Practical guide to choosing Equity mutual funds – Part 2

Last week we had filtered out 15 large cap funds from our initial list of 52 large cap funds. In case you missed it, you can read it here

Final 16

Source: MOSL, as on 17-Mar-2017

Applying Filter 5 – Capturing Lower downside + Reasonable upside

We shall use Mr Buffet’s help for this –

“Any superior record which we might accomplish should not be expected to be evidenced by a relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is achieved, it will be through better-than-average performance in stable or declining markets and average, or perhaps even poorer- than-average performance in rising markets.” – Warren Buffet Letters to Shareholders

The ability to fall lesser during bearish phases indicates the quality of the portfolio and also makes it relatively less difficult to hold on to the fund during market declines. Further if the fund also manages to outperform during market rallies then we are home.

We will measure this using the capture ratios (provided by morningstar)

Upside/Downside Capture ratios measure the degree to which a given fund has under or outperformed a broad market benchmark based on monthly returns during periods of market strength and periods of market weakness.

You can read more about them here

Now let us apply the upside and downside capture filter for our 15 funds

Upside & Downside Capture

Source: Morningstar

Both HDFC Top 200 and Reliance Vision get filtered out because of high downside capture ratios (>100% i.e they fell more than their benchmark during periods of decline)

5 funds get filtered out due to low upside capture ratios (<100% i.e they under performed during market rallies)

Thus this leaves us with 8 funds to analyze.

The “No-Brainer” fund selection technique

Now before we move ahead, just take a minute to answer this:

How will you select the funds if you saw the above table?

Instinctively, most of us (which includes me of course) would go by past returns. So all we need to do is simply sort the funds say based on 5 years (which we will assume is a reasonably long period). Pick the top 5 funds.

Top 5 based on 5y returns

Hey Presto!! The fund selection is done!!

Overcoming the lure of past returns..

While this method sounds extremely logical and intuitive, unfortunately for us, this method of selection has historically not been a great indicator of future returns. Most of us realize this a tad too late after we start investing.

If you are wondering why – please refer to my earlier post here where I have explained this topic in detail.

The key takeaway from my earlier post is this:

Performance outcomes are a combination of fund manager skill and luck.

When we evaluate only using the past performance, we are not sure if the performance is due to luck meeting fund manager skill (which is what we want) or a fund manager without skill getting plain lucky (which is what we don’t want)

Luck vs Skill

Luck is generally mean reverting – which means if we unfortunately ended up selecting a not-so-great-in-skill fund manager who got lucky – we are most likely to get disappointed with future returns of the fund.

This is the reason why we shouldn’t have past returns as the only metric to select funds.

But let me also state the other case – by using past returns if you are lucky, you may also end up selecting a skilled manager with luck by his side (in which case you are fine).

Since it is difficult to predict luck, our attempt should be to identify skilled fund managers – so that even if a few of them get unlucky in the interim – over the long run luck should average out and skill should provide us above average superior investment returns.

Luck vs Skill - 2

This means our fund selection will also include certain under performers i.e skilled fund managers who were unlucky (this is much easier said than done as it goes against our natural instincts).

Respecting Luck..

Now for those who are still not convinced on the contribution of luck, let us also listen to what few of the best fund managers in India have to say about this..

Luck is a big part. You can’t say it’s only because of my skills to analyse balance sheets and meet managements that my fund is doing good. If somebody is saying that, he’s fooling himself — rather than lying”
– Anoop Bhaskar – Head of Equities at IDFC Mutual Fund; R
ead the entire interview here

“The most of what has happened in the last 20 years with the benefit of hindsight I can say that it is more due to luck than by design, so whatever he said about me is probably more due to luck than skill. That is the case for probably most of the people in the market because I think the fact that equities draws too many intelligent people, too many smart people I think in itself negative because these people are too inquisitive, they cannot stand still, they want to keep doing something or the other, and as a consequence most of us have missed out on the biggest bull run we have seen in the last 20 years. We have seen so many great companies being created and we have been bystanders, so if performance has been good or even middling, I think it is more due to luck because we missed out on such great franchises which were created in last 20 years and just by buying these companies and sitting on them, we would have created more alpha then what most fund managers have managed to do in the last 20 years. ”
KN Sivasubramaniam – retired Ex-CIO of Franklin Templeton – also one of the most respected fund managers in the investment fraternity , Source – Ambit Capital

Both of them, have been extremely humble and to be honest, have severely downplayed their phenomenal investment track record, skills and acumen.

