Scheme Selection — putting it all together

Where the whole syllabus comes together

Everything so far has been building to this. Chapter 12 is 15% of the paper, joint-heaviest with Chapter 9, and it is where you stop describing products and start choosing them for a person.

The order is fixed and it never changes:

Scheme selection is the last step, not the first. A distributor who starts by recommending a fund has skipped the only part that makes the recommendation defensible.

Start with the need

Three broad needs, three answers:

But need alone is not enough. Risk appetite — the need, ability and willingness to take risk from Chapter 1 — and the investment horizon must both fit.

The workbook makes two careful points about this:

• An investor may want growth and be willing to take the risk, but without an adequately long horizon equity is still unsuitable, because equity markets are volatile in the short term and only smooth out over long periods
• An investor may have a long horizon and still be unwilling to bear equity risk, and may reasonably prefer lower returns from debt

Both matter. Willingness without horizon fails; horizon without willingness fails too.

Age is a weak proxy

It is popularly believed that younger investors can take more risk. The workbook pushes back:

Use the time horizon to the specific goal instead. Longer horizon → higher ability to take risk. Near-term goal → avoid risk. And remember that a portfolio may need liquidity for various reasons even when the investments are meant for long periods.

Core and satellite

Divide the portfolio in two:

• Core — invested for the investor's long-term needs and goals. Diversified equity, large cap, mid cap funds — things that generate long-term returns broadly in line with the markets
• Satellite — invested to exploit expected short-term market movements. Sector funds when economic factors favour that sector; long-term gilt funds when interest rates are expected to decline; gold funds when inflation is high or there is political, economic or fiscal uncertainty

Satellite holdings are tactical and held only while the conditions last.

The split depends on the investor:

The risk-return hierarchies

These are pure ordering questions, and they appear reliably. Learn all six.

Across categories — risk and potential return both rise left to right:

Debt funds by interest rate risk (assuming similar credit risk):

Debt funds by credit risk (assuming similar interest rate risk):

Equity funds by market cap — risk decreases left to right, so read this one carefully:

Diversification to concentration — risk rises left to right:

Hybrid funds — risk rises left to right:

Note the methodological point the workbook insists on: when comparing debt schemes on credit risk, assume interest rate risk is similar, and when comparing on interest rate risk, assume credit risk is similar. Otherwise you are comparing two things at once and the ordering means nothing.

Product labelling was introduced by SEBI in 2013 to address mis-selling and give investors an easy understanding of what they are buying and whether it suits them — including a disclaimer that investors should consult their financial advisers if they are not clear about the suitability of the product.

Choosing by strategy

Active versus passive. Passive funds suit investors wanting exposure to an asset class without the risks of fund manager selection and strategy. An index fund has no selection risk because the fund manager has no role in creating the portfolio, and therefore lower permitted costs, since there are no research or fund management expenses.

An investor in an active fund bears higher cost and higher risk to earn returns better than the benchmark — and the higher return is in no way guaranteed.

The workbook's guidance is well judged: an investor with the modest objective of having an equity growth component, rather than the aggressive objective of beating the benchmark, is better off in an index fund.

But it also states the limit plainly: this does not mean an index fund's NAV will not decline. If the benchmark index goes down, the NAV of the index fund goes down too.

Open-ended versus close-ended. The difference is not about objective or strategy but an operational feature — the exit option.

• Open-ended gives liquidity. To provide it, schemes maintain part of the portfolio in liquid assets, which can dilute the returns an equity fund would otherwise have earned. They are also subject to large fluctuations in net assets from heavy sales or repurchases, putting pressure on the fund manager
• Close-ended offers liquidity only through listing on a stock exchange — but units are not actively traded, a counterparty is needed, and the price may be lower than NAV with no limit to the discount (though towards maturity the market price converges towards NAV)

The compensating advantage: a close-ended equity fund lets the manager target better returns by investing in companies that may realise their potential over time, or in relatively illiquid stocks, without the pressure of investor redemptions.

Choose close-ended only if the money can stay locked in, and match the scheme's maturity to when the funds will be needed.

Diversified, focused, thematic, sector. Multi-sector exposure makes a diversified fund less risky, and in an actively managed one the manager ensures higher exposure to better performing sectors.

