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Want to Beat SIPs? Invest Through VIPs

Systematic investment plans have been a hit with investors because they help break investments into easy-to-pay instalments and deliver good returns. But there’s another instalment plan that beats even SIPs in returns. It's the value investment plan or value cost averaging. Here is a low-down on VCAs

By Devangshu Dattaand Tejas Bhope | Print Edition: December 28, 2006

 

When banker J.P. Morgan was asked to predict the stock market’s movements, he replied: "It will fluctuate." In the short term, that's a certainty. There will be bullish phases, bearish phases and random moves. In the long term, stock prices do move up.

It is impossible to time the market. However smart money management to minimise costs can help maximise returns, no matter how the market moves.

Good money management can even yield positive returns in bear markets. Say, you invest in an instrument when it is trading at Rs 38.5 and it drops to Rs 29.56 (down 23%) over the next three years. If you commit your money at one go, you lose 23%.

But what if you buy in equal monthly instalments? You might make a profit despite the drop. It depends on the interim fluctuations. Every time the price drops, the same EMI buys more units and lowers average cost. For example, you commit to an EMI of Rs 1,000. If the price per unit is Rs 15 this month, the EMI fetches 67 units. Next month, if the price rises to Rs 20, you buy 50 units. You now hold 117 units at Rs 17.14 each. The return is Rs 340 on Rs 2,000.

This is rupee-cost-averaging (RCA) or "time-averaging"-fancy names for the Systematic Investment Plans (SIP) that openended mutual funds offer. In the bearish example given in the chart Mr Cost, we tracked the Franklin Prima Fund in the bear market that followed the dotcom bust, from March 2000 (NAV: Rs 38.49) to March 2003 (NAV: Rs 29.56). An SIP during this period actually yielded a positive return of 32% as can be seen below.


An SIP is a more sophisticated method of money management than simple lump sum investment. But instead of an SIP, you can also target a portfolio value over time. This is value-cost-averaging (VCA). For example, a VCA may target portfolio appreciation at Rs 1,000 per month. Let’s say, you buy an initial 67 units paying Rs 1,000 when the price is Rs 15. Next month, if the price rises to Rs 20, the 67 units appreciate in value to Rs 1,340. So, you only buy Rs 660 worth, or 33 units. The net return is Rs 340 on an cost outlay of Rs 1,660.

Suppose in the third month, the price jumps to Rs 40. An SIP buys 25 units-leading to a total holding of 142 units at Rs 21.13. At the given price, the SIP has profits of Rs 2,680 on a cost of Rs 3,000, an impressive 89% return.

But the VCA's holding of 100 units is now worth Rs 4,000-an excess of Rs 1,000 over targeted value. So, the VCA sells 25 units at Rs 40. The holding comes down to 75 units worth Rs 3,000 and the total cost is reduced to Rs 1,000. The net return is a whopping 200%.

Profit-booking is the key difference between a VCA and an SIP. When prices fall, the VCA buys units cheaply as an SIP does. But if prices rise and targets are beaten, the VCA books profits.

As Gaurav Mashruwala, chief financial planner, explains: "Theoretically a VCA is better than an SIP because in addition to buying more units at low prices, VCA induces profit booking when markets rise. It thus helps investors to buy low and sell high. RCA only helps buy more units at a low price, thereby reducing the average cost."

Even in the 2000-3 bear market, where we tracked Franklin Prima’s performance, VCA continues to work well by exploiting momentary rises in NAV. For example, while the lump-sum investment loses 23% and the SIP gains 32%, the VCA returns an excellent 48%.

 


An SIP scores during a bear market because it lowers average cost.The same EMI buys more units when prices drop. Here, NAV dropped 23% between 2000 and 2003. But the SIP returned +32%


VCAs can profit in bear markets. It buys more units if prices drop.And books profits if prices rise. Here, prices dropped 23% from 2000-3 but the VCA returned +48%

 "VCA induces profit booking in a rise. It helps investors to buy low and sell high" GAURAV MASHRUWALA Financial Planner


"In a VCA, reconciliation of accounts could go totally haywire" SANDESH KIRKIRE CEO, Kotak Mutual Fund

 VCA: Do It Yourself
 1) Set a value target-let's say, Rs 1,000 per month
 2) Look at the NAV on the first trading day of the month (or any other convenient date)
 3) Multiply number of units held by the NAV to calculate current portfolio value. Say, after 10 months, you hold 686 units and the NAV is Rs 19.The portfolio value is Rs 13,034
 4) Compare the portfolio value with target value. In the above, your target is Rs 10,000, your portfolio is worth Rs 13,034
 5) If portfolio value exceeds the target, sell the surplus. In the above, you sell Rs 3,034 (160 units at Rs 19). If portfolio value is below the target, you buy the appropriate number of units
 6) Repeat steps 2-5 next month

The profit-booking mechanism in a VCA can cause a very dramaticlowering of costs. In strong, sustained bull runs, it may even lead to mathematically infinite returns. The VCA will book profits continuously, wiping out all costs while still meeting the time-target value. Look at the charts on the right depicting the bullish phase. These track Franklin Prima through March 1995 (NAV: Rs 18.01) to March 2000 (Rs 38.49). In this bull-run, every strategy worked.


A lump-sum investment in March 1995 yielded 113%. An SIP of Rs 1,000 per month yielded 201%, exploiting periodic dips in NAV to lower average costs. At the end of 61 months, the SIP committed a cost of Rs 61,000 and the portfolio was worth Rs 1,83,455.

Let's say a VCA targets portfolio growth of Rs 3,000 per month to yield a portfolio of the same value as the SIP. Over time, this VCA also books profits of Rs 44,545. As the NAV climbs, the VCA sells off surpluses. The costs turn negative, and hence, the returns are infinite.

In volatile markets too, VCAs outperform. For example, between March 2000 (NAV: Rs 38.49) and March 2005 (NAV: Rs 116.62), Franklin Prima gained substantially. But it hit a low of Rs 14.47 in October 2001 and spent several years in the doldrums. A lump sum gained 202%, an SIP gained 291% and VCAs gained an infinite amount due to profit-booking.

What are the downsides to implementing VCAs? One: It requires active money management. Mutual funds don't offer automated VCAs. Sandesh Kirkire, Chief Executive, Kotak Mutual Fund, says: "In case of SIPs, the monthly receivable is known. Yet, to reconcile those inflows with each investor account is very cumbersome. In enabling VCAs, where the amount to be invested by each investor is different every month, the reconciliation process would go totally haywire. It is also difficult to determine what NAV should determine the next instalment. The NAV is known only at the end of the day and the money comes in only the next day or later."

Well, take a look at the box "VCA: Do it Yourself". It does not take too long to make the calculations yourself and issue the appropriate buy or sell orders.

Two: You may need to reset VCA targets often as your income grows and investible surpluses increase. Revisit VCA targets every time an annual increment comes through.

Three: In a long bear market, you could theoretically end up with massive monthly costs. If prices drop sharply for years in succession, to maintain the target value costs a lot. Our number-crunching did not throw up such periods of losses; there are always interim periods of recovery. But it could happen and it is another reason to not take on very long VCAs.


Despite these caveats, the VCA does seem to be a profit-maximising method of managing money. If you can spare the time, the implementation of a VCA plan may add significantly to your returns.

The SIP lowers average costs while the rising NAV drives up portfolio value.While the NAV rose 113% from 1995-2000, the SIP portfolio value returned 201% due to the lower average cost


Between March 1995 and March 2000, F ranklin Prima's NAV rose 113% from Rs 18 to Rs 38.5.VCA plans booked infinite profits as the NAV rose, thus wiping out the costs

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