Real Returns. The flip side to SIPs

The Systematic Investment Plan (SIP) is among the rare financial innovations in recent years to have caught on like wildfire with investors. So much so that many newbie investors today believe that the SIP is an asset class by itself, rather than just a tool to invest in mutual funds.

True, SIPs are a great idea to instil savings and investing discipline. As the instalment gets auto-debited from your account every month, you are forced to save before you spend.

But having said this, SIPs are not a panacea for every product, investment goal and market situation. Amid all the hype and hoopla, here is the flip side to using SIPs that all investors should be aware of.

SIPs work mainly because they help us make large investment commitments in small instalments without really feeling the pinch. Even at a nil return, a SIP of ₹20,000 a month adds up to a hefty investment corpus of ₹48 lakh over 20 years.

SIPs also remove the temptation to make foolish investment decisions based on market swings. With lumpsum investments, you may be tempted to jump into funds when the indices are soaring, and stay off when they tank. SIPs help you to plod on, without paying much attention to market moves.

But if this trait of the SIP works for you when you are ploughing money into a good investment, it can also subject you to a large opportunity loss if you have signed up for a bad one. With a lumpsum investment, you only make the mistake of picking a dud fund once. With a SIP you compound it every month, by throwing good money after bad.

For instance, a ₹10,000 SIP in the best performing large-cap fund for the last 10 years (Quantum Long Term Equity Fund) would have grown your investment of ₹12 lakh into ₹27.8 lakh. But had you chosen the worst performing large-cap fund (JM Equity Fund), you would have received just ₹18.5 lakh for your ₹12 lakh investment. The SIP in Quantum Long Term Equity yielded an internal rate of return (IRR) of about 16 per cent while JM Equity earned 8.5 per cent.

Now, a lumpsum investment in these schemes 10 years ago would have yielded vastly different returns too. But the catch is that, with lumpsum investments, you would never have sunk as much as ₹12 lakh into JM Equity Fund.

The above catch argues for monitoring the performance of your SIP funds as closely as you do lumpsum investments. One good way to avoid big mistakes may be to sign up for SIPs for one year at a time and renew them only after a yearly performance review. Inconvenient, but safer.

With SIPs working well to create wealth in equity funds, market participants and advisors have taken to recommending them for all kinds of other products. Brokerages now offer monthly SIPs on your favourite stocks and thematic Exchange Traded Funds.

But before contemplating any of the above, think twice. SIPs in individual stocks can expose your portfolio to concentration risks. When you make a one-off investment in a stock, you can easily limit that exposure by buying it in limited quantities. But if you sign up for a SIP in a stock, it can grow to become a very large proportion of your portfolio without your realising it. The shortlist of the stocks that you buy changes a lot with market conditions and economic cycles. No stock is a perpetual ‘buy’ at any price. Therefore, when you sign up for stock SIPs, you are subjecting yourself to even greater risks from poor choices than with equity funds.

SIPs are equally inadvisable for thematic funds and sectoral ETFs such as banking funds, CPSE ETFs or pharma funds, for instance. This is because the fancied themes and sectors in the market typically keep shifting based on macro and business cycles. The same one is seldom in favour for many years at a time. To make the most of these fancies, an investor should have a keen sense of timing — investing when the theme is out of favour and exiting when it is at the peak of its popularity. SIPs do precisely the opposite. They deprive you of the benefits of timing by dribbling equal sums into a sector or a theme throughout the cycle. Thus, if you sign up for SIPs in thematic or sectoral funds, you are quite likely to miss the bus on the upside and keep investing long after the theme has stopped performing. If you have surpluses to invest every month, stick to SIPs in diversified equity funds with a good record, and don’t play the thematic flavour of the season.

While SIPs are good to ensure regular investments, it is important to understand that they don’t improve your returns compared to lumpsum investments, in all kinds of market situations. In most equity fund categories, for instance, lumpsum investments made three years ago have delivered much better returns than SIP investments spread over this period.

For multi-cap equity funds, lumpsum investments now sport a 19.5 per cent CAGR, while SIPs have managed only 14.5 per cent. SIPs have done worse than lumpsum investments in this window because equity markets and valuations were at relatively low levels in 2014. Investors who bet a lumpsum on equity funds in April 2014 were essentially entering equities at a Sensex level of about 22,500 and a price-earnings multiple of about 18 times past earnings. They were thus able to capitalise fully on the Sensex shooting up by over 30 per cent in this period. If you decided to sign up for SIPs instead, you would have essentially deferred your investments in April 2014, thus investing your money at much higher market levels over the next three years.

Now, it is quite difficult to say, at the start of your investment plan, if markets will head higher steadily or suddenly lose ground. If you have a windfall at hand, deciding between lumpsum investments and SIPs is a matter of assessing whether markets have higher downside or upside from your starting point. Broad market valuations can be a good guide. When Indian markets trade below a 15 PE, a lumpsum may create far more wealth than a SIP. But at a 22 PE, it’s safer to stick to SIPs.