How to choose the best Mutual Fund for Your Portfolio by Evaluating Risk and Objectives

In the previous chapter, we discussed the steps to analyse and evaluate an equity mutual fund. We selected Kotak Standard Multi cap Fund as an example and found that it excels in risk management.

It begs asking – is it worth including this fund in your mutual fund portfolio? After all, the indications suggest it’s a decent option.

At first glance, it seems like an obvious pick. We’ve examined the fund in terms of risk and reward, and it excels on all fronts. Hence, investing is the sensible route to take.

When considering a fund for your portfolio, you should not assume that it is a good or bad investment just based on its performance.

The decision to invest in a fund needs to be based on the mutual fund portfolio’s aim. Keep in mind, this goal should relate to reaching a financial target. Consider, if my objective is to set up an emergency fund, investing in Equity funds may not be suitable. Thus, regardless of how attractive the fund appears, there is no point in investing if it does not fulfil this goal.

Many may be surprised to be advised against investing in a good mutual fund.

It’s not a good idea to just take Dolo 650 if you have knee pain. A more sensible option would be to speak to a knee specialist and get their advice about any specialised treatments available, like physiotherapy or an MRI scan, which can help diagnose the issue.

Investing should only be done when the portfolio goal and the fund’s risk-reward ratio are in sync. Steering away from this approach could lead to a disorganised portfolio.

In the following sections, we’ll explore how to coordinate funds with portfolio objectives. But before that, let’s examine techniques for evaluating a debt mutual fund in this chapter.

– Risk recap

In this chapter, prior to selecting a debt mutual fund to analyse, let’s briefly review the main risks linked with it.

Credit risk – MFs invest their funds in debt obligations, for instance company A wants to borrow 50 Cr to help with its operations and decides to offer a 5-year bond with an interest of 9%. Should everything go as planned, the business receives the money and the AMC is paid the interest. Following completion of the 5 year term, repayment of the principal is expected from company A.

As you can imagine, this is fairly standard practice.

A potential issue may arise if the company experiences difficulties over the five year period. If conditions deteriorate, they could be unable to pay either interest or loan principal, leaving them with no other option but to apologise.

AMCs running debt funds bear the burden of ‘credit risk’, which can arise if a default occurs. Unfortunately, such events have caused substantial losses in several funds in the past.

Company A is doing well as of today, however the credit rating agencies have noticed issues on the horizon. This has led to a downgrade of their creditworthiness, bringing the rating from AAA to AA. This constitutes ‘credit rating risk’, which can cause major impacts.

Interest rate risk – Interest rate risk should be taken into consideration when investing in bonds. The prices are sensitive to changes in interest rates and thus must be monitored. Since they are inversely related, a decrease of interest rates causes an increase in bond prices and subsequently the NAV of the mutual fund. Conversely, if rates rise, the bond prices will decrease, bringing down the mutual fund’s NAV. We have already discussed this matter.

The sensitivity of bond prices to risks associated with interest rate shifts is measured as the modified duration of the bond. An increase in this figure indicates a corresponding rise in risk; conversely, a decrease in modified duration correlates to decreased risk. Debt mutual funds provide the aggregate modified duration for all bonds held within their portfolio.

Now that we’ve discussed the risks, let’s turn our attention to analysing a debt mutual fund.

– Portfolio check  

As I’ve stated earlier in this chapter, it is important to invest in a fund that is compatible with your portfolio objectives rather than on the basis of its merits or reputation.

Debt funds can be attractive to many investors as they often present a perception of low risk. They are promoted as secure ways to safeguard your capital as opposed to traditional fixed deposits with a bank. But this is not always the case.

I’m not trying to put you off investing in a debt fund; I’m simply stressing that there is always an element of risk involved. It’s important to remember that bond funds can be unpredictable and could result in a permanent loss of your capital.

Let us proceed with our analysis of the Mirae Asset Short Term fund. Since we are using this as a template to evaluate any debt fund, much of the analysis will be focused on its risk profile and portfolio composition. This is unlike analyzing an equity fund, where the focus would lie elsewhere.

This fund is still relatively new, with its NFO having taken place in early 2018, so there aren’t many data points to track; however, this is fine.

This fund is meant to provide a short-term investment opportunity, as indicated by its name; investments in bonds with maturities ranging between 1 to 3 years will be made.

Check out the maturation curve of the fund, provided by the AMC website –

The average maturity of the fund is approximately 2.5 years, leaving it vulnerable to default, credit rating and interest rate risk, as well as changes in the perception of these rates.

Should any of these risks be realised, the NAV would drop sharply and the fund may take longer to recover from losses. To counteract this, you must remain invested in the fund for an extended time period.

How long?

I firmly believe that investors should commit at least the same amount of time as the average maturity of a debt mutual fund when investing in it. Therefore, for this particular fund, I’d recommend an investment period of 2.5 to 3 years, minimum.

If I’m looking at a Gilt fund, then I’m in for a long-term investment; its average maturity is ten years.

Before investing in a debt fund, it is important to consider the investment tenure and understand it clearly.

We should take note of the quality of bonds when constructing a debt portfolio, rather than overlook it as we would with an equity portfolio.

Here is a quick look at the portfolio allocation (AMC website) –

The fund’s allocation of 67.31% to corporate bonds indicates a large exposure to credit risk. To evaluate the debt fund manager’s management of this risk, we must examine –

o   The diversification of the fund

o   Exposure to companies – high exposure to a single corporate entity draws a red flag

o   Credit rating check on the papers held by the fund.

