Building MF Portfolio – Avoid these 5 mistakes!

This is my MF portfolio – am I right?

I often receive reader queries on the blog stating their choices of schemes that should be a part of their winning MF portfolio. They then want to know if it is alright or any change is required.

I recently received another one. As I said this is not the only one. There have been several such in the past. So, this reader had been investing in the following funds and now wanted a ‘second opinion‘ if these funds continued to make sense.

Here is the list of fund scheme names with their options.

1. ICICI Prudential Export & Other Services Fund  – Dividend
2. SBI Pharma Fund – Dividend
3. UTI MNC Fund – Dividend
4. ICICI Prudential Value Discovery Fund – Dividend
5. UTI Transportation & Logistics Sector Fund – Dividend
6. Canara Robeco Emerging Equities Regular – Dividend
7. Reliance Small Cap Fund – Growth
8. MOST Focused Mid cap 30 Fund – Growth
9. Reliance Pharma Fund – Growth

The reader was concerned that his portfolio had a loss, that is, the current value of the investments was less than the amount he had invested.

He also made it amply clear that he was looking for ‘maximum returns‘. He mentioned that it was his hard earned money, which to me means that he does not want to take a lot of risk.

And you know what – his retirement is only 5 years away!

This is a perfect textbook example of how one can make all the mistakes in one go.  I believe we all have lessons to learn here.

5 mistakes to avoid in building your MF portfolio

As usual, I asked my reader a few questions.

• Why did you choose these schemes?
• Why do you have 9 schemes?
• Why do you have thematic or sectoral funds?
• Why do you have dividend option in some schemes?
• Are the investments in direct plans or regular plans?

These questions will be the basis of our learning today.

Mistake #1 – Returns is the only parameter to select investments

Apparently, the choice of the funds in the above mentioned portfolio was based on “money control and ICICI Direct recommendations. As per these recommendations, funds have higher returns since last 5 years and performed well. So I selected them.”

Relying only on past performance is like driving your car by looking only at the rear view mirror. What do you think is going to happen?

Past performance is only one of the indicators that you use while evaluating mutual funds. It would be prudent that you don’t make it the only one.

Read more: How NOT to select mutual funds?

There is so much more to a fund scheme – the objective, the benchmark, the fund manager, the past track record, investing strategy, etc. Pay attention to them too and not just performance.

Mistake #2 – More the schemes, the merrier it is

So, there are large cap funds, multi cap funds, mid cap funds, small cap funds, then banking, pharma, infrastructure funds. Not to mention the debt fund category too.

And you don’t want to miss out on what each one of them has to offer. So, what to do? Simple. Put some money in  many schemes.

There is a much misunderstood and misused word for this act – DIVERSIFY.

I have been seeing mutual fund portfolios with 20 schemes (a few here or there) become a norm. The money is spread too thin- all in the name of diversification.

Consider this. Let’s say you invest Rs. 10,000 in a fund in an overall portfolio sizes of Rs. 5 lacs. Now even if this Rs. 10,000 fund doubles in value, what total impact would it have on your portfolio? The reality is that it would even fail to move the needle.

In your search for variety and to benefit from as many as possible, you would probably end up with an average portfolio delivering an average return.

Identify your time horizon and what kind of risk you can tolerate and go for the funds that can best deliver on that. 5 to 7 mutual funds should be enough to deliver on any financial plan.

Mistake #3 – Get lured by thematic and sectoral funds

Why do you invest in a mutual fund?

I will give you my reason. I invest because I trust the fund manager to identify the right investment opportunities across market segments, sectors and themes to build a portfolio that will deliver returns that will beat inflation and help me reach my financial goals, faster.

When you pick a thematic fund (infrastructure, consumption, etc.) or a sectoral fund (pharma, banking, IT, etc.), in a way you are taking those calls. You have left very little for the fund manager to do.

You have also limited the universe of the opportunities that the fund manager can go and pick from.

And the worst part, themes and sectors play out in cycles. There could be extended periods when they do really well (and you feel like the smartest person on the planet) and even more extended periods when they don’t do well, at all (and you feel like the biggest idiot in town).

In a diversified mutual fund (which invests across multiple themes or sectors), the fund manager would keep moving to opportunities that make more sense. But with a thematic or sectoral fund, the game has to be played in the restricted boundary.

Having said that, if you are someone who can figure out when a particular theme or sector will work and leave the job of stock picking to the fund manager, great. Go for it! For all others, that’s not the thing to have in your MF portfolio. I would stay away.

Mistake #4 – Choosing dividend as an option

So, when I asked my reader, why did you choose dividend options in certain schemes, he had this idea that every dividend would grow the number of units he has and hence the value would increase.

Not just him, several other investors fall for this trick, sometimes themselves and sometimes because of their advisor’s recommendation. See, there used to be a time when choosing a dividend option gave you additional tax benefits but that is no more the case.

A reason I guess advisors push for this option is to make the investor feel good with “see your fund has declared a dividend“. That’s perception management. The investor thinks, if the dividend is declared, the fund must be making money. Some of us still equate a mutual fund with a stock.

Total sham!

If you are building an MF portfolio for the long term, simply go for the growth option. If you are seeking dividend income out of your MF portfolio, go for the dividend payout option.

There is absolutely no sense in opting for Dividend Reinvest. All it does is create several transaction entries and unnecessary accounting hassles. 

Mistake #5 – Failure to ask questions

That has always been my grouse with investors. We want a short cut, an easy way out. We are not interested in doing the ground work to find out what is the right and relevant investment for us. As mentioned in mistake no. 1, merely looking at the performance, the star ratings, is not enough.

You need to go in further with your choices and ask more questions about the fund, its performance, its costs and how does it fit in with your financial goals.

Reading a simple literature like the fund factsheet is a good starting point.

If you have an existing MF portfolio with more than 5 to 7 funds, you need to ask why so many schemes?

Further, investing in equity mutual funds for a retirement that is 3 to 5 years away may not be the most sensible strategy. Post retirement, you would need assured income per month to meet your expenses. That plan has to be made and subsequently the call to invest in equity or debt.

From the point of view of costs, you should also understand the difference between regular plans and direct plans of mutual funds.

Questions, questions, questions – that is the way to knowledge.

Read more: John Bogle’s 8 Rules to build a winning mutual fund portfolio

With this context, if you now look at the portfolio outlined earlier, you would probably realise the issues. Yes?

Here is one question for you: The reader is wondering if he should switch to ELSS (tax saving funds), hybrid or debt funds. What should he do?

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Between you and me: What would you do if you had this portfolio? I look forward to your comments and feedback.