Successful mutual fund investing requires a plan as well as the discipline to stick to that plan. MFs allow investors to allocate investment assets across different fund categories to achieve a variety of risk/reward objectives thereby reducing overall portfolio risk.
In other words, the right way to benefit from MFs is to balance the risk as well as the potential to earn. For that, one needs to know the right meaning of risk. No wonder, identifying the right level of risk tolerance and the right schemes remains the most important factors in ensuring success from a mutual fund portfolio.
In other words, a decision to invest in a fund has to be well thought out one and not based on some immediate urge. The key, therefore, is to focus on the fund selection. If you are invested in a good fund from a fund house with a proven track record, most of your worries are taken care of. This decision itself will save you of a lot of botheration in future and ensure success on an on-going basis.
Let us analyse some of the important factors that can contribute significantly to your selection process.
Investment objective and policy/philosophy of the fund
The investment objective statement of the fund usually indicates whether it will be oriented towards capital gains or income or both. The fund manager also explains his approach to market timing, risk assumption and the anticipated level of portfolio turnover in the offer document.
Some times, funds also indicate investment restrictions they have placed on the fund manager. Many a times investors have to face disappointment both in terms of performance and the volatility because they do not match their own investment objective with that of the fund.
To ensure that one achieves one's objective, it is important to place greater importance on the fund's investment objective and its investment policy.
Concentrated portfolio vs diversified portfolio
The choice between a diversified and a concentrated portfolio largely depends upon on the risk profile of an investor. It is well known fact that a well diversified portfolio enables an investor to spread his investments across different sectors and market segments of the market.
The idea is that if one or more stocks do badly, the portfolio won't be affected as much. On the other hand, if a few stocks do very well, the portfolio won't reap all the benefits. A diversified fund, therefore, is an ideal choice for someone who is looking for steady returns over the longer term.
A concentrated portfolio works exactly in the opposite manner. While a fund with a concentrated portfolio has a better chance of providing higher returns, it also increases one's chances of under-performing or losing a significant portion of portfolio in a market downturn.
Thus, a concentrated portfolio is ideally suited for those investors who have the capacity to shoulder higher risk in order to improve the chances of getting better returns.
Past performance
Though past performance has to be an important consideration in the selection process, it's critical that one keeps performance in perspective. No doubt, a fund's successful track record can be a positive indicator, but it cannot be a guarantee for the future growth at the same rate.
While reviewing a fund's performance, one needs to not only look at performance relative to funds with similar objectives over a period of at least 3-5 years but also the risk taken by the fund to deliver those returns. In other words, the objective should be to select a fund that is managed well and provides consistent returns.
Avoid those funds that are showing very high past returns but are inconsistent performers over different time periods.
Remember, it may not be wise to depend entirely on the past performance. It is equally necessary to have the right mix of funds in the portfolio.
Therefore, one should first decide the allocation to each asset class and then select funds for each one of them. By investing in a haphazard manner, one may end up having over exposure to an asset class and that may hamper the chances of success.
Level of risk
To determine the right level of risk tolerance is an important ingredient for investors and can go a long way in designing an optimum investment strategy. Besides, it helps in customizing fund category allocations and suitable fund selections. There are certain broad guidelines to determine the risk tolerance.
These are:
- Be realistic with regard to volatility - it is necessary to consider the effect of potential downside loss as well as potential upside gain.
- Determine a "comfort level" -- if one is not confident with a particular level of risk tolerance, then select a different level.
- Regardless of the level of risk tolerance, adhere to the principles of effective diversification -- the allocation of investment assets among different fund categories to achieve a variety of distinct risk/reward objectives and a reduction in overall portfolio risk.
- Reassess risk tolerance at least annually -- sometimes one's risk tolerance may change due to either major adjustments in return objectives or to a realization that an existing risk tolerance is inappropriate for one's situation.
Since it is the level of risk that provides the guidance about the level of volatility, and the kind of return one can expect, one has to be careful while assessing this.
Variety of funds offered by a fund house
Most fund houses offer a family of funds thereby allowing investors to diversify across different asset classes to achieve different investments objectives as well as to invest for different time horizons. Considering the variety of funds on offer from a fund house, is important, in case one is required to make changes in line with one's revised investment objective/s or time horizon.
In that case, it is much more convenient to move money within the same fund house rather than redeeming from one fund house and reinvesting in some other fund house. Besides, one can avoid the risk of redeeming at one level and reinvesting at a different market level.
However, if the fund house where one is invested does not have the required options or the performance of alternate fund being considered is not up to the mark, it will not be prudent to go for the convenience alone.
Tax Efficiency
Tax efficiency of an investment option considered for selection can be critical for the long-term success of a portfolio. As per the Income tax rules, there are two types of funds i.e. debt funds and equity funds.
Those funds that have exposure of 65 per cent or more to equities are considered as equity funds and all others are considered as debt funds.
As regards equity and equity-oriented funds, tax efficiency comes into play when one has to rebalance the portfolio or redeem holdings within one year of making investment. For debt funds, tax efficiency has a much bigger role to play in the selection process.
This is because one has to consider short-term capital gains rate, dividend distribution tax as well as long term capital gains for selecting the right option i.e. dividend or growth.
The author is CEO, Wiseinvest Advisors Pvt. Ltd. He can be reached at hemant.rustagi@moneycontrol.com
For more on mutual funds, log on to www.easymf.com
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