A perfect mutual fund portfolio is one that is commensurate with one’s risk appetite and in all probability is capable of meeting one’s financial goals. An investor – mainly in the equity markets especially through the mutual fund route – has to acknowledge that volatility is part and parcel of the markets and it’s near impossible to avoid volatility. The focus should, therefore, be on learning ways how to navigate volatile markets so that one does not get off-track from his/her investment thesis during periods of heightened market volatility.
The first step towards creating a mutual fund portfolio is the identification of one’s risk tolerance. Identification of risk appetite is important because it drives the decision-making process pertaining to asset allocation and the quantum of allocation in each asset class. Although risk appetite varies from person to person and it’s also dependent on the life stage of the investor, it is advisable to take on higher risk starting early on in one’s career because as life progresses and individuals taken on more responsibility the ability to bear risk decreases with time.
Once one has accurately identified individual risk tolerance, the next step is to identify financial goals. Financial goals should have a time horizon assigned to them and ideally goals should be clearly categorized into short term, medium term and long-term objectives. Short-term goals usually fall into the time horizon of one to three years; medium term goals should be defined keeping a time horizon of four to seven years in mind, long-term goals usually have a wider time horizon of over 7 Years.
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 & duration and create common portfolio for them, such as one can club retirement, 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 realize short-term goals one need’s predictable cash flows. Therefore, for shorter duration portfolios a higher component of debt instruments is 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 in on the asset allocation for all the goals the next step is to pick the right kind of mutual fund category that is capable of meeting a particular financial goals. Here, one’s risk tolerance becomes important because within the mutual fund schemes that include both equity and debt the specified risk varies from scheme to scheme. For example, within debt mutual funds 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 maximize income. Within the equity-oriented funds, there is a wide range of available schemes that cater to all risk appetites. A small cap fund equity fund can deliver higher returns in comparison to a large cap of 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.
Once the required mutual fund categories have been identified within both equity and debt-oriented mutual funds, the next step is to choose the right schemes within a particular mutual fund category. The selection criterion for a mutual scheme should hinge on the investment objective and consistency of returns that a mutual fund has been able to deliver. Efforts should be made to pick funds with larger AUM’s and with reputed brand names. The track record and the longevity of the fund manager at a particular asset management company are also an important consideration while making a choice. Total expense ratio is another important criterion that effects the choice between similar mutual fund schemes. A fund with lower expense ratio is always better than funds with higher expenses ratio other things remaining the same, as expense ratio can eat into the funds’ return in the hands of investors.
The following table presents demonstrative goal-based mutual fund portfolios for 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 per cent and within the equity mutual funds the exposure to midcap and small cap fund is 30 per cent. The asset allocation strategy captured in the table can be a starting point for investors for further research.
Based on one’s financial goals, one would need to invest in both equity and debt mutual funds and would also have to pick several mutual fund schemes. However, it should be remembered that finalizing the portfolio with too many funds is a bad idea. Diversification plays an important part in risk mitigation. However, after a certain point over diversification leads to lower returns, and tracking, monitoring and rebalancing become too tedious for an individual investor. One runs the risk of loosing track of the original investment thesis if the there are too many components to an individual mutual fund portfolio.
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 one wants to achieve, how much funds one needs for this and when one would require 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, and defined in quantitative terms and duration.
(By Rahul Agarwal, Director, Wealth Discovery/EZ Wealth)