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How to select best mutual funds: lessons from football

Jul 6, 2018 / Dwaipayan Bose | 75 Downloaded | 5227 Viewed | |
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We get many queries in Advisorkhoj asking for our opinion on which mutual fund schemes to invest in order to get the best return in the future. There are thousands of funds with different risk / return characteristics and they are not always comparable. Different investors have different risk capacities and investment needs. In our view, instead of trying to look for the best funds, you should try to identify the right funds for your needs. Choosing the right mutual fund category will help you narrow your investment choices to best mutual funds that are suitable for your needs and is therefore, one of the most important steps in investing; fund selection is of secondary importance.

Before you read further, we suggest go through this topic – How to invest in mutual funds: Facts and tips

What are mutual fund categories?

Mutual fund categories are essentially product families, where different funds are grouped according to their risk / return characteristics; sometimes funds are also grouped according to the investment strategies of their fund managers. There are broadly three mutual fund categories based on risk profiles – equity funds, hybrid funds and debt funds.

There are also other specialty categories like fund of funds and solution oriented funds (e.g. retirement funds, children’s funds etc). Since the world is now gripped with soccer (football) fever thanks to FIFA World Cup, let me try to draw analogies with soccer and mutual fund categories – hopefully the football analogy will help investors understand the role fund categories play in a balanced portfolio.

Mutual fund categories and football roles

A football team has 11 players; each player has a role and a specific objective. Similarly, each and every investment you make should have a specific objective. The different roles in a football team can be broadly grouped into 4 roles or categories. Firstly, there is the goal-keeper, whose sole objective is to prevent the ball from entering the goal – think of conceding the goal as losing money. You can think of the safest investments, e.g. liquid funds, ultra-short term funds, money market funds etc as the goalkeeper of your portfolio.

The next category of football players is the defenders – their primary role is to prevent the opponents from threatening the goal and their secondary role is to move the ball forward to the attacking players. The secondary role is very important, but defenders cannot ignore that their primary objective is to prevent the risk of a goal being scored. You can think of debt mutual funds as the defenders of your portfolio – they provide protection but also help you get returns. There are different types of defenders in a team – center backs mainly provide protection to the goal keepers, but also move the ball forward to the midfielders. The overlapping full backs, right back and left back, protect the flanks and at the same time join in attack. Similarly, there are different types of debt funds with different risk characteristics – short term accrual based debt funds(short duration funds) are the centre backs, while long duration funds, dynamic bond funds etc are overlapping full backs of your portfolio.

You can read – Should you invest in long term debt funds or avoid

The third category of footballers is the midfielders. They form the link between defense and attack and their role is extremely important in modern football. When the opponent team is attacking, midfielders break up attack and when their own team is attacking, midfielders join the attack. You think of hybrid funds (Dynamic Asset Allocation or Balanced Advantage Funds) as the midfielders of your portfolio. In volatile markets (equivalent of opponents attacking in football) hybrid funds will try to limit downside risks, while in bull markets (when you are attacking in football) they will try to generate good returns.

There are different types of midfielders in well balanced team in modern football – defensive midfielders, whose has mainly defensive responsibilities, box to box midfielders, who cover the entire field from their own penalty box to the other and has both offensive and defensive responsibilities, and attacking midfielders who mainly have offensive responsibilities. You can think of Conservative (Debt Oriented) Hybrid Funds as your defensive midfielders, Dynamic Asset Allocation Funds as your box to box midfielders and Hybrid Equity Funds as your attacking midfielders.

The fourth category of players is the attacking players or forwards –their main responsibility is to score goals. Equity funds are the forwards of your portfolio. Remember, forwards do not have much defensive capabilities and responsibilities – similarly, equity funds will not give protection in volatile markets. However, forwards are needed in a team because you cannot win a match unless you score goals. Think of inflation as your opponent team. In order to beat inflation in the long term and create wealth (win the match), you need to have equity funds in your portfolio.

Did you know equity is the best performing asset class in the long term

Like other football roles, there are different types of forwards - the striker (or centre forward) will be your main goal scorer, the wide forwards (or wingers) will mainly pass or cross the ball to your striker but they also have the responsibility of scoring goals. Depending on your risk appetite, large cap and multi-cap funds can be your striker, while midcap funds and small cap funds can be the wingers.

5 myths you need to know about mid and small cap mutual funds

Asset Allocation is important in a balanced portfolio

For decades, football lovers have debated, who is the best player – the names have changed from Pele versus Maradona to Messi versus Ronaldo, but they are all usually forwards or attacking midfielders. Fans love to see goals and the forwards are the ones to score, but as an investor, you should have put yourself in the shoes of a football manager or coach. You need your whole team to perform, otherwise you will not able to win matches. Argentina had the best player in the world in their team, Lionel Messi, but they had to exit the 2018 World Cup early, because their midfield was not able to stop counter-attacks and their defense / goal keeper was leaking goals. In order to win match, you need to have a balanced side, the right mix of defenders, midfielders and forwards. In investing parlance, this is known as Asset Allocationthe mix of debt funds, hybrid funds and equity funds in your investment portfolio.

You can read: What is asset allocation and market cycles

Right Asset Allocation for you

The technical football term for the equivalent of asset allocation is known as formation. Various types of formation (excluding the goal keeper) are employed in football like 4-4-2 (4 defenders, 4 mid-fielders and 2 forwards), 5-3-2, 3-5-2, 4-5-1, 4-3-3 etc. 5-3-2 for example is an ultra-defensive formation, while 4-3-3 is a very attacking formation. The formation will depend on your objectives. If you have relatively weak team playing against a very strong attack like France or Belgium, you may want to opt for a defensive formation. On the other hand, if you are down by a goal, you will bring an extra forward to give you greater goal-scoring chances. Similarly, your asset allocation will depend on your risk appetite and goal timeline.

