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Mutual Funds - The R factor: Draw up a risk-return equation
27-May-2008
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Don't go by size or what's hot. Make an informed investment decision.

Just a couple of weeks ago, I met up with an investor who had invested in Reliance Vision Fund through his old broker. I was checking his statements when I saw that exactly nine days down the line; his funds were switched from Reliance Vision Fund into Reliance Regular Savings Fund by an unscrupulous broker. He cited reasons such as Reliance Vision is too big to be managed and Reliance Savings being a smaller fund, would deliver higher returns.

Returns are never a function of size of the fund but just how quickly a scheme increases in size and whether it is able to deploy assets received in a short period of time productively.

There is no empirically available study or research in the Indian context, that shows that a big fund cannot manage its assets effectively or deliver outstanding results and that a smaller fund is indeed better than a larger fund.

This is absolutely rudimentary knowledge (if I can indeed call it knowledge) and I see such advice causing more harm to an investor's portfolio than benefiting it. In fact, there are a lot of small schemes with a paltry corpus which deliver pathetic returns. In fact, a larger investor corpus in small and mid-cap funds can have some impact, but investment in a sizeable large-cap fund managed by a competent manager should be safer - it won't have any significant impact on its performance. So what kind of funds should you have in your portfolio?

You should clearly know the rate of return you need to meet your goals. More importantly, you should know how much risk you are willing to take in hard times to earn the returns you are targeting. This will help you avoid more risk than necessary. The answers to these questions are not as easy as they seem, especially to the second question. It is easy to build a portfolio to achieve both of these needs, if you know what they really are.

People often look at returns ignoring the risk component. Most of us want an investment with high returns and no risk or less risk. Just like cigarette smokers who choose to ignore the warning that 'Cigarette Smoking is injurious to Health', investors too will look the other way when it comes to the caveat that mutual funds are subject to market risk. Investors tend to focus only on returns when investing in stocks and mutual funds.

Look at the following:

  1. What kind of stocks is this fund invested in?
  2. Is this concentrated in a few stocks or sectors?
  3. What is the Standard Deviation and Beta (something that your advisor should be able to explain) of the fund?
  4. What is the portfolio turnover of this fund? (Does it buy, sell and churn its stocks very often)? There are reasons why one fund earns more than another and the reasons can be any of the following:
  • High exposure to certain sectors or stocks
  • Calls taken by the fund manager have been spot on
  • Portfolio is concentrated or has a higher turnover
  • Market timing

However, the same reasons can go against the fund and its performance can suffer. Just because a scheme has been a hot performer does not mean it will continue to be one. Evaluate the performance over extended periods of time and not just over a quarter or so.

If your objective is capital appreciation, then indeed you should look at equity, real estate or gold funds. However, currently there are no choices as far as real estate funds are concerned, and gold fund options are limited. We will restrict the scope to equity funds.

Within equity funds, there are various types such as Diversified Equity, Sectoral, Thematic Funds, and Opportunistic Funds. Within this category, a separate classification in terms of market capitalization of stocks (Large Cap, Mid Cap, Flexi Cap and so on) can be done. Next, diversification across various fund houses, fund managers, investing styles such as growth, value or contra style of investing can be done.

The core of every portfolio should comprise of three diversified large cap funds. Next, around 20-40% of your portfolio can be exposed to mid and small caps, based on your capacity to take risks and your tolerance to risk.

If you feel this level to be unacceptable or high, based on your risk behavior, look at pruning the exposure to what your comfort level is all about.

Additionally, you can also look at adding a small percentage into thematic funds such as infrastructure, with the understanding that these are much more risky funds than diversified equity funds. Balanced funds can also play a role in a balanced investor's portfolio and some exposure to such schemes can be taken.

If, however, your objective is income and capital protection, then a debt fund is more appropriate. One can also look at hybrid options with 80% debt and 20% equity (Monthly Income Plans). Short-term funds that are required in a few weeks or months should be parked in liquid plus funds or floating rate funds.

Finally, avoid costly mistakes such as chasing hot funds or top performers of last year and acting on the basis of some rudimentary talk about fund size or promises about unrealistic performance.

Source : www.insuremagic.com back