Selecting equity mutual funds just got way too difficult..
In my last post here, I had discussed on why equity fund selection will become a lot more difficult going forward due to
- Recent fund manager changes
- Reclassification of funds due to SEBI regulations
- Poor communication from most of fund houses
This implies that for many funds, looking at past performance and all the other usual metrics (such sharpe ratio, treynor ratio etc) to compare and identify funds will not work well anymore.
So how do we solve this problem?
Let us take help from one of the best minds that ever lived..
I am lost! Dear Steve Jobs, can you help me with fund selection?
Let’s rewind back to a period, when Steve Jobs was facing a similar issue..
After being fired from his own company, in what would be one of the greatest comeback stories ever, Steve Jobs was once again called back after 12 years in 1997 to save Apple from the brink of failure.
When Steve returned, Apple was in a bad shape. It had a huge and confusing array of products, no clear strategy, and was losing several million dollars every quarter.
For eg, Apple had a dozen versions of the Macintosh, each with a different confusing number, ranging from 1400 to 9600.
“I had people explaining this to me for three weeks!” Jobs said.
Unable to explain why so many products were necessary, Jobs asked his team of top managers, a simple question –
“Which ones do I tell my friends to buy?”
When he didn’t get a simple answer, Jobs went ahead and reduced the number of Apple products by a whopping 70 percent!
Moving forward, his strategy was to focus and produce only four products: one desktop and one portable device aimed at both consumers and professionals.
“Deciding what not to do is as important as deciding what to do” – Steve Jobs
It is this ability to focus that saved Apple.
Takeaway: Focus & Simplicity..
How do we apply this to our fund selection process?
When it comes to investment portfolios, less is more..
Having reviewed over 2000+ individual investment portfolios over the years, this is my key learning – majority of problems arise because of us overlooking this simple question..
How many funds do we really need to build a decent equity portfolio?
For any equity investor, the simple objective is to become silent partners (owners) in a group of good Indian businesses from different sectors and patiently participate in the growth of these businesses.
Mutual Funds, ETFs, PMS, AIF etc are actually intermediaries who help us with the above objective.
However, since every fund we pick is a single line item in our portfolio reports, we often forget that each and every fund is well diversified in itself and usually holds around 40-60 businesses on average.
Just like all the above menu items, ultimately represent a form of maggi, all equity mutual funds are in essence an indirect form of ownership in a bunch of good businesses.
Most of us while we start with less no of funds, we eventually end up adding new funds in the name of diversification, based on the flavor of the season, recent performance, advisors recommendation etc. Gradually over time our portfolios end up having too many funds.
This is like ordering one spoon of all different maggi flavors in a single plate!
This generally leads to a large overlap of stocks across funds, insignificant impact on both upside and downside due to low exposure in individual funds and eventually ending up with far too many stocks thereby unintentionally replicating an index fund exposure (which you can instead buy directly at a much lower cost)
Let us see what Steve Jobs has to advise us in this regard..
“In product design and business strategy, subtraction often adds value. Whether we’re talking about a product, a performance, a market, or an organization, our addiction to addition results in inconsistency, overload, or waste, and sometimes all three. A designer knows he has achieved perfection not when there is nothing more to add, but when there is nothing left to take away.”
So the first starting point is to set a boundary on how many funds you must have in your portfolio.
While there is no sacrosanct rule – I have personally kept a limit of maximum 4 funds in my equity portfolio.
(Usually 2-4 funds is the range I would like to work with)
The idea will be to have low overlap and diversify across styles (value, quality, growth etc) and market cap segments (small, mid, large).
This helps us to focus and not to be distracted by new shiny toys (hot themes, NFOs, recent performers etc) every now and then.
Earlier there were no strict definition for the various categories of funds.
However, post the new SEBI ruling, fund categories have been clearly defined and all funds will have to stick to their category rules. This makes our job a lot easier as once we decide on the categories we don’t need to worry on whether the funds will stay true to their category.
So let us evaluate the various categories and decide on categories which will make sense for us.
There are 9 categories under equity funds which way too high a number!
