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Saturday, October 2, 2010

How to Build a Mutual Fund Portfolio?

Building a mutual fund portfolio is not a very simple task since many of these funds seem to be saying (as dictated by the investment objective) and doing (in terms of investments) totally different things. Also with plethora of funds the task gets further difficult.

For the benefit of investors, we have split this process of building a mutual fund into 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, and second step on the process of selecting a mutual fund.

Step 1: Process of elimination

You should not invest in a mutual fund only because it is recommended by a mutual fund agent. You must also question the existence of every mutual fund in your portfolio so that you are left only with the very best funds. Also, it’s important for you 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, one has to keep in mind the following points:

1. Refrain from investing in a sector/thematic mutual fund, since over the long-term there is little value that a restrictive and narrow theme can bring to the table. Also, thematic or sectoral funds have a tendency of plunging more during the downturn. Hence, it’s 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. Do a peer comparison.

3. Finally, evaluate a funds performance over the long-term (3-5 years) and over a market cycles.

This enables you to understand whether the equity fund under review has stood the test of time. Many NFOs launched over the last 2-3 years i.e. from 2008 till date, have done reasonably well, leading investors to believe they are well-managed funds. But, remember, the markets have appreciated sharply over this period. So, a fund manager would have to be quite
incompetent to have lost money over this period. It takes a bear phase to separate the men from the boys.

Step 2: Process of selection

Once the elimination process is performed by the investors diligently enough, the second step will come naturally. For instance, if you have ignored all the sector/thematic funds, that leaves you with just the well-diversified ones. Likewise, if even those funds that have not completed 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. Investors should have a mix of both large cap as well as mid cap funds, since both have their inherent strengths. When both are well-selected, they can reward the investor handsomely over the long-term. The proportion of investments in large cap funds will depend upon the risk appetite of the investor. For example, a 25-year old person would have a higher allocation towards to mid cap funds, when compared to a large cap fund.

Similarly, 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 commonly referred to as opportunities/flexi cap funds.

2. Investors should go for both – well-managed growth style and value style equity funds. This will help to 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. Investing in a balanced fund will help in bringing in stability in the portfolio on account of the provision in the investment mandate for investment in debt.

4. To top it all, the selection process must purely be based on research and analysis. Your agent, neighbours and colleagues are welcome to air their views, but remember at the end of the day it’s your money, not theirs.