How to diversify your mutual fund investment

Remember, equities are a long-term investment and, hence, even if a specific trend lasts one or two years, it may not earn you great returns. A sector or theme or a market-cap orientation that might have turned hot in 2010 would have become duds by now.

Jul 09, 2015 04:07 IST India Infoline News Service

Invest wisely
Mutual fund houses often show herd mentality. If one industrial sector is hot or being talked about in the market, you would suddenly find a bunch of mutual fund schemes trying to capture investor interest in that particular theme. That can be a recipe for disaster. Because such frenzies or themes are temporary in nature and the stock market itself being transient in terms of its biases, it is not healthy to go after such short-term trends when one is trying to build a long-term portfolio of assets.

Remember, equities are a long-term investment and, hence, even if a specific trend lasts one or two years, it may not earn you great returns. A sector or theme or a market-cap orientation that might have turned hot in 2010 would have become duds by now. This is a fact best borne out by the spasmodic performance of thematic mutual fund schemes.

So when you buy mutual funds, how do you choose which scheme is for the long term? First of all, the very basic thumb rule of diversification holds key even in mutual fund investment, even though most mutual fund portfolios themselves tend to have sectoral or market-cap diversification.

One can achieve this diversification by investing in a healthy mix of all kinds of equity funds – diversified, multi cap, large cap, mid cap, small cap, thematic. This will ensure that they do not lose out heavily in a downturn and earn you decent returns when the market is in an upturn.

Some financial planners would suggest you to put 70 per cent of your equity exposure in a mix of diversified (large cap and multi cap) equity funds and index funds, and the balance in themes and sectors that are more risky in nature.

Here to, the risk-reward arithmetic comes into play: the more risk you can afford to play the more returns you can hope to earn. Sectors and themes are at the bottom of the risk curve may look risky, but they can be good bets for long-term returns as all economic sectors follow the cycle of good and bad performance. Problem arises because any good thing gets overpriced quickly and thereafter starts giving negative returns.

On the other hand, diversified large cap equity funds, index funds and diversified multi cap funds carry the lowest risks, but then return expectations from these schemes should also be moderate.

There is one class of funds that bets on contrarian themes. These are counter-cyclical investment strategies, which work wonderfully well when the cycle turns. Some financial planners suggest betting on a reversion-to-mean strategy, which means relying on the norm that most fund categories end up being giving similar returns over a long term of four years or so, even though a few among them may have been star or worst performers for a year or two during this period.

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