Mutual Funds Are Your Best Bet, but Recognise Their Risk-Return Trade Off

6 MinsJune 18, 2018

The ultimate objective of any investment avenue is to earn a decent rate of return that counters inflation from eroding the purchasing power of our hard-earned money.

By far, mutual funds–––particularly the equity-oriented ones––––work the best.

Yes, there is risk involved, no doubt.

But if you select mutual funds wisely (suiting your needs), structure your portfolio astutely, and are willing to take some calculated risk based on your investment risk profile; investing in mutual funds can prove to be a rewarding experience.

Note that every category of mutual fund: equity-oriented, debt-oriented, hybrid (mix of equity and debt), and solution-oriented have their distinctive risk traits. And within each of these categories, there are sub-categories.

For example, under equity-oriented mutual funds, as per the capital market regulators diktat on mutual fund categorisation and rationalisation, there are 10 sub-categories:

1) Large cap Fund
2) Large & Midcap Fund
3) Midcap Fund
4) Small cap Fund
5) Multi cap Fund
6) Dividend Yield Fund
7) Value/Contra Fund
8) Focused Fund
9) Sector/Thematic Fund
10) ELSS (Equity Linked Savings Schemes)

Each of these has distinct characteristics defined by the regulator. For instance, a large cap fund is required to invest a minimum of 80% in equity & equity related instruments of large cap companies. Similarly, a multicap fund will invest across large cap, mid cap, and small cap stocks with a minimum 65% investment in equity & equity related instruments.

Similarly, debt-oriented mutual funds, which predominantly invest in bonds, Certificate of Deposits (CDs), Commercial Papers (CPs), Treasury bills (T-bills), etc., depending on the investment mandate of the scheme, also carry risk traits. There are 16 sub-categories debt-oriented mutual funds:

1) Overnight Fund
2) Liquid Fund
3) Ultra-short duration Fund
4) Low duration Fund
5) Money market Fund
6) Short duration Fund
7) Medium duration Fund
8) Medium to Long Duration Fund
9) Long Duration Fund
10) Dynamic Bond Fund
11) Corporate Bond Fund
12) Credit Risk Fund
13) Banking and PSU Fund
14) Gilt Fund
15) Gilt Fund with 10-year constant duration
16) Floater Fund

Each of these has distinct characteristics defined by the regulator. For instance, an Overnight Fund invests in overnight securities having maturity of 1 day. Similarly, a Credit Risk Fund invests minimum 65% of its total assets in corporate bonds below highest rated instruments, i.e. predominantly in AA and below rated instruments. A Dynamic Bond Fund, on the other hand, has the flexibility to invest across maturity (duration) papers.

So, every category and sub-category of mutual funds carries risk traits.

Risk, as you may broadly know is, a result or outcome which is other than what is / was expected. Thus what’s other than what was expected is a deviation — in portfolio management parlance; it is referred to as ‘standard deviation’ and determines the risk of a mutual fund.

When you invest in mutual funds, do not merely go by the returns clocked; compare returns to risk for a more meaningful selection, whereby you can gauge the risk-adjusted return of a mutual fund.

To gauge the risk-adjusted returns, access mutual fund factsheets and take a look at mainly the following ratios:

Sharpe Ratio – Named after William F. Sharpe, the Sharpe Ratio helps you measure the returns you can expect over and above a certain risk-free rate (for example, the bank deposit rate), for every unit of risk (i.e. SD) of the scheme. Higher the Sharpe Ratio, higher you are compensated for the risk taken by the fund. The ratio helps you recognise if the fund is justifying the risk taken.

Sortino Ratio – Named after Frank A. Sortino, this ratio evolved from the Sharpe Ratio and is a little more advanced. It measures risk-adjusted returns; but unlike Sharpe Ratio (which considers good as well as the bad volatility), the Sortino Ratio considers only bad volatility.

This ratio, in a way, sheds some light on how efficiently a fund manager has managed the mutual fund scheme. Ideally, higher the Sortino Ratio, the better it is.

The objective of doing this exercise is to have mutual funds in your portfolio that suit your risk profile and investment objectives.

If you are young and the objective is growth or capital appreciation; if you have the stomach for high-to-very high risk and an steady source of income; if you have an investment time horizon of at least five years, you’re your financial goals address long-term financial goals viz. children’s education expenses, wedding expenses, and your own retirement needs, etc., you may set a higher allocation to equity-oriented mutual funds.

