MF portfolio construction – choice of fund categories

In order to build a Mutual fund portfolio, the first thing you need to decide is how much is your final outcome and what is the level of investment you can do regularly. If you are not clear about this search this blog and read the posts on Financial planning and Gal setting. The next aspect is what type of fund you must invest in which is the topic of this post.

Now at a very basic level we can classify funds by their types of investments namely Equity, Debt and Balanced. As I have explained earlier the role of debt MF is really relevant when you are trying to build a passive income stream. Your PF and PPF investments will normally cater to all the debt allocation that you need. For a variety of reasons I do not like Balanced funds and I will cover this in a later post. So the question in the post really boils down to what types of Equity MF should you invest in? Let us examine this in some detail.

There are many categorization of Equity MF – you could classify them by the sizes of the stocks that they hold ( large cap, mid cap etc), you can classify them by their sector holdings ( Pharma, Banking etc), some funds are operating based on market levels ( Dynamic funds, PE based etc). Depending on your particular situation, all of these funds can be relevant to you at some point of time in your investment life. My individual belief though, is that the two asset classes debt and equity should be kept separate and asset allocation of re-balancing is best done by the individual investor.This being the case, I avoid any of the funds that take calls based on market levels to balance between debt and equity.

Many of you would have noticed the high returns from sector funds such as Pharma or Banking. As is clear from their nomenclature, these funds have concentrated holdings in a particular sector so if the sector is doing great, the fund returns will be spectacular. This, of course, works the other way too and the NAV levels can drop significantly when the sector goes through a bad time. If you want to invest in these funds then you will have to live with an increased volatility compared to other diversified mutual funds. However, volatility is not the main reason I do not invest in these funds. As you know, I am an ardent supporter of the 3 portfolio strategy – Debt, Stocks and MF. If I want to invest in a particular sector I would like to do so in companies of my own choosing. They will form part of my stock portfolio. For example, I have several stocks from the Pharma, Banking and Technology sector. Therefore an investment in sector funds will simply be an overkill for me.

For me and most other investors investing in diversified equity MF will meet all our needs. Within that space you need to look at funds based on the size of companies that they hold namely, large cap, multi cap, mid cap and small cap. While the returns, risks and associated volatility will be different for each of these categories, I believe for a robust long term MF portfolio it will be important to invest in all of these. The allocation you want to do in them will depend on your long term return expectations and the risk/volatility you are prepared to take. My own investments are evenly spread in these 4 types of funds and my overall experience has been fairly good so far.

Finally there is the question of whether you should be investing in international funds or not. Ten years back i would have probably not seen any real need for it. In today’s context though the world economies are much more closely linked and interdependent. In such a scenario investing in international funds can be a good hedge against any serious corrections in the domestic market. I therefore think one can invest in funds based on US, Japan and Europe in that order. Do not go overboard on this, a small allocation is sufficient. From my own perspective, I invest in US and Japan funds regularly now but for much of the time before I did not have these in my portfolio.

So in order to summarize selecting the types of MF these guidelines can be used:-

  • Avoid Balanced funds as debt and equity investments are best kept separate.
  • Avoid sector funds as they focus only on one part of the market. The only reason to invest in them will be if you do not have a stock portfolio, but even here good diversified funds are adequate.
  • Avoid funds that take calls on market levels such as Dynamic funds, same logic as Balanced funds.
  • Diversified equity funds are the best way to go. Choose funds falling under large cap, mid cap, multi cap and small cap category. This will give you a 360 degree coverage of the market and will suffice in most situations.
  • Have some exposure to international funds to take advantage of the opportunities and also for hedging.

In my next post I will talk about how you can build a robust long term MF portfolio with these choices.

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