Building a Good Portfolio

You have set a financial goal and your adviser has told you how much you should save regularly. You have also agreed that you will invest in mutual funds in a systematic manner. Now come the tough decision of selecting the funds. Should you trust the list given by the adviser? What should you look for? Let me provide some tips. I will restrict myself to equity funds here and deal with debt funds at a later date.

Identifying equity mutual funds is as important as pruning and maintaining them.

First your requirement is to invest in the equity market. The mutual fund is only a tool to get there. It is fashionable to assume that you can pick a few winning stocks and do better than a fund manager: However consider the time, effort, cost and, most importantly, your portfolio’s performance record before you do it. If you are honest with your analysis you are likely to find the mutual choice compelling.

Second, the simplest and cheapest mutual fund product is an index fund or an ETF. It gives you the exposure to equity without any risk of selection. Funds routinely publish performance data, stating that they have beaten the benchmark by a good margin. This may be factually correct, but you will get returns only if you select the winning fund at the right time. Advisers earn the least commission on index funds, so don’t wait for them to propose this product.

Third, a new fund offer at Rupees 10 is not cheaper than an existing fund at, say Rupees 100. An NFO is not cheaper than an existing fund; it just has a lower nominal value. It cannot generate a higher return than an existing fund just because it is priced at Rs 10.  But an existing fund has performance history, a track record. Unless it is an absolutely new idea, an NFO is an inferior choice to an existing fund.

Fourth, you should refuse to make a choice without any clarity on how a fund will deliver returns. If a fund manager tells you that the fund uses a process driven bottom up approach to select stocks across sectors, with a disciplined selling plan’ he is describing his job. If the fund says it will hold large cap stocks, you know it will modify sector weightage and stock weightage compared to the Nifty index, to deliver a better return. If this fund delivers better returns by picking up a few mid-cap stocks, it will amount to dishonesty.

Fifth, be clear about what you expect the fund to do and what you will do yourself. If you like to assemble your set of index, large-cap, mid-cap and sectorial funds, choose those that stick to such a definition. If you see the portfolio and performance at the fund website over 3-6 months, you will know. If you like the fund manager to do the juggling and like a loosely defined product, go for it, fully aware that you will not know what to expect. Investors like to give fund managers a long rope to do what they like as long as they deliver a return. This preference leads to more poorly defined products with fancy names.

Sixth, do not rely on past winners. What is important is to hold a well- diversified portfolio. A portfolio suffers damage when you persistently hold laggards; it is all right to miss buying a few winners at the right time as long as you throw out the rotten apples.

So, build a portfolio using a core and satellite approach. At the core of your equity portfolio should be index and large-cap funds comprising at least 50% of your portfolio. The next layer should have funds whose specific focus can be rewarding – mid-cap funds, infra funds, small-cap funds, value funds, contra funds. About 35% of your portfolio could be invested here.  The next layer should have funds that need an aggressive review. Sectorial funds, concentrated portfolios specific  strategies figure here. These will do well seasonally and need a close monitoring. This should comprise 15% of your portfolio and not over three to four funds.

If your portfolio holds too many names, acquired at different times for different reasons, you are doing yourself more harm than good.