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How to select mutual fund categories suitable for your financial goals?

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

I am pained to see investors select mutual funds utterly unsuitable for their goals. For example,

selecting diversified equity mutual funds or balanced funds with significant equity component for goals just a few years away.

investing in volatile debt funds without understanding the risks involved.

I strongly believe that if an investor knows how to pick the

suitable for her needs, the task of selecting a suitable mutual fund

category becomes utterly simple, if not obvious.

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 althoughthey could be understood quite easily.

When I made astep-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 thiswonderful analogyby Subra.

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 scoresdeviatemorefrom the average, we will need to calculate the deviation of each score wrt the average and take theaverage of the deviations.

This is thestandard 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, Dravids scores are expected to deviate very little from the average while Shewags scores are expected to deviate substantially.

So we say, Dravids batting average has lower standard deviation than Shewags.

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 theaveragestandard deviation in a particular category.

Notice thatreturnsare missing from this table.

As you go down the table, the equity component increases. Obviously, if a fund has more equity allocation, higher would be the fluctuations in return and therefore higher the category standard deviation.

category has different kind of debt funds (dynamic bond funds, diversified debt funds, that is funds that invest in paper that matures over different periods etc.). So it is not an exclusive group. This is why there is a huge variation in standard deviation and average maturity.

The red arrows point to the evolution in standard deviation. The average standard deviation of one category is close to the minimum standard deviation of the next category. For the above-mentioned reason, this does not apply to

I have not included gilt funds as they are specialised funds that resemble equity sector funds not for everybody.

Let us consider the first four entries that have no equity. Obviously, these are pure debt funds.

Notice the average age at which the category debt holdings mature. A debt paper is a simple agreement between two parties:

I will pay an amount Y. You hold it for n days and pay me an interest r

. Of course, this is an over simplification but should suffice for our purpose.

Liquid debt funds invest in short-term debt paper ranging over a couple of months while

debt funds invest in debt paper that can have an age of several years.

higher the age of the maturity, higher is the standard deviation and therefore higher the fluctuations in returns.

Of course, this also means higher returns . typically!

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 willtypically (68% probability!!)range from

If the answer is no, we can move on and choose somthing with lower standard deviation. What if the answer is yes?!

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.

standard deviation (3.70%), there is little or no chance of losing the capital invested.

standard deviation, chances of losing the capital invested are high.

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 anincomefund 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,alldebts 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 debtincomefund, and if bonds crash in the period, will my fund recover?

I would like to use the following rule of thumb when it comes to loss of capital risk associated with debt funds.

Longer the average maturity period, higher the

longer the time it would take for the debt fund to recover.

If Dravid and Shewag lose form at the same time, who is likely to spring back faster? The batsman who can scratch around at the crease, or someone whose instinct is to whack every ball?

Higher the standard deviation, bigger would be fall in the event of a crash and therefore longer it would take the debt fund to recover.

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 myNPS subscriptions as well🙁

What about the other categories? How soon would they recover?

Liquid fundsover a few days. Short term funds over a couple of months and ulta-short term funds a little earlier that that.

Therefore, for investment durations of just 1-2 years stick with Short-term/Ultra-short-term/liquid funds. Fixed maturity plans (FMP) are also a good option for such durations.

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.Thereforeinflation is not that important. So I will prefer to safeguard the capital, choose debt funds of low risk.

Why notRDs 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.

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!).

Asset allocation should be doneconsidering the risk profile of the goal,as beating inflation is major goal.

Now standard deviationmust 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 abalancedfund 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, inflationISthe 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 iskey to select mutual fund categories suitable for financial goals.

Note:Standard deviation has some serious technical limitations. Despite thatas 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 THISFORMit is for questions only.

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How to select suitable debt mutual funds with low

Want to use the same mutual funds for all your

Understanding Debt Mutual Fund Categories and why it

(PhD) is the author and owner of . He is an associate professor at the Indian Institute of Technology, Madras since Aug 2006.Follow @freefincal

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nicely explained , otherwise boring species of mutual fund community! thank you.

nicely explained , otherwise boring species of mutual fund community! thank you.

