Mutual fund portfolio construction using a investment style box

Here is a simple way to construct a diversified mutual fund portfolio, or to declutter and reconstruct an existing portfolio using the investment style box available at mutual fund star rating portals.

The following are the attributes of a ‘good’ portfolio.

  1. Diversification across assets classes (equity and fixed income should do)
  2. Diversification within each asset class. For example, a spread across market cap, sectors and geography. A spread across investing styles is also possible and can be used as an effective reference to simplify portfolios with several funds. This is the subject of this post.
  3. Minimalism. Each fund in the portfolio should have a unique identity. Else it will not provide any benefit. Minimalism is key to effective diversification.

The main purpose of diversification is ensure all eggs are not in one basket.  More details and how one can measure it are covered in this post: Quantifying Portfolio Diversification.

Young earners who are about to start their mutual fund investing journey can consider these minimalist portfolio ideas without worrying too much about investment styles.  If they want to add funds to such a portfolio, then  it could be useful to consider  investing style.

Investors who have accumulated several funds can consider using the following method to declutter their portfolios.

Stock investing styles can be broadly classified into two: Growth investing vs Value investing.

I am not an expert and therefore, will only offer crude non-technical definitions.

Growth investing refers to a style in which one predominantly chooses so-called growth stocks.  Growth stocks are those of strongly performing businesses which earn well and are expected to earn well in future (better than peers).  Since the business is doing well, the market would be willing to pay a premium for these. Hence, growth stocks are expensive. Growth stocks are also known as performing stocks.  Here is a method for identifying growth stocks:  Automated Stock Analysis with the Piotroski Score

A value stock is one which currently not performing, but has a sound underlying business that would do well in future. At present the market is unwilling to pay for what the stock is actually worth and therefore, relative to a wide range of valuation metrics, the stock is underpriced. About 5/6 such valuation methods can be found in the automated stock analyser: Stock Analyzer 7: Graham Formula and Graham Number

There are risks associated with both methods. A growth stock can tank in future and value stock can never pick up as expected.  Sometimes a clear distinction may not be possible. It is perhaps the dream of every stock picker that a growth stock become available at a discount during a crash so that more of it can be purchased and a value stock quickly becomes a growth stock.

“Growth investing vs value investing: which is better?” is a pointless debate. During bull runs, growth stocks outperform value stocks. During a bear market, identifying value stocks would prove useful.  So an equity portfolio requires both.

Mutual fund portfolio construction

A mutual fund portfolio is no different. In order for investors to understand the investing style of a fund manager, a style box such as this is provided by star rating portals.

Value-Research-Style-Box

On the top are the two investing styles with a value+growth blended style. On the right are the three market capitalizations – large-cap, mid-cap and small cap. A crude working definition would be large (established), mid-sized and small business typically.

Capitalization =  total market value = share price X no shares.

 

Looking at the PE of the fund to invest, makes no sense. The style box is a much better source of information.

The percentage of stocks held under each style is unknown if Valu Research Data is used. Morning star India offers a detailed style box. This is the style box of ICICI Prudential Value Discovery fund.

Morning-Star-Syle-Box

Note that Value Research scale goes Growth –> Blend –> Value. MorningStar scales goes Value –> Blend –> Growth. Guess  VR wanted to be different!

The ICICI Value discovery fund has changed style from Value to Growth which seems to be a key factor in Morning Star Analyst ratings downgrade. Read more these ratings: Quantitative vs. Qualitative Mutual Fund Analysis.

So while Value Research can be used to screen investing styles, the final choice can be made after consulting MorningStar.

Most of the large cap funds have growth stocks. Few with blended or value styles.  At the time of writing, there are no pure value portfolios in the small cap category and mid-cap categories listed at Value Research. There is just one value style multi-cap fund. No pure value style ELSS funds or balanced funds.

Pure value investing is not popular among AMCs as of now. Therefore, one will have to settle for a blend. 

A simple approach is to declutter a portfolio would be to reduce the number of funds in the same category and investing style. For example, I have seen portfolios with 6/7 large cap funds.

They can be trimmed down to say,

1 growth style + 1 blend style  (different amcs) or

1 primarily growth style + 1 primarily value style (if such a fund can be found)

The same approach can be followed for other categories. The basic idea is to introduce diversity in investing style so that the portfolio does well in all market conditions (assuming fund management is competent).  Extent of overlaps between the two funds can also be checked to approximately validate the difference in investing styles using the Moneycontrol edition: Equity Mutual Fund Portfolio Comparison Tool.

A  large portfolio can comprise of just 4 funds:  2 large cap funds (growth, value) and 2 mid and small-cap funds (growth, value).

A small portfolio for a new investor can simply have a growth style large cap + a growth style mid and small cap.

Or a blend style large cap + blend style mid and small cap.

You can review the portfolio styles of a particular category from a link such as this one:

https://www.valueresearchonline.com/funds/fundSelector/portfolio.asp?cat=23&exc=susp%2Cdir%2Cclose

Additional funds can be added later as the folio gets bigger, if felt necessary.

There are so many ways to build a portfolio. The purpose of this post is to merely to point out that diversification across investing styles is a good idea and can be used to weed out funds with same mandate and investing style.

The weeding out need not be done immediately. You can compute the net XIRR of the equity portfolio and compare the individual XIRR of each fund with it (taking into account investment weights). Funds with significant exposure and XIRR much lower than net XIRR can be removed first. Read more about this approach: How to review your mutual fund portfolio

What do you think?

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2 thoughts on “Mutual fund portfolio construction using a investment style box

  1. Sree

    Hello sir, thanks for all the great articles. Your site has been nothing sort of eye opener to me and now I have started doing it myself.
    While reviewing various avenues to invest, I was stuck with a question.
    I was comparing a scenarios between FD and Mutual fund:
    Let us say I have a FD that is giving me 8% return YOY for 3 years and a Mutual fund that is giving average 15% 3 year return.
    Just ignoring tax for now. Rs 1000 in FD would yield (compounded) ~ 1250, but a lumsum of Rs 1000 in mutual fund would just provide a return of 1150. Am I thinking correct?

    Reply
  2. Anil

    How to understand portfolio sector wise allocation and asset allocation(eq,debt and other)of sehemes as invt.policy

    Reply

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