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How to create sustainable returns with mutual funds
17 Jul 2023

We all know that investing in equity funds creates wealth over time and investing in debt funds gives predictability and regularity of income. Of course, if you want short term liquidity then money market funds can be the answer while you can look at hybrids if you want to combine the benefits of both these categories. When you invest in mutual funds you have a wide choice of funds, schemes, options and AMCs. How to invest in different mutual funds and different mutual fund investment plans? What are the best mutual funds with highest returns on a risk adjusted basis? The whole idea of creating sustainable returns is about being consistent and striking the right trade-off between risk and returns. Here are 6 ways to go about creating sustainable returns on mutual funds..

Investment in mutual funds that match with your goals

The best way in which your mutual fund returns can be sustainable is to match your fund choices with your goals.  The best way to ensure that your mutual fund returns are sustainable is to match your fund choices with your goals and risk tolerance. You can use a mutual fund calculator to help you make this decision. Let us take three instances. If your goal is wealth creation in the long term then opt for diversified equity funds. That is the right balance between risk and returns in equities. Secondly, if you are looking at allocating some portion to above average returns on a predictable basis then prefer debt funds with a mix of corporate debt. Finally, if you want to have liquidity within the next 2 years then prefer the safety and security of money market funds which are immune to rate changes, give above bank returns and also are extremely liquid to the point of being like near-cash.

Focus on consistency rather than actual returns

Getting the returns is one thing but consistency is more important. Let us take the case of two funds and their NAV movement over 3 years..

Time PeriodFund A - ReturnFund A - NAVFund B - ReturnFund B - NAVJan 01st 2014
100Dec 31st 201415%11513%113Dec 31st 201515%13202%115Dec 31st 201615%15232%152CAGR Returns15%
In the above case, both Fund A and Fund B have CAGR of 15% over the last 3 years as their NAV has appreciated from Rs.100 to Rs.152 in the last 3 years. However, look at the consistency and the dispersion. Any day Fund A is more consistent whereas Fund B is highly erratic and the dispersion is too high. If you are looking at sustainable returns then you should obviously prefer Fund A over Fund B. You can use a CAGR calculator to estimate the potential returns of your investment in either Fund A or Fund B. This can help you to determine how much money you can expect to earn over time.
Pick the right category of funds

If you are looking at sustainable returns then don’t focus too much on categories of funds that are too vulnerable to sectors, themes or macro events. For example, sectoral funds are more vulnerable to downturns in the sector. Similarly, commodity funds are too dependent on the commodity cycle which is a global phenomenon. Diversified funds work better in such cases. If you are looking at debt funds then a fund with a very long maturity is more vulnerable to rate hikes. Similarly, a fund with a lot of corporate debt with AA rating is vulnerable to default risk.

Look at them in risk adjusted terms

If you are looking at sustainable performance in mutual funds over a period of time then focus more on returns on a risk adjusted basis. Going back to the first instance, Fund B is a lot more risky than Fund A because of its lower consistency in performance. That is why when you are looking for consistency don’t just look at the absolute returns and benchmark with the index. You must also look at risk adjusted measures like Sharpe and Treynor which are normally disclosed in the fund fact sheet itself.

Create a mix of large caps and mid caps

Sustainability is all about getting the right mix. You need large caps because they are more representative of the economy. Also they are lower on the risk scale as they have established business models and they have a greater capacity to take on risk and volatility. On the other hand, mid caps provide the alpha to the portfolio. In the last 5 years it is mid caps that have outperformed the large caps and that stems mainly from their focused business models and lower debt. However, mid caps can be highly heterogeneous and stock selection becomes more critical. Get your mix of these two segments right.

Focus on schemes with large AUMs of over Rs.500 crore

When it comes to sustaining performance, size ultimately matters. An Rs.100 crore fund is more vulnerable to redemption pressure, rating downgrading, individual stock performance etc. That is not good news for sustainable returns. If you focus on funds with an AUM of over Rs.500 crores, you are likely to be invested in funds that are less vulnerable to such vagaries of the market.

Creating sustainable mutual fund investment returns is nothing close to the rocket science that it is made out to be. It is all about getting the right amalgam of risk and return. The rest follows!

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