Heres How To Handle Dilemmas That Can Impact Investment Success
Every mutual fund investor wants to build a portfolio of funds that have the potential to do well over time. One of the ways to analyse the future potential of a fund is to analyse its long-term performance track record. The long-term consistent performance track record of a fund confirms its ability to perform well over different market cycles. However, a fund with a long-term track record usually grows too large in size. Unfortunately, the large size of the fund often creates a dilemma in the minds of investors about its future prospects. Therefore, the question that needs to be addressed is whether the size of a fund should be a concern for you while investing in a fund.
Hemant Rustagi
Chief Executive Officer, Wiseinvest Advisors
No doubt, a fund can become unwieldy to manage efficiently if it grows too large. However, it may not be a disadvantage for all types of funds as the impact of the size of a fund on its performance depends upon the asset class it invests in as well as its investment strategy/philosophy.
For example, in the case of a pure large-cap fund or a multi-cap fund that invests predominantly in large-cap stocks, the size of the fund may not matter much. That’s because these stocks are quite liquid and hence buying and selling them in any quantity is not a problem for a fund manager. Similarly, the large fund size also may not have any impact on certain categories of debt funds like liquid fund, ultra-short duration, low duration, money market fund and short duration fund.
However, one needs to be careful when a fund outgrows its investment style. For example, a small-cap fund where the success depends on how effectively the fund manager does the stock picking out of the large universe, the large size of the fund may force him to make certain compromises in terms of quality of the stocks and liquidity. As we know, this segment of the market remains under-researched and hence finding too many good stocks can be time-consuming and tricky. However, considering that these funds do very well during the bull run, they attract large sums of money. In a way, at times, these funds become victim of their own success. Similarly, if a sector fund becomes too large, the fund manger may struggle to invest the money in the sector efficiently.
As is evident, you can ignore the size of the fund while investing in large-cap and large-cap oriented multi-cap funds as well as mid-cap funds and should focus on the fund’s investment strategy, quality of portfolio and long-term performance track record. In fact, investors benefit from lower expense ratio when they invest in large funds. However, the fund size can be an important consideration while investing in small-cap, thematic and/or sector funds.
Another dilemma for investors is to find a balancing point that can ensure that their portfolio risk remains within their risk-taking capacity. Risk tolerance plays a significant role in designing an optimum investment strategy. In fact, the key to investment success is to build a portfolio that maintains the right balance between risk and reward. Hence, you must follow the right process to determine your risk profile. Here are a few guidelines:
• You need to determine your “comfort level” with regard to volatility. Simply put, you must seriously consider the effect of potential downside as well as potential upside.
• Within a defined level of risk tolerance, you must adhere to the principles of effective diversification. This will help you in achieving a variety of distinct risk/reward objectives and reducing the overall portfolio risk.
• Reassess your risk tolerance at least annually. Remember, sometimes the risk tolerance may change either due to major adjustments in return objectives or due to a realisation that an existing risk tolerance is inappropriate for your current situation.