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:

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

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!

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?

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)

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..

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..

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!

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.