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Introduction to liquid funds

Liquid funds are getting increasingly popular these days because of the high interest rates, safety, and tax advantage that they offer.

Liquid funds invest in treasury bills, government securities, call money, repo and reverse repos and other such instruments that are quite safe in nature and have a short maturity. This means that they are good for parking that part of your money that you would have otherwise put in a bank savings account.

There are a large number of liquid funds available in India and to give you an indication of the returns they have generated in the past few years, I took the returns of 3 funds that were rated high, medium and low for the long term by Value Research.

You can see those returns in this chart.

As you can see, last year has been particularly good for liquid funds, and that is beginning to show in the fund inflows as well. ET reports that during the month of May 2012, liquid funds had the largest inflow of funds in any category and got over Rs. 25,000 crores.

Liquid Fund Tax Benefits

Liquid funds are taxed long term capital gains at 10% without indexation and 20% with indexation. The short term capital gains are charged at the marginal tax rate of the investor and the dividend distribution tax is charged at 25% but that’s in the hands of the fund house and not the investor, so the returns that you see in the chart above have taken care of that.

In general, liquid funds do not have exit loads, and the ones that I checked showed this to be true, however I’m not sure that this is true across each and every liquid fund that exists in India.

Liquid Funds versus Savings Account

It used to be that liquid funds were a lot better than savings accounts because their returns were higher than savings account interest rates and they were taxed at a lower rate than the savings account interest income.

While this is still true, two things have reduced their advantage in recent times.

The first one is that savings bank rates have been liberalized and you can get 6% or so in a savings bank account now, and secondly, bank fixed deposits for short periods like 3 months can now give you as much as 8.25%, and you can always move some part of your emergency funds to these short term deposits especially when a lot of these can be opened electronically and don’t have a penalty when you break them.

I feel that liquid funds definitely have a place in your portfolio if you are in the higher tax bracket but you can’t focus too much on it because the absolute difference that you get by investing in a liquid fund versus a savings bank account shouldn’t be a lot. If it is a lot, then you have to ask yourself where else you can invest this money for a longer duration to get better returns.

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ICICI Prudential US Equity Bluechip Fund Review

ICICI Prudential has launched a new mutual fund called the ICICI Prudential US Equity Bluechip Fund which will invest in stocks of American companies, and I think this is just the second fund after Motilal Oswal’s NASDAQ 100 ETF that allows Indians to get exposure to US equities using a fund vehicle.

A look at the chart of the Motilal Oswal’s NASDAQ 100 ETF’s performance overlapped with the performance of NASDAQ itself helps drive home a very important point that you must keep in mind before investing in any fund that invests in the American market.

The big thing that you see from this chart is that even though the NASDAQ only grew 7.4%, the index fund based on that grew a whopping 37.8%!

Most of these gains are due to the currency rate movements and Rupee’s depreciation in the recent past has really helped this fund show the kind of returns that it has. Kapil Visht has done an analysis of Motilal Oswal’s NASDAQ fund to show the relationship between Rupee movement and fund performance and that is worth a read as well.

Simply put, if the fund had 100 crores in INR and the USDINR rate is Rs. 50, you can buy USD 2 crore or 20 million dollars worth of shares. But when the same rate moves to 57, and you sell those 20 million dollars worth of shares you get 114 crores in Rupees.Â You can use the rupees crores to million dollars calculator that I developed some time ago to see how this works.

This is an important point that you need to consider because it is not quite intuitive how big of a difference these currency rate movements can make, and you might feel that over a longer period they may not make a difference, but at least so far that hasn’t been true, and I think that’s going to continue for some time to come due to the Rupee volatility that we have seen in the past couple of years.

PP commented earlier in the day what would happen if the Rupee were to appreciate which it eventually will and I would say that there is no guarantee that the Rupee will or should appreciate and you can’t take that for granted. For people who remember 39 Rupees to a Dollar, they thought that it would go back to 39 once it hit 45, but it hit 50 instead and I’m sure there were a lot of people who thought this would go back to 45 but look where we are today.

However, if the Rupee were to rebound and American market were to remain flat or go down then you will make losses on your investment.

