Comprehensive Guide to Mutual Fund Scheme Selection: NISM Series VA Short Notes (Part 1)

The selection of a mutual fund scheme is a critical process that shifts the focus from the investment products themselves to the individual investor’s specific requirements. This part explores the foundational elements of scheme selection, focusing on aligning investments with investor needs, risk profiles, and fundamental fund structures.

1. Scheme Selection Based on Investor Needs and Preferences

The primary driver for choosing a mutual fund is the specific financial need the investor intends to fulfill. Every investor has unique objectives that dictate the type of scheme most suitable for their portfolio.

Key Investor Needs

• Long-term Capital Appreciation: Investors seeking to build wealth over extended periods typically look for schemes that offer high growth potential, such as equity funds.
• Periodic Income: Some investors require regular cash flows to manage expenses, making debt schemes or hybrid funds with a history of payouts more attractive.
• Liquidity and Safety: For parking surplus funds for short durations, investors prioritize high liquidity and capital preservation, often selecting liquid or overnight funds.

The Importance of Goal Setting

A robust investment portfolio is built by assigning amounts and timelines to financial objectives, thereby converting them into financial goals. Understanding these goals is the first step toward selecting a scheme that provides the necessary asset allocation.

2. Assessing the Investor's Risk Profile

An investor’s risk appetite is not a single metric but a complex function of three distinct dimensions. Choosing a scheme without evaluating these factors can lead to a mismatch between expectations and reality.

The Three Pillars of Risk Appetite

1. Need to Take Risk: The level of risk required to achieve the desired returns based on the financial goal's target amount and timeline.
2. Ability to Take Risk: A measure of the investor's financial capacity to withstand potential losses without compromising their standard of living.
3. Willingness to Take Risk: The psychological comfort level of the investor regarding market volatility and potential capital fluctuations.

Factors Influencing Risk Profiles

• Age of the Investor: It is a common market belief that younger investors generally have a higher potential for taking risks compared to older individuals.
• Investment Time Horizon: The ability to take risk increases with a longer time horizon to the goal. Conversely, when a goal is near, investors should typically avoid high-risk assets to protect their accumulated corpus.

3. Strategic Asset Allocation and Portfolio Construction

Once the needs and risk profile are established, the next step is Asset Allocation, which involves deciding how much money should be allocated to different asset classes.

Core and Satellite Portfolio Approach

To manage risks effectively while seeking market opportunities, a portfolio can be divided into two segments:

• Core Portfolio: This is invested in line with the long-term needs and goals of the investor, providing stability and steady growth.
• Satellite Portfolio: This portion is used tactically to take advantage of short-term market movements or specific trends.

4. Risk Levels in Mutual Fund Schemes

The selection process must account for the inherent risk-return trade-off across different fund categories.

The Risk-Return Spectrum

As an investor moves from liquid funds to equity funds, both potential returns and investment risks increase.

• Liquid and Overnight Funds: Lowest risk and potential return, focusing on 1-day to 91-day maturities.
• Debt Funds: Involve two primary risks—credit risk (default) and interest rate risk (value changes due to rate movements).
• Hybrid Funds: Moderate risk, balancing debt and equity exposures.
• Equity Funds: Highest risk and return potential.

Risk Factors within Equity Schemes

• Market Capitalisation: Smaller companies are generally riskier than larger ones. Therefore, small-cap funds carry higher risk than mid-cap funds, which are in turn riskier than large-cap funds.
• Diversification: A focused fund (investing in a maximum of 30 stocks) is inherently riskier than a diversified equity fund.

5. Selection Based on Investment Strategy and Structure

The underlying management style and legal structure of a fund are pivotal selection criteria.

Active vs. Passive Management

• Passive Funds (Index Funds/ETFs): These are suitable for investors who want exposure to an asset class without the risks of fund manager error. They mimic a market index and offer lower costs.
• Active Funds: Investors in active funds pay higher management fees for the expectation of alpha (returns better than the benchmark) generated by the fund manager's expertise.

Open-ended vs. Close-ended Structures

• Open-ended Funds: Offer the significant benefit of high liquidity, allowing investors to exit at the current Net Asset Value (NAV) at any time.
• Close-ended Funds: These have a fixed maturity and offer liquidity primarily through listing on a stock exchange. However, they may suffer from low trading volumes, requiring a counterparty for the investor to sell their units.

Diversified, Sector, and Thematic Funds

• Diversified Funds: Lower risk due to multi-sector exposure.
• Sector Funds: High risk due to concentration in a single industry.
• Thematic Funds: Invest based on a broader theme (e.g., infrastructure), providing more diversification than a sector fund but more concentration than a diversified fund.

Key Takeaways for Part 1

• Investor-Centricity: Scheme selection must start with the investor's needs, not the product's performance.
• Risk Evaluation: Risk appetite is a combination of financial ability, psychological willingness, and the need for returns.
• Horizon Matters: Longer investment horizons generally permit higher risk-taking.
• Structural Choice: Open-ended funds are preferred for liquidity, while index funds are ideal for low-cost, market-linked exposure.

Important Terms

• Asset Allocation: The process of distributing investments across different asset classes like equity, debt, and gold.
• Risk-Return Trade-off: The principle that potential return rises with an increase in risk.
• Alpha: The excess return of an investment relative to the return of a benchmark index.
• Market Capitalisation: The total value of a company’s outstanding shares, used to categorise funds as large, mid, or small-cap.