This is the second blog in a four-part series that I am writing on the subject of constructing and reviewing your equity mutual fund portfolios.
In Part 1: “Active vs Passive Funds: Where should you invest?”, we discussed index funds in great detail. In this blog, we turn our attention to actively managed equity funds.
Active equity funds invest with a view to beat the benchmarks indices. The fund manger is responsible for the selection of underlying stocks. As a result, the fund portfolio is likely to be significantly different from the benchmark index. As there are several active fund choices, you need a framework to select these funds. In my view, you can leverage the SEBI guidelines on Product Categorisation to build this framework. Let us start by building a good grasp of these guidelines.
SEBI Product Categorisation: Equity Funds
In October 2017, SEBI issued a landmark circular on Categorisation and Rationalisation of Mutual fund schemes. These guidelines have made it easy to compare mutual fund schemes. Further, you can be sure that fund managers stick to the investment universe as defined in these guidelines at all times.
As per the circular, Equity mutual funds have been categorised into 10 categories. These are Multi Cap, Large Cap, Mid Cap, Small Cap, Dividend Yield, Value/Contra, Focussed, Sectoral/Thematic and ELSS. Equity Funds can also be launched in the category –“Other Schemes” which include Index Funds, Exchange Traded Funds (ETF) and Fund of Funds (Overseas and Domestic).
The important point to note here is that an AMC can only launch one fund in each of the above categories. The only exceptions are:
(1) Index Funds/ETSs replicating/tracking different indices
(2) Fund of Funds having different underlying schemes and
(3) Sector/Thematic funds investing in different sectors/themes.
Further, the circular provides uniformity in the definition of the investment universe. It defines the large, mid and small cap stocks as follows:
Large Cap: 1st – 100th company in terms of full market capitalisation
Mid Cap: 101st – 250th company in terms of full market capitalisation
Small Cap” 251st company in terms of full market capitalisation
So, why are SEBI guidelines on Product Categorisation so important?
There are a couple of ways you can leverage these guidelines to your advantage.
First, you can be assured that the fund managers will have to adhere to the scheme mandate at all times. For example, A small cap fund will have to invest atleast 65% of the assets into companies that have a market capitalisation of less than the market capitalisation of the 250th company.
Second, you can select funds in a manner that the underlying stocks are distinct in each of the funds. This ensures that you build a genuinely diversified portfolio.
Let me illustrate this with an example. Refer Chart below. If If you were to select one large cap, one mid cap and one small cap fund, and one FOF investing overseas, your will be able to construct a genuinely diversified portfolio as the investment universe is different for each of the above categories.
There are too many choices, How do you select?
At times, you get overwhelmed with the plethora of equity mutual funds available for investments. Refer table below. As per the Association for Mutual Funds of India (AMFI) data, there are 465 equity funds (including ETFs and FOFs) that are available to you for investing. Of these, 300 plus are active equity funds and 100 plus are passive funds.
It is rather difficult to select from such a wide range of funds. But if you start by selecting the categories that you should invest in, the number of choices can be reduced dramatically. Here is a framework that leverages category definitions to select equity funds.
The simple four step process to build your equity portfolio
- Start with a small focus list of categories: The starting point is to focus on a few categories. I would suggest that you make a beginning by focussing on the categories based on capitalisation viz. Large, Mid and Small.
- Identify passive funds in these categories: For each of these categories, you would able to identify the passive funds that replicate the benchmark indices for those categories.
- Select 1 active and 1 passive fund in each of these categories: With six funds, you would have built a robust and well diversified portfolio. However, if you have a view on the active vs passive debate in that category, you may select one over the other.
- Add equity funds from other categories which can add value to your overall portfolio. For example, you may add FOF that invests overseas or you may add a sector fund that you believe can do better.
Adjust your equity portfolios as you gain experience
The above framework gives you a head start in constructing your equity mutual fund portfolio. To select a particular fund, you may use the independent fund ratings like Value Research or Morningstar. The better funds get a 4 star or a 5 star rating. As you evolve as an investor, you can create your own framework for selecting funds.
Over time, it will become easier for you to add, replace or delete funds from your portfolio. For example, you currently own a large cap active fund and an index fund that replicates the Nifty 50 index. If you find that the Nifty 50 index fund is continuing to deliver better returns than your active choice, you can choose to replace this fund. You can either buy more into the Nifty 50 index fund or choose another actively managed large cap fund that you believe can do better.
I would only add that you need to give sufficient time before you make these judgments.
Conclusion
Active fund managers aim to beat the benchmark indices and add value to your investments. The proponents of passive fund investing argue that passive funds can potentially do better than active funds as they are low cost and many active managers are unable to deliver on their mandate to beat the benchmark indices.
As an investor, you can create a diversified portfolio of active and passive funds and basis your own experience decide what works the best for you!
Now that you have some idea about constructing distinct mutual fund portfolios, it’s time to ask the question, “ Is your portfolio positioned for a differentiated performance than the index?”. I will examine this question in greater detail in Part 3 of this blog series.
