Mutual funds allow investors to allocate investments across equities and debt fund categories to achieve a variety of risk/reward objectives thereby reducing overall portfolio risk.

However, the right way to benefit from mutual funds is to balance the risk as well as the potential to earn. For that, one needs to know the right meaning of risk. Simply put, risk refers to the fluctuations in the NAVs and can range from stable to very volatile. That's why, identifying the right level of risk tolerance and the right schemes remains the most important factors in ensuring success from a mutual fund portfolio.

Opt for the right mix of funds

While selecting funds, it is important for you to keep your risk profile in mind and the mix of funds selected for the portfolio should reflect that. For example, if you are an aggressive investor, the composition of your portfolio would be different from someone who may have different risk profile and time horizon.

Similarly, if you wish to invest in a sector fund, make sure that some other funds in your portfolio does not have substantial exposure to that sector. Besides, fund managers have different philosophies and styles. It is important to include funds with different styles to benefit from them.

As regards the importance of fund house in this process, the key is to examine its fund management philosophy and the fact whether it is consistent in following that. Besides, the past track record of its schemes provides a good idea about the fund management capabilities.

Prune your portfolio, if required

If you are an existing investor, for you too, it is essential to ascertain that your portfolio does not have a large number of funds. Besides, it is equally important to ensure that the exposure of your equity portfolio to different market segments i.e. large cap, mid cap and small cap is in the right proportion. If not, you need to realign it according to your risk profile, time horizon and investment objective.

The first step in the process should be to identify the non-performers. For this, the right way would be to compare the performance of your schemes with the peer group. In case, some of the non-performing schemes are about to complete one year in near future, phase out the redemption process to a paying short-term capital gains tax.

After ascertaining the right level of exposure to every segment of the market, consider weeding out some of the schemes to get the right allocation. While redesigning the portfolio, the focus should be on those schemes in the portfolio that have been performing consistently and have a good quality portfolio.

It will be prudent to also consider some of those on-going schemes that are not a part of your portfolio but have an excellent track record over the longer term. As a thumb rule, you should have exposure to around 8-10 schemes.

While realigning your portfolio, it is important to remember that negative returns from a fund do not necessarily mean poor performance. Even the best of fund mangers are likely to give negative returns during the periods where markets go down significantly.

Besides, the time period considered also signifies the true level of performance. For example, short-term negative returns, in line with the market, from a fund that has been doing well for years means nothing and should be ignored.

Similarly, even a bad fund manager can give decent returns when the markets are doing well. Besides, a fund manger can enhance the returns of a fund in a good market by increasing the risk exposure. Therefore, one needs to go beyond the performance numbers to judge the skill of a fund manager.

If you are a taxpayer, begin investing with an ELSS

Equity Linked Savings Schemes (ELSS) are the best example of an investment option that provides you a very simple way of investing in stock market and save taxes while doing so.

As a product category, it has given handsome returns over the years. While, the past performance alone should not be the sole criteria for making an investment, the fact remains that over a period of time equities have the potential to provide better returns compared to other instruments.

Being equity oriented schemes, ELSS have the potential to provide better returns than most of the options under Section 80C. Another notable feature is the tax efficiency in terms of returns earned through them.

It is important considering that ELSS also aims to distribute income by way of dividend periodically depending on the distributable surplus. As per the current tax laws, an equity fund investor is not only entitled to earn tax free dividend but also the long term capital gains are not taxable.

FMPs are an attractive option for risk-free investments

While mutual funds offer several options in the risk free category of investments, Fixed Maturity Plans (FMPs) require special mention.

FMPs have fixed maturity date and at the end of that period they mature like a fixed deposit. Under an FMP, the fund manager invests in fixed income instruments like bonds, government securities and money market instruments. The key here is that the fund manager invests in those instruments that will mature around the time of maturity of the plan. This not only eliminates the volatility risk but also makes it possible to know the indicative return that you can expect at the time of maturity.

Here again, the tax benefits for investing in mutual funds will ensure that investors in higher tax brackets get better post tax returns compared to other instruments like fixed deposits.

For example, if you opt for dividend option, the dividend received in your hands will be tax-free. However, the mutual fund will be required to pay tax of 14.025%. On the other hand, if you invest in the growth option of an FMP for one year or more, the long-term capital gains will be taxed @10% (without indexation).

In a fixed deposit however, the interest income will be added to your income and taxed at the applicable income tax rate. Clearly, FMPs are more tax efficient for investors in the higher tax brackets.

As is evident, mutual funds have the potential to be an ideal option for every type of investors. The key, however, is to select the right options and in the right proportion.

The author is CEO, Wiseinvest Advisors Pvt. Ltd. He can be reached at hemant.rustagi@moneycontrol.com.

For more on mutual fund investments, log on to www.easymf.com.