For those who do not have the time or expertise required to do the analysis involved in selecting good stock investments, mutual funds can be a good consideration.
Investing in mutual funds enables the investors, especially the not too savvy ones, to delegate the responsibility of researching and selecting what assets to invest in, to the mutual fund managers. In addition to that, it helps the investor achieve a level of diversification that may be suitable for his/her risk appetite or tolerance.
Even with mutual funds, it is not that easy to decide on which funds to invest in. This is because different funds have different objectives, different investment strategies and different performance track records while differing in suitability for different investors.
However, irrespective of an investor’s risk characteristic, some funds may be must-haves in a portfolio of investments. For those struggling to select which funds to invest in, here are tips on how to build your mutual fund portfolio.
There are direct sectors in the equity market, like the conglomerates, the consumer goods, the industrials, the energy, and the banking stocks. Unless one is very rich with a large capital base, one may not be able to invest in all sectors at the same time.
[Read Also: Understanding Mutual Fund Fees: Management Fee]
There comes the beauty of mutual funds, in that it is easier to get mutual funds that invest in each sector so much so that by investing in such mutual funds you end up investing, albeit indirectly, to the sectors.
For example, investing in Vetiva Banking ETF, you get exposure to such banking stocks like Access, Ecobank International, Fidelity Bank, Guaranty Trust, Sterling, UBA, Wema and Zenith. It is much easier and cheaper to invest in Vetiva Banking ETF than it is to invest in all the constituent equities at the same time.
Steps in Building a Sound Mutual Fund Portfolio
In building your mutual fund portfolio, first decide which sectors of the economy you want to get exposed to. That decision will help in choosing which funds to invest in.
Understand Your Risk Tolerance
Different investors have different preferences, or appetites or tolerance levels for risk and different funds have different risk profiles. So, before building your mutual fund portfolio, you should understand your risk tolerance level.
In investment, risk is measured by market volatility or the ups and downs of the market. If you have a long position, your investment goes up when the market trends up and it goes down when the market trends down. So, you should understand how much of those ups and downs you are ready to tolerate or accommodate. For example, if you get worked up or hypertensive when your N100,000 investment loses 10% of its value because the market went down, then your risk tolerance is low and equity mutual funds may not be for you.
Your risk tolerance is a product of many factors like your age, because the younger you are, the easier it is for you to make up on lost money, but if you are closer to retirement, it may not be that easy and as such, your risk tolerance tends to be lower as you age.
Another factor that can affect your risk tolerance is the availability of emergency fund. If you have set aside an emergency fund, the tendency for a forced liquidation of your investment in case of emergency decreases and your ability to hang on in the face of market down turns increases. These are just a few of the factors that can affect your risk tolerance.
Determine Your Time Horizon
Before building your mutual fund portfolio, you should know what period you need to invest for. Some mutual funds have redemption penalties if you withdraw before a stated period of time, so to avoid such penalties, you need to remain in the fund for a period long enough to escape the penalties.
Mutual funds make money through income distribution and capital gains. The longer you hold a fund, the more you are likely to receive those distributions and depending on market conditions, the more likely it is to benefit from price increases by way of capital gains.
Decide on Your Asset Allocation
Now it is time to choose the funds you want to invest in, bearing in mind the tips noted already. The virtue of diversification has taught us that it is not good to carry all your eggs in one basket. In no area has this been truer than in investment strategy.
After knowing your risk tolerance, time horizon and investment objective, it is now time to allocate your available capital to the assets that will help you achieve the investment objectives without compromising your risk tolerance and within the realms of your investment time horizon. So, you may wish to consider the following:
These are funds that invest mostly in equities but look for a fund that invests in blue chips, funds with good track records of performance. If your risk tolerance is relatively high, you could go for aggressive equity funds like Arm Aggressive, Stanbic IBTC Nigeria equity fund but if your risk tolerance is high and you have a bias towards a particular sector, like the banking sector, then you can look towards the Vetiva banking ETF or the likes.
These are funds that invest in equities as well as fixed income and money markets. These are suitable for investors with low to moderate risk tolerance. Again, it is good to pay attention to funds with good track records.
Fixed Income Funds
These are funds that invest predominantly in bonds, be they sovereign, corporate or local government bonds. These are good for you, if your risk tolerance is relatively low or you are retired or about to.
Money Market Funds
These are funds that invest predominantly in money market instruments like treasury bills, or commercial papers. Like fixed income funds, they are good for you, if your risk tolerance is relatively low or you are retired or about to.
But it does not hurt to have a blend of equity funds with balanced funds so that in very good markets, the equity fund pushes your portfolio above par while the fixed income or balanced funds help to hedge against downside risk
Fund Manager Selection
This is about the hardest of all the steps because it takes more effort and research than the others. In selecting a fund manager, you should consider the manager’s investment style purity and consistency. Also, find out the expenses charged by the manager by calculating the expense ratio of the fund.
A manager’s tenure, asset selection skills, and shareholder friendliness are also areas that you need to dig into. In more advanced and organized markets, fund manager selection is often done by specialized companies or experts who specialize in conducting fund manager due diligence for a fee.