How to Earn Respectable Alpha by Creating a Suitable Equity Mutual Fund Portfolio

October 22, 2021 Mutual Fund

Equity mutual funds have the potential to generate market-beating returns, however with more than 10 equity mutual fund categories available, it can be challenging to select the most suitable ones. Notably, for many investors nearly half the categories are irrelevant.

Selecting the right category is an important step in creating a successful equity mutual fund portfolio. Once you have selected a suitable equity mutual fund category, the task of choosing the right scheme becomes a lot easier. It also allows you to tread the path of wealth creation without much worry.

Why choose the right equity mutual fund category?

Often investors make the mistake of choosing schemes from the current top performing mutual fund categories or chasing themes that are the flavour of the season. What most investors fail to realise is that investment should be strictly based on your risk appetite and investment horizon.

It is important to note, that some equity mutual fund categories have the potential to generate higher returns compared to others, but these could be more volatile in the nature. For instance, during a broad-based market rally, such as the one we are witnessing now, Mid-cap Funds and Small-cap Funds tend to outperform Large-cap Funds, and therefore, attract lot of investors. However, when the market corrects, mid and small-cap funds are the worst hit, causing investors to prematurely redeem their investments.

This can prove to be a hurdle in realising your financial goals. But by customising your investment as per your needs, you will be able to earn a decent alpha from your equity mutual funds without taking unnecessary or excess risk.

In this article we will look at the equity mutual fund categories for investors with different time frames such as, 3 years, 5 years, 7 years, etc. We will also discuss various categories for investors with varying risk profiles viz. conservative, moderate, and aggressive.

1) Mutual Fund categories for less than 3 years

Since the equity market is at an all-time high, there is a possibility of correction in the near term. Therefore, an investment horizon of less than 3 years is ideally suited for pure debt mutual fund investments. However, if you are willing to take risks, you can consider investing in Conservative Hybrid Funds. These funds are more inclined towards debt instruments (75% to 90% of its assets) and come with a small equity allocation (10% to 25% of its assets) to boost returns, as compared to pure debt schemes.

Investors with moderate risk profile consider investing in Arbitrage Funds. These funds take exposure in hedged equities (derivatives), which makes it less volatile than pure equity mutual funds and other hybrid mutual funds. Ensure that you have an investment horizon of at least 6-12 months so that the fund managers have sufficient time to explore arbitrage opportunities.

Conservative investors and those having an investment horizon of less than 6-12 months should avoid equity exposure. You can look at relatively safer debt mutual fund categories such as, Overnight Funds, Liquid Funds, Ultra Short Duration Funds, and/or Bank deposits.

2) Mutual fund categories for 3 to 5 years

Investors with a time horizon of 3 to 5 years can explore pure equity mutual fund avenues. However, the time frame is not sufficient to assume higher risk. Therefore, it is important to balance the risk with some debt component.

Consider relatively stable equity-oriented categories such as Large-cap Funds, Flexi-cap Funds, along with hybrid mutual funds such as Aggressive Hybrid Fund or Balanced Advantage Fund.

Decide the weightage in each of these schemes based on your risk tolerance. For instance, investors with moderate risk profile can have higher exposure to Large-cap Funds and Hybrid Funds but lower allocation to Flexi Cap Funds. This is because Flexi Cap Funds have the flexibility to increase their allocation to mid-cap and small-cap stocks if it has positive outlook on the segment.

Similarly, if you are averse to taking higher risk, you can skip investing in Flexi Cap Funds altogether.

3) Mutual Fund categories for 5 to 7 years

This is an ideal time horizon for investors seeking high returns from high risk, but not ideal for investments with very high risk. You can allocate money in categories such as, Large-cap Fund, Flexi-cap Funds, Mid-cap Funds, Large & Midcap Funds, and Aggressive hybrid Funds.

Assigning appropriate weightage in these categories can give your mutual funds portfolio the power to generate high alpha over the long term. It will also give you the benefit of diversification across market caps and enable you to earn optimal risk-adjusted returns.

As mentioned, it is important to allot weights in these categories after assessing your risk profile. Limit your exposure in relatively risky categories such as Mid-cap Fund and Large & Midcap Funds if you do not have the appetite for higher risk.

4) Mutual fund categories for 7+ years

The horizon of 7 years or more is sufficient for equity mutual fund investors looking to realise long term goals by following an aggressive approach. However, you still need to allocate money in different categories based on your needs and diversify to mitigate the impact of volatility.

Even if you are an aggressive investor, Large-cap Funds should form a part of your core portfolio. Along with Large-cap Funds, you can consider adding Flexi-cap/Multi-cap Funds, Mid-cap Funds, and Small-cap Funds. Remember that even for very long term goals, it is not advisable to go overboard with your investment in Mid-cap Funds and Small-cap Funds.

Moreover, to boost your returns over a period of time, you can consider diversification towards International Funds and/or Sectoral & Thematic Funds. But ensure that the allocation to these funds does not exceed 15% to 25% of your entire mutual fund portfolio.

Final words…

Picking the right mutual fund category is an important first step, however, the job is only half done. You need to select worthy schemes within each of these categories that have the potential to generate high alpha, and thereby realise your financial goals.

This article first appeared on PersonalFN here