How Investors Can Make The Most Of Market Volatility

Equity markets have been on a roller-coaster ride this week. After posting one of the largest single day falls (roughly 6%) on Monday, today markets staged a minor recovery of sorts. Not surprisingly, business channels and newspapers are dissecting every market development in great detail. Experts are busy predicting where markets are headed next. On their part, investors are tuned in with rapt attention.

While investors’ engagement with the external environment is understandable, this is indeed the right time to do some soul searching. The latter can prove to be the proverbial silver lining in this phase of market volatility. Surprised? Read on.

Equity investing is not without risk given the uncertainties involved; over shorter time frames, the risk is further accentuated given that even extraneous factors can significantly impact stock prices. As a result, while investing in equities/equity-linked products, one needs to be able to take on a certain degree of risk. This in turn necessitates an accurate assessment of one’s risk appetite. Sadly, that is easier said than done. When markets are rising, investors can erroneously start believing that it is easy to make money in the markets. This can lead to an inflated notion of one’s risk-taking ability. 

Harsh as it sounds, a volatile phase like the present one can provide a much-needed reality check. Now is the time to revisit your assessment of the risk you can take on. Ask yourself if you are yet as comfortable with equity investing as you were when markets scaled record highs earlier in the year. While an investment advisor can help with this exercise, you will have to play the most important part. If an honest introspection reveals that you have jumped the gun, don’t worry. All you need to do is rejig the portfolio so that it aptly reflects your risk appetite.

This is also a good time to evaluate if you’ve fallen prey to the ‘Keeping up with the Joneses’ blunder. At times, because a friend, relative or colleague claims to have done well with his equity investments, investors feel the urge to emulate his investments. The trouble with this approach is that it violates a basic tenet of investing. At its core, investing is a personalised activity. Investments have to be right for the investor in question. Hence, adopting the ‘one-size-fits-all’ approach can lead to unpleasant results. 

For instance, the friend (whose investments you have copied) may have a portfolio dominated by equities, since he has an investment horizon of a decade; conversely, you may have an investment horizon of just three years. In such a scenario, replicating his investment pattern wouldn’t be the best option. Yet again, it takes a bout of volatility to expose this inherently flawed investment practice.

Admittedly, market volatility can be a bitter pill to swallow. But the fact remains that while investing in equities, it comes with the territory. Rather than fretting over it, investors would do well to embrace volatility, and use it to their advantage by sharpening their investments.

Don’t let the tax bogey affect your mutual fund investments

It’s official. The Finance Ministry has clarified its stance on taxation for non-equity mutual funds regarding the ‘retrospective’ aspect. Also, it is evident that there will be no rollback in other proposals; Finance Bill 2014 has been passed by the Lok Sabha and is now awaiting a nod from the Rajya Sabha. For all intents and purposes, fixed maturity plans (FMPs) have lost the tax advantage they enjoyed over fixed deposits (FDs), and now debt fund investors must have an investment horizon of at least 36 months if they wish to reap tax benefits on long-term capital gains.   

An interesting outcome of this development has been in the form of investment advice. Experts are falling over each other trying to determine which investment avenue is best suited for individuals in specific tax brackets. For instance, statements such as “if you are in the lowest tax bracket then FDs make sense, however for those in the highest tax bracket, long-term debt funds will be the best bet” have become commonplace. Fund houses seem to have been caught up in the frenzy as well. Media reports suggest that some of them are trying to extend/roll over one-year FMPs for a further 24-month period so that investments therein will become eligible for long-term capital gains.

The trouble with this tax-focused muddle is that it contravenes the basic principles of investing. Don’t get me wrong—I’m not suggesting that tax implications should be ignored; however, they certainly shouldn't be the primary basis for making an investment. For instance, a fundamental difference between FDs and debt funds (including FMPs) is that the former offer safety of capital and assured returns, while the latter are market-linked investments i.e. the capital invested is at risk, and there are no assured returns. It is imperative that investors first get a fix on what their risk profile is, and accordingly pick an investment avenue, rather than start off by evaluating which avenue is more tax-efficient.

Likewise, the investment horizon is no less important. Consider a scenario wherein an investor in the highest tax bracket has surplus monies to put away for 18 months. It would not be prudent to invest in a 3-year FMP only because the taxation thereon is more liberal versus that on an 18-month FD. Simply put, investors must focus on aspects such as risk profile and investment horizon, before considering the investment’s tax-efficiency. Failing to do so could result in investors deploying monies in avenues unsuitable for them, and for inapt tenures as well.   

Arbitrage funds to the rescue…

If the aforementioned experts are to be believed, debt funds have lost their appeal for good, and now investors should focus on a new silver bullet—arbitrage funds. Sadly that argument is both preposterous and flawed.

Arbitrage funds operate on the premise of exploiting mispricing opportunities between the cash and derivatives markets. They thrive on market volatility. At its core, it is a straitjacketed approach since it will only deliver in certain market conditions. Furthermore, unlike debt funds which invest in fixed income securities, arbitrage funds operate in the domain of equities—so much for their likeness. If you are wondering why arbitrage funds exist in the first place—the answer is herd mentality. In the NFO-driven era of 2005-06 when a couple of fund houses launched arbitrage funds, others followed suit lest they be left behind. Like most NFOs, the launch of arbitrage funds had little to do with conviction in investment merit.  

So why have arbitrage emerged as the season’s flavour? Because they are treated as equity funds for taxation (read liberal tax rates and provisions) while plying a market-neutral strategy. On their part, investors would do well to steer clear of experts who profess that arbitrage funds make apt replacements for debt funds. 

Admittedly, a higher tax liability on debt fund investments is taxing both literally and figuratively. But trying to circumvent it by investing in unsuitable avenues will only make matters worse. The solution lies in coming to terms with the new scenario and staying the course.