Let's Talk Mutual Funds: A Systematic, Smart Way to Make Them Work for You

by Monika Halan

What you need to know is that a low Sharpe ratio means lower risk-adjusted return and a higher ratio means more returns per unit of risk taken. Higher the risk-adjusted return, higher this ratio. Remember that we are not going to use ...

The Sharpe ratio measures both the up and the down volatility. What we want is a measure that gives us the upside without the downside dragging us low too badly. We use the Sortino ratio to measure downside volatility only. A high Sortino ratio tells us that the fund is safer as there is a lower chance of negative volatility. We are getting the excess return for a lower downside risk when markets go down.

You just need to remember that a higher Sortino ratio is good when you compare funds across the same category.

Do not make the error of using these ratios to compare across asset classes or even between categories. A small-cap fund will have a much lower Sortino ratio than a large-cap fund.

But we still have not removed the excess risk over the general risk in the market. A measure called alpha comes to the rescue. This measures the extra return of the scheme when compared to the relevant benchmark, for a given amount of risk that the scheme takes.

Alpha tells you whether the outperformance of the scheme was due to the fund manager’s skill of giving higher risk-adjusted return or due to higher risk. A high alpha tells us that the fund manager is good at her job—both in up-markets and down-markets.

Standard Deviation—low Alpha—high Beta—low Sharpe ratio—high Sortino ratio—high

Important. Create an excel to track this.

market experiences, flaws and learnings went into the new Risk-o-Meter that SEBI made mandatory from 1 January 2021. There were four major changes that were made.

One, the number or risk categories increased to six: low, low to moderate, moderate, moderately high, high and very high risk. Risk level 1 was low and risk level 6 was very high. Overseas funds were marked risk level 7—it was off the charts on the risk metrics.

Two, the mapping of the risk levels with the portfolios was done not on category basis but on the basis of the actual...

Three, the fund houses have to evaluate the portfolio risk at the end of every month and upload the risk rating on the AMFI site.

Four, fund houses have to count the number of times in a year the risk metric changes. Investors and advisors now have a better handle to check if the risk in the scheme they have is bounding around from low to high and then decide whether to stay in the scheme or not.

All equity schemes are marked as high risk and very high risk. Investors understand that this is a risky asset class. The real value of the Risk-o-Meter is in evaluating debt funds.

Do not make the error of bringing home the risk into the debt part of your portfolio. Do not shoot for the highest return in debt. Stay with a low risk rating of 1 and 2. Check the risk rating at least four times in a year so that you don’t get a shock.

SEBI has also made the categories truer to label than before. The chances of funds stuffing longer maturity funds in the low maturity category are now much lower. So, both the Risk-o-Meter and the new categorization make debt funds a much safer option than they were before.

One last thing you can do to manage the risk in your portfolio. Link the risk metric to your holding period. Any money you need within three years must have a low or low to moderate risk reading on the Risk-o-Meter.

Medium-term money that you need between three to seven years must have low to moderate or moderate risk. Holding periods of more than seven years you go from moderately high to very high risk.

Section 54EC bonds. Bonds issued by Rural Electrification Corporation Limited, National Highway Authority of India, Power Finance Corporation Limited and Indian Railway Finance Corporation Limited give you this benefit. If you invest the profit (limited to Rs 50 lakh in a year) in any of these bonds within six months of the sale of the property, your profit is tax free.

The lock-in is five years right now, but can change. These are low-interest-bearing bonds, and the interest you get is taxable at your slab rate. But when the principal returns to you, it is tax free.

Investors should manage their expectations when they invest in REITs. Debt plus returns and not equity returns is where you peg your return expectations. Anything over that is a bonus.

Rent, interest and dividend are taxed at slab rate. The product goes long term at three years. Short-term capital gain is taxed at 15 per cent and long term at 10 per cent, after a tax-free profit of Rs 1 lakh.

REIT

Physical gold and gold funds go long term at three years. The short-term capital gains tax is deducted at slab rate for both physical gold and gold ETFs and index funds. Long-term capital gain is 20 per cent of profit with indexation.

Sovereign gold bonds’ interest is taxed at slab rate and these go tax free on long-term capital gains after eight years. There is some confusion on whether this is five years or eight years and the answer is not clear as the tax department is yet to clarify this.

