A mutual fund is an extremely useful investment option for investors from all walks of life. In this post, I would touch upon how I shortlist a mutual fund scheme from a plethora of options available in the industry. This also ends up being the most frequently asked question. Investors often focus on past returns of an investment scheme and this forms the ONLY basis used by majority of the investors while shortlisting their investment in a Mutual Fund. Let us add more filters to the list.
If required, some bit of background reading of our other blog posts may help. These include :
Asset Allocation & Risk Appetite
In summary, this exercise assists the identification of an appropriate category of investment scheme to suit the needs of a person. There are a total of 36 categories of Mutual Funds to chose from – 10 categories of Equity Mutual Funds, 16 of Debt, 6 of Hybrids and four others. One can read about each of these categories at SEBIs website > Click Here
This is the starting point for me to identify the category of mutual fund scheme I am after. There are over 40 mutual fund companies (Asset Management Company or an AMC) offering close to 1200 investment schemes options. The number keeps on growing. My starting point is by answering the question – what is the investment requirement am I trying to address ? These range from an extremely short duration money parking, buying a home in 5 years, children education due in 15 years, financial retirement in 20+ years, post retirement investment for 30-50+ years. You may notice that each of these requirements have their own needs and one needs to marry the available options to such needs. A similar corollary is > If I need to visit a shop opposite to my home, I may choose to walk. If I need to go to my work place a few kilometers away, I will choose to take my car. But if I need to visit a city 1000 kilometers away, I may choose to take a flight.
Once I have identified the category(ies) of mutual fund I need to invest in, I need to identify the schemes which are true to their label. One can find this information in the investment objective description of the respective schemes to understand how the fund manager will manage the scheme. A few examples (with no investment recommendation) are below :
HDFC Flexi Cap Fund – To generate capital appreciation / income from a portfolio, predominantly invested in equity & equity related instruments.
HDFC Liquid Fund – This product is suitable for investors who are seeking regular income over short term l to generate income through a portfolio comprising money market and debt instruments
HDFC Gilt Fund – To generate credit risk-free returns through investments in sovereign securities issued by the Central Government and/ or State Government.
If you have a passion of following Formula 1 racing events, you would keenly follow the sports person behind the wheel rather than the car or brand he is driving for. Similar analogy goes for investment schemes. While each Asset Management Company have processes in place to enforce consistency of investment selection and risk management standards, the importance of a fund manager can not be understated. This may not be crucial for a passively managed schemes or index funds which are programmed to clone an underlying index and hence do not need an active brain power. For rest, the fund manager is the key driver to the future performance. If a star fund manager leaves the AMC, the respective scheme drops from my conviction list.
Diversification vs Focus
A fund house and particularly its fund manager has a style of investment which may be following a diversified pool of businesses ranging from 40 to 60 in a scheme. Other fund managers practice a relatively concentrated investment style having 20-30 stocks in a portfolio. Each of these styles have their merits and demerits. A focused approach could result in higher returns in the future as it may have lesser laggards. As a corollary, it also invites higher risk as one or more negative impacts to its underlying businesses could adversely impact the returns. It is here where one needs to match the investment style of a fund with underlying risk appetite of an investor.
It is here where the rubber hits the road. Often when people buy a car, they would look into its flashy design, asthetics, comfort, colour and fuel economy. But the magic happens below the bonnet where the engine’s specification drive the experience. The same analogy works for a mutual fund. By looking into the underlying portfolio I get a fair understanding of the investment style and qualitative metrics of a portfolio. Examples of a few things which I particularly look into are :
- How diversified the portfolio is – whether it under diversified or over diversified ?
- How much concentration is held in top 10 investment holdings of the scheme. This is particularly of focus in case of high risk funds.
- What is the sectoral diversification and if too much holdings is in high risk or cyclical sectors;
- Do the underlying Companies have a good earning potential, capital allocation, profitability, return on its equity.
- Valuation of the portfolio companies – High valuation vs cheap. Each of them have their merits and demerits;
- Whether the portfolio is a Growth or Value oriented – the cycle of growth & value investing repeats and often either one rules the markets.
- Whether the portfolio aligns to the investment mandate / objective. For example, if the fund states that it is going to invest in Healthcare, I would find it odd to a Banking & Infrastructure Company in it ? Or if it is going to invest in Large Companies, how much percentage of it is invested outside the Larger Companies universe.