How to choose the right mutual fund categories

Like the football team manager, you should first clearly define your objectives. You should also assess your situation and determine your risk capacity. If you have high risk capacity (e.g. when you are young, have low debt etc), your asset allocation will be aggressive and skewed towards equity funds. For moderate to moderately risk capacities hybrid funds are suitable and for low risk capacities, debt funds are suitable. If you have long goal time-line (say to 5 to 10 years or longer) then aggressive asset allocation is suited to give you the best results and equity funds are suitable investment options. For medium term (3 to 5 years) investment tenors, hybrid funds are suitable and for short term (less than 3 years) investment tenors, debt funds are suitable. For parking money for a few weeks or months to a year, liquid funds and ultra-short term debt funds are suitable. If you want to save taxes under Section 80C, then invest in Equity Linked Savings Schemes (ELSS).

The market regulator, SEBI through its circular to Asset Management Companies (AMCs) in October 2017 has defined multiple sub-categories within each of the five broad categories viz. Equity Schemes, Hybrid Schemes, Debt Schemes, Solution Oriented Schemes and Other Schemes.

Within the broad equity fund category there are 10 sub-categories, within hybrid funds there are 6 sub-categories and within debt funds there are 16 sub-categories. What we want to stress is that, selecting the right asset class / category (equity, hybrid and debt) is much more important than selecting the sub-category. I have seen investors spending a lot of time, analyzing whether X small cap fund is better than Y midcap fund and when the market falls by 10 - 15%, the same investors start to panic; maybe equity funds, in the first place, is not the right category for these investors.

Read – Are your risk averse: Understand your risk capacity

Remember asset allocation and investment tenors are the two most important factor driving investment results – if you get your asset allocation and investment tenors right, then most of the battle is won; the remaining part of the investment process viz. sub-categories and fund selection are nuances, which will help you fine tune outcomes. However, we understand that many readers may want to know how the sub-categories will help them make investment decisions. A discussion on the new sub-categories defined by SEBI is outside the scope of our post, but we have already givenyou some pointers for selecting sub-categories through our football example earlier.

Let us discuss it a bit more.

Selecting the right mutual fund sub-categories

Since I used to play a lot of football in my school and university days, I like to look at investments from a football perspective. Even if you do not understand football very well, but at least know the basics, you will find this approach useful. Firstly, bucket your investing needs into the three broad categories - defenders, midfielders and attackers (forwards). This will form the basis of your asset allocation. We discussed earlier that within each of the three broad roles, there are sub-roles e.g. in defense, some players will have purely defensive roles, while others may have both defensive and attacking roles. These sub-roles (centre back, right back, left back etc) are like sub-categories.

Defense and attack are essentially volatility profiles from an investment perspective – different sub-categories have different volatility profiles, e.g. short duration funds are less volatile than long duration funds. If you are a conservative manager, then you may want most of your defensive players to concentrate only on defense. Usually defensive structures in football have 2 centre backs and 2 over-lapping right and left backs, but some teams play with 3 centre backs and no overlapping full-backs. Similarly, if you have low volatility appetite, you may want your entire debt portfolio to comprise of low duration funds. Volatility appetite is driven by tenor – if your investment tenor is 1 – 2 years, then you should avoid long duration funds. On the other hand, if you have appetite for volatility and 3 years plus investment tenors, then you can go for a mix (say 50:50) of low duration funds and long duration funds.

Back to football, the manager may chose midfielders depending on the requirements for the situation. In a balanced midfield, the manager will select one defensive midfielder, one or two box to box midfielders and one attacking midfielder, but if the manager wants to provide more protection to the defense he will select two defensive minded midfielders. If the manager wants to strengthen the attack, he will have more attacking midfielders. Different hybrid funds have different volatility and returns profiles. If you want stability in the short term but higher than fixed deposit returns in the medium term, then you should invest in conservative hybrid funds. If you want stability in volatile markets and at the same time, higher returns in the medium to long term, then dynamic asset allocation funds (balanced advantage funds) or equity savings funds are suitable – note that in the short term, dynamic asset allocation funds or equity savings funds can be more volatile than conservative hybrid funds. If you have a higher tolerance for volatility, then you can invest in aggressive balanced funds.

Likewise, different types of equity funds have different risk/return characteristics. Small cap funds lie at one end of the volatility spectrum (most volatile in the short term, but may give the highest returns in the long term) and large cap funds lie at the other end. Multi-cap funds, which invest across different market cap segments, lie in the middle of the volatility spectrum – they are not as volatile as small and midcap funds and at the same time, have the potential of giving higher returns than large cap funds. As such, most investment experts recommend large cap and multi-cap funds to form the core of the investors’ equity portfolio.

Did you know the difference between investing in large cap funds versus midcap equity mutual funds

Conclusion

Is there an ideal category allocation model? Different financial advisory portals and robo-advisors have developed ideal or optimal category allocation models. But in our opinion, there is no such thing as an ideal category allocation because every investor is different, their temperaments are different, risk appetites are different and investment tenors, based on their personal situations, are different.

Did you know what are simple asset allocation strategies for different risk profiles

Your mutual fund portfolio is your football team, different mutual fund schemes are the players and you are the team manager. You will decide how to select your team based on what your needs are. You should consult with your financial advisor, to clearly define your financial goals and select the right category / sub-category and funds that will enable you meet your goal. We hope that through this post, we have given you some pointers as to how to go about selecting theright mutual fund category.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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