Were free lunches ever on offer to investors in mutual funds? Yes, yes, and yes, and a combination of two things made this possible. One, a traditionally undervalued stockmarket had to explode sometime (don't we know that now!) and anyone smart enough to invest some money in a diversified equity fund and patient enough to wait for returns wouldn't have been disappointed. For the record, most funds of this genus generated returns in excess of 100 per cent in 2003-04. And two, a consistent fall in interest rates-the bank rate has fallen from 10.5 per cent to 6 per cent over the past five years-made earning money on debt funds as easy as withdrawing cash from an automated teller machine.

The fairy-tale ride, alas, seems to be over. Although most analysts are bullish about the future performance of the stockmarket, it is unlikely that the upside will match the 2,904 to 6,250 ride the Bombay Stock Exchange's Sensex went on between April 28, 2003 and January 9, 2004. And interest rates will not fall any lower. If they do firm up, as some people expect them to, investors could actually end up losing money on ''safe'' debt funds.

Should the smart investor eschew mutual funds altogether? We wouldn't advise that. Mutual funds come with a clutch of advantages that few other investment instruments can match: a diversified portfolio, an expert fund manager, and tax benefits. To elaborate on the last, dividends from mutual funds, even debt funds, are tax-free. Ergo, unless you are completely risk-averse-opt for public provident fund, post office savings schemes, and RBI Relief Bonds in that case-you cannot afford to ignore mutual funds.

"Investors should not expect returns in excess of 4-5 per cent from debt fund" Nimish Shah/Director/Parag Parikh Financial Advisory Services

Now that you have decided to take the mutual fund route, what type of fund should you look at: equity, balanced, or debt? There's no one correct answer to this. An investor's choice of fund-type should logically be a function of his risk-taking ability. And investors can choose between a passive strategy of allocating assets between debt and equity in a pre-determined proportion, or an active one of altering their proportions according to market conditions.

The Passive Approach

This may be called a passive strategy, but it still requires you to do a few things. First, identify your financial goals. This could be a retirement cache, a child's education, or, simply, wealth accumulation. Next, identify your risk profile. This is a function of the time horizon of your investments (volatility evens out in the long-term, so you can choose a high-risk investment option if your time horizon is long), age and the quality of assets you already own. One simple rule of thumb: your exposure to equity (directly or through mutual funds) should be 100 less your age.

Arriving at an asset allocation ratio is easy; maintaining it is very, very difficult. ''Investors may have gone overboard on debt last year (because the stockmarket was doing badly),'' says Abhay Aima, Country Head (Equities and Private Banking) Group, HDFC Bank. ''Or they may have gone overboard on equity this year.'' Ergo, it makes sense to consciously balance this out year after year.

The Active Approach

Good, you've decided to take the road less travelled. Should you look at equity at all? Well, do not expect a repeat of the past six months but do invest in equity for more than modest returns. ''A 18 per cent to 20 per cent return from the current level is possible,'' says HDFC Bank's Aima. ''This makes equity a good asset class.'' And with debt returning between 5 per cent and 6 per cent, the 18-20 per cent return looks attractive. Aima also believes there is no need for investors to consider sector-specific funds given that ''the rally (in the stockmarket) will continue to be broad based.''

That doesn't mean investors should avoid debt funds. Only, they need to realign their expectations and understand what they are getting into. ''They shouldn't expect returns in excess of 4-5 per cent,'' says Nimish Shah, Director, Parag Parikh Financial Advisory Services. ''Short-term investments in debt funds with long maturity papers could impact returns, even put capital to risk if interest rates tune volatile,'' warns Namit Nayegandhi, a portfolio advisor at J.M. Morgan Stanley.

Fund-type chosen, we come to the tough task of choosing the fund itself. Past performance (after adjusting for risk) should give investors some idea of how this can be done. This magazine, for instance, tracks funds on a monthly basis and the best funds, in terms of their performance over 2003-04 have been listed in the article following this for ready reference. Investors would also do well to look closely at the management style of funds. An aggressive fund manager will likely focus on a few sectors and stocks, while a conservative one will work towards maintaining a diversified portfolio. ''There is nothing like a low risk, high return fund,'' laughs Aima.

There are enough mutual fund rankings around-although we'd like to swear by your own-and some credit rating agencies actually rate debt funds on the basis of asset quality. Still, diversification is a preferred investing strategy. ''Investing in the best four or five mutual fund schemes will help you create a well-diversified mutual fund portfolio,'' says Rajiv Bajaj, MD, Bajaj Capital. We'd recommend that.