’t moved anywhere. But investors get nervous and redeem.”

Hare or tortoise?

Does the SIP really smoothen out the volatility? To answer this question we back-tested the data for four equity funds—HDFC Top 200, Franklin Bluechip, Birla Sun Life Equity and Reliance Growth—to see what an SIP investor would make as against what an investor who invested in lump sums on days when markets were the highest and lowest in that year. The first investor would begin his monthly SIP on the lowest and the highest day and then continue the monthly SIP till December 2011. The second investor would invest in lump sums both at the highest point and at the lowest point of the market. We did this for each year from 2001 till 2009, assuming that the SIPs started in each year were continued till 31 December 2011.

We find two things from this data. One, over the long run, if markets are trending upwards, as expected, lump sum investments will always outperform an SIP. From 2001 to 2011, the market rose at a compounded annual growth rate of 17.26% from its highest point in 2001 making lump sum investing do better than SIPs.

Two, the difference in return between investing on the best day or the worst smoothens out over time. For investors beginning in 2007, the SIP did not see a large difference in returns even if he began the SIP on the best day or the worst, but the lump sum investor saw returns vary from negative of 0.35% to positive 12.17% if he invested on the highest point or the lowest point, respectively. The story is repeated for 2008 and 2009. But step back to 2002 and the benefit of market timing begins to fade away. So, yes SIPs work, but only to smoothen out the volatility in the medium term. Over the long run, in a rising market in a growth economy, lump sum investing will always outrun SIPs.

What should you do?

First, don’t compare returns of SIPs with lump sum investing—they both serve different purposes. In an overall rising market, even in the long run, lump sum investment is likely to beat an SIP as the start point will be the lowest and the end point the highest. However, in reality investments are made at various points in time and knowing the top or the bottom of the market is possible only in hindsight. Says Sikka, “Lazy money makes the most return. In equity, invest your money and forget about it. It will be more profitable for investors in the long run.” Second, most of us do not have the luxury of making large lump sum investments and therefore the SIP vehicle suits the best. But what if you get a large infusion of cash—a bonus or money back from a policy? If you have a strong stomach and don’t mind seeing the money evaporate in the short term, a lump sum is the best option. But rather than a managed fund that runs a fund manager risk, a lump sum could go to an index fund or an exchange-traded fund. Says Sadagopan, “For slightly risk averse investors who want equity exposure, index funds work well as the risk of fund manager performance is eliminated.” For all other investors, stay with the lower risk strategy to stagger the investment. Says Sadagopan, “Regardless of the market, we advise a staggered approach. We advise to use systematic transfer plans over 45 days to three months depending on the investors’ need.” In volatile markets he adds, its better to stagger regardless of the type of fund you invest in.

So, don’t panic too much if you see negative returns on your SIP; remember equity investing is for the long run and SIP removes short-term volatility.

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