The VIP way to lower investment cost

Investing pre-defined, equal sums every month in mutual funds (and sometimes even stocks) through what is called SIP (systematic investment plan) is a route taken by most investors. This helps them benefit through rupee cost averaging, as it involves periodic buying across market cycles.

Be that as it may, over the last couple of years another way of investing, called the VIP (value averaging investment plan), has emerged that could potentially beat SIP in terms of average cost per unit. The bottom line; higher returns.

Read on to know more about the VIP method and if it suits your investment appetite and style.

Better cost averaging

Those taking the SIP route invest the same amount every month, irrespective of market conditions at the time of investment. It is, therefore, a passive strategy, suitable for investors who wish to just sit back and relax after putting in the committed amounts.

But VIP is different. As the name suggests, it seeks to generate more value buying. It involves buying more number of units in a fund when the markets are moving down and lesser number of units when there is an upswing.

So how does that make it different from SIP? The answer is in the quantum of units bought. An example here would illustrate this in a better way.

Let us say a mutual fund scheme that you wish to purchase is at an NAV of Rs 10.

In the SIP mode, you would get 100 units for Rs 1,000 invested in the first month. You would get the same number of units in the VIP mode as well. In the second month if the NAV increases to Rs 11, through the SIP mode, you would be able to buy 90.9 units (1,000 divided by 11). But through the VIP route, the monthly commitment is to contribute only an amount that increases your portfolio value by Rs 1,000 every month.

So, you have Rs 1,000 of the first month and the same sum in the second month, which can together buy 181.8 units (Rs 2,000 divided by 11). As the portfolio already has 100 units purchased in the first month, the investor would now need to buy only 81.8 units. Similarly, if the NAV falls to Rs 10 again in the third month, through the SIP mode you would continue to buy 100 units, but the VIP mode would buy you 118.2 units.

Refer the table to see how the units purchased through the SIP and VIP routes through NAV fluctuations and how the average cost per unit is lower through the VIP mode.

This makes for the critical difference between cost-averaging and value-averaging investment methods.

FundsIndia.com has also done a real-life testing of VIP on Indian mutual funds vis-à-vis a SIP in different mutual fund schemes.

Over 2004-07, 2005-08 and 2006-09, in blocks of three-years in a five-year period, the performance of HDFC Top 200, DSPBR Equity, Reliance Growth and FT Nifty Fund were compared for monthly SIP and VIP returns. The result showed that VIP outperformed SIP by over 1.6 per cent compounded annually over this time frame.

Cash flows important

However, note that investing through the VIP route would require a more active role from you. This means that when markets correct sharply, you need to be able to commit higher sums than what you would have were it a normal SIP. So a certain surplus must be kept in your account to buy additional units during steep corrections.

Here, again, fund houses such as Benchmark and investment Web sites such as FundsIndia.com allow you to set a minimum and a maximum amount that can be taken from your account every month.

The base amount can be a nominal, say Rs 1,000.

The maximum available to be invested can be set at even 10 times the nominal amount. For the minimum amount, you have the option to set it to even zero, as continuous market up-moves may sometimes necessitate desisting from buying units.

Remember to set a target return and a portfolio maturity value for VIP for the investment route to be more effective. For instance, a 12 per cent return and a Rs 5 lakh target will make allocations easier.

As with all investment modes, a longer horizon is a must for VIP to work.

Does it suit you?

The value-averaging way of investment is, therefore, more suited for investors who can handle fluctuating cash flow requirements towards investments. It also requires you to actively track the markets (more than what a traditional SIP investment would require).

While the VIP route exposes to you the opportunity cost of accumulating lesser number of units or none at all during continuously rising markets, it makes up for it in the long run by way of enabling purchase of more number of units at lower levels. But if you have tightly-defined surpluses and multiple commitments such as loan repayments running in tandem, the SIP method may be more suited.

Source: http://www.thehindubusinessline.com/features/investment-world/personal-finance/article2153695.ece