Month: August 2018

While picking mutual funds, the usual practice is to start with the past returns, run several consistency metrics, ratios etc and finally come up with some funds based on the ranking of all these parameters.

The only issue I find in this process is that the conviction on the chosen fund is predominantly derived from the returns.

Inevitably as funds go through periods where the particular investment style is not in favor and returns lag, our conviction gets tested. Not knowing what to do, we run the process again and replace the existing ones with a new set of funds. Rinse and Repeat.

This unfortunately becomes a perennial trap where we always end up replacing funds and the new ones again repeat the same pattern of not-so-great-performance.

The key problem here is

• All funds good or bad inevitably go through short term under performance
• The tough part is to differentiate between a good fund going through short term under performance which is temporary and a truly dud fund going through under performance which is permanent
• This means we need to derive some way beyond the numbers to derive conviction in the fund so that we can actually hold on to it during the tough times

So, I propose a slightly unorthodox yet intuitive way to pick funds where the priority will be to ensure that you develop conviction and trust in the process. This would help you to stick with the funds for longer periods and have a much better mutual fund investing experience.

So let’s dive in..

Fund selection process

My process will emphasize primarily on a combination of

1. Fund Manager first philosophy
2. Understanding Investment Style & Strategy
3. Communication
4. Emphasizing performance across market cycles

Fund Manager first philosophy

Every fund house will have its own version of – we have a strong investment process and there is no star fund manager culture followed here.

Personally, I don’t think we are there yet (at least in India) and believe a fund manager still remains the single most important determinant of the future performance of the fund. Think Warren Buffet, Charlie Munger, Howard Marks, Peter Lynch, Seth Klarman etc

So my first step would be to filter out a set of good fund managers from the available universe of 100+ fund managers.

But how do we find them if not for the returns?

Simple. Find the guy who has the highest incentive and resources to figure out a good fund manager and follow him.

Any guesses?

Who else, it is the asset management company!

Think about it, the entire business and success of an asset management company is based on the ability to provide superior returns over the long run. And they obviously know a fund manager plays the key and hence would have done all the due diligence to pick whom they think is the best.

Step 1: Creating a fund manager universe

So let us take the top 15 largest fund houses (based on equity assets) and assume that these guys would have done their homework right and picked a good fund manager to lead the team. So all the CIOs (i.e Chief Investment Officers) of these fund houses will get added to my universe.

1. HDFC – Prashant Jain
2. SBI  – Srinivasan
3. ICICI Prudential  – Sankaran Naren
4. Reliance  – Manish Gunwani
5. Aditya Birla Sun Life  – Mahesh Patil
6. Franklin Templeton – Anand Radhakrishnan
7. UTI- Vetri Subramaniam
8. Kotak Mahindra  – Harsha Upadhyaya
9. DSP – Vinit Sambre
10. Axis – Jinesh Gopani
11. L&T – Soumendra Nath Lahiri
12. Sundaram – Krishnakumar
13. IDFC – Anoop Bhaskar
14. MOSL – Gautham Sinha Roy
15. Mirae Asset – Neelesh Surana

Source: http://www.thefundoo.com/Tools/AMCDashboard

Let me add two other fund houses which while small in size communicate extremely well and hence it is easy for us to understand their process

16. PPFAS – Rajeev Thakkar
17. Quantum – Subramaniam

Also the other source which I like to consider for identifying good fund managers is Morningstar qualitative rating. They do a decent job and I will consider all the Gold and Silver rated fund managers. You can check here

• Gold rated – Sankaran Naren, Prashant Jain, Anand RadhaKrishnan
• Silver rated – Roshni Jain (Franklin Templeton), Vikas Chiranewal (Franklin Templeton), Neelesh Surana, Jinesh Gopani, Sailesh Raj Bhan (Reliance MF)

So we add 3 more fund managers as all others are already included

18. Roshni Jain (Franklin Templeton)
19. Vikas Chiranewal (Franklin Templeton)
20. Sailesh Raj Bhan (Reliance MF)

Good, that’s a total of 20 fund managers to start with..

Step 2: Mapping fund managers on the investment style spectrum

Most of the fund managers investment style can be classified as value or growth or blended (i.e mix of both)

Now in order to classify the above fund managers, we need to check if they communicate about their style and investment strategy.

Let us eliminate fund managers who don’t communicate regularly on their website or public forums.

Now to be honest since I work for a large firm I get access to all of them and can get to understand their styles and strategies better. Also this is extremely helpful if there are any concerns on under performance as I can immediately get in touch and get a clear idea on what the fund manager is thinking. But I am ignoring this bias of mine since most of you won’t have access and the only way you can develop conviction is if they themselves communicate about their process and investment style.