I dug into the portfolio of this fund; you can do the same by visiting Mirae’s download section – https://www.miraeassetmf.co.in/mutual-fund-scheme/fixed-income/mirae-asset-short-term-fund

Here is the snapshot of a section of the fund’s portfolio –

The fund consists of over 56 papers, with the top three holdings (3% or more) all being sovereigns, ensuring no worries surrounding potential credit risk on one considerable exposure.

We have to assess the exposure at a collective level. For instance, in the picture above I observe that our fund has invested 2.44% of its resources in the 7% RIL bond expiring in August 2022.

We have devoted 1.64% of the fund to 8.3% RIL paper maturing in March 2022, and so the query is just how much total exposure to Reliance Industries Limited we have?

To answer the above, you can swiftly total the numbers from the excel or look up the facts provided on AMC’s website.

The fund has an overall exposure of 5.56% to Reliance, 5.23% to NHB and 5.12% to PFC. I would consider these allocations to be somewhat concentrated bets.

We can compare the fund’s performance to that of its category to see if 56 papers is an adequate amount.

The portfolio aggregates are provided by Value Research Online. While the fund in focus has 56 securities, its counterpart category has an average of 64. This fund contains a slightly more tightened portfolio than arguably anticipated, however, in this particular instance the gap isn’t substantial and shouldn’t cause major worries. But if a significant variance exists – let’s say 45 securities compared with 65 industry-wide – one can become concerned.

Progressing with our exploration, we now consider the standard of the papers. We can formulate an outlook of the quality of documents (bonds) held in the portfolio by analysing the rating profile.

14.41% of the portfolio comprises sovereign papers without any credit risk, so that’s one less thing to be concerned about. 66.3%, being the majority are rated AAA; however, ratings tend to fluctuate as rating agencies regularly reassess the creditworthiness of the securities.

A1+ and AA ratings are roughly 8.5%, naturally so due to debt fund managers’ need to demonstrate performance achievements. The quandary here though is to establish whether the fund manager is straying too far in search of yield.

Value research online is the source for this information. The fund has a higher than average exposure to AAA bonds, which comes with its own level of credit risk. On the other hand, its Sovereign bond exposure is lower and the cash equivalent rate higher than those across the category.

The data indicates that this fund is willing to take on more credit risk, which doesn’t bode well for a short duration one. Since individuals typically invest in this fund, expecting modest returns in a two-to-three year period, the implications are bad news.

The need to take on credit risk certainly calls for some consideration. Even with diversification, there’s still the possibility of a concentrated portfolio, which could be quite daunting.

– Other checks 

Let us go back to the portfolio aggregates –

The modified duration of this fund is 1.97, far less than its categories 2.34. This is due to its lower average maturity, as the modified duration measures sensitivity to changes in interest rate.

The average maturity of the fund is 2.28, while the category’s average is 2.89.

This suggests that the fund manager is comfortable taking on some extra credit risk by making concentrated investments, yet not so keen to take on any interest rate risk.

The fund’s YTM is 4.59, while the category’s is 5.18. This figure represents total returns anticipated on the supposition that the bond is retained until maturity and coupon payments are reinvested in the bond.

Intuition suggests that a higher YTM is advantageous; this is accurate. However, YTM can also be used as a risk indicator when compared to other category’s YTMs.

This serves as a demonstration that the fund may be taking on extra risk in order to attain higher yield than the category’s YTM.

I would hope for the fund’s YTM to be on par with the standard in its category, even if it is slightly lower.

I want to examine the fund’s market risk factors such as the standard deviation, beta, and alpha to determine its volatility compared to its benchmark. It would be helpful if we could study these parameters from a three-year view, however unfortunately that is not possible since this fund is new.

Lastly, I checked out the AUM of the fund; it was roughly 650Cr. This isn’t a huge sum when you look at other funds in its category. In terms of debt funds, I generally prefer to steer clear of those that are both very small and very large. If there’s an issue with the AMC and redemption requests surge, a massive debt fund could encounter liquidity difficulties in the debt market.

In contrast, a large fund will have better negotiating power for better rates and therefore be able to gain more. Therefore, funds with moderate AUMs are preferable.

So would I invest in this fund? I’d probably hesitate to do so for a couple of reasons –

o   The fund has a concentrated portfolio

o   Credit risk is higher compared to the category

o   It’s a new fund, and I’m sure there are better alternatives in the market

o   The fund has a low AUM, understandable since it’s a new fund

Rather than focusing on standard metrics such as fund rankings, rolling returns and capture ratios, it’s not really essential when assessing debt funds.

Before we wrap up this chapters, here are few things for you to note –

o   Investment in debt funds is intended primarily for capital protection. It’s not advisable to be influenced by returns or try to maximise returns on investing in a debt fund.

o   It is not advisable to rely solely on ‘star ratings’ when considering a debt fund. Generally, such funds will be rated highly if their returns are also high; which implies that the fund manager is taking on more risk in an attempt to obtain superior yields.

o   Apart from the standard debt fund risks, keep an eye on the liquidity risk. 

o   SEBI has now mandated that funds must reveal their portfolio information every two weeks, which is a wise decision. Keep track of any alterations to the portfolio.

o   Make sure to spread your investment across various AMCs. For example, if you’re looking to put money into a short-term fund, divide it among two short-term funds from different asset management companies.

o   I recommend that you steer clear of credit risk funds. These funds take on credit risk to achieve returns, which in my opinion should not be a main consideration when deciding to invest in debt funds. Rather, these types of investments should primarily be used as a way to protect capital.

o   Debt funds can sometimes loan to entities owned by the same promoter, and you need to be careful when considering such investments.

I urge you to consider debt funds, and to analyse them using the same method that we have demonstrated here. Having a fund with at least 5-8 years of history is recommended.

Throughout the following chapters, I will cover financial objectives and establish a mutual fund portfolio to fulfil them.