After asset allocation at broad level of debt-vs-equity, the second level of asset allocation that a portfolio must do is within these asset classes. There are a wide variety of funds available within both debt and equity.
The world of debt funds is an orderly one and the funds are rather neatly arranged in terms of the time horizon of the securities they invest in. While studying the impact of these is a science by itself all that an investor needs to do is to match the time horizon of the fund to his own. Thus very short-term money must go into ultra-short term funds, short-term into short-term and so on. The longer the period, the more volatile funds tend to be when interest rates change. This makes it dangerous to invest in longer-term funds for short periods of time.
While diversification within debt funds is a straightforward issue, equity funds are a different kettle of fish. The general approach that should be followed is to devote a large part of the portfolio to what can be called 'core' funds and the rest to supporting funds.
The next thing to understand is what are core equity funds and how much you should invest in them. The idea behind a core fund is that it should be a fund that is able to deliver returns in good times without being too volatile. While almost any fund can deliver returns when the markets are rising (as is obvious nowadays), it takes a special skill to keep a fund relatively stable during volatile or bad times. The Value Research star rating system is based on a methodology that captures the returns that a fund generates relative to the risk it takes. On ValueResearchOnline.com, you can peak behind the scenes and see how different combinations of risk and return can earn different funds the same rating.
For example, the June 2013 list of large cap equity funds has six funds that have a five star rating. Of these, Franklin India Bluechip has below average risk grade and above average returns grade. In contrast, IDFC Nifty has an average risk grade and high returns grade. Thus, compared to Franklin India Bluechip, IDFC Nifty delivers higher returns but takes more risk in doing so.
This is the kind of insight that should be the key driver in deciding which funds should form the core of your portfolio. In general, the core should be composed of funds that offer stability coupled with returns. It is dangerous to judge funds purely by short-term returns. Long-term risk-adjusted performance through a wide variety of market conditions should be the key parameter for selecting core funds.
Beyond the core lie the supporting funds, whose main functions is to fill up gaps that our core funds may leave and to add a chance of getting extra returns at the cost of extra risk. Of course, there may actually be no need for any non-core funds at all. If you are a conservative investor then you should, by all means, make core funds 100 per cent of your equity holdings and not bother about anything riskier. However, judiciously choosing some non-core funds can help. For example, your core funds could well be all large-cap funds. Adding 10 or 20 per cent in funds that focus on mid-caps could enhance your returns during the times when mid-caps are outperforming large-caps. Since mid-caps are also likely to be more volatile than large-caps, the exposure should be limited.
On the same principle, you could also use sector funds as non-core holdings. However, this needs to be done with a great deal of care. You could read the ad of a sector fund and buy into the argument that you need to invest in that sector but if the sector is worth investing in, the chances are that the managers of your other funds have already invested in it. If you analyse your portfolio using the online tools in the portfolio manager at
ValueResearchOnline.com, you can see how much of your money is invested in each sector.
If you decide to invest in a particular sector then you are actually saying that there is something wrong in the sectoral break-up that the fund managers of your existing funds have chosen and you need to correct that. Clearly, you should think of sectoral funds if you are really sure you know what they are doing.
How many funds?
How many funds should your portfolio have? After all, it is entirely possible to invest in just one balanced fund and be done with your portfolio. While this ultra-simple approach has its good points, in practice you should diversify a little bit because any individual fund manager can make mistakes. Diversification helps guard against such mistakes. In our opinion, two to four equity funds and one or two debt funds are quite enough for each type of fund that you need. So if you want a portfolio that needs short-term debt funds, floating rate debt funds, large-cap diversified equity funds and mid-cap funds, then one fund each in the two debt categories, three large-cap funds and three mid-cap funds are quite enough. Beyond this you are just going to add complexity of management without buying any additional stability.
Of course, looking at the actual portfolios that people send us, most investors tend to err on the side of having too many funds rather than too few. Portfolios of around 20 funds are actually quite common and 50 or more are not unheard off. To make matters worse, many of these portfolios actually have very little diversification because investors tend to buy many funds of same type that they like. One portfolio that we came across recently was a collection of practically every mid-cap fund in the country. This is not diversification by any stretch of the imagination.
Evolving a Portfolio
The last and possibly the most important part of building a great portfolio is that it must be monitored and must evolve to suit changing conditions. One major imperative for change could be that a formerly good fund could start consistently underperforming. This shouldn't but can happen even with a well-chosen fund. Of course you must not jump the gun and fire a fund for short problematic periods but if a fund is doing considerably worse than others of the same type for more than a year, you should think of switching to another one.
The other reason for changing a portfolio is that the time when you will need the money is getting nearer. A portfolio that started out as a five-year, medium-term investment will be a short-term portfolio four years later. The solution is clear--portfolios must be reworked as the time to liquidate them gets nearer. Otherwise, your hard-earned equity returns could get wiped out in a bear market just as you need the money. As the time comes nearer, you must start moving the money into debt funds gradually, perhaps a year or two beforehand. This is crucial in protecting you returns.
The overall message of what we are saying is really that while portfolio construction is not rocket science, it requires a great deal of careful thought and systematic actions. Besides great returns and just the right amount of risk, the most important payoff of building a portfolio methodically will be peace of mind. You'll know what you are doing and why you are doing it and you'll sleep peacefully at night for having done it.