Thank You so much for a detailed post. This gives the better idea of investing; who understand simple maths!

Thank You so much for a detailed post. This gives the better idea of investing; who understand simple maths!

thanks for the post, will appreciate if we explain wrt to any four particular MFs say may be Top200, SBI emerging, HDFC Midcap and may be ICICI Pru focussed. will wait for the post-cheers

Thank you. Not sure what you want. If you want analysis on these funds, you can do it yourself with the tools available.

If you want an explanation in terms of standard deviation, then not much to explain. It will be quite high. So they are suitable only for long term (min 10Y).

thanks for the post, will appreciate if we explain wrt to any four particular MFs say may be Top200, SBI emerging, HDFC Midcap and may be ICICI Pru focussed. will wait for the post-cheers

Thank you. Not sure what you want. If you want analysis on these funds, you can do it yourself with the tools available.

If you want an explanation in terms of standard deviation, then not much to explain. It will be quite high. So they are suitable only for long term (min 10Y).

Most mutual funds give standard deviation in their fact sheets but not the mean returns for the period under consideration. SD without a mean has no meaning and is not a useful tool to select any fund.

The post is about using SD for choosing fund categories and not for choosing funds. So returns are immaterial. SD gives an idea about volatility and this is good enough for choosing fund categories.

If you look at my step by step guide to choosing my mutual fund, I would have used all risk return parameters together.

Most mutual funds give standard deviation in their fact sheets but not the mean returns for the period under consideration. SD without a mean has no meaning and is not a useful tool to select any fund.

The post is about using SD for choosing fund categories and not for choosing funds. So returns are immaterial. SD gives an idea about volatility and this is good enough for choosing fund categories.

If you look at my step by step guide to choosing my mutual fund, I would have used all risk return parameters together.

Nice Pattu. Your post answers a number of questions which an investor must ask himself before investing. And good information about Debt fund behaviour, which in my opinion are tougher to understand than the equity funds.

Thank you very much. I agree with you reg. debt fund behaviour.

Nice Pattu. Your post answers a number of questions which an investor must ask himself before investing. And good information about Debt fund behaviour, which in my opinion are tougher to understand than the equity funds.

Thank you very much. I agree with you reg. debt fund behaviour.

Enriching post.. Thank you. Needs to be bookmarked

Enriching post.. Thank you. Needs to be bookmarked

Thanks Pattu once again for answering a question for which I would have visited many sites and spent hours

Thanks Pattu once again for answering a question for which I would have visited many sites and spent hours

Thanks Pattu Sir, very nicely written article.

I have a query on debt funds. If all my financial goals (atleast the ones I have thought of), are minimum 15 years away, is there any point in having a debt fund in the portfolio at all? I have PPF, EPFas my debt category, will that be alright? I understand that both PPF n EPF are not flexible and cannot be converted to liquid cash when required.

Thanks Pattu Sir, very nicely written article.

I have a query on debt funds. If all my financial goals (atleast the ones I have thought of), are minimum 15 years away, is there any point in having a debt fund in the portfolio at all? I have PPF, EPFas my debt category, will that be alright? I understand that both PPF n EPF are not flexible and cannot be converted to liquid cash when required.

Sir, if i have Rs 100,000 today n i want to invest it in mf say, i have 4 scenarios- for 1.5 year, for 3.5 years, for 6years, and for 9 years- with moderate risk capacity n specific target goals-aim fr tax savings- which all specific funds do u seggest?

i mean Rs 100,000 is fixed for different scenarios- how to put Rs 100,000 for 1.5 years period, than again where to put Rs 100,000 for 3.5 years period, etc etc-

Sir, if i have Rs 100,000 today n i want to invest it in mf say, i have 4 scenarios- for 1.5 year, for 3.5 years, for 6years, and for 9 years- with moderate risk capacity n specific target goals-aim fr tax savings- which all specific funds do u seggest?

i mean Rs 100,000 is fixed for different scenarios- how to put Rs 100,000 for 1.5 years period, than again where to put Rs 100,000 for 3.5 years period, etc etc-

Also can there be a fund- to keep lumpsum money for say 6 month to 2 years to 3 yearsmay need it..may not need it also.. just to keep aside..?? no specific time, just safety n return n tax efficiency??

