Why You Need a Portfolio Approach in Mutual Fund Investment?

Mutual Fund Portfolio Strategy

Mutual Funds offer the investors various benefits – cheap diversification, professional management and economies of scale to name a few. But, that does not mean mutual funds are flawless. One of the limitations of mutual fund investment is that they are not completely customized to a specific investor. There are thousands of schemes and they are customized for different classes of investors – the keyword here is “classes”. So, every investor needs to understand that he/she does need to create an effective portfolio customized for his/her specific needs and situations even if he/she is investing in mutual funds.

Tell Why We Need This …

Let us see what are the reasons for which a portfolio approach is preferred.

1. Personal risk, return and liquidity requirements.

Before you start deciding on what mutual fund to invest in, you need to be clear about what you need to achieve though that investment – not what you want to achieve but what you need in light of our needs and circumstances.

This is defined by three major factors –Return, Risk Tolerance, and Liquidity.

Now, the return requirement should be defined by a set of well thought out financial goals.

The risk tolerance has two sides – risk attitude and risk capacity. Risk attitude is defined by  the psychological makeup of the investor about risk. Some people are fundamentally more risk taking while some people are fundamentally risk averse. Risk capacity is a more tangible measure of risk tolerance and measured by various factors including age, employment or employment prospects, type of employment, number of dependents in the family, etc. Just because someone is comfortable with risk defined by risk attitude, does not mean he should take higher risk if the risk capacity is low. The alternative is also true- a risk averse person may end up with a low return portfolio even though his risk capacity warranted a higher return portfolio.

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A perfect match in risk attitude and capacity is rare and when in doubt, take decisions based on risk capacity.

Now, let us talk about Liquidity- the most neglected issue by retail investors. Consider this case – say someone just starting to invest in mutual funds. He inquired and ranked the schemes by return. It is quite likely that some equity fund will top the list. So, he chose the equity fund and invested all his disposable income to that scheme. Now, after three months an unforeseen incident happened and now he needs money. He liquidated some part of the equity fund.

There are a couple of issues with the approach taken here –

1. Because he chose an equity fund, it is much likely to be volatile and three months is a small time for any equity strategy to play out. He can actually get less money than he invested.
2. Because it is an equity fund, he was charged a considerably higher expense ratio, which was deducted from the Net Asset Value even if the scheme did not grow.
3. Even if there is a NAV growth, he will have to pay a short term capital gains tax.

The point is, like return and risk tolerance, liquidity is a major factor for financial planning. We tend to make stupid mistakes in a liquidity crunch and higher than required liquidity lowers our return prospects.

2. Rebalancing

Re-balancing is an important topic. Re-balancing is required for different reasons – changes in the economic conditions, periodic re-balancing between asset classes to maintain strategic asset allocation and changes in the situations of the investor.

In case of a mutual fund, re-balancing required for the first two reasons are managed by the fund managers. But, re-balancing required for changes in personal financial situation needs to be done by the investor. Now, if the investor is only invested in one mutual fund, re-balancing cannot be done.

Consider an example, a young salaried employee started investing in mutual fund. At that time, he started to invest in equity funds based on his risk profile. In the next five years, he gets married and become a father. His risk profile has obviously changed because of one (or more) dependents. Does it make sense to stick with the same fund that he started with? No, his portfolio needed re-balancing at different life events. Now, he is carrying a bottle (of a single scheme) of much higher risk that his situations warrant. Re-balancing is possible in a portfolio approach of mutual fund investments.

3. Fund Management Diversification

One factor of return from a fund is the skill of the fund management. Unfortunately, it is quite difficult to predict which fund managers will outperform others. A portfolio approach in mutual fund investment gives a diversification benefit in this respect.

Conclusion

Mutual funds are not a completely tailor made solutions for individual investors. A portfolio approach which requires understanding the return, risk, liquidity requirements, gives the ability to re-balance and provides a fund management diversification is much more effective.