A perfect mutual fund (MF) portfolio is one that is commensurate with one’s risk appetite and is in all probability capable of meeting one’s financial goals.
An investor mainly in the equity markets, especially through the MF route, has to acknowledge the volatility of the markets, which is impossible to avoid. The focus is on learning ways on how to navigate in such volatility, so that one does not go off-track from his/her investment.
The first step towards creating a MF portfolio is the identification of one’s risk tolerance; identification of risk appetite is important as it drives the decision-making process pertaining to asset allocation.
Once individual risk tolerance is identified, the next step is to identify financial goals. Financial goals should have a time horizon assigned to them and ideally, goals should be clearly categorised into short, medium and long-term objectives. Short-term goals usually fall into the time horizon of one to three years; medium-term goals will fall under four-seven years in mind, long-term goals be over seven years.
Goal-based asset allocation and MF investment strategies: The smartest way to create a goal-based portfolio is to separate portfolio for each financial goal or club similar goals based on risk profile and duration and create common portfolio for them, such as one can club retirement, a child’s higher education in one portfolio and for the purpose to buy a car or future foreign trip in another portfolio.
Asset allocation strategies are dependent on the time horizon of the financial goal, to realise short-term goals one needs predictable cash flows therefore for shorter duration portfolios a higher component of debt instruments are necessary, similarly for medium-term goals the portfolio should have a healthy mix of both equity and debt instruments and for longer-term goals the portfolio should have a higher component of equity to be able to beat inflation.
After one has zeroed on the asset allocation for all the goals the next step is to pick the right kind of MF category that is capable of meeting a particular financial goal. Here, risk tolerance becomes important because within the MF schemes that include both equity and debt the specified risk varies from scheme to scheme.
For example, within debt MFs there are various categories, a Gilt fund mostly invests in government securities and therefore is inherently safe, whereas income funds invest in corporate debt that is riskier in comparison to a Gilt fund to maximise income.
Within the equity-oriented funds, there is a wide range of schemes available. A small cap fund equity fund can deliver higher returns in comparison to a large cap of the diversified fund but it’s riskier and the returns are volatile, on the other end of the spectrum, there are index funds that track benchmark indices and are therefore stable and tend to be less volatile.
Selection of MFs within categories: Once the required MF categories have been identified within both equity and debt oriented MFs, the next step is to choose the right schemes within a particular MF category. The selection criterion for a mutual scheme should hinge on the investment objective and consistency of returns that a MF has been able to deliver. Efforts should be made to pick funds with larger AUMs and with reputed brand names, the track record and the longevity of the fund manager at a particular
asset management company is also an important consideration while making a choice. Total expense ratio is another important criterion that effects the choice between similar MF schemes, a fund with lower expense ratio is always better than funds with higher expenses ratio other things being remained same.
A Sample MF Portfolio:The above table presents demonstrative goal-based MF portfolios for a varying degree of risk appetite. A low risk appetite short-term portfolio has a debt component of up to 90% and a minimal equity exposure; on the other end of the spectrum a high-risk long-term portfolio has an equity exposure of 70% and within the equity MF the exposure to midcap and small cap fund is 30%.
Some precautions: Based on one’s financial goals he/she would need to invest in both equity and debt MFs and would also have to pick several MF schemes. However, it should be remembered that finalising the portfolio with too many funds is a bad idea as beyond a certain limit,for example maximum 6-8 fund schemes; there is no benefit of over diversifying. Diversification plays an important part in risk mitigation, however after a certain point over diversification leads to lower returns.
Finally, building a perfect portfolio is always based on a suitable asset allocation that is derived from one’s risk appetite and investment horizon. And for that the most essential thing is clarity of goals and realism around one’s cash flows, one has to be clear about what he wants to achieve, how much funds he needs for this and when he requires this. The perfect way of investment over a long term is continuous asset allocation focused on goal-based portfolio creation. Each goal should be precise, defined in quantitative terms and duration.
(The writer is a Director of Wealth Discovery at EZ Wealth)