This article was written by Personalfn for Business India, and was carried in its May 6, 2007 issue with the title, "Building a mutual fund portfolio". The original draft, in its entirety, has been retained here.
With new fund offers (NFOs) becoming the order of the day (there are dozens launched every month) in the mutual fund industry, investors often find themselves stumped while evaluating whether a particular fund should be a part of their portfolio. Add to this the fact that most of the NFOs fail to offer anything significantly different from existing mutual funds. This confuses the investor even further, since he is forever agonising on whether the NFO is truly a great investment opportunity as the advertisement often claims.
At PersonalFN, we are flooded with queries from investors on how to go about building a portfolio that will involve minimal tracking and churning and can help them achieve their investment objectives over the long-term.
To be sure, this is not an easy task given the number of mutual funds in the market, many of which seem to be saying (as dictated by the investment objective) and doing (in terms of investments) totally different things.
Out of the varying categories of mutual fund investors (long-term, short-term, risk-taking, conservative), we have considered the category “ i.e. risk-taking, long-term investor since a lot of investors belong to it or will belong to it at some point of time in their lives.
Among the numerous problems plaguing the mutual fund industry, we have highlighted the ones that are particularly irksome for the risk-taking investor attempting to build a long-term mutual fund portfolio.
Building a Mutual fund portfolios is not an easy task. For the benefit of investors, we have split this process in two steps. The first step, outlined below, is relatively easy as it involves eliminating the mutual fund schemes that should not be a part of your portfolio.
Step 1: Process of elimination
Reason why we started with the process of elimination is because for some unfathomable reason, investors like to populate their mutual fund portfolios with a lot of schemes. Even more unfortunate is when you ask them why they invested in a particular scheme, there is no answer except the customary " my agent told me it's a great fund."
To investors who believe that more mutual fund schemes is in harmony with the principle of diversification and therefore a virtue, we would like to quote Warren Buffet, arguably the most successful investor of all time. With regards to diversification he says, "Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing."
So the need of the hour for the mutual fund investor is not to go by what his agent is telling him, but question the existence of every mutual fund in his portfolio so that he is left only with the very best and critical funds. The rest of the funds can be redeemed. It is vital for the mutual fund investor to guard against over-diversification; your fund manager (if he is smart) is taking care of the diversification. There is little point in diversifying something that is already diversified.
While eliminating mutual funds (whether they are a part of your portfolio or not), one has to keep some points in mind.
1. Restrain the urge to invest in sector/thematic funds no matter how compelling an argument your agent or the fund house makes. Over the long-term, there is little value that a restrictive and narrow theme can bring to the table. It is best to opt for a broad investment mandate that is best championed by well-diversified equity funds.
2. If there are two or more mutual funds that seem to be doing the same thing (in terms of mandate, style), then you have to ensure that you are left with just the best in that category and eliminate the rest.
3. Since equity funds are long-term investments, it's a must to evaluate them over the long-term (3-5 years) and over a market cycle. That way you get a fairly good idea about whether the equity fund under review has stood the test of time. Many NFOs launched over the last 2-3 years have done reasonably well leading investors to believe they are well-managed funds, while the fact is that the markets have appreciated sharply over this period. So a fund manager would have to be really incompetent to lose money over this period. It takes a bear phase to separate the men from the boys.
Step 2: Process of selection
If you have performed the elimination process diligently enough, the second step should come naturally. For instance, if you have ignored all the sector/thematic funds, that leaves you with just the well-diversified ones. Likewise, if you have disregarded the equity funds that have yet to complete a 3-Yr track record, you are automatically left with those who have a minimum 3-Yr track record. While selecting mutual funds, you must keep the following points in mind:
1. The debate on whether large caps or mid caps reward the investor better is an ongoing one and it would be inadvisable to choose one over the other because both have inherent strengths and (if well-selected) can reward the investor handsomely over the long-term. Therefore, there is merit in selecting a well-managed mid cap and large cap fund for your mutual fund portfolio. It also pays to invest in an equity fund that can invest in both large caps and mid caps depending on the opportunity; these funds are therefore referred to as opportunities/flexi cap funds.
2. On the same lines, investors should go for both “ well-managed growth style and value style equity funds. This way they can capitalise on opportunities across the board. Growth funds invest in well-managed companies that are fairly valued with a view that they are likely to perform even better going forward. Value funds invest in well-managed companies that are undervalued (temporarily) with the view that they will achieve their fair value going forward.
3. Although, balanced funds have their own set of critics, for one, we are firmly in favor of them. We are further vindicated by the fact that most equity funds to be launched in the recent past have a provision to invest a portion of their assets in debt. The fact is, everyone, including equity fund managers, realizes the importance of debt in a mutual fund. So including a well-managed balanced fund in your portfolio is a must.
4. Your selection process must be based on cold research and analysis; your agent, neighbor and colleague are welcome to air their views, but remember at the end of the day it's your money, not theirs. While researching equity funds, go for the ones that have a 3-5 track record over a market cycle. The performance (or lack of it) of an equity fund during a market downturn should be noted. Usually, investors are enamored by 'bull run wonders', ignoring the fact that it is actually the downturn that is the biggest test for the fund manager.
Speaking of the fund manager, don't rely too heavily on him either; instead rely on a fund management team. This way, even if the fund manager quits the fund house (which is very common today), the processes of the fund management team can replace him seamlessly.
To summaries, the mutual fund portfolio of a risk-taking investor must include the following funds:
- Large cap fund
- Mid cap fund
- Opportunities fund
- Growth style fund
- Value style fund
- Balanced fund
A lot of what we have said in terms of the research process may appear a little difficult and time-consuming to the investor. That is not surprising, after all investing is a full-time activity and if you give it part-time attention, the results can be disastrous. That is why it is important to engage the services of a competent and experienced financial planner who can help you build a mutual fund portfolio on the lines we have recommended.