Have you made up your mind to invest in mutual funds?
Investing in mutual fund requires one to be disciplined and can be suitable even for those who have limited knowledge and time to invest in equity markets. However, one should plan well before starting to invest in mutual funds.
An ideal mutual fund portfolio depends upon the investor’s risk-taking ability, age and investment objective. Generally, a mutual fund portfolio is divided into two parts: Core, which is considered for stability and predictability; and Satellite, which is especially good for investments with a lot of potential but risky in nature.
Understanding the two parts of the portfolio will help reduce volatility and lower the tax burden. Investors can use the premise of the core and satellite portfolio strategy to minimize transaction costs and tax liability in case of short- and long-term capital gains, and also manage volatility when looking for opportunities to outperform the market.
The Core Portfolio
One of the objectives of the core is to give the mutual fund portfolio stability while generating steady returns. This is also considered as the backbone and can comprise 70-80 per cent of the total portfolio.
In the core portfolio, Index funds or passively-managed funds can be chosen by an investor. One reason is that an index fund replicates a benchmark index not only in portfolio composition but also in returns. The risk of wrong judgement is eliminated since the fund manager does not have any say in stock selection. Index funds are well-diversified and the fund management costs are also low.
Investors can rely on actively-managed funds that have consistently beaten benchmarks over the years and as the same trend is likely to continue in the coming years. This is one of the reasons for including actively managed large-cap funds as a part of the core. Actively-managed funds mostly invest in large companies and are considered less volatile than mid-cap and small-cap funds. If the portfolio core has such funds, there are less chances of any sharp drop or jump in value.
An investor should know that the core should be built with a combination of index and large-cap funds that have stable fund management teams and a good track record.
Apart from the index and large-cap funds, core can also include equity-oriented hybrid. Mostly, equity-oriented hybrid funds should have over 65 per cent exposure to equities and around 30-35 percent to debt instruments.
One can also include Gold ETFs and gold fund-of-funds as part of the core portfolio. However, the exposure to these should not exceed 5-10 per cent of the total portfolio. You can also add debt funds to the core portfolio from asset allocation perspective.
The Satellite Portfolio
While the core part of the portfolio is for stability, the satellite part of the portfolio is considered for earning higher than benchmark or market returns. Aggressive mutual fund schemes like mid- and small-cap funds, sector funds, thematic funds and international funds can be used to generate higher returns.
Financial Advisors advise to never use money from the core part to re-balance the satellite part when the satellite part is not doing well. Instead an investor needs to play to their strengths and stick to the core portfolio.
It is important to perform periodic rebalancing between equity and debt in order to create a good portfolio. Such a strategy helps an investor to keep up with the changing market conditions. The different approaches for doing so can be as follows –
Fixed ratio approach
Ratio based approach is followed based on age and risk-taking ability of an investor, which keeps exposure rebalanced between equity and debt. Investors can shuffle the investments at pre-determined ratio when there is any significant change due to various reasons in equity and debt markets.
For example, consider a portfolio of Rs.10 lakh with 70:30 equity and debt mutual funds ratio. This means the equity mutual fund portfolio is valued at Rs.7 lakh and the debt at Rs.3 lakh. If there is 12 percent rise in the equity mutual fund portfolio after a year then the amount increases to Rs.7.84 lakh while the value of debt goes up by 7 per cent to Rs.3.21 lakh. Such changes will alter an ideal ratio (70:30), and an investor can balance this by selling equity mutual funds worth approx. Rs.10, 500 and investing the money in debt.
Investors can re-balance the portfolio periodically, may be once a year or set a trigger, say, a 10 per cent change in favor of any asset class.
Variable ratio approach
The equity-debt ratio rises to a new pre-determined ratio when there is a change in the value of the equity mutual fund portfolio. For instance, the equity-debt ratio was 1:1 at the beginning, and if there is 10 percent rise in the equity portfolio then an investor can sell a part of the equity mutual funds and re-invest it in debt funds to make the ratio to, say, 4:6.
Consider a portfolio is of Rs.20 lakh which is perfectly balanced between equity mutual fund and debt. If there is a rise in the equity mutual fund portfolio to Rs.11 lakh and the debt portfolio to Rs.10.6 lakh then an investor needs to sell the equity mutual fund to bring the equity-debt ratio to 4:6, which may include selling equity mutual funds worth Rs.2.36 lakh and invest the proceeds in debt.
Constant rupee value approach:
An investor, under this approach, will keep the value of the equity mutual fund portfolio constant by investing any appreciation in value into debt or vice versa.
Say, an equity mutual fund portfolio is valued at Rs.10 lakh, which rises 10 per cent to Rs.11 lakh. The investor then sell equity mutual funds worth Rs.1 lakh to re- invest the money in debt. Similarly, when the portfolio value falls to Rs.9 lakh, an investor sells Rs.1 lakh of debt to re-invest in equities in order to maintain the value of the stock portfolio at Rs.10 lakh.
An individual requires planning before building a mutual fund portfolio, which also depends on individual preferences. Remember there is no ‘one size fits all’ solution in mutual funds, thus an investor should consider his or her financial goals and investment objectives while choosing a fund to invest. Therefore, financial goals and objectives should be the first and the most important step towards creating a mutual fund portfolio. You may also think about the purpose of investing, the time horizon to realize goals and the amount you want to invest before making any investment decisions.