Q1. What is inflation? How does it affect my returns from my investment?
When you need to spend more money to buy the same quantity of something, the price of that item is said to have gone up. When all prices are higher, what has gone down is the purchasing power of money. That is inflation at work. It is the rate of increase in prices over a period.
Suppose your investment gave you a return of ₹5,000 every month five years ago. That easily covered the cost of groceries you needed for home. Today, the investment is still giving you the same return but because of the rise in prices you are having to buy less or get more money from somewhere else to buy the same quantity you used to buy five years ago. See how inflation can pinch you?
When the return on an investment is not sufficient to cover the rise in prices, you run an inflation risk or a purchasing power risk.
Inflation risk is highest in fixed-return instruments (like bonds, deposits, and debentures) where you get a fixed rate of interest periodically and, on maturity, get the principal back. In absolute terms, both the principal and the interest are fixed amounts.
If you hold a bond that pays a coupon rate of 8% while the inflation rate is 7%, then the real rate of return is just 1%. If inflation goes up to 9%, the bond will yield a negative return. Thus, even as you hold the bond, its real value has eroded on account of inflation.
You must be mindful of inflation risk when you invest after your retirement, when your income will be limited and absolute. If you invest in debt instruments that earn about 6% to 8% p.a. and the expected average inflation for the next 5 years is 9%, you are looking at a negative return of up to minus 3%. That can be tough when, as a retired person, you are unlikely to have other sources of income to make up for the deficit.
When you start collaborating with a qualified financial planner early in your career, inflation risk is something that will be worked into your financial plan. Inflation becomes another contingency that you are prepared for and not something that can seriously compromise your quality of life.
Q2. I am a regular investor. What happens if I miss an SIP instalment?
The easiest way to ensure you do not miss any instalment of a systematic investment plan (SIP) is to set up a standing instruction. Then the amount will be automatically transferred from the source to the destination fund at a specified date.
If you have set up an auto debit for your SIP with your bank and you fail to maintain adequate balance in your account on the date, your SIP transfer will not happen. The bank may levy a penalty for non-maintenance of sufficient balance.
Normally, mutual funds do not levy any penalty if you miss a SIP instalment. However, the registered SIP will get cancelled if you fail to make the payment for three consecutive months.
If they anticipate any situation which will force them to miss an SIP or two, investors should pause the SIP by sending an advance request (this facility is generally available online) to the mutual fund house. Some mutual fund houses allow investors to pause SIPs only for three months at the most. The SIPS will resume after expiry of this pause period.
On receiving a pause request, the mutual fund house sends instructions to the bank, asking them to pause the SIP mandate for a certain period. This can then save the investor from paying any penalty.
Q3. Can mutual funds be used to avail loans?
Banks, financiers, and non-banking financial companies accept mutual funds as collateral against loans. If you are planning to take a loan against mutual funds, please bear in mind a few factors:
Some of the key points to remember before taking a loan against mutual funds are:
- The loan limit is different for different lenders. It is usually 50% of the market value in the case of equity funds and 80% for debt schemes.
- The borrower must be at least 18 years of age, but this can vary from bank to bank.
- The borrower should sign a lien that gives the lender the right to deal with the fund units in case of a default.
- The mutual fund units offered as security should not be in the lock-in period (during which the units cannot be redeemed).
Q4. What is an ETF?
An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, an ETF will track a particular index, sector, commodity, or other assets. Unlike mutual funds, ETFs can be purchased or sold on a stock exchange like regular stocks.
ETFs work like mutual funds but charge lower fees. Most ETFs simply track an index, which is a chunk of the stock market. It takes a lot less work to replicate an investment strategy that already exists inside the index.
On the other hand, many mutual funds try to create a strategy that’s meant to beat the market.
An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. They can even be structured to track specific investment strategies.
Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.