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How to build a Mutual fund portfolio

The top performers are not always the obvious picks— diversification matters, as do your preferences and needs

By Shruti Jain, Arihant Capital Markets
An article sourced from:Times of India, published 18th Dec 2007

PICKING the right mutual fund out of more than 3,000 options in the market is tricky enough. But it can be truly daunting to figure out how to bring the right ones together to make a portfolio that can outperform the index, while also being in sync with your personal risk tolerance, investment objectives and tax situation.

There’s just no one size- fits-all strategy, nor one “correct” way, to build a mutual fund portfolio. Putting together a group of mutual funds is a matter of your personal preferences and goals. But there are some universals you should think about when choosing and combining funds to create your portfolio.

You can use the following steps as a guide to building and monitoring your mutual fund portfolio. Starting with asset allocation one starts out by selecting an asset allocation plan designed to meet your goals and risk tolerance.

The rest of the investment process includes picking funds—either for taxable or tax-advantaged accounts— putting them together in a portfolio, monitoring the portfolio over time, and rebalancing it so it remains in line with your risk tolerance.

The foundation of your portfolio is asset allocation— your preferred combination of large-cap and small-cap Indian stocks, international stocks, bonds, and cash. It determines the broad risk level of your portfolio, which should match your risk profile, and is the first step towards constructing a diversified portfolio.

The basic premise of diversification— which is to reduce certain risks unique to an asset class, sector or security by combining different securities together—works because different asset classes, sectors and securities don’t move in tandem.

Even when well-known asset classes such as large-cap stocks are dropping, other asset classes may be rising. Outperforming the benchmark When you put together a portfolio of mutual funds, your goal should be to outperform the relevant benchmarks for each asset class in your portfolio (evaluated using index returns) without taking on excessive risk of underperformance.

This guiding principle implies that we’re not going to be so conservative in our investment decision-making that we completely eliminate any upside opportunity versus the benchmark, which would be the case if we selected all index mutual funds, for example.

But we’re not going to be so aggressive that we fail to adequately diversify the portfolio within asset classes. The key to achieving that goal is picking the right funds.

Picking funds wisely: When you select funds for portfolios, you should look for funds that will do well in the future and that will work well together.

These need not necessarily be funds that have been at the very top of their categories in the past. You should consider the following factors when picking the right funds: past performance, including past risk- and style-adjusted performance (a measure of the fund manager’s security selection skill), the fund’s operating expense ratio, assets under management, and cash flows.

Use a blend of quantitative and qualitative analysis. The first thing to remember in evaluating a mutual fund scheme’s performance is to separate performance luck from skill.

A fund’s return is what it is for a variety of reasons, some having to do with luck and some with skill. You should see the fund’s year-on-year performance to see if it has been doing consistently well, or if this is just a onetime good performance which has boosted returns.

A fund heavily invested in technology stocks might have performed well in years past, but remaining heavily invested in tech now could have greatly hurt returns. So check whether the fund’s strategy is flexible, and whether the fund manager shuffles the portfolio regularly.

The second thing to keep in mind is to look beyond past performance. Non-performance- related characteristics— for instance, expenses, assets under management, and cash flows into the fund—can influence future performance. For example, conventional wisdom says it’s difficult for small cap managers with many assets under management to do well, because it’s hard to put large sums of money to work in management’s best investment ideas without negatively affecting the price of those small-cap stocks.

Generally, small-cap funds with low expense ratios and few assets under management eventually significantly outperform their peers with high expense ratios and many assets under management. But keep in mind that this theory is relevant for evaluating small-cap funds, and not, for example, large-cap funds.

Which brings us to point number three: don’t use a one size- fits-all approach. The amount of consideration, or weight, that should be given to each factor varies depending on the category.

A fund’s operating expense ratio, for example, is always an important consideration. But it’s more important for categories such as intermediate-term bonds, where returns are low and the underlying investments are traded in very efficient markets, versus, say, international funds, where returns are higher and the underlying investments are traded in both efficient and less efficient markets.

In other words, expenses take a bigger bite out of bond fund returns, and managers have less opportunity to make it up by security selection. The fourth thing to remember when evaluating fund performance is to remember to look at the whole story. The numbers are important, but qualitative considerations matter too.

Look at the fund manager’s profile, the performance of his/her other funds, and his/her investment strategy. For instance, it could happen that the fund is categorised as a low-risk investment, but the fund manager is actually taking an aggressive stance.

Making a portfolio of funds: The most critical task is, of course, creating the portfolio. It entails analysing your profile—your risk capacity, objectives for investment, time horizon, and the amount to be invested. Different factors determine the appropriate mix for you, how much exposure you should have to any asset class, and what the time horizon should be for your investment.

Equity markets are too volatile in the short-term, but can give good returns in the long run. Debt funds, on the other hand, give steady but low returns. Therefore, depending on your goal and risk profile, the asset class will be determined. If, say, your retirement is 15 years away, an equity-dominated portfolio would be a good option.

But if you have taken a personal loan, which you have to pay up in just one year, debt funds will be more suitable. If you have a medium term goal, like a trip abroad, balanced funds may be the right answer. And generally, liquid funds are a nice place to park very short-term funds.

Depending on the corpus, you could invest in an average of 4-7 funds for an equity portfolio, and maybe 3-4 funds for the debt and balanced category.

If you invest in too few funds, it could make your portfolio concentrated and risky. If you invest in too many, the portfolio becomes unmanageable and doesn’t really serve the purpose.

So it’s important to strike the right balance. Also, while selecting funds, study each one’s portfolio mix to ensure that the funds are not all similar.

If most of them are similar, you will not achieve the desired diversification even with 6-7 funds. In order to achieve diversification across asset classes, consider options such as real estate fund, gold fund, international fund, and so on. Once these factors are decided, a portfolio plan can be created that includes an appropriate mix of funds.

Rebalancing and monitoring: Discipline is a highly desirable trait, because it can lead to success in many aspects of our lives. Just as a disciplined diet and an exercise routine are critical to your physical health, a disciplined rebalancing strategy is critical to your financial well-being.

Unfortunately, many of us don’t rebalance our portfolio on a regular schedule, because we’re either too busy or because we let our emotions get the better of us, choosing to hold on too long to investments that have performed well. Following a disciplined rebalancing strategy means you are more likely to sell higher-priced assets in favour of lower-priced ones— which makes plenty of sense.

We recommend rebalancing back to your target allocation at least annually. You may want to rebalance sooner if there is an extreme change in value in some part of your portfolio. Portfolio management doesn’t stop with the creation of your portfolio. It’s important to monitor funds on an ongoing basis.

You should consider selling a fund if there is a change in management, organisation, or strategy, or if you foresee a significant deterioration in the fund’s prospects. If you don’t have the time, desire and expertise to construct, monitor and rebalance a diversified portfolio of mutual funds, a mutual fund advisor can help.

Sourced from: Times of India