| Planning a Mutual Fund Portfolio |
Even today when you sit down to evaluate your portfolio, do you have trouble remembering exactly why you bought certain funds in the first place? Do you buy funds randomly, based on recent magazine or newspaper articles? If you answered yes to either of these questions, you may be guilty of fund collecting. And are defeating the basic purpose of investing in mutual funds. Mutual funds are pools of securities, which typically offer diversification within one or more asset classes. In general, people invest in mutual funds in order to achieve diversification in their portfolio without the trouble of managing a large number of stocks and bonds. But with a huge choice of mutual funds available today, however, some people have started collecting mutual funds as if they were art. The downside of holding too many similar funds is potentially lower returns on your portfolio.
Let us look at the type of mutual funds that are there in the market. Pure Equity funds-which invest over 70% in equities, Sector dedicated funds-which invest in equities of a particular sector, Balanced Fund-These funds use a mix of stocks, bonds, and money markets to try to generate moderate growth and income while carrying moderate risk. Bond Funds-Invests in government, Treasury, and municipal bonds to provide revenue and reduce market risk. Index Funds- Strives to post returns comparable to benchmark index for investment category. Risk varies with asset class. Money Market Funds- Invests in high-quality bonds, commercial paper, and bank notes. Seeks to maintain a stable share price and generate income. Carries a low market risk but lower returns are highly susceptible to inflation risk. Value Funds-Seeks to maintain principal and generate modest income by investing in out of favor or undervalued securities. Low annual returns may not outpace inflation.
Then funds also differ according to their investing styles-Active and passive investing are the two most basic investment styles. While active investors believe that managed funds have the ability to outperform the market, passive investors have faith in the long-term success of the market index. Active investors are further divided into the two categories of growth and value. Growth funds typically invest in well-established companies with strong earnings potential. Value funds, on the other hand, invest in companies that have recently fallen out of favor but are expected to bounce back. Many investors prefer to combine investment styles in order to potentially gain through different market cycles that favor different approaches.
So how many funds should one own? The number that is right for you depends on your investment goals and the amount of your investment capital. If you have both short- and long-term goals, you will likely want different types of mutual funds for each time frame. The more capital you have to invest, the greater your ability to afford diversification among different asset classes and investment styles. Asset allocation is the way in which you weight investments in your portfolio. There are three main asset classes: stocks, bonds, and money markets. Each has its own characteristics in terms of value fluctuation, level of market risk, and ability to outpace inflation. Which asset classes you decide to invest in depends on how your investment time frame and goals match up with the risks and return potential of the various asset classes.
Most financial planners suggest a minimum of three mutual funds if you have at least Rs 1,00,000-Rs 1,50,000 to invest. These first funds would likely include a stock fund, a bond fund, and a money market fund. How much you invest in each fund will depend on your investment goals and time horizon. With higher amounts to invest, you might consider adding a mix of different stock and bond funds. Following such a strategy of holding different types of funds, an investor with Rs 1,50,000 –Rs 10,00,000 to invest can achieve a well-diversified portfolio with just six –eight funds. For those with even more to invest, some experts suggest that no more than a dozen funds should suffice. With so many funds in the market, it is inevitable that there are several funds with similar strategies and performance. These funds invest in the same stocks and follow identical investment styles. If you hold several funds that all use similar investment strategies in your portfolio, you essentially hold the market. You could achieve the same result much more cost-effectively by simply buying an index fund. Each fund that you invest in should play a specific, defined role in your portfolio. An investment adviser can help you evaluate each fund and its role in your portfolio. If you find yourself surrounded by a sea of similar funds, or can't remember why you bought a fund in the first place, it could be time to pare down your portfolio.
After you have decided the number of funds then comes the daunting task of how to choose the funds. Well there are simple steps which will help you decide. Firstly-Assess Your Investment Objectives. When you set out to select a fund, your first task is to formulate your investment objectives and identify your time frame. For example, you may plan to buy a new house in three years, to invest for your children's college education in 15 years, or to fund your retirement in 30 years. The length of time you have pretty much dictates the level of your risk tolerance. Generally speaking, the longer your time horizon, the greater your tolerance for risk. Secondly match Your Goals With Funds' Investment Objectives. Find out which types of mutual funds match your investment goals and risk tolerance. Don't be confused by the seemingly endless differentiation of the mutual fund industry, which can be boiled down into a few large groups. In terms of investment objectives, stock funds, for example, include "aggressive growth," "growth," and "growth and income" depending on the kinds of securities they hold. Each group of funds can further be categorized by risk level, as "above-average risk," "average risk," or "below-average risk."
Once you have identified the fund categories that seem appropriate to your investment objectives, you will want to take a close look at individual funds in each of the categories. Performance over a period of time is usually an important factor, but not the only consideration. Other factors may include the consistency of fund management, investment policies, and variability in returns over time. Other than websites and magazines which will give you data on the funds, you'll need to review the prospectus, which are available free with just a phone call. A fund's prospectus describes the fund's investment objective, types of securities it invests in, and the risks these investments involve. The prospectus is intended to help you to understand exactly what you are investing in. Fund prospectuses also tell you the funds' performance, fees and expenses, and other information that investors should have when looking for mutual funds. Performance over the time frame that you are investing for, with an appropriate level of risk, is the bottom line.
Then hunt for Top Performers, When you hunt for top-performing funds, don't focus on the funds' latest performance only. A common mistake of picking funds is buying the "latest" hottest fund. But be aware that buying a fund based solely on its latest performance can be very risky. Instead, look for funds that consistently provide above-average investment returns in the same fund category for the past three, five and 10 years. Lower volatility is evidenced by funds that are ahead of their peers during bull markets, while not falling more than the averages in bear markets. Compare the annual percentage returns of a fund with its major benchmark index over the same period. Consider Sales Charges, whether front-load - when you buy shares, normally about 5% for stock funds (less for bond and money market funds); or an exit fee -if you sell shares before a specified period of time. There is also an increasingly large number of no-load funds available. For a truly superior fund, however, it might be worthwhile to pay a load particularly if you plan to stay with the fund for a long period of time.
In addition to sales charge, mutual fund charge various management fees. Everything else being equal, lower total fees and expenses result in higher returns. Also make it a point to buy directly from the Funds. To buy funds through a broker, you normally have to pay a commission. And finally, first-time mutual fund investors are often advised to start small, and all investors can practice diversification to lower risk.
Points to Remember
1.People invest in mutual funds in order to achieve
diversification without the time and cost of tracking hundreds of individual securities.
2.There is no ideal number of mutual funds to own.
3.Before picking a mutual fund, consider your investment goals, time frame, and amount of
investment capital. 4.Diversify among different asset classes to help reduce risk and
potentially increase the rate of return of your portfolio.
5.Diversify among different investment styles to potentially reduce risk and increase
returns.
6.Owning too many funds means you may be paying for active management when you really hold
the market. 7.Your investment adviser can help you evaluate each fund to determine its
role in your portfolio.
8.In choosing mutual funds, your first task is to formulate your investment objectives and
identify your time frame.
9.The next step is to identify which types of mutual funds match your investment goals and
risk tolerance. 10.Companies such as Crisil and dedicated websites provide statistical
information on mutual funds.
11.Once you have identified the fund categories that seem appropriate to your investment
objectives, you will want to take a close look at individual funds in each of the
categories.
12.A fund's prospectuses describe the fund's investment objective, types of securities it
invest in, and the risks these investments involve.
Aru Srivastava