Source: Value Research
“If you give the consumers too much freedom, they are overwhelmed by choice and confusion. If you limit their freedom by too much simplicity, they feel constricted. The trick is selecting the right places to restrict consumer options.” – Steve Jobs
Since we have already restricted ourselves to less than 4 funds, I usually prefer the core funds of my portfolio not to have any restrictions in terms of which market cap segment to invest (across small, mid and large cap segments). I would rather let the fund manager decide wherever there is opportunity and to invest without any restriction.
Hence, multi cap category funds (which don’t have any market cap restrictions) will form the core of my portfolio.
Also if you notice, the categories Dividend Yield, Value/Contra have no clear cut definition – in other words for all practical purposes these are again multi cap funds.
I would also consider focused funds as a part of the multi-cap category as they also don’t have any restriction in investing across large, mid and small caps. Their only requirement is to keep the overall no of stocks to less than 30.
Also Large and Mid cap category while they have restriction of 35% minimum each in mid cap segment and large cap segment, still in reality will end up more or less similar to any other multi cap fund.
Thus Multi Cap Category funds for my selection process will include
- Multi Cap funds
- Large & Mid Cap Funds
- Dividend Yield Funds
- Value/Contra Funds
- Focused Funds
“We wanted to get rid of anything other than what was absolutely essential, but you don’t see that effort. We kept going back to the beginning again and again. Do we need that part? Can we get it to perform the function of the other four parts?” – Steve Jobs
Sector Funds will be eliminated..
To pick sector funds implies I need to do my analysis on what is happening in the sector, take a view on the various drivers of the sectors and most importantly time both the entry and exit into the sector. Too much of an effort and hence the lazy me has decided to give this category a skip.
Thus we are left with Large, Mid and Small cap categories.
Large Caps: Prefer Index funds instead
This is a space where I believe post the new classification norms, beating an index fund is going to become incrementally difficult.
Let me explain why..
- Going forward, new rules by SEBI make it compulsory to hold 80% of portfolio in top 100 stocks at all points in time – earlier since there were no agreed rules, the mid & small cap allocation was used to improve returns and used to be in the range of 10-30%. This gave funds an unfair advantage over pure large cap Nifty index against which they were compared. This advantage is reduced to the extent that they can take exposure to mid/small caps only upto 20%.
- Earlier the Nifty Index returns were reported without the dividend portion which meant the returns were understated by roughly 1%, giving an additional advantage for large cap funds to optically show out-performance. This advantage is no more available for funds as the new total return index includes dividends.
- The costs of large cap ETFs have dramatically come down, to the extent that they are almost free (they are available at 0.05%. Check here)
- In developed markets, evidence points out that the passive funds (read as index or ETF funds) have a clear advantage over active funds. Thus eventually as the Indian markets mature and gets more participants and wider tracking, it will become incrementally difficult for large cap fund managers to provide large out performance in the well researched large cap segment
- Ambit has done some research on this here and comes to the same conclusion
- Even a fund house (Edelweiss mutual fund) has acknowledged this and has reduced their expense ratios in large cap category. (source)
Thus given the above apprehensions I am doing away with this category.
Mid Cap Category and Small Cap Category: Will be used opportunistically when category valuations are attractive
Over the long run, the mid and small caps are expected to outperform the large cap category. However they will remain extremely volatile with severe ups and downs and valuations need to be taken into account while investing in this category. This will be our second and third category for fund selection.
Thus we will in effect have three categories from which to select funds:
- Multi-cap Category – 4 funds
- Mid Cap Category – 2 funds
- Small Cap Category – 2 funds
These 8 funds will be our universe from which we will be constructing our portfolios. Mostly as stated earlier, I will be working in the range of 2-4 funds picked from the universe.
Summing it up:
- Inspired by Steve Jobs, my philosophy of fund selection and portfolio construction – Focus and Simplicity
- I will limit the number of equity funds in my portfolio to less than 4
- I will have only 3 categories for my fund selection process
- Multi-cap Category (core) – 4 funds
- Mid Cap Category – 2 funds
- Small Cap Category – 2 funds
(to be continued)
In the coming weeks, I will discuss in detail my thought process on how I personally go about with my fund selection and portfolio construction.
Till then, keep rocking and happy investing as always 🙂
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Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. 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