Also we are currently trying to pick only for our multi-cap universe and hence we will ignore large, mid and small cap fund managers

So I am eliminating the below fund managers based on the basis of insufficient communication (i.e they don’t communicate well enough on their style and process via publicly available resources)

1. Reliance – Manish Gunwani
2. Reliance – Sailesh Raj Bhan
3. Aditya Birla Sun Life  – Mahesh Patil
4. Franklin Templeton – Anand Radhakrishnan
5. Franklin Templeton – Roshni Jain
6. Franklin Templeton – Vikas Chiranewal
   
7. Kotak Mahindra  – Harsha Upadhyaya
8. L&T – Soumendra Nath Lahiri
9. Sundaram – Krishnakumar
10. Mirae Asset – Neelesh Surana

Further, I am eliminating the below fund managers since they manage only mid & small cap strategies

1. DSP – Vinit Sambre – Communication is good but a mid and small cap focused fund manager
2. SBI  – Srinivasan: A mid and small cap focused fund manager + no clear communication in the website

If there are some managers who communicate well and yet I have left out in the list do let me know with the source link.

This leaves us with 8 fund managers and their respective funds:

1. HDFC – Prashant Jain – HDFC Equity Fund
2. ICICI Prudential  – Sankaran Naren – ICICI Prudential Large & Mid Cap
3. PPFAS – Rajeev Thakkar – Parag Parikh Long Term Equity Fund
4. Quantum – Subramaniam – Quantum Long Term Equity Fund
5. UTI- Vetri Subramaniam – UTI Value Fund
6. IDFC – Anoop Bhaskar – IDFC Core Equity Fund
7. Axis – Jinesh Gopani – Axis Focused 25
8. MOSL – Gautham Sinha Roy – MOSL 35

Now we will have to fit them along the growth-value spectrum

Lets first fill the value bucket first..

1.HDFC – Prashant Jain – HDFC Equity Fund

What is his investment style?

• Early identification of a cycle: He believes that the Indian market operates on the basis of cycles with clear sector leadership and positions himself ahead of a cycle
  • 1995-2000: Infotech was the sector leader
  • 2001-2007: Capex, Banking, Commodities
  • 2008-2015: FMCG, Pharmaceuticals, Automobiles
  • Going forward: Positioned for cyclical recovery via Infra/Banking/Capex
• Contrarian and Value Bias
• No cash calls
• Large cap bias
• Buy and Hold investing – has a low portfolio churn

Source: https://www.morningstar.in/posts/39930/prashant.aspx
Source: https://www.morningstar.in/posts/44081/conversation-prashant-jain.aspx

Wow factors:

• Value investing or early cycle investing means you will have to be ready to go through short term pain.
• Both the fund manager and the AMC must be patient enough to let such a style run its course
• Any new fund manager had he taken the same call  (of being overweight cyclicals and corporate banks) would have been out of job by now
• In Prashant Jain’s own words – “The nature of a fund manager’s job is such that performance tends to be volatile particularly over short to medium periods. Further, given the relative nature of performance measurement, it is virtually impossible for a majority of managers to do well at any point of time. This, and the short-term focus of many market participants, could be important factors for the short tenures of mutual fund managers.”
• So I think the biggest edge of Prashant Jain is behavioral – his conviction to stick with his call and the patience to ride short term pain
• Given his long term track record, thankfully the AMC is also supportive of this style

Performance across market cycles

• Historically he has been able to stay out of both the tech bubble of 2000 and Infra bubble of 2008 and has a proven long term track record of performing across cycles (19% CAGR for HDFC Equity vs 11% for Nifty 50 TRI for the 23 year period from Jan-95 till 29-Jul-2018)