Sector funds are risky because of concentration in one sector. They require the investor to have the skill to understand and interpret the factors signalling that a sector is ready for investment or exit — and returns depend on entering before the up-cycle starts and exiting before the downturn begins. Timing is the key, which is exactly why they suit the satellite portfolio.

Thematic funds — MNC funds, PSU funds, infrastructure funds — fall between diversified funds and sector funds, for investors more comfortable identifying a theme than a specific sector.

And the line worth quoting to clients: "Diversification is a protection against ignorance." If you are not sure, diversification is always a good idea.

Large, mid and small cap. Large caps are established companies with stable revenues and profitability and the financial strength to withstand competition and downturns. Mid and small caps are in the initial stages of growth — they can grow tremendously when the economy does well, but many fall by the wayside during economic turmoil because they lack the resources to survive.

The cycle described is worth understanding: as the economy recovers and investors return, valuations in front-line stocks turn expensive — at that stage mid and small cap funds offer attractive opportunities. And over a long period some mid and small caps become large companies whose stocks are re-rated, boosting returns.

But: mid and small cap stocks require careful evaluation and selection, so it can be risky to invest a large portion of a portfolio in them.

Multi cap spreads across the spectrum to benefit from opportunities everywhere while keeping risk lower than mid and small cap funds. Flexi cap gives the fund manager freedom across market caps.

Growth versus value. Growth seeks companies expected to grow faster than the average economic growth rate; such stocks do well in a bull phase but fall much more in a downturn, making them riskier. Value seeks stocks available cheap relative to the value that could be unlocked in future.

Choosing among debt schemes

Liquid funds — the lowest risk choice, with correspondingly low returns. For retail investors the comparable is a savings bank account. Suitable for parking funds for very short periods (up to 91 days), with negligible volatility. And a good warning: using these schemes for longer periods is not advised, since the investor needlessly loses out on returns.

Ultra short term — slightly longer tenor, 3 to 6 months, playing a similar role.

Short duration funds — 1 to 3 years, earning returns in line with market yields, low volatility, suitable for the core portfolio of an investor with low risk-taking ability. And a tactical point: if interest rates are expected to rise, it is safer to increase allocation to short duration funds, because as rates rise the short-term bonds mature and the manager redeploys at higher rates.

Floater funds — invest in floating rate instruments, whose value holds even if interest rates fluctuate, so the NAV tends to be steady.

FMPs versus Target Maturity Funds. FMPs cannot be redeemed before maturity except through the stock exchange. TMFs are gradually replacing them — portfolios of G-secs, State Government Securities and AAA-rated PSU companies, and where they follow an index they can be purchased from or redeemed with the AMC in the normal course, like open-ended funds. Liquidity is the advantage of TMFs over FMPs.

Two debt strategies to distinguish: funds focused on earning interest income produce steady, low-volatility returns — though some lower the quality of securities to earn higher interest. Funds targeting total return from coupon plus appreciation manage duration against interest rate expectations: when rates are expected to fall, modified duration is increased for greater gains. Those returns are more volatile, and there is the risk of the manager's call on rate direction being wrong.

Hybrid and gold

Hybrid funds give equity exposure with lower risk — the equity component provides appreciation, the debt component provides stability.

The trap the workbook flags: the word "conservative" in a conservative hybrid fund refers only to the equity allocation. You must still check how the equity portion is managed (large, mid or small cap; diverse sectors or not) and the credit quality and duration risk of the debt portfolio.

Gold ETF versus Gold Sector Fund. A Gold ETF's NAV closely tracks the price of gold, since it reflects gold held in custody — a more efficient way to take exposure to gold. A Gold Sector Fund invests in shares of gold mining and processing companies, whose performance is linked to the profitability of those companies. Such shares can appreciate much more than the metal when gold rises, and fall more when it declines, and are driven by factors other than the gold price — concerns about a company's management can sink the share price regardless of gold.

Judging a scheme — seven criteria

1. Matching portfolio with objective. An investor buying into a scheme is essentially buying into its portfolio. Most AMCs publish portfolios monthly. Check whether the portfolio reflects the stated objective and whether the manager is true to the promised style.

The workbook's examples of untruthfulness are worth memorising: a "value fund" holding a large proportion of fully-valued front-line stocks; a "short-term debt fund" taking significant long-term exposure; a "hybrid fund" taking aggressive equity positions or high credit risk; a liquid or ultra-short fund taking high credit risk.