Also can there be a fund- to keep lumpsum money for say 6 month to 2 years to 3 yearsmay need it..may not need it also.. just to keep aside..?? no specific time, just safety n return n tax efficiency??

It was nicely explained. When i tried to come to conclusion, bit confused.

Example, I am a kind of investor who want to achieve child education goal which is 20 yrs down to line, with only one fund. So it become confusing, to go with only large cap, large & mid cap, or multicap?

I hve investment in some funds like hdfct200, QLTEF, FIBCF,IDFC premier equity. Now Should i put my current requirement in one of this or should go with one as explained by your procedure ( UTI OPP, UTI mid cap, uti Equity, )???

Need ur view as i wana start SIP ASAP for my 1 year old.

If you already have funds tagged to these goals. Please continue in the same funds. If you are starting fresh, use a single balanced fund or 1 large and mid-cap fund with PPF. Down the line you can use a debt fund.

It was nicely explained. When i tried to come to conclusion, bit confused.

Example, I am a kind of investor who want to achieve child education goal which is 20 yrs down to line, with only one fund. So it become confusing, to go with only large cap, large & mid cap, or multicap?

I hve investment in some funds like hdfct200, QLTEF, FIBCF,IDFC premier equity. Now Should i put my current requirement in one of this or should go with one as explained by your procedure ( UTI OPP, UTI mid cap, uti Equity, )???

Need ur view as i wana start SIP ASAP for my 1 year old.

If you already have funds tagged to these goals. Please continue in the same funds. If you are starting fresh, use a single balanced fund or 1 large and mid-cap fund with PPF. Down the line you can use a debt fund.

Are you suggesting to go for equity mutual funds only for goals more than 10 years?

I have realised that most of the advice is from a risk averse perspective but have I understood the above post correctly

On a diff note I really appreciate all the efforts taken by you to simplify the overall process

Thank you. Yes, I am in favour of significant equity allocation only for 10Y plus goals.

Are you suggesting to go for equity mutual funds only for goals more than 10 years?

I have realised that most of the advice is from a risk averse perspective but have I understood the above post correctly

On a diff note I really appreciate all the efforts taken by you to simplify the overall process

Thank you. Yes, I am in favour of significant equity allocation only for 10Y plus goals.

I couldnt export this page to PDF using the embedded Print/PDF link (which points to Im getting an empty page.

Perhaps it is an issue with the plugin. Try using the print option in Chrome.

I couldnt export this page to PDF using the embedded Print/PDF link (which points to Im getting an empty page.

Perhaps it is an issue with the plugin. Try using the print option in Chrome.

Thanks a lot for explaining in detail regarding choosing fund categories.

You have mentioned that gilt funds are like equity sector uld you please elaborate on that.Are they suitable for long term debt portion of asset allocation (along with PPF).would they help in balancing a scenario where interest rates for PPF may fall?

Thanks a lot for explaining in detail regarding choosing fund categories.

You have mentioned that gilt funds are like equity sector funds.could you please elaborate on that.Are they suitable for long term debt portion of asset allocation (along with PPF).would they help in balancing a scenario where interest rates for PPF may fall?

Thank you so much sir. Very clear explanation.

Thank you so much sir. Very clear explanation.

Great Post Sir. Please Continue your Great Work.

Great Post Sir. Please Continue your Great Work.

Sir, How did you get this figure My returns will typically (68% probability!!) ?

Sir, How did you get this figure My returns will typically (68% probability!!) ?

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

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

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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