But, the key point for us to note here is the acknowledgement that..
“Luck plays a large role in returns”

Time to move focus from “Fund” to “Fund Manager”..

So putting all this together, how do we select funds ?

My thought process is on the lines below..

  1. Evaluate fund manager for skills and process
  2. Understand how every fund manager invests and how their styles will fare in different periods. No style will thrive at all times, and understanding when a manager’s style will excel and suffer will help us keep the performance in context.
  3. Does the fund mandate place any constraints on the fund manager to execute his typical investment style and strategy – size, stock concentration, sector calls,style (mid cap, large cap) etc
  4. Figure out if size will adversely affect performance. Good fund managers can become mediocre ones if they have too much money to invest.
  5. All fund managers go through intermittent periods of under performance – so the key is to understand if the AMC (Asset Management Company) is mature enough to support the fund manager during his bad times and the fund manager himself has the emotional stability to withstand the pressure and stick to his style
  6. And then top it up with some quantitative measures to check for consistency in returns, understand style and strategy
  7. Finally, identify 3-4 different skillful fund managers with diverse investment styles & strategy and put them together while constructing portfolios

So instead of a quick fix list of funds, we are going to spend each week understanding the background, investment style, strategy and performance track record of each and every fund manager and the fund he manages.

We shall start of with one of my favorite value investors,  Mr Sankaran Naren of ICICI Prudential Mutual Fund for the next week. So hang on till I see you the next week.

Happy investing as always 🙂

And here comes the most important part:

I understand it’s a busy world. So thanks a ton for dropping by and if you liked what you are reading, do consider subscribing/following the blog along with the current 1200+ awesome people so that you don’t miss out on the upcoming posts in this series.

Note:

As will all fund selection methods, it is inevitable that some skilled fund managers will get left out in the above method. So in the upcoming  posts, we shall also investigate on some flaws in this methodology and the possible remedies.


Disclaimer:
 
No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.
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Practical guide to choosing Equity mutual funds – Part 1

There are several categories in Equity Mutual Funds..

  1. Diversified Equity Funds
    • Diversified across various sectors and stocks
    • Further split into Large Cap, Mid Cap and Multi Cap funds (i.e mix of both large and mid cap funds)
  2. Sectoral/Thematic Equity Funds
    • Concentrated towards a particular sector or theme
    • Eg Pharma, Financials, Infrastructure, Consumption etc
  3. Global Funds
    • Funds which invest in global companies listed outside India
  4. Index/ETFs
    • Replicate the index
  5. ELSS
    • Its simply a diversified fund but with a 3 year lock in period and can be be used to tax deduction of up to Rs 1.5 lakhs under Section 80C
  6. Closed Ended Equity Funds
    • These funds are locked in for a particular period (generally between 3 to 5 years) and can belong to any of the above categories – Diversified or Sector/thematic or Global

There are also other equity oriented categories such as

  1. Balanced funds (70% Equity + 30% Debt)
  2. Dynamic equity allocation funds (which automatically adjust overall equity allocation based on some valuation framework)

We will stick to Open ended Equity Diversified Schemes for our fund selection process as this will form the core of the portfolio.

The other categories if required can be layered on top of this based on our risk appetite and requirements.

Oops..a mind numbing 160 open ended diversified funds ..How in the world do we pick the right ones?

In fact in my opinion, this is one of the primary reasons why many of us don’t invest in mutual funds.

It’s simply too overwhelming to decide amidst so many choices!

