My fund selection methodology

There are 62 open ended, diversified equity mutual funds with a longer than 7-year operating history as of today. There are 21 such open ended, equity oriented hybrid mutual funds. They make a total of 83 funds.

The reason I treat the two types together is that they are quite similar to each other. Most of the equity funds normally maintain around 5% cash/debt allocation which can even reach 10-15% or more in certain market conditions. This is comparable with the overall average of around 20% cash/debt allocation for hybrid funds.

By treating the two types together, I also attempt to achieve a seemingly impossible goal: to find mutual funds which have downside risk similar to hybrid funds with the upward return potential similar to pure equity funds.

I compare these funds with one another for their last 7 year of performance. I take the measure of downside risk and returns for a total of 9 periods as explained in the previous post.

I look for consistency in risk adjusted returns. I must admit here that I am fanatic about consistency. Therefore, it is very much possible that a fund hot in last 2 years is still not rated well.

Ratings: What you can expect

The risk and return figures are categorized into 8 groups: “Very High”, “High”, “Above Average”, “Average”, “Below Average”, “Low”, “Very Low” and “Unacceptable.” Funds with “Unacceptable” risk (high) or “Unacceptable” return (low) should be avoided at all costs.

Attempts should be made to select funds with “Above Average” or better (higher) return which take “Below Average” or better (lower) risk.

The 5-star funds are actually “super-star” funds. Invest in them and you will never regret the decision. My suggestion: run a 5 year SIP each in some (or all) of them and let the money grow for another 5 years and see the magic.

The 4-star funds are as good as any 5-star funds suggested by most of the finance websites. However, be informed that you need to monitor them closely. The ones with poor 3-year and/or 5-year returns should be axed. One should be looking for acceptable recent performance and excellent long-term performance.

The 3-star funds are trickier. The caution applied to 4-star funds is even more applicable here. Usually, depending upon the risk appetite one could choose a low risk, low return fund or a high risk, high return fund.

It should be noted that at this level the “index-like” HDFC Index Sensex Plus provides a better risk adjusted return than many other funds. So a high risk, high return fund would serve better or one should go for a pure index fund.

I would not suggest investing in 2-star funds. However, if already in portfolio, they need not be removed either. A better strategy would be to keep monitoring their performance (you lose the luxury of “auto-pilot” mode) and redeem if things get worse to worser J or at a high market level (e.g. Nifty P/E > 22).

In the unfortunate case of you having invested a 1-star fund, you must have paid less than enough attention to either its past performance or its recent performance or both. In any case, all these funds have screwed up their risk-return profile beyond redemption and you better exit them now than any later.

How should one go about selecting a good mutual fund?

Time and again this question has been put to me by many of my previous selves and every time I have tried to answer it to the best of my ability and according to what looked like the right approach at the time of questioning.

The process has been an educating one. My fund selection has matured over the years and I can claim sufficient expertise in the area. At the same time, it will be stupid to claim any finality over my current choices.

In the following paragraphs, I will attempt to elaborate my fund selection “philosophy.” The goal my strategy will try to achieve is that there should be no sleepless nights: neither in a rising market nor in a falling one.

Return: The raison d'être

This reason for investment could be different for different people according to their purpose of investment. However, underlying every investing activity is a craving for and the expectation of above average returns.

There are many methods for measuring the investment returns. However, the easy and simple one is also the most obvious (and popular) one: the annualized returns taken over a long period of time, usually many years.

I have seen many mutual fund websites providing “long term” return figures for 3 years. With due respect to all of them, I beg to differ. My personal long term is never less than 7 years. 3 to 5 years is medium termin equity investments including equity and equity-oriented hybrid mutual funds. Anything less is pure gambling. Accordingly, I have an arbitrary rule to exclude all mutual funds with less than 7 years of operating history.

I take a total of 9 performance numbers (5 3-year annualized returns, 3 5-year annualized returns and the 7-year annualized return) and assign them different weights. The most recent periods are assigned the highest weights. I also see to it that erratic performance in a certain period is duly penalized by assigning two worst performances much higher weights. The final weighted average is taken as the representative of the overall return.

Risk: The possibility of loss

Mutual fund returns are, as the disclaimer goes, subject to market risks. The market risk is the systematic risk associated with all sorts of equity investment. In addition, there is also a risk of underperforming the market.

However, the real risk is not underperformance but the extent of the loss of capital. For example, a fund which marginally underperforms a rising market could be a good pick if it can convincingly beat a falling market.

Therefore, irrespective of the superlative returns generated by a fund in rising market conditions, what matters is the magnitude of its fall when the overall market is on a declining trend. A consistently excellent record in the falling markets could ensure a good night’s sleep even if the fund is not a chart buster otherwise.

I take the simple average of ‘n’ number of worst monthly performances of a fund over a certain period of time. The value of ‘n’ is proportionate to the length of the period under evaluation and is roughly aligned with the number of months when the overall market slides. I have done some analysis of the last 10 years of monthly performances of all the mutual funds for this purpose.

As with the returns, I take 9 performance numbers and assign different weights to them. After accounting for the erratic performances, the final weighted average is taken as the representative of the overall risk of a fund.

Consistency: The sleeping pill

The entry into and exit from a mutual fund is a costly (and painful) affair. So there is no point in buying a mutual fund if its performance is going to be different from what it has been in the previous years.

Besides, the whole point of buying a mutual fund is to keep one's life simple by letting the fund manager do the stock selection and churning. So, if I have to select my fund manager too often, it defeats the whole purpose of investing in a mutual fund.

Therefore, a fund should be severely penalized for any inconsistency. For example, a low risk fund should always be able to beat a falling market. If it takes unwarranted risks and the market slides, it will not be able to avoid the resulting severe fall.

Therefore, as explained above, I assign much higher weights to erratic performances, both on the risk and the return front. At the same time, one should remember that it is not always possible to avoid mistakes. I tend to give lower importance to the older mistakes of a fund manager and amplify the most recent ones. This is my way of granting that she is learning from her mistakes.

It should be noted that both of these adjustments only aim to put sense to some apparently random performance numbers. They cannot, in any way, guarantee that the fund will not behave erratically in future. As they say: past performance is not necessarily indicative of future results.