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How to Select a Mutual Fund
With too many categories and thousands of mutual funds, it can get confusing when selecting mutual funds. Various selection strategies for mutual funds explained here
It is important to understand that selection of mutual funds is NOT the first or the most important step in the making of a portfolio.
For all long-term investors, there is only one objective – maximum total real returns after taxes (John Templeton). Warren Buffett has specified the same with the phrase, across the prospective holding period.
Investing is a young field with only a few decades old historical data. And new data cannot be created so scientific analyses cannot be applied rigorously to different trading / investing systems. That is probably a reason why there is no consensus system of something which works across everything (no irrefutable laws). So, you believe or you do not believe in them!
Some of the major beliefs can be:
- 2.Markets show return predictability over the long term but not over short horizons. So, a dynamic / tactical long term allocation strategy is better while short-term timing strategies (eg day trading) should be avoided.
- 3.Markets are imperfectly efficient. The more liquid the markets, more will be the efficiency.
- This is a static mix of asset classes, intended to be long-term plan to best meet the investor’s objectives. This is considered to be the Principal determinant of long term performance (risk/return) of the portfolio.
- It should be based on long-term relationships of asset class returns and the behavior of investor’s liabilities.
- It is important as a behavioral map/guideline so that investor does not get tempted to follow short-term market trends.
- 1.The ratios are based on short term past data which may or may not sustain in the future.
- 2.Small changes in the values can lead to major changes in the outcome. Eg a 0.1 change in value of beta of 1 class can cause 5-10% change in the proposed allocation.
- 1.Determine the allocation between equities and bonds.
- 2.Establish domestic versus international equity and fixed income splits.
- 3.If needed, alternative asset classes can be introduced.
- 4.Asset-liability analysis shows that any allocation less than 5% does not have any major effect on the risk and return of the portfolio. A gradual buildup over time can be done so as to test waters and gain confidence.
- 5.5 year evaluation horizons are quite optimum for testing and evaluating strategies.
This allows for adjustment of the asset mix as stated in Strategic Asset Allocation, when the prices of the asset classes are too far away from their longer averages. It requires the belief of Mean-Reversion. It is better done by investors / managers with relevant experience (otherwise, stick to SAA).
An active investor is anyone whose portfolio of Indian equities is NOT the cap-weighted portfolio. In US, there is Vanguard’s total stock market index.
I. Reasons to deviate from Passive cap-weighted index-
- 1.Availability - We do not have any here. Not in equity, not in bonds.
- 2.Tax-reasons – International funds are not tax efficient. So, the after-tax returns are lesser for international funds than for a comparative Indian fund. Any fund with >65% and Indian equities get a tax-free status beyond 1 year. International funds like Birla International equity fund or the ICICI US focused blue chip funds which directly invest in foreign markets do not get tax benefits and are charged like debt funds (now with LTCG applicable above the holding period of 36 months). While, Templeton India Equity Income and PPFAS Value fund get those benefits since their international allotment is <35%.
- 3.Some investors do not want to hold stocks of sin companies (cigarette, alcohol, etc). For them, there are some shariah based funds like Goldman Sachs Shariah index fund and Tata Ethical fund.
- 4.Short-term liabilities for which fixed-income is better, much better.
II. Number of Active Equities/Funds:
- 1.A single active fund can deviate largely from the benchmark (both up or down) called as high tracking error.
- 2.Multiple active funds have lower tracking errors.
- 3.While both single and multiple active funds tend to have higher returns than benchmarks on an absolute basis (with fees, this comes down).
III. Style Orientation:
- 1.There are 3 major groups – value, growth and market oriented (who lie in between, sometimes denoted as Blend).
- 2.The different styles work in different ways in terms of risks and returns over different phases of the market cycles.
- 3.A particular style can have long periods of underperformance as compared to the broad market index, so that should be understood well. There should not be any unintended style bias.
- 4.Any style which becomes popular makes that part of the market very efficient causing decrease in future performance.
- 5.Complimentary styles can work synergistically.
Style Agnostic / Diversified portfolio, by using multiple managers, can be better for investors who have:
- 1.Shorter time horizons for performance evaluation.