Psychologist Barry Schwartz calls this choice paralysis.  He argues that more choices make us less likely to take action, and to be less satisfied with our eventual decision.

So the key is to ensure that we don’t get into this trap of “The Paradox of Choice”

Hence the idea is:

Image result for precisely wrong approximately right

Remember,

  1. We will not be exactly able to identify the top performing funds of the future
  2. But our intent is to put together a reasonable team of funds which will help us earn superior returns
I have attempted to provide a simple common-sense approach to picking funds. Instead of adopting the method as it is, I would recommend you to see if the overall logic makes sense to you (else do feel free to throw your brickbats via the comment section). You can then modify the method to suit your requirements.
I understand that there are more rigorous analyses that can be done. But again, these extra variables only add to the complexity of the task without much incremental value add. So let us stick to “practical” over “perfect” mindset.

So let us get to work and reduce the number of choices..

The simplest way to begin is to start with Large Cap Mutual Funds.

For our analysis let us download the MF daily score card provided by Motilal Oswal here (You may need to register to get access. But no worries it is free.)

There are a total of 52 Large cap funds (according to MOSL classification). A lot better than the earlier 160!

Large Cap.png

as on 17-Mar-2017

But how do we reduce?

Applying filters..

Filter 1: Remove all the funds with 10Y performance below the Nifty 50 and Nifty 100

Logic: If the fund hasn’t been able to beat even the index in the last ten years, why bother?

10Y Returns Below Nifty 100

That knocks off 11 funds!

Filter 2: Remove funds which are extremely small

Logic:
1) Given the small contribution from the fund to the overall revenues of the fund house, the focus logically will be predominantly towards the larger funds (of course not a rule cast in stone, but its a simple behavioral bias of “incentives”)
2) In periods of under performance, withdrawal of money from investors may put the fund under severe redemption pressure (sample this in the last 1 year, approximately 1700 cr was withdrawn from Reliance Equity Opportunities Fund)
3) The fund house may try some aggressive calls in the fund to improve performance. (Since it is small in size even if the call goes wrong it won’t impact the overall revenues of the fund house)

Size below 500 crs
That knocks off another 17 funds!

Filter 3: Remove funds with less than 5 year track record

Logic: We would want to know how the fund has done over a reasonably long period covering both the bullish and bearish phases of the market. Ideally the longer the better but from a practical point of view at least 5 years is needed to get some hang of the consistency in the fund performance

In this case, all the remaining funds have more than 5 years track record

That leaves us with 24 funds..

Remaining Funds

Filter 4: Check for recent fund manager change

Now comes the slightly trickier part. While all the funds have more than 5 years in existence, we also need to check if the fund was managed by the same fund manager to ensure that the evaluation of returns is appropriate.

The fund houses may argue that they have robust processes and the change in the fund manager will not have an impact, but I think it would be extremely naive of us to believe that. All said and done, in my opinion fund manager is the biggest factor responsible for superior returns from a fund. (Think Warren Buffet,  Charlie Munger, Ray Dalio, Howard Marks, Seth Klarman etc)

This becomes all the more relevant at the current juncture given the significant shift of fund managers across mutual funds.

Sample this:

  • Kenneth Andrade who was the CIO of IDFC Mutual Fund left in 2015 to start his own PMS.
  • Anoop Bhaskar replaced him as he moved from UTI to IDFC in 2016.
  • Vetri Subramaniam (earlier the CIO in Invesco Mutual Fund) in turn replaced Anoop as the CIO in UTI.
  • Taher Badshah who was the fund manager at Motilal Oswal has replaced Vetri as the CIO of Invesco mutual Fund
  • Axis Asset Management Co. Ltd lost two of its senior-most fund managers -Pankaj Murarka and Sudhanshu Asthana
  • Shreyas Devalkar – the fund manager in BNP Paribas Mutual Fund has moved to Axis Mutual Fund
  • Gopal Agrawal, the CIO of Mirae Asset Mutual Funds quit recently

Confused!! So am I. But please hang on..

So let us remove funds where the fund manager has changed..

