Where beginners in mutual funds should invest in the time of Covid-19

The key is to develop an asset allocation plan and then fill each slot with an appropriate fund

The mutual fund industry added more than 8.1 million folios in 2020-21, higher than the nearly 7.29 million it added in 2019-20, according to data from the Association of Mutual Funds in India (Amfi). Despite a pandemic raging throughout the year, new investors continue to join the industry and use mutual funds as a vehicle for securing their financial future.

These new investors must, however, make the right start. If they have a bad experience in their initial foray, they could get turned off mutual funds forever and lose out on their potential for wealth creation over the long term.

Decide on your asset allocation   

New investors must first take into consideration their investment horizon, their age, their stage in the wealth accumulation cycle, and their risk appetite. Those who are younger, have a longer investment horizon, fewer financial burdens, and a higher risk appetite can take more risks, that is, allocate more to equities.      

After considering these factors, they should decide on a suitable asset allocation for themselves. For instance, a 25-year-old, reasonably aggressive investor while setting up his retirement portfolio could allocate 70 per cent to equities, 20 per cent to debt, and 10 per cent to gold. A more conservative investor, an older investor, or one having a shorter investment horizon could have a 50:40:10 allocation.  

Once the overall asset allocation has been decided, investors need to decide on the sub-asset allocation. On the equity side, an investor could have, say, an 80 per cent allocation to domestic equities and 20 per cent to international equities.

The domestic equity allocation could in turn be split as follows: 70 per cent to large-caps, 20 per cent to mid-caps and 10 per cent to small-caps (conservative investors may avoid small-cap funds). More conservative investors may have a higher allocation to large-cap funds and a smaller allocation to mid- and small-cap funds, and vice versa.

These are broad guidelines. Based on the principle explained, investors should tweak these ratios to suit their specific situations, like their ability to tolerate volatility.

Generally, it is better to build separate portfolios for different goals. Suppose that you have a medium-duration goal, say, you want to accumulate the down payment for purchasing a house in five years. In such a portfolio, your equity allocation should not exceed 30-40 per cent.

Picking equity funds

First, think about a fund for your large-cap allocation. “Here, it is becoming increasingly clear that active funds are going to find it very difficult to beat an index such as the Nifty 50 over the long term, so go for a low-cost index fund,” says Deepesh Raghaw, founder, PersonalFinancePlan, a Securities and Exchange Board of India-registered investment advisor.  

For your mid- and small-cap allocation, you may use actively-managed funds. In these spaces, there is greater scope for active fund managers to beat the index. Also, there can be quality issues with many stocks (say, corporate governance related). So, blindly picking an entire index can backfire. If you wish to go passive even in this space, then go with a fund that picks stocks selectively from a broad index, based on, say, higher liquidity.       

For your international allocation, you may go with an S&P 500 based index fund.

Picking debt funds

In all portfolios, including a retirement fund, you will need some debt allocation. A pure equity-based portfolio can become too volatile and should be avoided. You also need some debt allocation because you may have to withdraw from these portfolios at some point (and you don’t want to dip into the equity portion which could be down then).

Salaried workers would already be contributing to Employee’s Provident Fund and perhaps also to Voluntary Provident Fund. Next, they can also take exposure to Public Provident Fund. Bank fixed deposits are an evergreen option. “Initially, you can manage your long-term debt allocation with these safe, government-backed instruments. Once you enter the 30 per cent tax bracket and need a more favourable tax treatment, you can turn to debt mutual funds,” says Raghaw.

The bulk of your debt fund allocation should be through shorter-duration funds. “About 80-90 per cent of your debt allocation in long-term portfolios should be in short-duration funds and corporate bond funds, where there is very little duration or credit risk. Only about 10-20 per cent should be in riskier funds like dynamic bond funds or credit risk funds,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.

For your gold allocation, you may use sovereign gold bonds if you don’t need the money for eight years. If you could need it earlier, use gold exchange-traded funds.

Mistakes to avoid

The most common mistake new investors make is to go to a platform where past returns of various fund categories are given, and invest on the basis of past performance. In the case of equity funds, the best-performing funds are usually sector funds or thematic funds, which are very high-risk (new investors should definitely steer clear of them). Similarly, investing only in mid-cap or small-cap categories, instead of building a diversified, asset-allocated portfolio will hurt investors at some point or the other.

In the case of debt funds, investing based on past returns can be even more disastrous. In the past year or so, longer-duration bond funds have done well. But now interest rates seem to have bottomed out. If inflation rises or growth picks up, interest rates could harden. In such circumstances, longer-duration debt funds could show negative returns. Most new investors will not be able to handle such volatility in debt funds.

A few points to remember

Investments in equity funds should be done with a 7-10-year horizon. “In case of debt funds, the investor should have an investment horizon that at least matches the modified duration of the fund,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisers. He adds that investments should be made through the systematic investment plan (SIP) route. Not only do they make you a regular and disciplined investor, they also help you circumvent the risk of market timing.     

Investors should also pay heed to the expense ratios of funds and avoid over-paying. “New investors should consult a Sebi-registered investment advisor who will charge them a fee for developing a portfolio and then get them to invest in direct plans, whose expense ratios are lower than that of regular plans,” says Saumya Shah, founder, Tarrakki. Avoid getting duped by people who say they are getting you to invest in a zero-commission fund but actually make you invest in a regular plan, where they earn a trail commission. 

A few crucial dos and don’ts for novice investors 

• Winner asset and sub-asset categories keep changing from year-to-year, which is why you need to build an asset-allocated portfolio     
• Do not extrapolate past returns into the future
• Do not build a portfolio consisting of only mid-cap and small-cap funds
• Skip exposure to thematic and sector funds
• Too many funds from the same category or sub-category will lead to portfolio overlap and will not boost performance
• Don’t chuck an active fund from your portfolio if it has underperformed for a short while