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All the
investments of an investor are collectively referred to as a
portfolio, which is meant to serve a particular goal.
Here's how to build a portfolio of
mutual funds
Define your goal
You need a
distinct portfolio for each goal because you will be requiring the
money at different points of time.
For instance, if you are saving for your wedding two years down the
road and your retirement 30 years down the road, you will invest
differently for each. If saving for your wedding, then you don't have
much time. So your risk cannot be too high. Neither can you put it in
an investment which will be locked for a longer duration. So you would
not be able to consider an Equity Linked Saving Scheme which has a
three-year lock-in period. These are diversified equity funds with a
tax benefit. You will probably have to consider a debt fund (fund that
invests in fixed return investments) or a Fixed Maturity Plan or a
balanced fund (fund that invests in both shares and fixed return
investments). But, with a 30-year time frame you have lots of time on
your side. You could definitely consider equity funds that invest in
shares of companies. Over long periods of time, the risk of investing
in equity (and hence equity funds) is minimal and the rewards you can
expect are high.
At the
broad level, money that is needed within the next three to five
years must be in debt funds while money that is going to be needed
after that can mostly be in equity funds.
Asset allocation
Asset
allocation means how much should be split between the various types of
funds.
At a higher level, you need to decide how much to invest in equity
funds and debt funds. On the next level, you need to make selections
within these broad categories.
Equity
The first
step that you should take is to invest in diversified equity funds.
The risk and returns should be considered as the key driver in
deciding which funds should form the core of your portfolio. The core
should be composed of funds that offer stability coupled with returns.
You could try sector funds and mid-cap funds. Don't judge funds based
on the short-term performance, always look at the long-term
performance. But look carefully at your current investments before
deciding. Let's say that you have invested in HDFC Equity and Franklin
Bluechip. If you take both the fund manager's investments into
account, 22% of total investments would be in technology stocks and
15% in auto stocks. Now, if you decide to invest in a tech fund or
auto fund (both sector funds), you are taking the call that these two
fund managers have not invested sufficiently in this sector and you
are really keen on investing in such stocks. Go ahead only if you are
certain that you want to invest heavily in these sectors.
To compare
funds, you need to look at returns as well as risk.
Debt
There are
ultra-short term funds, known as cash funds, which are suitable for
those who want to park surplus money for a very short duration,
ranging for a few weeks to a few months. Then there are short-term
debt funds for those who want to invest for a year or so. Floating
rate funds invest in instruments where the interest rate fluctuates
depending on the overall interest levels in the economy. When one is
unsure of which direction interest rates are headed, this is a good
option. There are also medium-term debt funds which have the potential
to deliver higher returns than the above. Gilt funds are those that
only invest in government securities (investments with the government
backing).
How many funds?
Even within
mutual funds, diversification is a must. You must invest in different
types of mutual funds and they should be from different Asset
Management Companies (fund houses). Most investors tend to err on the
side of having too many funds, rather than too few. To make matters
worse, many of these portfolios have funds of the same type. In our
opinion, two to four equity funds and one or two debt funds are quite
enough for each type of fund. Let's say you want to invest in
short-term debt funds, floating rate debt funds, large-cap diversified
equity funds and mid-cap funds.
Our suggestion:
Short
term-debt fund: 1
Floating rate debt fund: 1
Large-cap equity funds: 3
Mid-cap funds: 3
Evolving a portfolio
You must monitor your portfolio. Let's say a fund might have been an
excellent performer years ago but has consistently been
under-performing. In such a case, you should think of selling your
units or at least stopping further investments if you are doing it via
a Systematic Investment Plan. This is a scheme where you put in fixed
amounts every month. Also, if you have been saving with a 10 year time
frame in mind and eight years later a bull run is on, it would be wise
to take a look at your investments.
After all,
you invested because you needed the money in 10 years time. Now, you
need it just two years down the road. If you are making a good
profit, sell your units and put them in a fund that is meant for a
shorter time frame.
Look at More Than a Fund's Past
Performance
You can't open a newspaper or read a magazine without seeing ads
promoting the stellar performance of "hot" mutual funds. But past
performance is not as important as you may think, especially the
short-term performance of relatively new or small funds. As with any
investment, a fund's past performance is no guarantee of its future
success. Over the long-term, the success (or failure) of your
investment in a fund also will depend on factors such as:
-
the fund's
sales charges, fees, and expenses;
-
the taxes
you may have to pay when you receive a distribution;
-
the age
and size of the fund;
-
the fund's
risks and volatility; and
-
recent
changes in the fund's operations.
So, look at
more than the fund's past performance when making your investment
decisions. Read the fund's prospectus and shareholder reports, and
consider these tips:
Scrutinize the fund's fees and expenses.
