Let your investment strategy decide mutual fund choice

Picking the right mutual fund out of more than 3,000 options in the market can be really tough. But if you decide your investment strategy and fit it to your personal goals, things get much simpler. A mutual fund scheme’s investment strategy describes the fund manager’s approach to building a portfolio. Most equity mutual funds fall into one of the three categories: index funds, actively managed funds and enhanced index funds. Within each strategy there are a wide range of options.

UNDERSTANDING THE DIFFERENCE

Index fund managers attempt to replicate the performance of a benchmark index, say BSE’s Sensex or NSE’s S&P CNX Nifty, by creating a portfolio that mirrors the composition of the chosen index. In other words, there is no effort to beat the index, merely to earn the same return. Index funds are also called passive funds due to their passive investing style.

Active fund managers seek to outperform the market as a whole and attempt to meet this goal with a combination of smart stock picking, market timing and asset allocation decisions. Enhanced index funds, not a commonly used term, fall somewhere in between the two. They aim to track an index, but also attempt to generate higher-than-market returns by straying from the index in order to take advantage of market timing, specific stock selections, and/or leverage. See the chart for a brief summary of all the three types of funds.

FITTING INTO YOUR PERSONAL GOALS

As with any financial decision, choosing an investment strategy largely depends on your personal goals, as well as other considerations, including the asset class you’re investing in, fund management and operating costs, interest in tax efficiency and your risk tolerance. And you have plenty of choice. The mutual fund industry in India is still in a nascent stage, and new schemes are being launched almost by the day. Given the perplexing array of funds and schemes to choose from, it’s imperative that you understand what suits you best and what will meet your financial goals.

Your choice of investment strategy may depend on your perception of the financial markets. The two common market perceptions are whether the markets are ‘efficient’ or ‘inefficient’. This is an age-old debate in which proponents of efficient market theory argue that prices fully reflect all the available information on a particular stock and/ or market and hence no investor has an advantage in predicting a return on a stock price because no one has access to information not already available to everyone else.

So when markets are perceived as efficient, it becomes harder and nearly impossible to beat the market. Index funds and enhanced index funds can be smart choices if you think the markets are efficient and because they seek to offer performance similar to the market average and in the long run returns from the markets will be higher than any active management.

In contrast, in an inefficient market, some securities will be overpriced and others will be underpriced and fund managers may be able to gather information through their research and analysis that is not widely available to the public and be able to outperform the market average. Consequently you may favour actively managed funds if you think that markets are inefficient.

Most markets, particularly Indian markets, are inefficient and skilled fund managers have the potential to add genuine value for investors. The more inefficient a market is, the easier it may be for skilled active managers to outperform the particular market as a whole. Financial markets of developed countries are more efficient than those of developing economies and hence in India, the opportunity to outperform the markets are greater, which is also reflected in the performance of active funds vis-à-vis index funds.

In addition to your personal view about whether the markets are efficient or inefficient, it’s important to make decisions in the context of your long-term financial plan. So consider all your options before choosing a particular investment strategy.

MAKING THE RIGHT CHOICE

Choosing an investment strategy is largely a matter of making informed decisions, with few right or wrong answers. Identifying the strategies that is best aligned with your personal goals is a smart way to keep your financial plan on track. You can also benefit from including different investment strategies in your portfolios. The key is to stay focused on your long-term goals and choosing your investment strategies accordingly. And it is imperative to understand that if you invest in equity your investment horizon should be at least three years as equity funds are not advisable for short term.

Source : Economic Times

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