Mutual
Funds are for everyone and they can cater all kind of requirements. The selection
of mutual fund schemes should be based on investment goals. For each investment
goal, we should identify the following:-
- What is the Investment Objective? Capital
appreciation or Income generation.
- What is the Time horizon to achieve the goal? Short
term, Medium term or long term, in years.
- Investor’s risk tolerance level and appetite for
volatility
- Investment style? Is it passive or active, and how
much time can be devoted to manage the investments
- Liquidity needs
In
this post, we will discuss on how to construct a optimum mutual fund portfolio
based on these considerations. Of the various investment goal related factors, as
mentioned above, investment horizon and risk tolerance are interlinked. In
general, the shorter the investor's horizon, the less risk an investor should
be willing to accept. However, within the same investment horizon, the degree
of risk tolerance may be different for different investors.
Let
us discuss the various investment options in mutual funds depending on the
investment horizon and risk tolerance levels.
·
Investment
Horizon less than one year:
If we need to park our
cash for just a few months, then we should look at liquid funds, ultra-short
term debt funds and arbitrage funds. If we need our funds within one to three
months, then you should go for liquid funds. Or If we can wait for 3 to 6
months, then we should go for ultra-short term debt funds. Ultra-short term gives
slightly higher returns than liquid funds, but they may be volatile in the very
short term (1 to 3 months). Withdrawals from liquid funds are processed within
24 hours on business days Now many mutual funds offer instant redemption (within
an hour) upto certain amount (normally upto Rs. 2 lakhs). Therefore, other than
the funds we need for our day to day expenses and we can park our surplus cash
in liquid or ultra short term debt fund. If an investor is in the highest tax
bracket, arbitrage funds could be more tax efficient investment options. Liquid
fund returns will be taxed at applicable income tax rate, for investment
holding period of less than 3 years. Arbitrage funds returns, on the other
hand, for an investment holding period of less than a year will be taxed at
15%. For example, if an investor is in the 30% tax bracket, if an arbitrage
fund gives you an annualized return of 7%, while a liquid fund gives you a
return of 8%, Still you will be better, from a post tax perspective, investing
in the arbitrage fund.
·
Investment
Horizon from 1 year to 3 years:
If we can remain invested
for one to two three year time horizon, investing in short term income and
credit opportunities funds are good investment options. Short term bond funds
invest in Commercial Papers (CP), Certificate of Deposits (CD) and short maturity
bonds/debentures etc. The average maturities of the securities in the portfolio
of short term bond funds are in the range of 2 – 3 years. These funds run
predominantly on accrual (hold to maturity) strategy and hence the interest
rate risk is low. In the current interest rate scenarios these funds are giving
around 8 to 9% returns. However, if yields decline then the returns will be
lower. Credit opportunities fund are similar to short term debt funds. However
in Credit Opportunities funds, the fund managers lock in a few percentage
points of additional yield by investing in slightly lower rated corporate
bonds. The average maturities of the bonds in the portfolio of credit
opportunities funds are in the range of 2 – 3 years. The fund managers hold the
bonds to maturity and so there is very little interest rate risk. Good credit
opportunities funds have given double digit returns in the recent past.
·
Investment
Horizon from 3 to 5 years:
If our investment horizon
is more than 3 years and have low risk tolerance levels then, then investors
can look at fixed maturity plans. Fixed maturity plans (FMPs) are close ended
schemes that aim to generate income for the investors in a fixed term. Generally
FMPs have given better returns than bank fixed deposits even on a pre tax
basis. On a post tax basis, FMP returns are even better compared to bank fixed
deposits, because FMPs get indexation benefit on taxes. However, investors
should note that since FMPs are close ended schemes, there is virtually no
liquidity before the fixed term. If liquidity is an important consideration,
then investors should opt for open ended income funds. Between FMPs and income
fund, the predictability of returns is higher in FMPs. FMPs are particularly
suitable, in a high interest regime environment, where you can lock in higher
yields. On the other hand, if interest rates are falling, income funds are more
suitable. Income funds invest in a variety of fixed income securities such as bonds,
debentures and government securities, across different maturity profiles. Their
investment strategy is a mix of both hold to maturity (accrual income) and
duration calls. This enables them to earn good returns in different interest
rate scenarios. However, the average maturities of securities in the portfolio
of income funds are in the range of 7 to 20 years. Therefore these funds are
highly sensitive to interest rate movements and are suitable for investors with
low to moderate risk tolerance levels.
