The stock market has been doing well for over a year now. As there are indications of structural improvement in the economy, the rally is likely to continue for the next few years. Moreover, inflation has hit multi-year low and all the parameters are indicting that it is likely to fall further.
Simply put, equity investors will have a lot to cheer about going forward, too. Of course, as always, there are going to be periods that could test their patience.
If you are an existing equity investor or intend to start investing now, you must have a strategy to tackle these volatile periods.
A combination of clearly defined time horizon and a disciplined approach can help you tackle volatility and enhance your returns. It is equally important to choose an appropriate combination of investment options as it helps in creating the right balance between risk and reward.
For example, you have an option of either buying stocks directly or investing through a managed investment vehicle like mutual funds or a mix of both.
Each of these options requires a different investment strategy. If you decide to buy stocks, you must select the companies carefully. The companies belonging to different segments of the market, i.e., large cap, mid-cap and small cap, provide different level of opportunities, with the attendant risks.
Similarly, while investing in mutual funds, you must select the funds based on a combination of factors such as suitability, investment philosophy, portfolio composition and past performance.
Make sure that there is an appropriate representation of different segments of the market in your portfolio. For a long-term investor, it always pays to have a bias towards large cap stocks or funds that invest predominantly in large cap stocks.
If you opt for a combination of stocks and equity funds, you must decide the allocation depending on how confident you are about managing your stocks portfolio.
Don't invest in stocks aggressively just because others around you are doing so.
Whatever your portfolio mix, you need to monitor and manage it actively and realign it with your changing needs as well as economic scenario.
For example, for your stocks portfolio, you must keep an eye on major national and international events that may impact the prices and the prospects of the stocks in your portfolio.
At times, it may be imperative to make changes in the portfolio to tackle the ever changing economic scenario. If you fail to do that actively and effectively, your portfolio could suffer by way of increased risk and/ or inconsistent returns.
Similarly, when you invest in actively managed equity funds, you entrust the job of realigning the portfolios to the fund managers.
Most fund managers actively manage the portfolios so as to protect you from volatility as well as to earn higher than market returns for you.
In other words, you can benefit from the expertise of a fund manager only in actively managed funds. No wonder, these funds, on an average, are able to outperform their benchmark indices over longer durations.
However, despite this kind of track record, investors often end up exiting from actively managed funds when faced with uncertain times and hence fail to benefit from the upside that follows.
While it is true that returns from actively managed equity funds tend to fluctuate more than changes in their benchmarks during certain time periods, you need to ignore such volatilities to benefit from their true potential over the longer term.
There are a number of reasons that make actively managed funds more volatile during short term.
First, since actively managed funds have varying degree of exposure outside their benchmark indices, they tend to fluctuate more.
Second, multicap funds may underperform at times due to collective impact of volatility on different segments of the market. Third, an increased volatility could either be on account of poor stock selection or because of aggressive investment strategy followed by the fund manager.
That's why it is important to build a quality portfolio.
Simply put, it's all about the portfolio composition of the scheme, i.e., the quality of the portfolio as well as exposure to different market segments that influences the level of fall and rise in the NAV [net asset value].
Investors often get perplexed when they see different funds in their portfolio performing differently and often equate these variations with poor performance.
However, in reality, some funds that react slowly during the initial phase of the recovery in the market outperform others as the rally spreads to all the segments of the market. Unfortunately, many investors do not wait that long and exit from these funds.
No wonder, investors often look for strategies that can ensure that their portfolios move in line with the market.
Index funds and Exchange Traded Funds (ETFs) are often projected as an answer to this need of investors.
These are passively managed funds that seek to track the performance of a benchmark market index like BSE Sensex or S&P CNX Nifty. While one can invest in an index fund in a traditional manner, an ETF can be bought through the stock market like any other stock.
In an index fund, the fund maintains the portfolio of all the securities in the same proportion as in the benchmark index. The offer document of an index fund clearly states as to which index the fund would track.
The major advantage of investing in an index fund is that one knows exactly which stocks the fund would invest in.
Moreover, it is practically impossible for investors to create a portfolio that matches an index fund portfolio.
Also, index funds charge lower expenses than actively managed funds to keep the tracking error in check.
However, the major drawback of index funds that neutralises these advantages over the longer term is that one forfeits the possibilities of earning higher than market returns.
A good quality actively managed fund scores on this aspect as one can earn higher returns over the longer term.
This happens because the ability and flexibility to move in and move out gives an active fund manager a great advantage over a passively managed fund.
Considering that index funds are effectively run by computers and the fact that price sensitive information keep appearing regularly, the actively managed funds have to the mainstay of your equity portfolio.
Remember, to benefit from the true potential of actively managed funds, it is important to choose your funds well and give them sufficient time to perform.
However, for an investor who does not monitor his portfolio regularly, a blend of active and passive funds can be a good strategy. While the right way to decide on the portfolio composition depends on your time horizon, risk profile and the size of the portfolio, as a thumb rule the portfolio can be indexed to the extent of 15 to 20 per cent.
Hemant Rustagi is the CEO at Wiseinvest Advisors