How to quickly select equity mutual funds and build a diversified portfolio (resolve step 1)

Last Updated on September 24, 2020

As readers may be aware Re-assemble is series on the basic of money management aimed at beginners and young earners. Since it now pretty much complete with a compiled free e-book released, I think it is time to move on to the next step. Introducing. Resolve: a series of steps on investing and portfolio management.  In the first step, let us discuss how to quickly select equity mutual funds and build a diversified (equity) portfolio.

Resolve stands for “finding a solution” or “make firm decisions”. In this case, we shall find quick, simple solutions and make firm investment and portfolio management decisions. As always the series is meant for beginners to DIY with confidence and conviction. Once the essentials are covered, I shall discuss how to evaluate a portfolio using different methods, how to choose tactical asset allocation method etc.

For step 1: How to quickly select equity mutual funds and build a diversified portfolio we shall utilize the List of mutual fund benchmarks (2018) with funds sorted by benchmark published yesterday.

I present four choices below and you can pick one. Each choice will result in a shortlist of funds to choose from you. You can either then pick funds with a good track record (even though they are different now) or go with a new fund. If you are a person who has trouble choosing then I suggest you get started with My Handpicked Mutual Funds May 2018 (PlumbLine): Revised and Updated and then start learning other aspects of investing.

Please note: Selecting the right equity mutual fund scheme is not possible! Run away from anyone who claims otherwise! Once you have a portfolio construction method in place, you can use Inky Pinky Ponky for selecting Mutual Funds!  It does not matter how you select mutual funds as long as you have a solid process in place to review them (this will be resolve-step:2). The focus in this post will be on the type of portfolio you wish to construct.

I doing this excercise with NSE indices. You can do the same BSE indices as well. What matters is the approach.Also ignore the regular plan from the fund names. Always choose direct plans.

The NSE broad market index classification

Starting from the top 500 companies based on full market capitalisation, NSE has derived the following indices. Source: broad market methodology.  This will be the basis for the portfolio construction. With the exception of NIfty Midcap 100 and NIfty smallcap 100 where the bottom 50 stocks are based on average daily turnover, the rest of the indices are based on market capitalization. A stock with a higher market cap will have higher weight. If you trace the lines from the top, it is easy to understand how the indices are different (related) from (to) each other.

Choice 1: I wish to choose index funds

As seen from a series of posts on Nifty Next 50 (another e-book perhaps?) it is a fantastic choice to beat many active funds in terms of return (but not risk). However, be warned Nifty Next 50 is NOT a large cap index! The Nifty 100 Equal weight fund is a good lower risk, comparable reward alternative, but the index funds have low AUM when I last checked. So if we sort by benchmark, we get:

The ICICI fund is fast becoming popular. Avoid all ETFs unless you wish to trade in Nifty 50, Bankbees, liquid bees, Goldbees and the CPSE ETF.

Low AUMs are not a danger for index funds with reg to redemptions but since commissions are low, no one will sell them and the AMC may shut down the fund. I think only the ICICI fund has moved past that danger.

Also see: Index Investing: advantages and disadvantages of being a passive investor There is more to it than cost.

Choice 2: Large +mid+ small cap funds

A well-diversified portfolio can be built with two/three active funds benchmarked to the above indices. You choose large cap + mid-cap or large+mid+small cap funds. The weights depend on how much risk you can stomach. But be warned that higher risk does not mean higher returns.

Sorting funds benchmarked to NIfty 100 we have

Pick one from Franklin Bluechip, ICICI Bluechip and Hdfc Top 100.

Now if we sort by the mid and smallcap indices:

Or you can also sort by

I had a quick look at some of the funds in the above two lists and I notice that it could be a tough time for many midcap and small-cap funds to consistently beat these new indices. In the absence of midcap and small cap index funds, there is not much choice available to investors.  You can go with familiar names such as HDFC Mid-cap Opportunities and Franklin Smaller Companies fund.

Choice 3: Single multi-cap fund (A)

Nifty 200 is a multicap index with a bit of a large cap tilt. Sorting by this:

With the exception of Kotak Select Focus, not many familiar names (to me).

Choice 4: single multi cap fund (B)

This should have a bit more balance between large and mid-cap. I can see ICICI Top 100 here (that I like)

I hope the reasoning behind these choices is clear from the NSE flowchart. Sorting by benchmark offers a simple way to build diversified portfolios.

Choice 5: Equity oriented balanced funds

There is a 5th choice that I personally follow: Using Balanced Mutual Funds As The Core Equity Portfolio Holding

So for this sorting, we need to go a bit wider in terms of a benchmark.

This is a pretty mixed bag and it is better to stick to known players like HDFC Balanced, Prudence or Franklin Balanced.

Obviously, the benchmark that you choose will decide the shortlist here. If you are not familiar with any funds in the list, you can go ahead and pick the oldest one. If you wish to dig deeper, you can find out how it has changed recently. Whatever you do, however you choose, if you do not know how to review performance, do not use mutual funds. We will consider performance reviews in the second part.

What articles would you like to see as part of Resolve?