How to profit through mutual funds

The recent correction in the stock market has left many investors unsettled. It is quite common to see many investors moving to sidelines every time the market turns volatile or "corrects" itself. I am sure as the market starts rallying again, some of them will move back quickly but would be willing to move out even more quickly at the next sign of downside volatility.

No doubt, watching the value of investments go down day after day can be pretty tough. However, the pain becomes more bearable if one follows a proper investment plan and invests for the long term. Having a well-diversified portfolio as well as a plan to rebalance it from time to time also helps a great deal. No wonder, mutual funds are considered to be the best way to invest in stock markets.

Successful mutual fund investing requires a plan as well as the discipline to stick to that plan. Over the years, MFs have proved to be an ideal and effective investment vehicle to build wealth while managing risk. While it is quite natural to be concerned about the safety of one's hard earned money, it is important to understand that the level of risk has direct co-relation with the potential to earn returns. As the level of risk increases, both volatility and return potential increases proportionally.

MFs allow you to allocate investments assets across different fund categories to achieve a variety of risk/reward objectives thereby reducing overall portfolio risk. In other words, the right way to benefit from MFs is to balance the risk as well as the potential to earn.

For that, one needs to know the right meaning of risk. Simply put, risk refers to the fluctuations in the NAVs and can range from stable to very volatile. No wonder, identifying the right level of risk tolerance remains one of the major factors in determining an optimum investment strategy for a mutual fund portfolio.

There are three categories of overall risk tolerance: conservative, moderate or aggressive. 

While a conservative investor will accept lower returns to minimise price volatility, a moderate investor would be all right with greater price volatility than conservative risk tolerances to pursue higher returns. An aggressive investor will accept large swings in the NAVs to seek the highest returns.

While trying to determine your risk tolerance, the following guidelines can be of help:

First of all, you need to determine your comfort level. In other words, if you are not confident with a particular level of risk tolerance, then select a different level.

It is important to be realistic with regard to volatility. Always consider the effect of potential downside loss as well as potential upside gain.

It is necessary to adhere to the principles of effective diversification, irrespective of the level of risk tolerance.

You need to reassess your risk tolerance periodically. Remember, your risk tolerance may change either due to adjustments in return objectives or to a realisation that an existing risk tolerance is not suitable for your current situation.

Having understood the process of determining your risk tolerance, let us now discuss about the right way to select the funds for your portfolio and ensure success over time:

Select the funds that are right to achieve your goals:
It always helps to begin with a specific type of fund with a specific investing objective. However, over a period of time, one need to build a portfolio that includes equity as well as debt funds with various investment objectives and investment styles for maximum diversity.

Achieve the right level of diversification:
The right level of diversification can be achieved when you invest in different asset classes such as equity and debt. For further diversification in equity portfolio, you could invest in sub asset classes such as large and mid-cap stocks well as value and growth funds. For debt portfolio, you could invest in funds with varying maturity profile and credit quality.

While selecting an equity fund, it is important to keep the investment objective and risk profile in mind and the mix of funds selected for the portfolio should reflect that. For example, if you are an aggressive long-term investor, mid-cap and small cap funds have a definite role to play.

Another thing to remember is that if you decide to invest in a sector, make sure you don't have another fund in your portfolio that has substantial exposure in that sector. Besides, fund managers have different philosophies and styles. It is important to include funds with different styles to benefit from them.

Monitor your portfolio:
While it is critical to evaluate a fund at the time of investing, it is equally important to monitor its performance. Apart from monitoring the performance of the funds in terms of returns, it is necessary to keep an eye on the developments in the fund houses in your portfolio.

For example, if the fund manager changes or the fund manger suddenly changes his fund management style or the composition of the portfolio starts looking different compared to what you saw at the time of making investments, it can have a bearing on the performance of your funds.

Besides, it is important to evaluate your fund's performance in the right way. It is quite common to see many investors or advisors comparing the fund's performance with its benchmark. While there is nothing wrong in doing so, it may not give the accurate picture of how well the fund is performing. The right way to access this would be to compare the fund's performance with the peer group.

Look beyond good performance:
Good performance is a subjective thing. Ideally, to analyze performance, one should consider returns as well as the risk taken to achieve those returns.

Besides, consistency in terms of performance as well as portfolio selection is another factor that should play an important part while analysing the performance.

Therefore, if an investment in a mutual fund scheme takes you past your risk tolerance while providing you decent returns, it cannot always be termed as good performance.

In other words, you need to address the question as to how much risk did the fund manager subject you to, and did he give you an adequate reward for taking that risk. Besides, you also need to consider whether your own risk profile allows you to accept the revised level of risk.

There are several techniques to determine a fund's stability. Some of them are:

Beta factor: A standard beta is 1.00. If a fund has a beta of 1.10, it should perform at 10 per cent better than the index it is benchmarked against during an up market and 10 per cent worse during a down market. A low beta, below 0.80, signifies that the fund's market-related risk is low. You can check a fund's beta to make sure the risk matches your objectives and risk tolerance.

Alpha factor: A positive alpha means that a fund has performed well, given its beta factor. Alpha indicates whether the fund manager has added value to a fund's return given the level of risk taken. For example, if a fund has a beta of 1.2 and the market index returns 10 per cent, the fund should return 12 per cent since it took on 20 per cent more risk. If the fund actually performs 13 per cent, the fund has a positive alpha of one per cent.

Standard deviation: Standard deviation reflects the degree to which returns fluctuate around their average. It is based on monthly returns over a period of 36 months. The higher the number, the greater the volatility.

The standard deviation generally works better than beta as it is not based on the relationship of return to fluctuations in the index.

Ideally, your advisor should be able to guide you through this entire process of selection, monitoring and elimination. However, it always helps to know these factors to be able to grow as an investor and achieve the success on an-going basis.

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