SIPs or Value Averaging

Do you wish to build an equity portfolio in a mutual fund? If so, you can now choose between lump investments and the popular systematic investment plan (SIP).
A recent addition to the menu is the value averaging investment plan (VIP). For investors having a one-time surplus on their hands, their obvious choice will be the lump sum investment. However, for salaried individuals, who are likely to retain some amount of surplus every month, the option to build the wealth is naturally to invest through monthly instalments either by way of the SIP or VIP, where investment is made based on their financial goals or the target they wish to achieve.
Now let us consider a case where an individual plans to build a portfolio. By investing a monthly sum of Rs 10,000, he wishes to invest for 36 months in an index fund to reach a target of Rs 4.5 lakh.
We have assumed index funds to avoid any fund-specific risks. The assumed equity returns we consider here is 15 per cent. Here we take a look at whether SIPs or VIPs would have more beneficial for such an individual, in terms of maturity value and how much money he needs to meet the target.
First an overview of how the two options will work.
Systematic investment plan (SIP): Under this option, one invests the same sum without worrying about market movements. By investing regularly over a period of time, market volatility will be evened out. As units are acquired at different NAVs, more units are bought when markets are down.
At the time of selling, an investor sells all the units at the prevailing NAV and takes out his profits.
Under systematic investment plan, one optimises the returns rather than maximising them.
For instance, if you start an SIP close to the market peak, you will continue to buy units at higher levels all the way down to the bottom.
Value averaging investment plan (VIP): Under the VIP the sum invested (and not the number of units) varies based on market levels. The investor sets a target return from the portfolio at the outset, say 15 per cent per annum. The VIP then ensures that you invest a larger monthly sum when the market falls and a lower sum when the market is high.
Assuming you can spare a minimum monthly amount of Rs 10,000. At the start of the investment assume the NAV of the scheme is quoting at Rs 35. If the NAV shoots up to Rs 39 next month, your portfolio value will be Rs 11,142. The plan will measure this against your target portfolio value. If it falls short, the fund will deduct only the remaining sum from your account and buy a lesser number of units.
How VIP compares to SIP
Let's take an example here. Suppose you have started an SIP in December 2006 and are contributing a monthly sum of Rs 10,000 to be invested in a CNX 500 index fund for the past 36 months. Currently your investment of Rs 3,60,000 stands at Rs 4,40,000.The annualised return on your cash flows works out to 12.7 per cent. Assume you made the same investment in a VIP for 36 months. In VIP, because your monthly instalment will tend to vary, you need to mention both the minimum monthly commitment as well as the maximum that you can set aside. If you have opted for maximum of 10 times of the monthly commitment, calculations show that the actual deduction could have varied very widely from Rs 10,000 to as high as Rs 84,700 a month.
In periods where your portfolio value was higher than you targeted, the fund would have not debited any sum from your account. But in all you have paid Rs 4.8 lakh towards the investment but your current value stands at Rs 6.8 lakh.
That works out to an annual return of about 22.5 per cent (based on a monthly return of 1.87 per cent), much higher than the SIP returns.
Conclusion
The VIP may be a good method to invest for the long term because it ensures that you commit large sums to equity funds when markets are at a low. It also automatically “rebalances” your portfolio when its value rises or falls.
However, the key disadvantage of the VIP is that the sum you invest each much will be highly unpredictable.
A salaried individual whose income is constant may find it difficult to commit to a VIP knowing that the sums debited to his account may vary so widely. This may prompt him to commit to a low monthly investment. Therefore, investors who have the flexibility to overshoot their investment targets significantly can consider the VIP.
The second factor is that investing through a VIP is most effective when the market is not moving in one direction.
If on starting the VIP the market is in a steady decline for many months, investors in a VIP would find themselves committing larger and larger sums to the equity fund, even while the investment loses value. Such a course may be difficult to stick to, as the absolute loss to the investor can be very high.
This suggests that even in a VIP, investors need to set a portfolio target on which they will book profits.
via BL