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How to Create a Diverse Mutual Fund Portfolio for Better Returns

It is true when they say that “Mutual Funds sahi hai”, but that does not mean that one can build a mutual fund portfolio without any effort or research. A random selection of funds (even the top performing ones) is not a good idea. Effective diversification is the magic ingredient that ensures that investors benefit from mutual investments in the long-term. This ensures that asset categories are chosen in such a way that brings down the overall risk and investment cost. Additionally, it enhances the ease of management. A downfall in one particular asset category can get offset by the growth in the other asset classes.

Here are six tips that will help to build a diverse and well-balanced portfolio.

1. Understand the various types of mutual funds available

In order to create a diversified portfolio, it is important to first be aware of the different kinds of mutual fund schemes available in the market. For instance,

Based on the asset class
One can opt between equity funds (seen as high risk and high return), debt funds (safer alternative as money is put in fixed income securities, money market funds (easy liquidity as an investment is done in money market securities such as T-bills, bonds, dated securities and CDs. Hybrid or balanced funds aim to strike a good balance between equity and debt investments

Based on investment goals
Here the choice is between growth funds (suitable for investors willing to bet their money in growth sectors), income funds (debt funds which give periodic dividends) or liquid funds (debt funds and money market funds with a short-term investment plan).

Additionally, there are tax saving schemes which qualify for deduction under Section 80C, pension funds (to secure your future in the retirement phase) and capital protection plans.

Specialized Funds
Examples in this category include Sector Funds (invest the corpus in specific sectors such as IT, banking, etc.), index funds (mimic the performance of a benchmark index such as Nifty, Sensex, etc.), foreign funds (invests in international schemes), global funds (benefits of domestic as well as foreign funds) and exchanged traded funds.

Based on market capitalization
Companies are segmented into 3 different ranks on the basis of their market capitalization. Large Cap (well-established, stable and financially sound companies with a market cap of usually more than 20,000 crores), mid-cap (market cap between 5000 -20,000 crores) and short cap (start-ups, new companies in niche sectors with a market cap below 5000 crores). The risk quotient is the least in the case of large-cap and highest in case of short-cap funds.

2. Understand your financial goals and risk appetite
Now that you know what the mutual funds world has to offer, it is important to look within and know your financial goals as well. One needs to look at these goals from two perspectives:

Time Horizon
All financial goals need to be further bifurcated into short-term, medium-term and long-term goals. This will not only help in the proper allocation of funds but also ensure timely achievement of these goals. A good Asset Allocation strategy relies heavily on the timing of the goal. For instance, debt instruments are considered more suitable for short-term needs (due to predictable cash Inflows). Medium term goals call for a healthy mix of debt and equity funds. Whereas, long-term goals should ideally have a higher weight of equity funds.

Risk Appetite
Your risk tolerance levels are based on factors such as age, income levels, financial commitments, etc. Your mutual fund portfolio should be in sync with your risk profile. For instance, if an investor is nearing the retirement age and is neck-deep in commitments, sector funds may not be a good choice due to their high-risk component. On the other hand, if you are just starting your career and do not have many financial obligations, equity funds are a good bet.

3. Pick the right schemes within the chosen category
Once you have finalized the overall category (debt, equity or a combination of both), it is important to choose the schemes that are best for you. The selection criteria should depend on the overall investment objective and consistency of returns delivered by the mutual funds.  One should try to pick funds with larger AUM, reputed names and a steady past record. Another crucial factor to be considered is the Total Expense Ratio (TER). A fund with lower TER is always better as compared to the ones with a higher ratio, ceteris paribus.

4. Risk of concentration
This happens when investors concentrate their investments in a specific sector or industry. For instance, if we take a portfolio which consists of 8 funds, it might seem like the perfectly well-diversified portfolio. However, the reality may be far from that. A look at the constituents show 1 Large-Cap and Mid Cap Fund, 2 Small-Cap Funds, 2 Banking Funds and 1 each in technology and pharma fund. This composition is highly risky (37.5% exposure in mid and small-cap funds) and also has concentrated sectoral bets (50% exposure). Ideally, one should try to limit exposure to sectoral funds and small-cap funds at the same time, since their risk quotient is very high.

5. Beware of over-diversification
The more the merrier” does not hold true while building a portfolio. If one has too many funds in the portfolio, there is a good chance that they will have similar stock compositions or holding. It will negate the good effects of diversification. Rather than reducing the risk level, it will only intensify the manageability problems and bring down the returns. Ideally, one should restrict the number of funds to a maximum of eight in the portfolio.

6. Review and respond
Creating a diverse mutual funds portfolio is a continuous process. It is important to track the performance of your funds on a regular basis from three perspectives- risk, expected returns and cost.

With this information in your ammunition, you are all set to build a well-diversified mutual fund portfolio and reap their sweet benefits for a long time to come.