3 reasons why SIPs put off investors

This article written by Personalfn for Business India, and was carried in its April 25, 2005 issue with the same title Right now in the mutual fund industry, if there is one 3-letter word that can give the other one – IPO, a run for its money, its SIP (Systematic Investment Plan). The benefits of SIP investing and the convenience to retail investors have been much touted. However, at Personalfn we came across some investors who felt short-changed after having started their SIP investments. There can be little debate that SIPs promote two traits that are invaluable to financial planning – §  Regular investing that makes market timing redundant §  Rupee cost-averaging that beats investing lumpsum Despite the pros, investors would be well-advised to note some demerits associated with SIPs. Although its not like the negatives bring down the entire edifice on which the argument for SIPs is based, they are nonetheless pertinent. 1) Exit isn’t as cheap as you thought Most SIP investors probably aren’t aware that there is an exit load slapped on premature redemption since the entry load is waived off on SIPs. In a lot of cases 12 months is the minimum time period for which investors have to be invested to escape without an entry load. So investors assume that they can redeem the entire amount in the 13th month after investment. While this assumption is flawed, it is not necessarily the investor who is to be blamed. Often, investment agents in their ‘enthusiasm’ to promote SIPs forget to mention exactly how the redemption schedule for SIPs work. Know your redemption schedule Cheque date SIP Number Earliest redemption 1-Jan-04 SIP 1 1-Jan-05 1-Feb-04 SIP 2 1-Feb-05 1-Mar-04 SIP 3 1-Mar-05 1-Apr-04 SIP 4 1-Apr-05 1-May-04 SIP 5 1-May-05 1-Jun-04 SIP 6 1-Jun-05 The earliest redemption of SIP1 can be made only in the 13th month since the cheque date. Likewise in the 14th month, the investor can redeem SIP2. Notice each SIP has a minimum investment time frame of 12 months, not just SIP1. So you can redeem SIP6 only in June 2005. If you want to redeem the entire SIP amount in one go without incurring a sales load, you will be able to do it only in June 2005. 2) Rupee-cost averaging does not always work How many times have we heard elaborate presentations and seen fancy tables and graphs that show how rupee-cost averaging is one very important reason to take the SIP route to mutual fund investing. However, rupee cost-averaging does not always work. It certainly does not work in a rising market. This is because a market that shows a consistently rising trend, will ensure that every subsequent SIP in an equity fund is at a higher NAV than the previous SIP When rupee-cost averaging fails Cheque Date NAV (Rs) SIP amount (Rs) No. of units 1-Aug-04 11.72 1,000 85.3 1-Sep-04 12.53 1,000 79.8 1-Oct-04 14.03 1,000 71.3 1-Nov-04 14.12 1,000 70.8 1-Dec-04 15.84 1,000 63.1 1-Jan-05 18.68 1,000 53.5 Average NAV        14.48 (This is a real example of an existing diversified equity fund.) It is obvious from the above illustration that the SIP mode of investing wasn’t such a great idea. Rupee-cost averaging did not work its charm for the investor who had the option to enter the equity fund through a one-time, lumpsum investment on at least four occasions from August 1, 2004 till November 1, 2004 to beat the average NAV of Rs 14.48, but yet chose the SIP way. If he had taken the opportunity to enter lumpsum on anyone of these occasions he would have been better off than opting for the SIP route. Of course, that is not to say that rupee-cost averaging is a failure, but it works particularly well if you have taken an SIP over a longish time horizon of 12-18 months to benefit from a falling market. 3) The exit load could really pinch you Some investors opt for SIPs thinking that despite the drawbacks it is nonetheless a smart way to invest as opposed to one-time lumpsum investments. This is right, but SIPs work best only if you last the entire tenure and don’t redeem units prematurely. Some investment consultants advise their clients to go in for SIPs because the entry load is waived off. Their argument is that since the entry load is waived off, then even if the client withdraws prematurely, the 2.00% exit load (approximately) is not really damaging as its just a charge for not paying the entry load. This argument is flawed because the entry and exit loads are charged on different amounts. For example, from the above real life illustration its easy to understand how the exit load can be particularly high on premature redemptions from an SIP. Take the first SIP at an NAV of Rs 11.72 (in the table above); if the investor had entered one-time at that level at 2.00% entry load it would have cost him Rs 0.23 (2% of Rs 11.72). But since he has opted for the SIP route let us understand how a premature redemption works for him. Say, the investor wants to redeem his units by January 1, 2005 because the NAV has climbed significantly and he wants to capitalise on the opportunity. He will be slapped with a 2.00% exit load since the entry load was waived off on the SIP. However, the 2.00% exit load will be calculated on Rs 18.68, which amounts to Rs 0.37. Compare this with the Rs 0.23 he would have had to pay if he had entered lumpsum in August 2004. Of course, our illustrations are on hindsight and the investor has no way to know this in advance. That is understandable and as we have outlined we are not out to debunk SIPs. However, SIPs need to be promoted by the investment agent/distributor community after explaining all the merits and demerits to the investor so as to enable him to take an informed decision.