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Several people are convinced about using equity mutual funds as a preferred tool to invest, but they hit a roadblock when it comes to selecting the right fund. Some are promising, but new; others are established, but floundering. The advisers who clamour for trail commissions should be asked to demonstrate proven capability to select good funds for investors. We are not there yet primarily due to limited regulation on what advisers should do and how they earn their income. Investors end up buying funds based on past performance, which may not be repeated, as the fund houses themselves point out.

The focus for the investor should be on selection from the peer group, which these lists enable. A fund's performance may fall along with the markets in which it invests. Even the best equity fund may not post a positive return when the equity market return is negative. The decision at this point is an asset allocation decision-whether to remain in equity or not. It should not be confused with the fund selection decision, which is about choosing the right fund among peers that may be impacted by the market too.

First, there are funds for which you don't need to take a view; in case of others, your view matters. For example, if you buy a diversified equity fund investing in both large- and mid-caps, you leave it to the fund manager to take a view on the segment that will work well, and allocate accordingly. If you buy a fund that focuses on the mid-cap segment, you are going for a diversified portfolio, but are implementing a view on how midcaps will perform. Make sure you understand where you need to have a view and where the fund manager can do it for you.

Second, ensure you invest in the best. The simplest way to choose a good fund is to use its performance ranking. If your fund is 8/40, it is a top quartile fund (25% of 40 is 10, so funds up to the rank of 10 are top funds in this category). It is important to stick to funds that are above average, preferably top quartile funds. Check this ranking across time periods. This data is publicly available with fund research agencies such as Value Research. Funds that do not even beat the market index are not worth buying, but those that compete efficiently and stay ahead of the pack most of the time, are the favourites.
Third, do not look for consistency, that is, a fund that is always at the top of the league. In the 25-year history of competition in the mutual fund industry, there is no single fund that has stayed in the top quartile at all times. This is because different strategies work in different kinds of market cycles. Value funds, for example, will slip if the market is driven by growth. Slipping is not an issue, look for corrective action. Check how soon the fund bounced back after slipping. Your fund should stay in the top 50% mostly, not in the bottom 50% for over a year. In your yearly review, knock out the fund if it slipped for four quarters in its ranking.

Let's consider three qualitative factors to look for once you have chosen your fund based on peer ranking. First, the fund should clearly say where it will invest and how. Most fund objectives are hazy and fund managers tend to give themselves too much leeway on how they will generate returns. Without being too restrictive, if the fund says that it will invest in a diversified portfolio of equity shares, across sizes, it is good enough. To the investor, what matters is the manager's ability to select stocks carefully, manage sector exposure, and deliver a return that beats the benchmark index.

Second, the fund should demonstrate the ability to stay honest to its objective. Some funds are termed value-oriented, but most stocks they hold would not qualify. Some funds will tell stories about their ability to pick failing companies and turnaround stocks. These stories do not happen every day, and these funds degenerate to a diversified equity fund with a fancy name. Do not pick funds with vague objectives and strategies; they show erratic performance and corrective action is mixed.

Third, the fund house should have an investment philosophy that permeates most of its products. It is not possible for a fund manager to adopt diametrically opposite approaches to two products managed by the same fund house. If it has both value and growth products, see if the fund managers are different.

 

Some funds label such differences clearly and are transparent about how they function. In most cases, in order to push a new product, a fund house may come up with a fancy investment style, but not pursue it. Try and understand how the fund house does its job and choose the funds aligned to a stated philosophy. Ensure you buy into a specified, comparable, competitive product that is managed transparently. Review annually and replace laggards. Leaders fight to persist, but laggards always find the climb back tough. 

Happy Investing!!

 

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