- 2.Low risk tolerance as compared to equity indices (some people look at Sensex/Nifty rather than say BSE 500 or BSE small cap).
- 3.Multiple uninformed parties to whom performance has to be explained. Put spouse and relatives here.
IV. Different Structures in Equities:
- 1.Separate Large-cap, mid-small cap and separate growth and value groups. This gives a more granular control but it limits the individual managers to particular segments of the markets.
- 2.Multicap structures across growth and value groups – this allows the managers to work as per market conditions.
- 3.Stable Equity structure which allows the manager to take bets across asset classes. Eg ICICI dynamic fund can take large cash calls if it feels that the markets are overheated. Other funds cannot do that because they have a minimum 65% or 85% equity mandate.
- 1.Some funds have fixed duration styles (short term versus long term bonds).
- 2.Some funds have flexible style and use duration and yield curve forecasting for selection of bonds.
- 3.There are some funds which are restricted to govt bonds while others are restricted to corporate bonds.A Complimentary combination of styles in terms of duration and govt/corporate can give a structure which will work across time horizons.
- 1.Too many funds. If one has too many funds, it becomes difficult to monitor and assess them. Short-term performance then becomes the short-cut for assessment leading to a ‘hire-and-fire’ policy and ‘hot-fund-chasing’ phenomenon. Solution: Have Lesser Funds.
- 2.Rather than having a top quartile fund selection, which is not sustainable, a target of second quartile performance is more realistic.
- 3.Not investing internationally. Diversification across economies and markets is a good practice (depends upon investment beliefs).
- 4.Unclear policies. Write the policies in such a way so that if given to a competent stranger (or spouse / relative), the portfolio can still give the desired results.
- 5.Short-term performance horizons for long term strategies. Eg, looking at 1 month / 6 month / 1 year performances of equity funds when they have been chosen for 5-10 years.
- 6.Excessive focus on peer performance (star ratings).
Define the asset class structure Whether one wants a large cap/small cap/flexicap or growth flexi-cap or value-large cap or international, etc. The selection of the appropriate asset class structure helps in refining the fund search universe, so that a fund which fits in the portfolio structure is selected rather than one which has performed recently. There is no point in keeping in mind the sensex and then selecting a small cap fund.
- 1.Is the AMC investment team stable or undergoes rapid changes? I do not like ICICI AMC for that specific purpose despite being good performers.
- 2.Vision of the firm and their practices. PPFAS and Quantum AMCs are unique in this sense.
- 3.How do the managers get promoted? Is their some kind of hierarchy or is it hotch-potch? Templeton AMC has a pretty solid structure. Their managers stay for decades and go on from individual manager status to CIO equity / income / overall levels. This makes me very confident in keeping and recommending them.
- 4.How often new funds are launched and their overall history? If the business focus on more on asset gathering rather than value adding, it is red alert.
- 5.Investment philosophy of the AMC and do their funds follow those overall philosophies. This can be in terms of diversification across a large number of stocks or only few stocks. And a general style. This will also tell how the funds of the AMC will behave across different market conditions. Eg, Reliance funds behave great during bull phases while they are down in bear phases. Franklin Templeton’s funds have much better downside protection during bear phases, but do not work very great during bull phases.
- 6.Is the business profitable for them? If it is not, the long term viability is suspect.
Only after the qualitative assessment is complete and proper, quantitative analyses should come into picture.
Two important points:
- 1.Are the returns (highs and lows) consistent with the fund’s dictated policies? The measurements should be against the proper benchmark and not against some other arbitrary one. Eg, Templeton India Growth fund is benchmarked against MSCI Value and not Sensex.
- 2.How does performance compare with other funds with similar investment strategy?Good sign is excess performance across bull and bear phases adjusted for risk. A lower fee structure is preferable if all other things are equal.
- 1.Objective of the fund changes.
- 2.Objective and/or risk tolerance of the investor changes
- 3.Asset class structure changes. Best example of this is Reliance Growth fund. It started as a mid-small cap fund but because of size bloating, it got converted into a large-mid cap fund.