If you opt for the income distribution cum capital withdrawal—the IDCW (check page 88 in Chapter 5 to remember what these are) option in debt funds—it gets added to your income and you get taxed at slab rate.

Debt funds are now taxed similar to fixed deposits. But again, tax rules change often and check the latest rules at the time of your reading this book.

Similar to debt funds, if you have chosen the IDCW option, the money that comes into your account from the income of the fund gets added to your income and is taxed at slab rate.

For Equity funds.

We use the distance from today to shortlist products and not the return they give. The closer to today the money need, the lower will be the return and we should be okay with it.

The money that you need in the next three years must be there when you need it. You cannot have a downturn in the stock market at a time when the fees for your course abroad need to be paid or when the down payment of the house is due.

The other attribute is that the money should be liquid. You cannot go to market with a property and assume that the money will be with you in a month.

For money needs that are immediate, you need your savings deposit (or current account if you use one) to have the money to spend.

For needs within three years, the risk-free product you can use is a fixed deposit with a large commercial bank (not cooperative, not corporate deposits). We all know this product and for money you don’t mess with, it is still a go-to destination.

Within debt, which has sixteen categories, we can shortlist three. The categories you need that are matched to your money needs across three years are liquid, money market and banking and PSU funds.

For goals within 3 years.

So, if you have a money market fund for the goal that is one year away, you will need to move it to a liquid fund in nine months. Extend this exercise to five or six short-term needs and the cost of time and attention to this becomes very large.

Use the liquid fund category as a very short-term deposit and redeem a week before you need the money and have it ready for use in your bank account. Be very risk averse when it comes to money needs that are immediate.

use the money market funds to park money that you will need within the next two years. As the time for withdrawal comes nearer, redeem at least a month in advance from this category as well.

use banking and PSU bond funds for needs that are two years or more away, but do remember to check the average maturity of the scheme you select as this varies quite a bit over the schemes in the category.

The further away from today the need is, the more risk I can take. There can be many strategies to target your returns for this time band and I use a simple two-category route. I use a mix of banking and PSU and conservative hybrid.

For money beteeen 3 to 7 years.

As you move beyond five years to goal time frame, begin using the conservative hybrid category.

I am not a big fan of debt funds for money needs more than seven years away. Of course, your long-term debt portfolio should have PPF and PF (if you are eligible) as the core.

have kept large-cap funds out because it is getting increasingly difficult for them to beat the benchmarks. In repeated studies it is found that most large-cap funds underperform the benchmarks. You are better off in a low-cost index fund.

Greater than 7years bucket

The large- and mid-cap category gives a minimum 35 per cent allocation to mid- and large-caps each, with the rest usually in large-caps, allowing fund managers to show some outperformance.

Flexi-cap as a category leaves the allocation between the three market caps to the discretion of the fund manager. Most flexi-cap funds seem to have a large-cap bias. A better way to get a multi-cap exposure is the multi-cap category that mandates a minimum exposure to each cap.

My credo is: let perfect not be the enemy of the good! There is nothing that is perfect in life. There are moments that approach perfection, but it is not a continuous state.

Index funds are a great option if you don’t want to do all the work laid out in Chapter 10 and do not want fund manager risk. You want a fill it–shut it–forget it approach to your money decisions.

The simplest passive investing strategy is to simply follow one of the two oldest broad-market indices on the Indian stock market. Broad market means that the index stocks account for some of the largest and best-known companies on the stock market.

Step one. Choose only from index funds and not ETFs. The ETFs are listed like stocks and when you go to buy or sell, there has to be somebody on the other side making the opposite trade.

While there are market makers whose job is to provide liquidity, there can be instances that you go to sell and there aren’t enough buyers. Index funds are different—the units are sold and bought by the mutual fund itself.

Step two. Reduce the choice of index funds to only those that track the bellwether indices. These are Nifty 50 and the S&P BSE Sensex and both indices show very similar return history.

Shortlist all schemes that have S&P BSE Sensex total return index and Nifty 50 total return index as the benchmarks. Remove the ETFs from this list and keep only the index funds.

Step three. Use the filter of assets under management to remove schemes that are small. We are looking for a scheme with performance history and a minimum size of at least Rs 500 crore. Smaller funds, if not new, might suffer from the problem of lack of attention of the fund house. Tiny, old passive funds must be avoided, these are obviously neglected by the fund house.