Concerns

1.Fund size is very large

• He manages two funds HDFC Top 100 and HDFC Equity and both have an overlap of 73% (check here)
• The size of HDFC Top 100 is Rs 14,376 cr while HDFC Equity is Rs 20,352 cr. Also the balanced fund that he manages is 36,500 cr (of which 70% is in equity =  ~Rs 25,500 cr)
• So he is in effect managing a whopping Rs 71,000cr in equity
• It has been globally proven that a large fund size is detrimental to returns
• Now the million dollar question is “What exactly is that large size?”
• His historical arguments have been that “You guys are making a big deal about size. Internationally, these kinds of situations arise when the size of a fund reaches say 1 percent of the market. Why should I get worked up about size when my fund is around 0.12 percent of the market? The Indian markets are growing and as the size of my fund grows, the market will be even bigger”
• Unfortunately since there are no formulas available to capture the size at which the fund performance will get impacted, we need to trust the fund manager or the AMC to close inflows when size becomes large
• Their mid cap fund HDFC Mid Cap Opportunities is a whopping Rs 20,000 cr and also the largest mid cap fund (the next largest being 1/3rd of the size at ~7000 cr) – this implies possibility of a liquidity risk (i.e not being able to sell off their holdings if investors suddenly redeem) and also taking meaningful exposures becomes difficult as explained in the article here
• Despite a lot of mid and small cap funds shutting their inflows at sub 5000 cr levels, HDFC Mid Cap Opportunities continues to be open for inflows
• Now while its difficult to pass a judgement whether this is right or wrong, I am not getting the confidence that they would close their funds when size becomes an issue
• He is currently addressing the size issue via concentrated positions (Top 10 stocks account for 60% of the entire portfolio) and higher exposure to large caps

2.Higher large cap exposure

• Given the large size, there is large overlap with the large cap index – ~40% overlap
• In my view, out performance in the large cap space will become incrementally very difficult as the segment is tracked widely and hence the possibility of informational arbitrage is very low here (compared to mid and small caps)
• Only behavioral edge can produce out performance i.e positioning early in the cycle and riding through short term pain – which is exactly what he is attempting

Communication:

• The investment style of the fund is well communicated via their presentations available in their website
• A lot of public interviews and videos are available
• Further, morningstar which has a gold rating on him also takes extra efforts to explain his philosophy and his current bad patch as seen here and here

My view:

• This fund will fit perfectly in the value end of the style spectrum
• There is a good possibility that the fund will have one or two years of sharp out performance if his call of cyclical recovery starts playing out
• However, size at some point of time will become an issue
• Unfortunately, going by recent evidence (in HDFC Mid Cap Opportunities) I am not sure if they would let us know when that happens
• Since I am on the lookout for a fund which I can stay invested for a long time (say 5-10 years), I am giving it a skip despite my high regards for the fund manager considering possible size constraints

2.ICICI Prudential  – Sankaran Naren – ICICI Prudential Large & Mid Cap

Let me start with a honest confession. Out of all the fund managers I have ever met, I have learned the most from his interviews (be it the private ones via my organization or public ones). So I will be extremely biased and hence do take my views on Naren with a pinch of salt.

What is his investment style?

I have a done a extremely detailed post on Naren here which will help you understand his investment style better.

Click here for the short snapshot

Also here is the recent interview which you must not miss – Link

Wow factor:

1. 27 years of Market experience covering 3 cycles
2. 13 years of fund management experience
3. Robust long term performance track record
   
4. Consistent Investment Style  = Value investing + Contrarian + Evaluating Cycles + Top Down (using the big picture to arrive at stocks to invest in) + Bottom Up
5. Macro overlay + takes advantage of cycles
6. Knowledge of credit markets and credit cycles – its interplay with equities
7. Ability to withstand and stick to investment process during occasional periods of short term under performance
8. Widely read
9. Investment Gurus – James Montier, Howard Marks, Michael Mauboussin
10. Deploys checklists for investing – inspired from Atul Gawande’s Checklist Manifesto
11. Communicates strategies and thought process regularly on public forums (making our lives a lot more easier)

Concerns:

• The AMC has too many funds – more bordering on the asset gatherer types – especially had too many funds launched under their closed ended series
• Signs of corporate governance issues at the AMC: Securities and Exchange Board of India (Sebi) has found that ICICI Prudential Asset Management Co. (AMC) Ltd bailed out the ICICI Securities Ltd initial public offering (IPO), and short-changed its unitholders in the process. Read here
• There were some other questions raised by a site called Mutual fund critic here and here (while not a game changer, nevertheless it needs to be noted)

My view:

• While there are some concerns on the AMC, I have a strong conviction on the integrity of the fund manager
• Here is some support for my conviction from a very experienced and popular blogger Mr Subra in his blog Subramoney – Link: In defense of Naren
• Naren’s experience and stature allows him the rare luxury to take near term pain and stay patient till the contrarian call plays out (which a lot of new fund managers will never have as the short sighted industry won’t let him/her survive)
• I have high regards for him and I believe having his fund is one of the best ways to play the contrarian + value style in your portfolio

3.PPFAS – Rajeev Thakkar – Parag Parikh Long Term Equity Fund

• Value Investing – buy an investment at a discount to its true value – applies to high growth companies, low growth companies as well as declining companies
• Buy and Hold (reflected in low churn)
• Concentrated Portfolio (<20 stocks)
• Agnostic to geographies: 1/3rd portfolio in global companies
• Not averse to taking cash positions if opportunities are not available

