How To Build A Diversified Mutual Fund Portfolio?

Building a diversified mutual fund portfolio requires investing in a set of two or more mutual funds. Generally, wechoose funds on the basis of popular parameters such as our investment objectives, past performance of the funds andexpense ratio etc. However, the returns from your mutual fund portfolio can be further optimized by bringing in some form of structure into the decision-makingprocess. This involves linking your fund with your financial goals and risk appetite and diversifying investment for minimizing risk.

Let’s look at how we can build diversified mutual fund portfolio with minimal assistance. As first step, consider categorizing the entire process into two parts – asset allocation (identifying investment amount across various asset classes) and security selection (identifying and investing in funds within various asset class).

Asset allocation:

This is the process of determining your exposure to different asset classes for deriving optimum risk-adjusted returns. Your asset classes would be in the form of equity funds, debt funds, hybrid funds and gold funds and your investment in these asset classes will depend primarily on your investment horizon and liquidity requirements. For example, a 55 year old man with earning children and having enough liquidity and investments to care of his retirement life can opt for higher exposure in equity funds than say, a 30 year old man, who has just started saving for the down-payment of his home loan.

• Equity funds: Invest in equity funds for your long-term financial goals (more than 3 years) as equities generally tend to outperform other asset classes for a horizon of more than 3 years. However, given the good prospect of Indian equity markets over the next 18-month horizon and provided you have a higher risk appetite, you can also opt for equity funds for meeting your financial goals maturing after 18 months.

• Debt funds: As equities are volatile in nature and can even deliver negative returns in the short-term, choose debt funds for short-term financial goals for which you cannot afford to take the risk of losing your investment capital.

• Balanced funds: These funds invest in both equities and debt instruments to deliver growth from its equity component and provide stability through its debt component during market downturn. Invest in them for your long-term goals if you have a low risk appetite and prefer stability over high returns. However, you can also opt for balanced funds for goals in the 12–18 months horizon, provided you have a high risk appetite.

• Gold Funds: These funds provide an alternative to investing in physical gold or gold ETFs. More than capital appreciation, the main aim of investing in gold funds is to provide yourself a hedge against inflation, global and domestic turmoil, and fall in equity markets. Typically, your investment in gold funds should constitute around 5–10% of your mutual fund portfolio.

Security selection:

The process of security selection within the asset classes starts after you have determined your exposure to different asset classes. In this process, your risk appetite or risk management will determine your investment across various fund categories.

• EQUITY FUNDS:

Large cap funds: Large cap funds invest in bluechip companies and hence they are considered to be the least risky among all equity fund categories. Ideally, these funds should constitute around 70-75% of your equity fund investments in order to provide stability to your equity portfolio. Consider opting for higher investment in these funds if you have low-risk appetite.

Mid-cap &Small-cap funds: These funds invest in companies having lower market capitalization than large cap companies. Generally, these companies are in their initial growth stage and thus, offer the maximum scope of growth for your investments. However, the risk associated with such companies is also on the higher for the same reason. Based on your risk appetite, these funds should constitute around 25–30% of your total portfolio. Opt for higher investment if you have a high risk appetite and/or if your investment horizon is long.

Diversified/multi-cap/flexi-cap funds: An easier alternative to allocating funds between large-, mid- and small-cap funds is to invest the bulk of your equity portfolio in 3 or 4 diversified or multi-cap or flexicap funds. These funds have the flexibility to take advantage of investment opportunities across market capitalization and sectors and thus, align their investment according tochanging market conditions. Moreover, investing in two or more diversified equity funds would also allow you to achieve diversification in terms of fund houses. So, even if one fund underperforms the market, the rest will take care of your portfolio. Under this approach, the rest of your portfolio can also consist of 1 or 2 funds in large-cap or mid-cap or sectoral fund space depending on your risk appetite and market assessment.

• DEBT FUNDS:

Accrual funds: Accrual funds invest in short-term debt instruments with the intent of generating interest income from them. As these funds stay invested in short-term debt instruments till maturity, they are less susceptible to interest-rate risk. These funds are best suited for investors preferring stable returns from debt funds.

Long-term income fund: These funds invest in debt securities with the maturity of more than 3 years. As these funds are highly vulnerable to fluctuation in interest rates, invest in them only if you have  high risk appetite with an investment horizon of 2-3 years.

Short-term income fund: These funds invest in debt instruments with maturity of up to 3 years. As they perform the best during the falling interest rate scenario, opt for these funds if you have low to moderate risk appetite with an investment horizon of 9 to 12 months.

Fixed Maturity Plans (FMPs): These are closed ended debt funds with a pre-specified date of maturity. As these funds invest in debt securities of similar maturity, they eliminate the interest rate risk. Opt for these funds if you have a low risk appetite with defined goal at the end of the maturity of the fund.

The best way to build a diversified mutual fund portfolio is to select fundson the basis of your financial goals, investment horizon and risk appetite. However, while doing so, take caution to avoid investing in too many funds as it may be cumbersome to track them. Also, adjust your portfolio periodically as per your age and requirement. For instance, while equity funds may form the bulk of your retirement corpus when you are less than 35­­–40 years, the share of debt funds should steadily increase as you approach your retirement age.