There are ‘n’ number of funds to choose from and one has to scrutinise several factors, besides just past returns, to make a bouquet of funds that best aligns to one’s goals

Most people who do not seek the advice of professional advisors, usually tend to look at the last one-month or one-year returns and go for mutual funds that are relatively giving higher returns in comparison with their peers.

However, this is a rather simplistic approach. Selecting your funds should be based on a lot of factors, such as your investment goals, tenure and risk tolerance, among others. Here is a guide on what to consider when choosing a portfolio of funds and how to maintain it.

Step I: Portfolio Allocation

To start with, you have to decide your overall portfolio allocation. This is basically about deciding how much you want to invest in equity, debt, gold, and so on. Zeroing in on a particular fund is the subsequent step. Your portfolio allocation will depend on your investment objectives, risk appetite, and investment time horizon.

Let us say, you decide on an allocation ratio of 60:30:10 in equity, debt and gold. This allocation ratio will provide you with the basic framework on which you will proceed with the next step towards selecting the funds of your choice towards building your portfolio.

Step II: Category Allocation

There are multiple fund categories available, each with their own nuances. You have to understand either all the categories, or to keep life simple, know a few of them which you will go for. There are 11 equity fund categories, 16 debt categories, and six hybrid categories. Here are some relevant ones.

Equity Large-Cap: Large-cap stocks are the top 100 stocks according to market capitalisation. In other words, these are the leading 100 companies of the country. These are relatively less volatile than, say, small-cap stocks, but are subject to the usual market movements.

Equity Multi-Cap Funds: These funds have an allocation of minimum 25 per cent each in large-cap stocks (top 100 companies), mid-caps (companies ranked 101-250), and small-caps (beyond the top-250 companies), with the rest 25 per cent left to the discretion of the fund manager. This fund category gives a balanced exposure to companies of various sizes, according to market capitalisation.

Equity Flexi Cap Funds: These funds allocate to companies of various market capitalisations, according to the discretion of the fund manager.

Equity Passive/Index Funds: These funds replicate the underlying index, such as the Nifty or the Sensex, and charge relatively lower expenses.

Debt Corporate Bond Fund: These funds invest in highly-rated corporate bonds. Usually, the portfolio credit quality is very high in these, but volatility is moderate.

Debt Government Securities Fund: The portfolio credit quality is of the highest grade, but volatility in these funds is relatively higher than other debt funds.

Liquid Funds: These are the most stable in terms of performance, and are also suitable for parking your money for short-term and/or for creating an emergency component for your portfolio.

Debt Target Maturity: These funds have a defined maturity date. On that date, the fund is closed and money flows back to the investors. There are multiple maturities, such as three, seven, and 13 years, available in this category of funds. You can choose one according to your requirement of cash flow.

Step III: Fund Selection

Let us bifurcate the fund selection parameters into two broad categories: performance and others.

For performance, when you are looking at returns, look at long periods of time, as that captures the essence of performance over a long period. The market goes through cycles. Even fund managers go through cycles, in the sense that their decisions sometimes play out favourably and sometimes not. A longer timeframe, such as 10 or 15 years, captures the cycles.

Analysts use the parameter of volatility and volatility-adjusted returns, but for investors who are not finance professionals, this calculation is not essential. The annualised return over a long period of time is arrived at after calculating market cycles and volatility. This is a reasonably good parameter.

For index funds, it is the tracking error which shows to what extent or how accurately the fund is tracking the underlying index. A simpler way to assess this is to look at the tracking difference which shows the difference between the returns from the index and the fund over that period of time. To compare your returns in the fund with the underlying index, such as the Nifty or the Sensex, look at the tracking difference.

For the non-performance parameters, you may look at the following:

AMC Pedigree And Fund History: A proven asset management company (AMC) with a long history is better. This is not to say that a new fund or new AMC cannot do well, but a proven one would have already demonstrated what it is capable of. We mentioned earlier that a long performance history is desirable, as it shows what the fund manager can do across market cycles.

Fund Size: Though not essential, a larger fund size shows that many more investors have reposed their faith in the fund. The volatility in corpus when the fund size is affected in case of sudden redemptions is lower in relatively larger funds. There is a notion that when a fund grows too big, it becomes difficult to manage. However, in the case of large- and mid-cap funds, the market has the requisite depth to provide the necessary liquidity. That may not be case with small-cap funds.

Portfolio Liquidity: As long as you are investing for the long term, you need not worry about portfolio liquidity. Some fund categories have relatively lesser liquidity, such as small-cap funds in equity or credit-risk-oriented funds in debt. You may check if your fund has an exit load, and compare that with your investment time horizon.

Debt Funds’ Credit Quality: This is gauged by the credit rating of the instruments in the portfolio. AAA is the highest rating, followed by AA+, and so on. This information is available in the fund factsheet, which is uploaded on the website of AMCs every month.

Debt Funds’ Portfolio Maturity: The longer the portfolio maturity of the fund, the more it moves with the market. This volatility can work in your favour or against you, depending on the market movement. Government securities (G-sec) funds are more volatile, while liquid funds are the most defensive.

Final Step: Tracking

Tracking the funds in your portfolio is mostly about performance. But it could also be about any fundamental change. If your fund is not doing well, do not chuck it out at the first instance. Give it reasonable time to recover, as funds go through cycles. If it underperforms consistently for a long period of time, then you may consider switching your fund.

Refer: https://outlookmoney.com/magazine/story/guide-to-build-your-mf-portfolio-1729