The mutual funds a high-to-very high risk profile individual may consider are a combination of large-and-mid cap, mid cap, small cap, value fund, focussed equity funds, and so on. But do note that at stretched market valuations, it best to avoid small-and-mid cap mutual funds unless you are addressing to financial goals that are a decade away.

For a moderate-to-high risk profile, consider a combination of large cap funds, dividend yield funds, equity-hybrid funds, multi-cap funds, which can prove less volatile when equity markets turn volatile.

For tax planning needs, Equity Linked Savings Scheme (ELSS) also known as tax-saving mutual funds, can be considered by investors willing to stomach high risk.

If you have low risk profile, planning for short-term goals (which are less than 5 years away), and the investment objective is not high growth, but very modest returns, debt-oriented mutual funds would be appropriate. For an investment time horizon of 3 years, you may consider short-term funds or dynamic bond funds. For an invest horizon less than 3 years, ultra-short term fund and/or liquid funds would be an appropriate choice.

Should you rely on star rating to pick mutual funds?

Do note that ratings subscribe to “one-size fits all approach”. And according to Barry Ritholtz (an American author, newspaper columnist, and equity analyst), when it comes to investing, there is no such thing as a one-size-fits-all portfolio.

Moreover, after the capital market regulator’s diktat on categorisation and rationalization norms, basing investment decision on star ratings may not be a prudent approach; because several schemes have changed their fundamental attributes and many have been merged with other schemes, and thus their historical performance will have no significance.

To pick mutual funds for your portfolio among a plethora of them available, it would be sensible to seek expert opinion.

Axis Bank’s SEBI registered investment adviser’s holistic approach and superlative guidance (considering your needs, investment objectives, investment horizon, risk profile, and financial goals among many other facets) can help you select best mutual fund schemes across categories – equity, debt, hybrid, and so on.

How to invest: Lumpsum or SIPs?

Well, a combination of both. But Systematic Investment Plans (SIPs), in particular, are an effective medium of goal planning. These render market timing irrelevant, facilitate rupee-cost averaging, offers the benefit of compounding, lighter on the wallet, and infuse the discipline of saving and investing regularly.

[Read: How SIPs Can Help You Maintain Stable Financial Health]

Direct Plan vs. Regular Plan

Finally, when you invest in mutual funds you have two plans: Direct Plan and Regular Plan.

The Direct Plan was introduced by the capital market regulator in January 2013. It was made mandatory for fund houses to have a Direct Plan for all their schemes.

With a Direct Plan, you eliminate the services of a mutual fund distributor/agent, who work on commissions. You invest directly with the fund house, either offline or online.

A distinguishing feature about Direct Plan is, since you bypass a mutual fund distributor/agent and thus no commissions are to be paid, the expense ratio is lower compared to a Regular Plan.

Further, the Net Asset Value (NAV) of mutual fund scheme for a Direct Plan and a Regular Plan is separate ––slightly higher in case of the Direct Plan.

However the underlying portfolio of a mutual fund scheme, whether you invest in a Direct Plan or a Regular Plan, is the identical. This is because the fund manager follows the same investment strategy.

The three key benefits of a Direct Plan are:

• You avoid the rampant mis-selling
• The cost of investing in a Direct Plan is lower owing to the lower expense ratio
• The lower expense ratio facilitates you to earn extra returns over the long run

In a Regular Plan on the other hand, your purchase transaction is routed through mutual fund distributors/agents/relationship managers. And hence indirectly commission is paid by the fund house on the money you invest. The expense ratio for Regular Plan is thus higher compared to a Direct Plan.

To conclude…

If you select mutual funds wisely and structure your investment portfolio doing a scientific need-based assessment seeking professional guidance, it can be an enriching wealth creating experience and aid you accomplish the envisioned financial goals comfortably.

Avoid investing in mutual funds in an ad hoc manner and/or mirroring your friends and relative portfolio; it can cost your financial wellbeing.

Remember, the old adage: One man’s meat is another man’s poison.

So, be a responsible investor, select mutual funds wisely portfolio by comparing returns to risk, and be a successful investor.

Happy Investing!

Happy Banking!

Disclaimer: This article has been authored by Dialogbox, a Mumbai based Content Design firm known for offering unbiased and honest opinion on investing. Axis bank doesn't influence any views of the author in any way. Axis Bank & Dialogbox shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.