Fund Manager Changes

This is not to say that the fund performance will decline post a fund manager change. This simply means we have to evaluate the fund in the context of the new fund manager with respect to his earlier track record (which may be in a different fund) and investing style/strategy (which may or may not be similar to the current fund’s historical style/strategy). As I had earlier mentioned, the intent is to keep it “practical” over “perfect” and hence I will filter out these funds. (having said that you are free to include  funds from the filtered out funds based on your evaluation of the fund manager)

Phew..That leaves us with a manageable 15 funds!

Final 16

I guess this post is becoming too long. So let us take a pause here and continue the rest next week.

In our next post,

  • We shall analyze these 15 large cap funds in detail
  • Evaluate each and every Fund manager (this is the most critical)
  • Understand the fund investment style and strategy
  • Check for consistency in performance and risk taken
  • Based on the above, gradually drill down to 3-4 funds

And here comes the most important part:

I understand it’s a busy world. So thanks a ton for dropping by and if you liked what you are reading, do consider subscribing/following the blog so that you don’t miss out on the upcoming posts in this series.

As always, Happy investing folks 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

Equity Mutual Fund Selection – Process vs Outcome

One of the world’s best investors – Mr Warren Buffet..

If I asked you to name the world’s best investor, most of you would answer Warren Buffet without the blink of an eye.

Image result for even warren buffett has underperformed

He is currently the world’s 3 rd richest man with around USD 60.8 bn  net worth, thanks to his long term investment track record.

Source: http://www.longboardfunds.com/

But here is something you didn’t know about his performance

According to the research done by Eric Crittenden, the Chief Investment Officer of Longboard Asset Management,

“If you look at Berkshire Hathaway on a daily, weekly, monthly, quarterly, or six-month basis over its entire history, an investor in Berkshire Hathaway would have underperformed the S&P 500 more than half the time. But despite that, an investor in Berkshire Hathaway would have made tremendously more money than an investor in the S&P 500.”

If interested you can listen to the entire interview here – Meb Faber Podcast


Even Buffet was not spared from the curse of short term under performance..

In fact, during the tech bubble Warren Buffet was massively underperforming the S&P 500 and many began to doubt his investment process.

Berkshire_vs_SP500.png

But, instead of abandoning his strategy he stuck with it, and the rest is history as Berkshire Hathaway returned 53% compared to a loss of 25% for the S&P 500 over the next three years.

As mere-mortal investors, this makes one thing clear

Even the best of investors inevitably go through temporary periods of under performance!


But why does this happen?

This doesn’t seem to happen in other fields such as running, chess etc where the consistency in performance is reasonably high and past performance is a good indicator of future performance.

Image result for usain bolt Image result for viswanathan anand

Why is investing different?

Let’s take the help of the brilliant investment strategist, Mr Michael Mauboussin who discusses this issue in his book “The Success Equation”.

Image result for michael mauboussin

The Role of “Skill” and “Luck”

The outcome from many activities such as sports, business, investing etc are the combination of Skill and Luck.

However, the degree of contribution of skill and luck vary across different activities.

But how do we determine the level of skill in a given activity:

Here is an interesting way. Just answer the question –

Can you lose on purpose?

If yes, then there is some degree of skill involved.

A good way to think about business, investing, sports etc is in the form of a continuum of activities with pure luck and no skill on one end to pure skill and no luck on the other end.

For example, the outcomes for activities including chess and running races are close to pure skill, while games of chance, such as the slot machines and lottery are close to pure luck.

Generally, most activities fall somewhere in between these extremities and combine both skill and luck.

Boyles_Fund_I_Q3_2014_Letter_to_Partners(11)


Investment returns – combination of luck and skill

Now coming to our most important question,

Where do we place investing?

Now while it is definitely difficult to build a portfolio which outperforms the benchmark, what makes it interesting is that it is equally difficult to intentionally do a lot worse than the benchmark over a short period of time.

This tells us that investing is slightly tilted towards the luck side of the continuum.

Image result for outcomes vs process + poetic justice

This also means that we have a problem!

