You might be wondering why the title refers to mutual fund ‘categories’. Would it not be more enticing and perhaps more useful had it read, ‘how to select mutual funds suitable for your financial goals’?
Perhaps so. However, I choose to focus on how to select mutual fund categories first, for two reasons
Mutual fund returns, and associated volatility (fluctuating returns) can be evaluated in a number of ways. Trouble is very few among us take the trouble to understand these although they could be understood quite easily.
When I made a step-by-step to select a mutual fund, I used 5 of these risk-return parameters. I am delighted to note that many investors, with a near-zero experience in mutual fund investing, have started using these parameters in choosing mutual funds.
In this post, let us discuss how to select a suitable mutual fund category using just one parameter: the standard deviation.
In order to understand what standard deviation is, I will borrow this wonderful analogy by Subra.
You are give two sets of numbers:
We all know how to determine the average: add up all the scores and divide by the number of such scores.
Once we get the average, we immediately recognise that some scores are higher than the average and some lower than the average.
Now if we wish to know, between Dravid and Shewag, whose scores deviate more from the average, we will need to calculate the deviation of each score wrt the average and take the average of the deviations.
This is the standard deviation. It is defined such that it is always positive so that we are not confused (assuming we are not thus far!)
Even without any data, we will recognise that Shewag is just about is capable of scoring anything from a duck to a triple hundred. Dravid on the other hand is a lot more sedate, and we can typically expect at least 30-40 runs irrespective of the conditions.
Therefore, Dravid’s scores are expected to deviate very little from the average while Shewag’s scores are expected to deviate substantially.
So we say, Dravid’s batting average has lower standard deviation than Shewag’s.
Such is the power of this analogy that it drives home the point without using any data!
Before we use the standard deviation to select a suitable fund category, let us recognise that mutual funds can be grouped together in several ways. There is no right or wrong way and each fund portal (Value Research, Morning Star, Money Control etc.) have their own categorisation scheme.
In this post, I will use the scheme categorization of VR online.
The category standard deviation, along with the typical asset allocation and maturity of debt paper (for debt funds) is listed below for some of the categories define by VR online.
Category standard deviation refers to the average standard deviation in a particular category.
Notice that returns are missing from this table.
Let us get to the business at hand, with a few examples.
I understand that equity will be too risky for just a few months. So let me eliminate all fund categories with equity.
This leaves me with the top four categories in the table.
If I choose a debt income fund that matches with the category average standard deviation of 3.71%,
My returns will typically (68% probability!!) range from
X -3.71% to X+3.71% before taxes!
Can I afford such a swing in returns?
If the answer is no, we can move on and choose somthing with lower standard deviation. What if the answer is yes?!
What if I say, I don’t mind this fluctuation?
Then you will have to worry about what X is, or what it can be.
Let us now introduce a simple but reliable rule of thumb.
If we adopt this thumb rule, the next question is, what is the kind of returns (X) one can expect from a debt income fund over a few months?
Well, for an income fund X should, under normal circumstances, be higher than the standard deviation.
However, as most of us realised in July this year, debts market can crash too (has happened many a time before). That is the NAV of a debt fund can sharply decrease in a day or over the course of a few weeks.
If this occurs, all debts funds are likely to be affected. Some will bounce back after a few days, some after a few weeks, and some after a few months.
If I want to invest for only a few months in a debt income fund, and if bonds crash in the period, will my fund recover?
Chances are, it will not.
I would like to use the following rule of thumb when it comes to loss of capital risk associated with debt funds.
Funds with typical maturity period of more than 1 year are likely to take about 6 months to recover from a crash. I have kept track of some income funds and many are yet to recover. Unfortunately, this includes my NPS subscriptions as well 🙁
What about the other categories? How soon would they recover?
Liquid funds over a few days. Short term funds over a couple of months and ulta-short term funds a little earlier that that.
What about an investment duration of 5 years?
I will choose debt funds with maturity of 1 year or less.
Why? For durations less than or equal to 5 years, the power of compounding is not that important. Therefore inflation is not that important. So I will prefer to safeguard the capital, choose debt funds of low risk.
Why not RDs or Bank FDs? If the goal is crucial and I know exactly how much I need, I will use these even if I fall in the 30% slab. If the goal is less important, then low-risk debts offer a tax advantage.
Invest durations between 5-10 years
Debt income funds that invest in debt paper of short duration with low standard deviation.
Debt-oriented Hybrid-funds with about 20-30% equity . Debt portfolio should have low maturity duration. Equity folio should have a good amount of large cap stocks. Again, both factors lead to low standard deviation (relatively!).
Invest durations above 10 years
Asset allocation should be done considering the risk profile of the goal, as beating inflation is major goal.
Now standard deviation must be high! High volatility is important for beating inflation.
Tough to choose just one fund. Perhaps if someone monitors the fund regularly, they can pull it off with a fund like HDFC Balanced. However, even for 10-year duration I would be wary of using a balanced fund like HDFC Prudence that has a high standard deviation – comparable to many large-cap equity funds!
The point of this post is to share with you how I use standard deviation to select fund categories for my financial goals.
Am I being too conservative? Am I being too risk-averse and missing out on returns?
The way I see it, for short term goals, inflation is not a major issue. So I will not risk losing capital by investing in a fund with large standard deviation.
If the asset class crashes, there will not be enough time to recover back.
For a long term goal, inflation IS the issue. So one must embrace high standard deviation, bear with short-term loss of capital and invest in mutual funds with high standard deviation. That is, those that have a good amount of equity.
Standard deviation is key to select mutual fund categories suitable for financial goals.
Would you agree?
Note: Standard deviation has some serious technical limitations. Despite that as a first step, it is good choice. I am working on suitable alternatives. Watch this space.
____________________
And I will respond to them in the coming weekend. I welcome tough questions. Please do not ask for investment advice. Before asking, please search the site if the issue has already been discussed. Thank you. PLEASE DO NOT POST COMMENTS WITH THIS FORM it is for questions only.
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This post was last modified on June 26, 2017, 8:50 am
Sir, How did you get this figure "My returns will typically (68% probability!!) " ?
Thank you
Thank you
That is from the definition of the normal distribution or the bell curve.
That is from the definition of the normal distribution or the bell curve.
chief, thanks for the wonderful write up. u write so clearly. pl keep it up
chief, thanks for the wonderful write up. u write so clearly. pl keep it up
Great post.
it is indeed a pleasure to read an article written by someone who has understood the subject well.
Keep up the good work really appreciate your enthusiasm in spreading awareness in these dense topics
Sir,
These investments for equal to 5yrs, u preferred debt fund. The investment u considered is lump-sum only or SIP also?
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Sir, How did you get this figure "My returns will typically (68% probability!!) " ?