Equity mutual funds play a vital role in helping retail investors creating wealth. Of course, mutual funds are not just about equity funds. There are debt funds for the sake of stability, there are liquid funds for liquidity, there are arbitrage funds for tax-efficient returns and there are balanced funds which combine the best of equity and debt. But what is more important is to create the portfolio of mutual funds, which combines the best of equity, debt, liquids, and other asset classes…
- Start with your goals in mind…
This is the way to start creating your mutual portfolio. All your mutual fund investments must be tagged to a specific goal. For example, tag equity funds to your long-term goals, balanced funds to your medium-term goals, debt funds to your short-term goals and liquid funds to your very short-term goals. Once your investments are tagged to goals, the task becomes much simpler. The key is to start with your goals in mind and then work backward towards your investment.
- For equity exposure, bet on diversified funds; not on thematic…
Sectoral funds and thematic funds are great ideas when the particular sector is the justification of attention. But the downsides can be nerve-wracking. You invest in mutual funds for diversification of risk, above all else. Remember that sector funds are normally victims of hard-sell at the peaks of the sector euphoria. IT funds in 2000 and Infrastructure Funds in 2007 are classic examples. Your equity fund portfolio should be quality diversified funds and other types can at best be opportunities.
- Focus on risk as much as on returns
This is a common mistake where the focus is purely on whether the fund in question has beaten the index and outperformed its peers. The actual focus should be on risk. A fund manager who earns higher returns by taking on undue risks is working against your interests. Measures like Sharpe, Treynor, and Fama can help you separate the wheat from the chaff. They capture the risk-adjusted returns rather than pure returns. Fama also tells you how much of your fund’s outperformance is generated by your fund manager’s skills and how much by pure luck.
- Adjust your overall allocation to debt, equity, and liquids…
A lot of investors faced this challenge in the last 5 years when the Nifty has nearly doubled in value. Assume that you invested in equity funds and the NAV appreciated over the last 5 years on the back of a solid bull market. As a result of the capital appreciation of equity, your equity funds have become 65% of your overall portfolio instead of 50% due to the Nifty rally. It is time to reallocate your portfolio. You not only book profits at higher levels, that way but also keep liquidity ready when the market comes down at a future date.
- Buy mutual funds to a plan and don’t try to time the market
The tendency among many investors is to buy mutual fund units when they have surplus cash available. That is not the right way of doing it. Mutual fund investments are part of your overall financial plan. Hence, any allocation to equity or debt mutual funds must be designed within the framework of your overall financial plan and aligned to your inflows. SIPs would be a better way to align to flows. Secondly, don’t try to time the market because it is practically not possible and it is also not meaningful in the long run. Ideas like increasing your SIP contribution when markets or reducing SIP amounts when markets go up is not a good idea. Rather, prefer the discipline of systematic investing over the allure of lump-sum investing.
- Growth plans always work better than dividend plans; stick to growth
Growth plans are not only more tax efficient but also better aligned with long-term goals. Firstly, if you keep taking money out of your fund via dividends then your final wealth creation target gets disrupted. Secondly, dividends on equity funds may be tax-free in the hands of the investor but now they attract 10% tax in the form of DDT. Growth plans are a better way to ensure that wealth actually gets accumulated.
- Focus on the fund manager; it makes all the difference.
Does an individual really matter for a mutual fund? When it comes to funding management, the individual does matter a lot. Focus on a fund manager who has been consistent in past performance and who has been able to hold the core fund management team together. That is a point that most MF investors tend to ignore. In India, it is often seen that a good and consistent fund manager has made the difference to the fund’s performance.
- Keep your mutual fund portfolio as compact as possible
Stop handling excessive funds. You cannot create a mutual fund portfolio of 25-30 different schemes. That does not have any incremental value. A large portfolio becomes unwieldy, an unwieldy portfolio is hard to manage and monitor which leads to risk substitution. Ideally, a mix of 5-6 schemes should serve your purpose. The more you keep adding schemes, the more you need to track in terms of performance and risk metrics. Keep it small and tag these fund schemes to your goals.
Creating a mutual fund portfolio is a fairly complex task. To begin with, your mutual fund portfolios have to be built within the framework of your overall financial plan. Creating a mutual fund portfolio is the easier part. Monitoring and rebalancing it continuously is much harder!
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