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.