Investment Churn or Portfolio Turnover
A fund manager is expected to buy good businesses with a long term holding expectation. However, this should not restrict exit from portfolio Companies if the investment assumptions didn’t work. After all, investment into Equities is all about looking into the future. Many assumptions may fail and should result in revisit of the investments. Reasonable churn of the portfolio Companies may explain this need and could be healthy. Excessive churn beyond 25% of the portfolio in a year may need a clarification. Such kind of rapid churn not only adds to the overall expenses associated with the management of the investments, but also casts doubt upon the long term vision of the fund manager. Some good funds have a low churn of ~5% indicating that the fund manager does not make change to 95% of the portfolio in a year.
Sticking to the Mandate – Thick & Thin
This paragraph is an extension of earlier paragraphs on investment mandate – but this requires one to track the way portfolio maintains its strategy & holdings through good and bad times. There are often years where the investment philosophy of a fund may not align with the current hot sectors of Mr. Market. This could result in a poor performance of a fund for several quarters if not for several years. Despite of poor performance, the underlying portfolio Companies may be of great quality. It is just that their stocks haven’t caught the fancy of the market participants. It is here one sees the discipline and organizational ethos of the fund manager and the Asset Management Company. A fund manager operates under extreme pressure to deliver a market beating investment performance to its investors. A continued underperformance may nudge him to give into the pressure and hop the portfolio to the hot sectors, thereby making a shift from its mandate. This is a big red signals for me requiring an early exit from a fund. An investment into equity by the investors requires them to hold onto the investments through good and bad times. What if the investors are holding onto a poorly performing fund waiting for good times, but the fund manager changes the portfolio construct midway ? To clarify, if the fund manager identified an error of judgement and there by making a course correction – this is a welcome step. However, chasing the market momentum, thereby deviating from the investment objective is a red flag.
Size of the Fund – Assets Under Management (AUM)
Size matters when it comes to the amount of money an investment scheme manages. The threshold point beyond which size may impact the nimbleness of the fund manager depends upon the underlying objective of the fund. For example, a fund having an objective of investing in Smaller size companies may find lesser opportunities after approximately 5000 crore of AUM. However, for a fund managing Large size companies may be even comfortable at 20,000 crore of AUM. At the same time, larger the scheme size, lower will be the underlying fund management expense ratio. One needs to find a right balance between the size vs expense ratio.
This brings naturally into the most discussed point in the investment space after scheme returns. The only certain part in an investment are its fund management charge or expense ratio. The net asset value seen by the investors is after deducting daily expenses incurred by the fund. Where possible, it is a good idea to shortlist a fund which has a lower expense ratio amongst similar options you are after. I would caution investors not to get overboard. I am increasingly seeing a trend whereby investors end up choosing an investment category which does not match their needs. Their choice inadvertently get driven by a lesser expense. To know more about expense ratios, you could read our older posts > Mutual Fund Expense Ratios
Portfolio Quantitative Metrics
Each fund publishes regular investment metrics over and above the returns. A brief of the relevant quantitative metrics which are helpful in identifying the risk reward ratio of a fund are mentioned below:
- Standard deviation or how volatile / riskier the fund is (lower the better)
- Beta – What is the risk of the fund versus the market, whereby Beta of market is 1. Lower the better.
- Correlation versus other schemes in a portfolio – if there is low correlation between two schemes, their performance will be more independent to each other, i.e. a more risk managed portfolio;
- Sharpe & Sortino Ratio – these are two sibling ratios indicating how efficient is the portfolio in earning higher returns along with garnering higher risk. Higher the better;
And finally this is also important – How much wealth a specific fund generated over others. There was a reason why this paragraph came right at the last. A fund which got mind boggling returns but scored negatively in all other metrics may not have the right processes, skills and ethos to repeat such performance in the future. It may be taking on more risks versus its peers. It may be deviating from its investment objective thereby impacting the investment allocation of investor’s overall portfolio. I do look into investment return performance of the scheme, but with after going through the points mentioned above in this post. More often than not, the outcome of this full exercise ends up selecting an investment option which may be the five star performance fund in the future.
My concluding thoughts – investment goals are more likely to be achieved consistently if we follow right processes. Following returns as the only metric may blindside us from the risks which comes with investments and could result in a bumpy ride. The video below of a car game is quite insightful to explain the concept. Happy investing.