• High Conviction – The entire fund house just has one single fund – and this single fund runs a concentrated portfolio of around 20 stocks. So all the resources will be focused on this single fund and shows their conviction and belief. This is a welcome change from the majority of AMCs where they have several funds running different strategies so that at all points in time there will be one fund or the other performing.
• Skin in the game – their own employees own around 10% of the scheme
• Simple to track – as there are only 20 stocks and churn is low
• Clear communication – These guys are way ahead of the industry and have phenomenal transparency in communicating their views and process. They have a good youtube channel (link) where the fund managers regularly communicate their views and also their annual investor meeting is available where they talk about the investment thesis behind their stocks
• Exposure to global stocks – The fund provides diversification via 1/3rd exposure to global stocks

Performance across market cycles

• The fund was launched in Jun- 2013 and has returned around 18.5% vs 15.5% in Nifty 500
• Earlier it was running a PMS where it had returned 15% vs 13% in Nifty for the 17 year period between Nov-96 and Dec-13. This is very low compared to other good funds such as HDFC Equity (26%) , Franklin India Bluechip (25% CAGR) etc

Concerns

• While intent and integrity is unquestionable, the past performance of their PMS over the long run has been very mediocre relative to other decent funds
• However in their new fund avatar, their performance has been very good till date
• They take large cash calls which might be a drag on their returns at some point in time

My view:

• Personally, I like the fact that they have skin in the game, one single fund showing their conviction and they communicate extremely well allowing me to develop a high conviction on them
• Global exposure is an added advantage
• I don’t expect them to do well in a raging bull market and mostly their returns will be decent over a complete market cycle (as they fall less in a down market)
• Their cash calls might be an issue in the longer run
• I personally like the fund and would add it to the “value” end of the style spectrum

4.Quantum – IV Subramaniam – Quantum Long Term Equity Value Fund

What is his investment style?

• Value Investing
• Buy and Hold (reflected in low churn)
• Concentrated Portfolio (25 to 40 stocks)
• Not averse to taking cash positions if opportunities are not available
• Large cap bias

You can read about their entire process here

• High Conviction – The fund house technically has single diversified equity fund (ignoring the fund of fund and ELSS) runs a concentrated portfolio of around 25-40 stocks. So all the resources will be focused on this single portfolio and shows their conviction and belief.
• Simple to track – as there are only 25-40 stocks and churn is low
• Communication is decent – earlier it used to be much better when their founder Ajit Dayal was in charge (he quit recently)
• Ability to stick to their process in the face of short term under performance (read here)

Performance across a market cycle

• The fund was launched in Mar- 2006 and has returned around 14.4% vs 11.7% in Sensex
• In the ~7 year period between Jan-2008 and Aug-13, which was one of the toughest investing environment for fund managers, the fund was the top performing fund amongst its peers with 4.5% CAGR compared to Sensex returns of -1%

Concerns

• Their founder Mr Ajit Dayal has recently quit the firm (while a process has always been emphasized I generally take it with a pinch of salt)
• They take cash calls which can be a drag on their returns

My view:   

• Personally, I like the fact that they have they have one single fund showing their conviction and they communicate reasonably well
• I don’t expect them to do well in a raging bull market and mostly their returns will be decent over a complete market cycle (as they fall less in a down market)
• Their cash calls might be an issue in the longer run
• My primary concerns are with two things – 1)Ajit Dayal moving out and 2) predominantly Large cap biased portfolio (more a personal choice as I would want a fund which is flexible to take mid cap exposure when valuations are attractive)
• The fund would fit into the “value” end of the style spectrum
• While I like the fund, I would give it a skip as Rajeev Thakkar and Naren’s style is very similar in nature and also they have far more flexibility in moving across mid and small caps

Now don’t get too fixated by the final choice of funds but rather focus more on the thought process and gradually you can evolve your own process. Remember, there are no sacrosanct rules to pick funds and you can pick any fund based on your own parameters.

The real idea is to go beyond returns and identify funds/fund managers where you can derive conviction based on better understanding of their investment process and style. This will allow you to patiently stay with the fund across a market cycle and reap the benefits.

(to be continued…)

In the coming weeks, I will fill the other two buckets – Growth and Blend. Then I will build a live SIP portfolio where I will be investing my own money for the next 5-10 years.

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Stay blessed and happy investing folks!

If in case you have any feedback or need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com