Mutual Funds Strategy 112: Will Mutual Funds Work for Business People? Three reasons why it will.
Systematic Investment Plans (SIPs) work perfectly for the salaried class. People who have a regular income can plan for an auto debit every month towards mutual fund investing. What about people who do not have a regular income, like the business owners or the self-employed professionals? Will SIPs work for them?
The short answer is no, it is because these people may not be able to time their income or ensure sufficient fund balance on the SIP due date. On a yearly basis, these business people may be earning more than their salaried-class counterparts, but the irregularity of income may pose troubles for systematic investments.
For these classes of people, the old school investment method works best — lumpsum payments. That’s right, before the launch of SIPs, mutual fund investments were done in lumpsum mode, i.e. manual deposits instead of automated debit from the bank account.
Referring to the above image, I have listed the monthly income of a business person in a calendar year. Notice the irregularities in the income, so whenever the income drops below a threshold, we advise the customer against investing. When his income is surplus, we ask him to contribute more. At the end of the year, he is able to maintain a healthy savings rate of 25%.
And that is what really matters. If you can save 25 to 30% of your annual income into stocks or mutual funds, you will have a huge assets corpus in 10 to 15 years.
The second advantage business people get from mutual fund investing is the safe parking of working capital. Earlier, people used to book a fixed deposit with the same bank that gave them the current account. You know the disadvantages of booking an FD — the income is taxable even though you have opted for a re-investment of interest (cumulative option).
With mutual funds, the business owner can invest in either of these funds
- Overnight Funds (100% Debt exposure).
- Liquid Funds (100% Debt exposure).
The advantages are:
- The ones with debt exposure generate income like an FD but are friendlier with taxes. You do not get a tax load until you redeem it.
- Unlike FDs, the redemptions do not have charges or penalties and most likely you get the amounts credited back to your bank account the same day or within 24 hours.
- Another advantage is that these funds rarely have a drawdown as the exposure to equity markets is zero.
So the next time you have a sizeable working capital excess and would like to hold it safely as the capital expenditure is only coming up 5 to 6 months from now, then you may park it safely in a liquid mutual fund.
The third reason is the sweetest of them all. The mutual funds are considered as proper assets and you can pledge that as collateral and apply for a loan. These loans are called “loans against mutual funds”. The interest rates are generally low ~ 7 to 9% per annum and the biggest advantage is that you do not have to redeem the funds.
You might be familiar with the term haircut, i.e. the amount deducted for the final consideration of the collateral. This is usually very low for mutual funds ie 10 to 15% only. What this means is you get a better loan value. Let me try to explain it with an example.
Suppose you have a house worth 50 lakhs and you wish to raise a loan against it. Mostly the banks will give you a maximum of 35 lakhs against it, ie. 70% of the asset value, wherein the haircut is 30%.
If you were pledging mutual funds worth 50 lakhs, the sanctioned loan amount would be 42.5 to 45 lakhs ie. 85 to 90% of asset values, with haircuts between 15 to 10%.
The advantage of going for a loan instead of redeeming would help you in 2 ways:-
- No tax burden as you have not redeemed.
- If the markets are generous and in a bull run, the mutual funds will continue to appreciate.
The interest rates of 7 to 9% per year are decent enough, it is much cheaper than a housing loan (10 to 12.5%). You just need to ensure that you are paying back the EMIs on time, as the banks to which you submitted the collateral will redeem those funds to the extent you have defaulted.
Okay, that’s it from me today, do comment with your suggestions & feedback here.
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