If we have slightly
higher risk tolerance then, monthly income plans or Debt oriented balanced
funds could be better option. Monthly income plans invest primarily in fixed
income instruments, while maintaining a small allocation in equity instruments.
They are suitable for investors with moderate risk tolerance, particularly
retirees looking for regular income from their investments as well as a bit of
capital appreciation.
Equity oriented Balanced
funds on the other hand are suitable for investors, with a moderate to high
risk tolerance level and a longer time horizon (4 years or more). These funds
typically have 65 – 70% of the portfolio invested in equities and the rest in
fixed income securities. These funds are suitable for investors, looking for
capital appreciation, without assuming substantial risks on the capital
invested. These funds are suitable for investors, who are 5 to 10 years away
from retirement or other long term financial objectives. On a risk adjusted
basis top performing balanced funds have delivered excellent returns compared
to diversified equity funds.
·
Investment
Horizon of more than 5 years:
If our investment horizon is say 5 to 10 years or more, and are
willing to take more risks, then equity funds is the way to go. Investors
should note that, equity as an asset class provides the highest returns in the
long term. However, investors in equity funds do have to contend with
volatility, which means that they cannot have a short time horizon. Top
performing equity funds have given more than 15% compounded annual returns over
the last 10 years, despite intervening bear market periods. Equity funds are
suitable for long term financial objectives like, retirement planning,
children’s education, children’s marriage, house purchase etc. There are a
large number of investment options within equity funds like, large cap funds, multi
cap funds, small & midcap funds, diversified equity funds, Equity Linked
Savings Schemes (ELSS), Sector or thematic based funds etc. What option is
suitable for an individual depends on his/her personal situation, however, we
will discuss several considerations which may help you make the appropriate
choice:-
· Many investment experts believe that
diversified equity funds, also known as flexicap or multicap funds, comprising
of stocks across different market capitalization segments, are the best long
term investment options for financial objectives like, retirement planning,
children’s education, children’s marriage, house purchase etc. Diversified
equity funds carry slightly more risk than large cap funds, but also give
higher returns, compared to large cap funds. At the same time, they are not as
volatile as small and midcap funds.
·
If tax saving is a consideration, then ELSS
is the option. Under Section 80C of Income Tax Act, investment in ELSS up to Rs
1.5 lakh (subject to the overall limit within Section 80C) is eligible for
deduction from the taxable income and therefore will qualify as tax saving
investment. ELSS funds have a lock in period of 3 years from the date of
investment, and therefore will have an impact on the liquidity considerations.
While tax saving is a big benefit for ELSS investors, these funds have given
excellent returns, over various long term investment.
· Large cap funds, which comprise mainly of
large cap stocks, have the lowest risk among equity funds categories. Large cap
funds, to some extent, limit downside risks in bear market conditions. However,
in the Indian market context, large cap fund performance is more sensitive to
FII activity than small and midcap funds. In fact, in the market correction
over the past 10 months, large cap funds have underperformed small and midcap
funds.
·
Small and midcap funds are inherently more
risky than large cap and diversified equity funds. But these funds have the
potential to give higher. However, it is important to ensure an optimal
balance, consistent with an individual’s risk tolerance profile, between large,
mid and small cap segments in the investment funds should constitute, only a
portion of equity funds portfolio.
Though there are no hard and fast rules for allocations to midcap funds, there
are some broad guidelines (subject to the personal financial situation and the
risk tolerance level of the individual investor):-
o
Very aggressive risk tolerance: 40% large
cap / diversified equity and 60% small & midcap
o
Aggressive risk tolerance: 50% large cap /
diversified equity and 50% small & midcap
o
Less aggressive risk tolerance: 70% large
cap / diversified equity and 30% small & midcap
Conclusion
In
this post, we have discussed how we can construct a proper mutual fund
portfolio, based on the investment horizon of our various investment goal
related factors. A thoughtfully constructed investment portfolio will ensure
success in meeting our financial objectives. However as every individual is
different and has different needs it is always advisable to discuss with your
financial advisor, what investment options are suitable to meet the objectives
in your financial plan.
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