Unlike activities where skill dominate (eg a top tennis player, where outcomes are almost a pure indicator of skill), in investing we can’t focus only on the outcomes (read as short term returns) to judge skill.

What this means is that, good investment returns from your mutual funds over a short period (say 3 years) may be because of your fund manager’s skill or that he just got lucky. He may have been just riding a trend, such as Internet mania. Is that investment skill or dumb luck? Returns can’t tell the difference.

Similarly, bad performance from a fund manager in the short run, maybe because he got unlucky or that he truly lacks the skill. Returns yet again can’t tell the difference!

But unfortunately, more often than not, most of  us select funds only based on their recent returns.

Luck is mean reverting..

Any activity where there is luck , there is reversion to the mean.

Reversion to the mean simply says that for outcomes that are far from the average, the expected value of the next outcome is something closer to the average.

That doesn’t mean that it is going to go all the way back, but it indicates that it should move closer to the average.

Now, this is exactly the problem – when we pick equity mutual funds purely on the basis of their recent performance. We have no clue if it is led by skill or luck. And if it is driven by luck then it means it will mean revert and we are looking at lower returns in the future (which is exactly what matters to us)

So, how do we evaluate if our fund manager has the skill?

“If you compete in a field where luck plays a role, you should focus more on the process of how you make decisions and rely less on the short-term outcomes. The reason is that luck breaks the direct link between skill and results—you can be skillful and have a poor outcome and unskillful and have a good outcome.” – Michael Mauboussin


In search of skill

Thus the key here is to focus on process instead of short term returns.

But therein lies a problem.

Image result for not everything that can be counted

There is no precise objective method to evaluate the investment process of a fund manager. It is a lot more subjective. And unfortunately not all of us have access to fund managers. Add to it the fact that Indian fund managers hardly communicate, our job becomes even more difficult.

So how do we solve this problem?

When skill determines an outcome, a relatively small sample of outcome is enough to identify skill. However we need a large sample of outcomes when luck plays a large role in an outcome.The reason is that we have to evaluate large enough outcomes to ensure that luck has averaged out and that only skill is revealed.

Thus while evaluating equity mutual fund managers for skill, we need a sufficiently long time frame to evaluate their performance. Obviously, the longer the time frame the better. But for starters, we would at least need a 7 year track record (in the Indian context a 7 year time frame generally captures an up and down cycle) to evaluate skill and investment process.

Now there is no denying that the fund manager may sometimes end up getting lucky even for 7 years. This is where diversification comes into play. If we select 4-6 fund managers who have consistent long term track records, then we can afford to go wrong with 1 or 2 of them and still come out reasonably ok in the long run.

Parting thoughts

  1. Short term investment returns are not the best indicator of future returns as they maybe driven by skill or luck
  2. Over the long term, a good process (driven by skill) provides the best chance for desirable returns as luck averages out
  3. Hence, evaluate fund manager returns over long time frames (at least 7 years or a period covering a bull and bear market) to judge skill & investment process
  4. Track fund manager interviews to evaluate the investment process
  5. Diversify across fund managers

But,

  1. How exactly do we evaluate equity fund performance over long periods?
  2. How do we evaluate fund manager investment process from interviews?

Hang on. We will explore the answers in the coming weeks.

By the way, thanks for dropping by and if you liked what you just read, do consider subscribing to the blog so that you don’t miss out on the future posts in this series.

Disclaimer:
 
No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

How to select the best equity mutual fund

I don’t know..

Yes. You heard that right.

I am a part of a large investing firm..
I am expected to do this selection stuff day in and out for a living..
I write a blog on investing..

And yet, I don’t know. Dumb me.

Now before you curse yourself for having landed here and move on to something else more useful, bare with me for a few more minutes.

While I do not know how to select the best fund, I am as interested as you are to find out the best fund. (apart from my personal portfolio returns, I unfortunately also have my career prospects at stake)

By the way, what do you mean by the “best” fund?

