Making apt changes to your MF portfolio, the right way

Asset allocation is the holy grail of investing! You need to first determine the amount that you should be investing in equity

There are tonnes of choices to make while investing in mutual funds. No wonder, it is fairly confusing selecting the right funds. As a result, you end up buying too many mutual fund schemes or funds that may not be right for you. So, how do you assess if you need to make any changes to your MF portfolio?

Before you begin constructing your MF portfolio, you need to first determine the amount that you should be investing in equity as an asset class. The big four asset classes are stocks, debt or fixed income, gold and real estate.

Asset allocation is the holy grail of investing! So, the proportion you invest in each of the above asset classes will determine your overall return. This is further supported by a lot of research that shows that over 95 per cent of your returns can be explained by the asset class you invest in and not individual investments within the portfolio.

Let us now discuss a simple way to construct a mutual fund portfolio. In my view, you can use the SEBI Product Categorisation for constructing a genuinely diversified mutual fund portfolio.

In October 2017, SEBI issued a landmark circular on categorisation and rationalisation of mutual fund schemes. It has not only made it easy to compare mutual fund schemes but also ensured the fund manager adheres to the scheme mandate at all times.

As per the circular, equity mutual funds have been categorised into 10 categories. These are multi cap, large cap, mid cap, small cap, dividend yield, value/contra, focussed, sectoral/thematic and ELSS. Equity funds can also be launched in the category –'other schemes' which include index funds, exchange traded funds (ETS) and fund of funds (overseas and domestic).

The important point to note here is that an asset management company can only launch one fund in each of the above categories except index funds/ETSs replicating/tracking different indices, fund of funds having different underlying schemes and sector/thematic funds investing in different sectors/themes.

The circular also ensured that there is uniformity in respect of the investment universe and defined the large, mid and small cap funds as follows:

Large Cap: 1st – 100th company in terms of full market capitalisation

Mid Cap: 101st – 250th company in terms of full market capitalisation

Small Cap" 251st company in terms of full market capitalisation

Why are SEBI guidelines on categorisation so important?

There are a couple of ways you can leverage these guidelines to your advantage.

First, you can be assured that the fund managers will have to adhere to the scheme mandate. For example, if you invest in a small cap fund, the fund will have to invest at least 65 per cent of the assets into companies that have a market capitalisation of less than the market capitalisation of the 250th company.

Second, you can select funds in a manner that ensures there is no or little overlap between the underlying stocks of the funds that have been selected by you. This used to be a major issue as investors may think they are diversified as they own several funds but in reality the underlying funds could have significant overlaps. Refer chart below. If you were to select one large cap, one mid cap and one small cap fund, and one FOF investing overseas, your portfolio would be genuinely diversified as the investment universe is different for each of the above categories.

As you gain experience, you can keep adding funds from other categories or dropping the choices that do not work for you.

In conclusion, you must always start with asset allocation. In simple terms, decide on how much of your portfolio should be invested in the stock market and the rest may be invested in fixed deposits, gold or real estate.

While investing in the stock market, a good mutual fund portfolio should be constructed in a manner that provides genuine diversification. This is achieved by investing in schemes that invest in different segments of the stock market and hence have lesser stock overlap between them. MF products are classified under various categories. In order to construct a diversified portfolio, start by creating a MF portfolio of schemes that fall under different categories.

(The author is a veteran of Indian MF industry)

Suraj Kaeley