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Suresh Krishnamurthy

ARRIVING at a selection of mutual funds to include in a portfolio is a tricky challenge. There are close to 100 equity funds to choose from now. Selecting two or three from this list is difficult.

The question of allocation of one's monies across the funds selected is another factor.

Essentially, the exercise requires that the investor:

— Understand the character of the funds

— Understand his investment objective

— Marry the two

Choosing the universe: To start with, the investor has to decide on a set of mutual funds. Choosing a set from the universe of mutual funds will make it easier for the investor to keep abreast of the developments in each fund.

For example, we chose 10 mutual funds for evaluating the impact of diversification. The 10 represent the sub-set from which combinations for two- and three-fund portfolios were made. Investors can decide on a set of funds that has a higher or lower number.

Such a universe will be helpful in making changes to the portfolio as and when required.

However, the choice of funds that need to be part of the universe involves the exercise of judgement and the investor needs to be careful.

The case for a higher number of funds in the universe is less convincing. A higher number of funds will ensure that a higher proportion of the out-performers will be part of the list. However, a higher proportion of under-performers will also be present in the list. In fact, a number of average and poor performers dominate the list of equity mutual funds. This increases the probability of backing a downright loser.

In contrast, a universe with a lower number of funds is more appealing. This is also because of the consistent presence of a handful of funds among top performers. For example, Zurich India Equity, Bluechip, Templeton India Growth Fund and Alliance Capital Tax Relief sport impressive performance records across varying periods.

In this backdrop, by choosing from a smaller universe of funds, an investor is unlikely to miss out on a consistent out-performer. A possible set of mutual funds to choose from could be: Zurich India Equity, Franklin India Prima, Alliance Capital Tax Relief and Templeton India Growth Fund. This could be expanded to include Alliance Equity, Franklin India Bluechip and Birla Advantage, if the investor desires.

However, it is essential that inclusion and exclusion from the universe is carefully deliberated. A fund should not be included or excluded merely because of its performance over a particular period. In effect, you would end up chasing performance. This, however, may backfire if the trends reverse. For example, had you invested in Alliance Equity or Birla Advantage in early 2000, your experience would have been quite bitter.

Understanding funds: Investors need to understand the character of funds on offer. For example, funds such as Zurich India Top 200, Franklin India Growth, Alliance Frontline Equity do not aim for substantial out-performance. They aim to outperform their benchmarks, such as BSE 200 or National Index, without taking as much risk. Their strategy is higher returns per unit of risk.

Zurich India Equity, Bluechip and Alliance Equity are funds that take concentrated exposures to large-capitalisation stocks and seek to deliver significantly higher returns. On the other hand, funds such as HDFC Growth, Templeton India Growth and Sundaram Growth blend "value-investing" into their investment strategy that still may predominantly include growth stocks. In contrast, the universe of stocks is itself wider, and different for funds such as Prima and a host of other mid-cap funds launched now.

Knowing these characteristics may help you pick funds from each basket to represent that investment strategy or style that you are comfortable with. For example, you can invest in the portfolios of a large-cap aggressive growth fund or a large-cap index tracking fund, a mid-cap aggressive growth fund and a fund with a value bias.

Knowing these characteristics will also help you pick funds that suit your investment objective. For example, if you are not chasing (or do not have to chase) large returns a low-risk, relatively low-return fund such as Zurich India Top 200 may suit your objective. For this, you also need greater clarity on investment objectives.

If these are in place, you can expect your portfolio to perform both in line with your expectations and in line with the average performance of equity funds. Any divergence will, at least, not shock you.

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