You can see this simply based on the above example where you have 20 million dollars worth of shares, and instead of selling it now, you hold them for a year when the Rupee rebounds to 45. In this situation your 20 million will just be able to buy 900 million rupees or 90 crore rupees and you will be left with a loss of 10%.

Now, the offer document does say that they are going to try and employ currency hedging but it doesn’t go into a lot of detail so you will have to wait and see what this really means and see how it actually plays out.

Now let’s look at some other aspects of this fund.

ICICI Prudential US Equity Bluechip Fund Is An Actively Managed Fund

This is an active fund and not an index fund, the benchmark is the S&P 500 and the fund will buy stocks only in companies that are listed in NYSE or NASDAQ. In their review of the ICICI Pru US Equity Bluechip Fund, Business Line says that the fund will invest in 20 – 25 stocks and I think that was mentioned at the press conference.

This is not a fund of fund

The good aspect of the fund is that it will invest directly in equities so there won’t be any double fees. There have been some international funds that have been fund of funds so this is also an important thing to keep in mind.

Expense Ratio

The expense ratio that’s mentioned in the fund document is 2.5% and this is pretty high, it remains to be seen whether they actually charge this much but 2.5% is a bit high for any fund.

Open and Close Dates and SIP Amounts

The NFO opened on June 18 2012 and will close on July 2 2012, and the minimum application for NFO is Rs. 5,000 and then for the SIP the minimum amount is Rs. 1,000. Regular readers know however that there is no benefit of investing in the NFO of a mutual fund.

Conclusion

This is an interesting product and and it is good that fund houses are coming up with funds that invest directly in American markets but the expenses seem to be high and it’s a lot better to have a passive index fund that’s low cost than an active fund with higher cost.

In two or three years there will be plenty of funds in this category and then perhaps you will have lower cost options but till then if you wanted to take exposure to the US markets then this is a viable option along with the Motilal Oswal NASDAQ fund.

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What is the difference between basic and diluted EPS?

The P/E multiple or the Price / Earning ratio is probably cited more than any other when it comes to financial numbers.

The EPS (Earnings Per Share) is one of two inputs of the P/E ratio and companies have to report two types of EPS numbers – Basic EPS and Diluted EPS.

Basic EPS is calculated by taking the total net profit and dividing it by the total number of ordinary shares that are outstanding for the company.

If the total number of shares were increased then the profit per shareholder would reduce and that’s primarily what happens in the case of diluted EPS.

Diluted EPS is calculated by assuming that everyone who has an instrument that can be converted into an equity share converts it into an equity share and so the total number of outstanding shares of the company increase, thereby reducing the EPS.

Stock options are one example of these kind of instruments, preferred stock is another, and in the case of many Indian companies – FCCBs (Foreign Currency Convertible Bonds) feature prominently among instruments that can dilute the earnings. Subject to certain terms, all these instruments can be converted to ordinary shares by the instrument holders and if they did that then the profit available to each shareholder will be reduced and earnings will be diluted.

Now just because an instrument can be converted into a share doesn’t mean that it will be converted and that will be true in a lot of cases where the dilution occurs due to preferred stock or FCCBs.

The other aspect of this is that when you convert such instruments to ordinary shares the company is relieved of the obligations that arise due to them. So, if FCCBs were converted to shares then the company no longer needs to pay any interest on them and if the preference shares were to be converted to ordinary shares then they won’t have to pay dividends on that any longer, so that will actually increase the profit available to shareholders and that’s why the net profit that’s used to calculated the Basic EPS and Diluted EPS is different.

Although not exactly diluted EPS, one thing that comes to mind while talking about this subject is when companies do an IPO – they often sell promoter stock and issue new shares as well.

The EPS and PE ratios that are normally reported in the papers and present in the prospectus are the ones that are calculated before the new shares are issued. But that is a bit inaccurate because as soon as the IPO hits the market, the new shares will be issued and the earnings will be diluted to that extent. I have an extensive post on that with the specific example of Power Grid FPO and that will make a good further subject and also give some context on how the dilution actually works with some concrete numbers.

As always, questions and comments welcome!

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