Pretty simple right. All we need is to identify a fund which will be the top performer in the next year. And then we shift to a new fund which will be the top performer the year after and so on.

But the million dollar question:

Is it really possible to identify the best performer of the future?

In search of the Best Equity Mutual Fund..

Assuming that the best performing fund for the next year can be identified for real, by some weird algorithm or complex metric, who do you think would be in the best position to figure this out?

Take a guess..

Ok. Here is a clue..

Image result for takes one to know one

It takes one to know one..

Yup. It’s the “Mutual Fund” fellas!!

Think about it.

Majority of us go by a simple thumb rule while selecting funds

Past Returns = Best funds indicator

(Some go a step further and use Morningstar and Value Research Ratings which is again based on these past returns)

So if you were the CEO of a large mutual fund house,
Your only aim in life is to figure out how to provide chart-topping returns.
Everything else would be taken care of.

And the best part is you can afford to have the

  1. Best fund managers and analysts working for you
  2. Access to the best sell side research
  3. Access to company managements
  4. Instant access to every possible market related information and data

Just have a look at the insane amount of salaries that AMCs pay for their fund managers.. (Warning: Skip the below image if you have a weak heart)

Source: Livemint

Further, the top 10 Mutual Funds put together make a whopping profit of ~Rs 2200 cr!!

fy16-top-10-amc-profits
Source: AMC Annual Reports

But here comes the sad news. Even the 2,200 cr profit making top 10 mutual fund companies haven’t cracked the code..

As seen below, none of the fund houses have cracked the formula to be consistently in the top 5.

table-2Source: http://multi-act.com/mutual-fund-investing-simple-but-not-easy/

I would request you to read this brilliant article to see as to how even the best long term performers inevitably go through intermittent periods of under performance.


Putting it all together

My simple brain says if a Rs 2,200 cr industry armed with the best brains and resources, working to improve returns each and every day for two decades, hasn’t been able to crack the code to deliver short term performance year after year, then it simply means any attempt from the ordinary-me to identify the top fund for the next 1 year is a futile exercise.

In other words. There is no way you can identify the best mutual fund performer for each and every year. No one including the fund manager of that fund knows that beforehand.

But hang on, all is not lost

What we were earlier attempting in cricketing parlance was to identify the top scoring batsmen for the next match.  While we can hazard a guess based on the current form of the batsmen, it is still impossible to precisely predict the top scorer. This is the reason why we depend on a team and not a single player.

And again though we have constructed a good team, its extremely difficult to predict the next match’s outcome. A good team if chosen well is expected to perform well in majority of the matches it plays over a long term.

indian-team-photo

Equity Mutual Fund investing is no different!

When building portfolios the key is to build a team of funds (5 to 7 funds is more than enough) with varying styles, strategies, fund managers and market capitalization.

Now the idea is that irrespective of how good a fund you choose, even the best of funds will have to go through periods of under performance.  And unfortunately you have no clue when that’s about to happen.

So a team of funds ensures that at least 2 to 3 funds at all points in time compensate for the under performance of the other funds and ensures that as a team your portfolio performs consistently over the longer term.

A reasonable way to check if you have constructed a good team is to see if your mutual fund team outperforms the Nifty, BSE 200 and multi-cap peer group average over a 5-7 year period.

Hence remember,

  • While we won’t be able to identify the top performer of the next 1 year, we will still be able to build a reasonably strong & reliable team of diversified and long term consistent performers which will do well over a 5-7 year period
  • All of us irrespective of how smart we are in choosing funds will have to go though periods where our selected funds will under perform

  • The key is to stay focused on the entire team’s overall long term performance (rather than getting swayed by the individual fund’s short term performance)

Some unanswered questions..

But this leaves us with few questions

  1. Why do even good fund managers have to go through periods of under performance?
  2. How in the world do we build our mutual fund team?

No worries. Let us explore these topics in the coming weeks.

BTW Thanks for dropping by and if you liked what you are reading, do consider subscribing to the blog so that you don’t miss out on the next posts in this series.

Happy investing folks 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.