Seek to build a healthy mutual fund portfolio? Key things to keep in mind

• When building a MF portfolio, defining clear goals is essential.
  
• An investor needs to keep in mind what kind of risk taking ability he/she has.
  
• An investor should know his/her investment horizon and see if it aligns with that of the fund.
  

More and more Indian investors are believing in the slogan often heard during the ongoing ICC World Cup 2023 telecast – ‘Mutual Funds Sahi Hain’. According to data by Association of Mutual Funds in India (AMFI) in October, ₹16,928 crore (approx $2 billion) flowed into SIP accounts, adding up to a total inflow of ₹1.75 lakh crore over the preceding twelve months. In October 2022, it stood at ₹13,040 crore.

With over 44 registered mutual fund houses in India and a wide variety of fund categories, it is not easy to construct a mutual funds portfolio that is suitable for one’s needs. Here we take a look at some key factors that will help you build a mutual funds portfolio and select the categories of funds to invest in.

Constructing a portfolio

When designing and then constructing one’s mutual fund portfolio, there are three crucial factors to consider. “First, age plays a significant role in determining the investment strategy. Second, defining clear financial goals is essential – whether it's retirement planning or funding your child's education, specifying when these goals should be met is key. Lastly, one must assess their risk tolerance,” says Soumya Sarkar, Co-Founder, Wealth Redefine, a mutual funds distribution firm.

For example, when you are in your 30s or 40s, there is still a long time to go for retirement, so you can have a greater portion of your portfolio invested in equity funds, but when you are near to a goal like child’s education or retirement, you should make a shift to debt because capital preservation becomes important.

“While age and goals are important, the emphasis should largely lean towards risk tolerance, accounting for around 60% of the decision-making process. Understanding how comfortable one is with potential fluctuations in the market is paramount, as it guides the selection of mutual funds that align with their risk profile,” says Sarkar.

The remaining 40% should factor in age and goal timelines to craft a well-balanced mutual fund portfolio that suits individual financial aspirations and risk appetite.

Deciding on the type of mutual fund to invest in

It all starts with asset allocation and depends on the individual, his preference and his requirements. Shaily Gang, Head-Products, Tata Mutual Fund, explains.

Let us say someone decides 70:30 in equity and debt. Within that 70% if someone is very aggressive and has the horizon and has the capacity to take volatility then one can go very aggressive on thematic, sector and small cap funds, which could total to 35% of that 70%.

The rest of the 65% of the 70% of equity allocation will be formed by diversified funds. Someone else with a high risk appetite may decide to invest 50% of his equity exposure into large cap funds and another 50% in small cap funds.

However, it is advised that if a person has a horizon of three to five years, hybrid funds like equity savings funds and balanced advantage funds, are a good option because they carry less risk than pure equity funds.

“So an investor needs to keep in mind what kind of risk taking ability he has, his horizon for that part of the investment and also map that to the horizon of the fund. For example, if someone has a high risk taking capacity and the investor has a horizon of beyond five years, then he can invest in a small cap fund,” says Gang.

Making the most of market trends?

Predicting specific market periods is challenging, as rallies can be unpredictable. “Investors can use various parameters to make informed decisions, such as the price-to-earnings ratio, price-to-book value, standard deviation, and rolling returns in mutual funds,” says Sarkar.

Rolling returns indicate how fund managers have performed over different time frames, providing insights into potential future performance. While not always foolproof, these metrics are often reliable.

Should a sector remain undervalued over an extended duration, there exists a probability that it will eventually exhibit strong performance, irrespective of whether it falls into the large-cap, mid-cap, or small-cap category. This positive performance has the potential to yield favourable returns for investors.

“Currently small cap valuations are attractive. Let’s say that when markets are heated small caps trade at 40-50% of the large caps but currently they are trading at 5% premium. So they are very reasonably valued. One would need to visit all of these things before making a decision,” says Gang. To sum up, although accurately timing market periods is challenging, slightly evolved investors can utilise these metrics to make informed decisions and potentially capitalise on rallies specific to particular sectors.