Funds
charge investors fees and expenses. A fund with high costs must
perform better than a low-cost fund to generate the same returns for
you. Even small differences in fees can translate into large
differences in returns over time. For example, if you invested
Rs.1,00,000 in a fund that produced a 10% annual return before
expenses and had annual operating expenses of 1.5%, then after 20
years you would have roughly Rs.4,97,250. But if the fund had
expenses of only 0.5%, then you would end up with Rs.6,08,580.
Know how the fund impacts your
tax bill.
The law
generally requires a fund to make a capital gains distribution to
shareholders if it sells a security for a profit that can't be offset
by a loss. If you receive a capital gains distribution from a fund,
you will likely owe taxes on it – even if the fund has had a negative
return since you invested in it. For this reason, you should call the
fund to find out when it makes distributions so you can time your
investment in the fund to avoid receiving a capital gains distribution
immediately upon investing and paying more than your fair share of
taxes. Some funds post that information on their websites.
Consider the age and size of the
fund.
Before
investing in a fund, read the prospectus to find out how long the
fund has been operating and the asset size of the fund. Newly
created or small funds sometimes have excellent short-term
performance records. Because these funds may invest in only a small
number of stocks, a few successful stocks can have a large impact on
their performance. But as these funds grow larger and increase the
number of stocks they own, each stock has less impact on the fund's
performance. This may make it more difficult to sustain initial
results. You can get a better picture of a fund's performance by
looking at how the fund has performed over longer periods and how it
has weathered the ups and downs of the market.
Consider the fund's portfolio turnover rate.
A fund's
portfolio turnover rate measures the frequency with which it buys
and sells securities. A fund that rapidly buys and sells securities
may generate higher trading costs and capital gains taxes.
Think about the volatility of the fund.
While past
performance does not necessarily predict future returns, it can
tell you how volatile a fund has been. Generally, the more volatile
a fund, the higher the investment risk. If you'll need your money to
meet a financial goal in one year, you probably can't afford the
risk of investing in a fund with a volatile history because you will
not have enough time to ride out any declines in the stock market.
Read the fund's prospectus and annual report, and compare its
year-to-year performance figures. These figures can help tell you
whether the fund earned most of its returns in a few small bursts or
whether its returns came in a steadier stream. For example, over ten
years, two funds may have gained 12% per year on average, but they
may have taken drastically different routes to get there. One might
have had a few years of spectacular performance and a few years of
low (or negative) returns, while the performance of the other may
have been much steadier from year to year.
Factor in the risks the fund takes to achieve its returns.
Read the
fund's prospectus and shareholder reports to learn about its
investment strategy and associated risks. Funds with higher rates of
return may take risks that are beyond your comfort level and are
inconsistent with your financial goals. For example, a fund that
invests primarily in stocks whose prices may change quickly – like
initial public offerings or high-tech stocks – will usually be
riskier than other types of funds. But remember that all funds carry
some level of risk. Just because a fund invests in government or
corporate bonds does not mean it does not have significant risk. For
example, the fund's investments could be very sensitive to interest
rate changes. Thinking about your long-term investment strategies
and tolerance for risk can help you decide what type of fund is best
suited for you.
Ask
about recent changes in the fund's operations.
Has the
fund's investment adviser or investment strategy changed recently?
Has the fund merged with another fund? Operational changes such as
these can affect future fund performance. For instance, the
investment adviser or portfolio manager who generated the fund's
successful performance may no longer be managing the fund.
Check the types of services offered and fees charged by the fund.
Read the
fund's prospectus to learn what services it provides to
shareholders. Some funds provide special services, such as toll-free
telephone numbers, check-writing privileges, and automatic
investment programs. You should find out how easily you can buy and
sell shares and whether the fund charges a fee for buying and
selling shares. You can expect funds that require extra work by
their managers, such as international funds, to have higher costs.
Assess how the fund will impact the diversification of your portfolio.
Generally,
the success of your investments over time will depend largely on how
much money you have invested in each of the major asset classes –
stocks, bonds, and cash – rather than on the particular securities
you hold. When choosing a mutual fund, you should consider how your
interest in that fund affects the overall diversification of your
investment portfolio. Maintaining a diversified and balanced
portfolio is key to maintaining an acceptable level of risk.
Don't chase winners. Funds that rank very highly over one
period rarely finish on top in later ones. When choosing a fund, look
for consistent long-term results. Index funds should be a
core component of your portfolio.
Index
funds track the performance of market benchmarks, such as the BSE
Sensex. Such "passive" funds offer a number of advantages over
"active" funds: Index funds tend to charge lower expenses and be
more tax efficient, and there's no risk the fund manager will make
sudden changes that throw off your portfolio's allocation.
Don't be too quick to dump a fund.
Any fund
can, and probably will, have an off year. Though you may be tempted
to sell a losing fund, first check to see whether it has trailed
comparable funds for more than two years. If it hasn't, sit tight.
But if earnings have been consistently below par, it may be time to
move on.
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