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.