The Risk-Return hierarchy of mutual funds


Posted By : Kushal Kothari
Tags :  debt equity Funds

8th November 2016 was a very important date for India. A surprise decision by Mr Modi rocked the life of 1.2 billion Indians across the nation. Much about that has already been discussed in every medium possible, India and abroad. Interestingly, there was one particular outcome of the monetary shock - it peaked the interest of Indian investors in debt mutual funds of all kinds. For a variery of reasons, deposit rates, which were already in a declining pattern, suddenly spiked down causing an alarming sense of uneasiness among the fixed deposit investors to look for better avenues outside their safe and secure bank deposits.

 

This is when a lot on money started flowing into GILT (Government bonds) funds and dynamic bond funds. Pitching the idea of investing in government backed safe securities that gave astounding returns in the few weeks post demonetization, a whole of lot of advisors and fund houses pulled the attention of investors to GILT and Dynamic bond funds, without providing a true understanding of the risks involved. A great many of them saw their guts twisted when the interest rate movements fluctuated their seemingly risk-free debt portfolio, adding to the woes of an already perplexed investor.

 

On 31st July 2017, SBI, the country's largest PSU bank, annouced the decision to lower the savings rate for accounts upto 1cr in value to 3.5%. Forget the FD rates, even the savings rate were now under attack. With the average FD rates being ~6.25-6.5%, a lot of interest has been garnered in the debt mutual funds that promised 8%+ returns. Most new investors tend to perceive debt funds as risk-free. However, the fact is, nothing is risk-free, not even Liquid funds! When investing in markets, one has to know that there will always be market movements in the portfolio. 

 

The most dangerous thing for an investor is not the actual volatility in his portfolio, but setting the wrong expectation of the volatility in his portfolio. 

 

Once you understand the product, the risk and return pattern, you are prepared for the unknown. On the other hand, if you invest without understanding the product enough, you are bound to get disenchanted with investing altogether and return to Fixed Deposits the next time market movements cause a swing in your portfolio. And that'll pretty much be the end of your financial planning journey. Instead of your goals driving your investments, your limited and capped FD rates will be driving (or limiting) your goals.

 

We thought we could help. There are more than 25 categories of Mutual Fund schemes out there. But only a few really matter. We picked the ones you should understand better, and normalized them on a scale of risk and return. The chart below is just a visual approximation of the kind of risk return expectations you should have from your Mutual Funds. The more extreme you go up the scale (Equity side), the longer your investment holding period needs to be to realize the risk return tradeoff as indicated in the chart.

 

Risk return scale of mutual funds


Liquid funds: We've already talked about these in detail. They are least risky in terms of price movement, though rare defaults are known to happen. This one is our favorite recommendation to park any surplus cash which you plan to invest/spend in the near short-term (<6 months).  

Money Market / Ultra Short debt funds: These are relatively risk-free debt funds. Best suited for those looking for above FD returns with controlled risks, as they provide great balance between returns and volatility. 

Short & Medium Term Debt funds - Targeted towards those with a 1-5 years investment horizon and looking for enhanced returns. It is best advised to go for GILT schemes so that the only exposure is to price movements and not towards any credit downgrades and defaults, typical of a corporate debt fund.

Credit Opportunities funds: Best suited for the risk-seeking investors, wanting enhanced returns by investing in slightly lower rated debt instruments. It is best to choose a consistent fund manager who knows to manage risks as credit events, when they happen, can happen quickly in the blink of an eye.

Long term / Dynamic bond funds: For the patient investor with a >5 yr investment horizon. Expect a lot of price movement from these funds as interest rates fluctuate. Consistent performers can deliver excellent returns over a long term horizon (>5 years).

Income Funds or Monthly Income plans: Why not add a little equity (<35%) to debt investment for better returns from the same scheme? Probably the worst idea ever! Very less tax efficient as compared to a separately managed portfolio of Debt and Equity schemes. Also, less flexibility to choose the equity fund manager. Only suited for those who are averse to review their portfolio even once a year and leave the management to the same fund manager.

Balanced funds: One of the best entry point for a beginner investor. Tax benefits of Equity schemes, with the buffer provided by upto 35% debt investments. 

Large-cap funds: Any equity investor should have some of these in the portfolio. These funds only invest in consistent bluechip companies which tend to give the most stable returns among equity funds.

Multicap funds - Consider adding a few high risk/reward stocks to a pool of blue-chip stocks with these schemes. In fact, most ELSS schemes would fit this description. Good option for relatively patient Equity investors.

Mid-caps/Sector/Small cap funds- Not for the faint hearted. Expected to see their annual returns in the range of +100% to even -100% at the extremes. Over longer a horizon, >7 years, these funds tend to give the best returns among equity schemes. However, we personally suggest avoiding sector funds as they shift the basic job of research from fund manager back to the investor. Doesn't that beat the purpose of mutual fund investing?

 

We've already written in detail about some of the categories in our series, Funds Intro. We'll keep you updated as we expand our coverage to other categories of funds as well. Hope this helps.

 

Happy Investing!

 

P.S: Some of the views above are general opinions of advisers at Expowealth. Every investor is best recommended to analyse the suitability of investments themselves or with the help of a professional adviser. At Expowealth, we help investors with a risk profiling and investment planning tool to create the best-suited portfolio of mutual funds for themselves, curated by registered professionals twice a year.