2. Fund manager. Long-term watchers develop views on which AMCs and managers are more prescient in identifying changes in market trends.

3. Fund performance. The primary criterion. The fund should have consistently outperformed the benchmark — and critically, not only outperformed in a bull market but protected the downside in a falling market.

Minimum periods to examine:

Compare against benchmark, against the peer group, over multiple periods including rolling periods, and across bull and bear market cycles.

4. Fund portfolio. For equity: diversification across sectors and stocks, market segment, cash held, length of holding and churn, and selection strategy. For debt: average maturity and duration, credit risk profile, the contribution of interest versus capital gains to total returns, and liquid holdings.

5. Fund age. A long history gives a track record that can be studied. A new fund managed by a portfolio manager with a lacklustre track record is definitely avoidable.

Fund age matters most where divergence within a category is wide. After SEBI's categorisation circular there may be little difference across large cap funds, but major differences across multi cap funds, since the investment universe is much larger.

6. Fund size. See size in the context of the investment universe. For a large cap fund, large size is an advantage — better diversification and economies of scale. For a sector or mid cap fund with limited options, large size is a disadvantage. A small fund is more flexible and better able to take advantage of market opportunities.

7. Portfolio turnover. Churning adds broking costs and indicates unsteady investment management.

₹10,000 crore of transactions on average net assets of ₹5,000 crore gives a ratio of 2, or 200% — implying an average holding period of 12 ÷ 2 = 6 months.

Judge turnover against the investment style. Six months may be too short for a value style but perfectly acceptable for a momentum-driven scheme. A short holding period may indicate the manager is seeking tactical short-term opportunities rather than investing in fundamentally strong companies for the long term.

Plus: scheme running expenses. Any cost is a drag on returns. Be particularly careful about the cost structure of debt schemes, because debt returns are normally much lower than equity. And since index funds follow a passive strategy, a high cost structure is questionable.

Ratings and rankings — read the warning

Research agencies rank and rate schemes, often with stars. Two cautions:

• In almost all cases the rating assesses past performance and has no predictive ability
• Quarterly rankings show the best fund in one quarter is not necessarily the best in the next. Chasing the top fund every quarter is neither an ideal objective nor a feasible proposition, and the costs of switching between schemes are likely to severely impact returns

The sensible aim: stay invested in schemes that are in the top "few" in their category consistently — 3 to 5 where a category has few schemes, or the top 10–15% where there are many.

And remember: beyond scheme performance, taxes and exit loads make a big difference to the investor's return.

Choosing the option — and why SWP usually wins

The three options share the same portfolio, so the difference is cash flow and tax.

IDCW payout gives money flow. Growth lets money grow in the fund on a gross basis — without annual taxation.

Now the argument that matters commercially. IDCW payout seems attractive for investors wanting regular income. But:

And on tax: dividend income is taxed at the investor's applicable slab rate, which reduces returns. IDCW is therefore not preferable, except for tax-exempt investors.

The trade-off to check: an SWP sale may attract STT (equity schemes) and capital gains tax (equity and debt schemes), so the capital gains impact must be assessed. But a predictable payment taxed at capital gains rates generally beats an unpredictable one taxed at slab rates.

Note also that repurchases are treated as a sale of units, creating capital gain or loss — which some investors deliberately book to set off against another capital loss or gain, where set-off is permitted.

The six do-and-don't rules

1. Ensure suitability. SEBI's Fraudulent and Unfair Trade Practices regulation applies to the sale of mutual fund units, so the distributor must ensure the scheme suits the investor's needs and situation. This is the fourth limb of mis-selling from Chapter 6.

2. Stick to the investor's asset allocation. Keep asset allocation at the core of scheme selection.

3. Do not chase past performance. The disclaimer "past performance may or may not be sustained in future" exists for a reason: top performers in one period do not necessarily remain top performers. Buying a scheme simply because of good recent returns is not a wise approach — and this is the recency bias of Chapter 1 in its most expensive form.

4. Understand the investment objective and strategy — both help you know what to expect from the scheme.

5. Keep an eye on taxes and loads. Both reduce returns. When withdrawing, assess capital gains tax and exit load implications, and periodically compare the tax treatment of dividend and growth options.

6. Develop a consistent methodology for scheme selection — and keep it in writing, so you stay on course.

That last one is the most practical advice in the entire workbook. A written method is what stops a distributor being swayed by whatever performed well last quarter.