Disclaimer – The funds or fund houses discussed on this post are NOT meant to be investment recommendations. Reader discretion is advised. Please do your own due diligence or discuss with your financial advisor before investing in any of the mutual funds discussed on this post.
The art of picking equity mutual funds
Equity mutual funds in India are probably the most popular kind amongst retail investors because they are easily understood. But when there are 465 different schemes to choose from, where do you even start!
We assigned each of these 465 equity mutual funds into 10 broad categories (similar to SEBI’s classification with some minor changes) and extracted their historic performance data. History is not usually the best indicator of future performance, but the fund’s track record is the only real tangible piece of data available to us to make a judgement. So, we begin there
Have you heard the story about Snow White and the evil queen? The evil queen owned a magic mirror. Every morning, the queen looked at the mirror and asked, “Mirror mirror in my hand, who is the fairest in the land?” The mirror never lied and faithfully kept telling the queen the truth that she is the prettiest. On the day Snow White turned 7 years old, she became more beautiful than the evil queen. It is not difficult to guess what happened next!
Given that the mirror (data) never lies, we will pose the questions to it.
Looking at the chart, 2 broad observations can be made.
- During good times, all the different categories made positive returns. When the going got tough, it got tough for everybody. In portfolio management, these are called homogeneous asset classes. For all the different varieties they come in, they are more or less similar at a high level.
- In at least 5 of the 10 years, the small-cap and mid-cap funds seem to have delivered returns that are on par with or better than the other funds. This is not entirely surprising. Midcap and smallcap funds are riskier than largecap/index funds and hence should deliver higher returns. More risk means more returns.
But looking at historical returns is not the best judge of any asset or asset class. Returns always have to be examined in context with risk. How do we measure risk in mutual funds? – Finance comes to the rescue. Remember the Greek letters Alpha and Beta? Now turns out, Beta is the measure of risk. What Beta does, is measures how volatile a particular stock or mutual fund is in relation to the index (Sensex/Nifty).
In simple terms – If Nifty goes up (or down) by 1% and Fund A goes up (or down) by 2%, Fund A’s Beta is said to equal 2.0. A Beta of > 1.0 indicates higher risk than the market while a Beta of <1.0 indicates lower risk than the market. Beta = 1.0 indicates risk level exactly equal to the market. Most index funds/ETFs’ Beta is close to 1.
Time to go back and ask a second question.
Unsurprisingly, smallcap and midcap funds seem to be the riskiest. Notice how the Beta of index/ETF and largecap funds is equal to 1?
The takeaway here is that if you will lose sleep at night looking at wide swings in your portfolio value, stick to largecap/index funds/ETFs. Your search for equity mutual funds begins and ends there.
We have looked at returns, we have looked at risk. Time to put 1 and 1 together – The category which delivers the highest returns at the lowest possible risk is what we would prefer, but how do we find that out?
Finance to the rescue again. There is a metric in finance called the Sharpe ratio – make it your best friend. Oversimplifying it, Sharpe ratio is “returns” divided by “risk”, better known as return per unit risk. Don’t worry about the exact formula. The only thing you will need to remember is that if mutual fund A has a higher Sharpe ratio than mutual fund B, then A has historically delivered higher returns per unit risk than B. You should obviously prefer A to B.
Now, with that new knowledge let us go back and ask another question.
RISK-WEIGHTED RETURNS ANALYSIS
Once again, midcap and smallcap funds have done better than all the other funds over the last 10 years. But did you notice how index/ETF funds have done terribly compared to the others? There is a very important take away here – In the last decade and on an average, active funds managed by portfolio managers have delivered better returns compared to passive funds that just invested in one of the indices (like Sensex/Nifty). This is an important finding because fund managers in the western countries are struggling to beat their benchmarks. But this finding does not necessarily mean that Indian fund managers have a magic wand or are superstars; it could simply mean that there are inefficiencies in the financial system which Indian portfolio managers are able to exploit to deliver better returns for their investors.
The key takeaways from the answers we got for all these three questions are these – If your investment timeframe is sufficiently long (a decade) and if you can take the pain associated with wild short-term swings in your portfolio value, midcap and smallcap funds have offered a good investment avenue in the last 10 years and may continue to do so (no guarantee whatosever). But if your time frame is short or if you cannot take the pain, it might be best to stick to large cap funds. Our experience in the last decade shows that index funds/ETFs and other passively managed funds have not performed well.
We have talked about the categories. What about the different fund houses that are offering these schemes? Like Motilal Oswal, BNP Paribas, HDFC etc. There are 44 of them in total as on date. Who do we go to?
Let us ask the question then.
FUND HOUSES ANALYSIS
This is a tricky question to answer – primarily because each fund house offers several different schemes. Some perform better than others, some are riskier than others and some have better Sharpe ratios than others.
But what we are looking for is not THE best performing individual fund from each of these fund houses, because history is not the best predictor of the future. What we will look for instead is performance on an average across all the schemes the fund houses offer. Good performance on an average across all schemes indicates a culture of rigorous research, fund managers’ pedigree, good processes in place for stock selection etc. But how do we measure that average performance?
You should have guessed it by now…Finance to the rescue. Let us say that you have invested in fund B which has a Beta of 2.0 with respect to the market (Sensex/Nifty). If the market goes up by 1%, you’d expect that the fund on an average would go up by 2%. But supposing the fund actually goes up by 3%, where did this extra 1% outperformance come from? It is like buying into a $1M lottery and actually winning $2M from it! We will not say no to the money, but how did it happen? This extra outperformance is called Alpha and is to the credit of the fund house/fund manager’s ability to deliver returns better than that expected for the level of risk taken. Higher the alpha, better the fund house/fund manager is. We can use this metric to compare the historic performance of different funds, fund houses and fund managers.
Now check this table below for the top 7 and bottom 3 fund houses by average Alpha generated over the last 6 calendar years.
Word of caution – IIFL and Parag Parikh only offer a handful of schemes while the other fund houses offer many.
Your work is now cut out. You now have a fair idea of which amongst the 10 equity mutual fund categories (largecap, smallcap etc.) are most suitable for you. You also have the knowledge of the names of fund houses that have performed the best & worst in the last 6 years. All that is left, is to dig out the schemes that are available and evaluate where to invest.