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How to pick winning mutual funds

January 31, 2017 10:16 IST

'To ensure you remain with the better performers, you need to consistently monitor your MF portfolios and weed out the non-performers, even if they are from a star fund manager or a fund house with a sound record,' says Tinesh Bhasin.
Illustration: Dominic Xavier/Rediff.com

Illustration: Dominic Xavier

With leadership positions changing every few years, betting on their past performance is not the best strategy

If you were to choose between a mutual fund (MF) that gave 24 per cent annualised returns for 20 years and a scheme that has 20 per cent annualised returns for the past five years, the choice will be obvious.

A fund with higher returns over a longer duration appears to be a consistent performer that has weathered many market cycles.

But if an investor would have made the 'obvious' choice five years earlier, his returns would be much lower.

Franklin India Bluechip Fund has given 23.91 per cent return over the past 20 years, while Mirae Asset India Opportunities has delivered 20.10 per cent over the past five years.

An investor would have made Rs 4.12 lakh (approximately) if he had started a systematic investment plan (SIP) of Rs 5,000 in Franklin's fund five years ago, according to data from Value Research.

The same investment strategy in Mirae Asset India Opportunities would fetch Rs 4.71 lakh.

So, where does that leave you as an investor? What should you go by?

"Financial advisors select MFs on many parameters, including consistency, risk-reward ratio, expense ratio and third-party ratings. But historical return is one of the key parameters for choosing a fund. While we cannot ignore it, most financial planners grapple with how much weight should be assigned to past returns," says Suresh Sadagopan, founder, Ladder7 Financial Advisories.

In his fund selection criteria, Sadagopan assigns around 50 per cent weight to past performance and the rest to other parameters.

"The chance of the same fund being in the first quartile of performance year after year is very low. We, therefore, base our recommendations on both qualitative and quantitative parameters," says Umang Papneja, managing partner and CIO at IIFL Wealth Management.

The weights on quantitative parameters, which include past returns are 50 to 60 per cent, processes (20 to 30 per cent) and downside capture ratio (10 to 20 per cent).

The company also comes out with recommendations on qualitative parameters based on a fund's underlying portfolio.

Called high conviction funds, these are shortlisted based on interactions with fund managers and has no weight on past performance.

Papneja says many of their conviction fund calls don't pass the test of quantitative analysis, but have done better or equally well.

To ensure they remain with the better performers, investors need to consistently monitor their portfolios and weed out the non-performers, even if they are from a star fund manager or a fund house with a sound record.

Financial advisors say if a large-cap or multi-cap fund's performance does not improve for four quarters, it's time to exit slowly.

First stop your SIP, then withdraw money in parts, keeping short-term capital gains tax in mind.

However, in case of mid- and small-cap funds, one needs to rely on a fund house and manager with a track record and be more patient.

New investors need to comprehensively analyse funds and look at different parameters, along with returns.

History matters in large-cap, not so much in mid- and small-cap funds

If you look at top schemes by returns for the past 15 to 20 years, you will notice they change every few years.

From 2001 to 2006, Reliance Vision, HDFC Top 200 and Taurus Bonanza were the best performers. But from 2006 to 2011, only HDFC Top 200 Fund remained.

UTI Opportunities and Quantum Long Term Equity replaced the other two.

In the past five years, Mirae Asset India Opportunities, SBI Bluechip and Birla Sun Life Top 100 occupy the top slots.

"The best performers keep changing because the market rewards different investing styles in different phases," says Kunal Bajaj, founder and chief executive officer, Clearfunds.com, a Securities and Exchange Board of India-registered online investment advisor.

"Sometimes the market rewards growth, sometimes value, and at times pure momentum," he explains. "But fund managers stick to their style of investing."

Some schemes may also underperform if the fund manager changes.

The new manager usually makes changes to the portfolio based on his investing style and conviction.

In case of small- and mid-cap funds, it's rare that the same schemes would feature among the top performers regularly.

Stocks in these segments are highly volatile. Hence, it's even more difficult for a fund manager to consistently pick winner stocks.

In the case of large-cap or flexi-cap funds, the underlying companies have a stable business and more wherewithal to tide over tough times.

Stock prices of smaller companies can change drastically for reasons such as rise in commodity prices, change in government policy, higher interest rates, and so on.

Mix-and-match of tenures to decide

Like Sadagopan, financial advisors do give weight to returns, but also consider other parameters to shortlist funds they recommend to clients.

But for small investors, it might not be possible to analyse funds like an expert.

To do your own research, start with analysing funds based on returns across different time lines -- one, three, five, seven and 10 years.

Shortlist those appearing among the top 10 more often.

Make sure the same fund manager who earned those returns is still at the helm.

Then check their star ratings with different research companies.

Narrow down your list to around five schemes.

You can then go deeper into researching these schemes.

Check rolling returns of the selected schemes to further narrow down on funds.

This means, an investor should look at returns over different periods, rather than just point-to-point returns.

The simplest way of doing this is by looking at one-year returns every month -- from January 2016 to January 2017, December 2015 to December 2016, and so on.

"Investors need to see then which funds offer better risk-adjusted returns," says Kaustubh Belapurkar, director of manager research, Morningstar Investment Advisor India.

For this, an individual needs to look at different parameters such as sharpe ratio (shows the return per unit of the total risk taken by the scheme), beta (measures the fund's performance compared to the market) and standard deviation (measure of the volatility in a fund's returns).

There are funds that will not perform for four years, and then they will have one very good year, which will make up for past four years.

Avoid such schemes.

You could find it difficult to analyse mid- and small-cap funds via a quantitative method.

For such schemes, put your bets on the fund house and the fund managers.

Tinesh Bhasin
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