Building up Mutual fund portfolio

Selecting the right mutual fund out of more than 3,000 options in the market is tricky enough. But it can be truly daunting to figure out how to bring the right ones together to make portfolio that can outperform the index, while also being in sync with investor’s personal risk tolerance, investment objectives and tax situation. The top performers are not always the obvious choice – diversification matters, as do investor’s preferences and needs.
There’s just no one size-fits-all strategy, nor one “correct” way, to build a mutual fund portfolio. Putting together a group of mutual funds is a matter of personal preferences and goals.
An investor can use the following steps as a guide to building and monitoring mutual fund portfolio. Starting with asset allocation one starts out by selecting an asset allocation plan designed to meet his goals and risk tolerance. The rest of the investment process includes picking funds either for taxable or tax-advantage accounts putting them together in a portfolio, monitoring the portfolio over time, and rebalancing it so it remains in line with the investor’s risk tolerance.
The foundation of an investor’s portfolio is asset allocation and a preferred combination of large-cap and small-cap Indian stocks, international stocks, bonds, and cash. It determines the broad risk level of the portfolio, which should match investor’s risk profile, and is the first step towards constructing a diversified portfolio.
The basic premise of diversification is to reduce certain risks, unique to an asset class, sector or security by combining different securities together work because different asset classes, sectors and securities don’t move in tandem.
Even when well-known asset classes such as large-cap stocks are dropping, other asset classes may be rising outperforming the benchmark. When an investor puts together a portfolio of mutual funds, investor’s goal should be to outperform the relevant benchmarks for each asset class in investor’s portfolio (evaluated using index returns) without taking on excessive risk of under performance.
This guiding principle implies that we’re not going to be so conservative in our investment decision-making that we completely eliminate any upside opportunity versus the benchmark, which would be the case if we selected all index mutual funds. But we’re not going to be so aggressive that we fail to adequately diversify the portfolio within asset classes. The key to achieving that goal is picking the right funds.
When an investor selects funds for his portfolio, he should look for funds that will do well in the future and that will work well together.

These need not necessarily be funds that have been at the very top of their categories in the past. An investor should consider the following factors when picking the right funds: past performance, including past risk and style adjusted performance, the fund’s operating expense ratio, assets under management, and cash flows.
Use a blend of quantitative and qualitative analysis. The first thing to remember in evaluating a mutual fund scheme’s performance is to separate performance luck from skill.
A fund’s return is what it is for a variety of reasons, some having to do with luck and some with skill. An investor should see the fund’s year-on-year performance to see if it has been doing consistently well, or if this is just a one time good performance which has boosted returns.
A fund heavily invested in technology stocks might have performed well in the past, but remaining heavily invested in tech now may affect or lower returns. So check whether the fund’s strategy is flexible, and whether the fund manager shuffles the portfolio regularly.
The second thing to keep in mind is to look beyond past performance. Non-performance related characteristics for instance, expenses, assets under management, and cash flows into the fund can influence future performance. For example, conventional wisdom says it’s difficult for small cap managers with many assets under management to do well, because it’s hard to put large sums of money to work in management’s best investment ideas without negatively affecting the price of those small-cap stocks.
Generally, small-cap funds with low expense ratios and few assets under management significantly outperform their peers with high expense ratios and many assets under management. But keep in mind that this theory is relevant for evaluating small-cap funds, and not, for example, large-cap funds.
Which brings us to point number three: don’t use a onesize- fits-all approach. The amount of consideration, or weight, that should be given to each factor varies depending on the category.
The most critical task is, of course, creating the portfolio. It entails analyzing investor’s profile that is investor’s risk capacity, objectives for investment, time horizon, and the amount to be invested. Different factors determine the appropriate mix for an investor, how much exposure an investor should have to any asset class, and what the time horizon should be for investor’s investment.