Investing in mutual funds? Diversify to reduce risks and enhance returns

Dec 3, 2018

Return tables for equity mutual funds are painted in red, at least for a period of last one year. Though the systematic investment plan (SIP) book is seen growing, investors are worried. Bout of volatility has made them rethink their investment decisions in mutual funds. Focus on asset allocation and bringing in meaningful diversification can be of immense help if one wants to earn healthy risk-adjusted returns, say experts.

Diversify – it is essential

Warren Buffett once said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” That means you ought to know a business in great depth before you invest in it. Many take it otherwise and want to invest everything in one asset class – stocks.

When one invests in mutual funds either he does not have the skill set to invest or lacks necessary time and resources to devote. It is better to diversify in such circumstances.

Not everything moves in the same direction – up or down. In the worst of the times for stock markets, individuals invested across asset classes are less hit as compared to investors betting all their money on stocks. The negative correlation between equity and gold can be used to one’s advantage. For example, one can invest around 5 percent to gold ETFs, while investing in equity mutual funds.

“Investors should ideally start with their risk profile. You need to understand what amount of risk, you are comfortable with,” says Ashish Shanker, head – investment advisory, Motilal Oswal Private Wealth Management. Getting your asset allocation right can save you from a lot of trouble.

Even within an asset class, you must diversify

Many a time investors prefer to avoid paperwork. That makes many go with one product. Some prefer to pick all the best performing schemes without giving it a second thought. Both these approaches do not work in most cases.

Going with one product generally deprives you of diversification. If you pick three or four schemes basis past returns, there is a high possibility that you will end up investing in one type of product. For example, at the beginning of 2018 had you sorted equity mutual funds basis one-year returns, then you would have got small and mid-cap equity funds as your top picks, which must be in the deep red by now.

To avoid such a situation, you must diversify within each asset class. “Investors must diversify across market capitalisation and across investment styles. A portfolio brings in benefits of diversification when you invest in both large-cap funds and mid-cap funds. You must also ensure that you have exposure to growth investing oriented funds and value investing oriented funds,” says Nishant Agrwal, managing partner and head – family office, ASK Wealth Advisors.

In bond funds, you may want to invest in a mix of high-quality bond funds focused on accrual and credit risk funds. For time being, the credit risk funds are seen with utmost caution. But a small allocation to well-managed credit risk funds can fetch superior returns, provided your risk appetite allows.

Diversify across geographies and timelines

Familiarity with the local markets and ignorance about overseas markets make them stick to a smaller lot of investment options. As individuals choose to migrate for education, employment or better lifestyle they are exposed to a new world. This should be instilled in the portfolio building approach. This not only gives exposure to various currencies but also lets you invest in businesses that you do not have in your home market. For example, Indian stock exchanges do not offer investment options such as search engine and social media, for example, Google and Facebook. However, the US does.

Indian mutual funds let you invest across the globe through feeder fund route. This effectively brings in geographical diversification. Not all equity markets go down simultaneously. While the Indian markets are down along with most emerging markets, mutual fund schemes focussed on US equities have given more than 20 percent returns over last one year. But a word of caution, do not chase the highest return offering schemes.

“Stellar performance of the US focused funds is an outcome of growth in the US economy and weak rupee compared to US dollar. In the near future, US-focused funds may offer lower returns than the returns offered in recent past,” says Ashish Shanker. It is time to moderate expectations. Exposure to mutual fund schemes specialising in stocks overseas investing should be taken more from the risk management perspective than from earning higher returns.

When you are investing in bond funds, depending on your view on interest rates, you can pick bond funds. For example, if you expect interest rates to go up, stick to short-term bond funds. If you expect otherwise, consider investing in long-term gilt funds.

You may also want to invest across the products involving varying credit risk– from bank and PSU bond funds to credit risk funds. Either take a view on interest rates or take a view on credit risk. Do not mix up. “Your core portfolio can be high-quality accrual-based bond funds. Depending on your view you may invest up to 30 percent in credit risk funds or duration funds,” says Ashish Shanker.

If you are investing in fixed income investment options with maturities—fixed maturity plans, bonds or fixed deposits—try to invest across maturities. This will ensure that all your money won’t get stuck. You keep getting cash inflow by way of maturities from time to time. You can keep deploying it at applicable rates and you reduce your reinvestment risk.

Too much diversification does not help

“You need maximum 10 schemes in your mutual fund portfolio. If you exceed, your portfolio will offer market returns,” says Nishant Agrawal.

Keep a tab of costs associated with diversification

There are no free lunches. When you diversify you have to keep a track of all your investments. Each time you rebalance you incur a cost of transaction and you have to pay taxes. Account for it before you diversify.

“Even after following the best practices while investing, if you can’t sleep at night, probably you are overinvested in equity funds. Sell down to the sleeping point,” concludes Ashish Shanker.

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