Here is a recap of how the strategy was designed and the thought process behind it.
What is the challenge in building an equity portfolio using mutual funds?
Building an equity mutual fund portfolio can feel confusing and overwhelming.
- Too Many Choices!
With over 45 fund houses offering a vast array of equity fund schemes across multiple categories, the choices can feel endless. And the nagging question remains: What if I choose the wrong one? - Fund Ratings don’t work!
Have you ever wondered why rating agencies never show the performance track record of their 5-star-rated funds? - Past Performance does not help in picking future winners!
Evidence suggests that portfolios made up solely of recent winners tend to underperform in the future.
How do we solve this?
Identify proven investment styles that can outperform the passive index (Nifty 50 or Nifty 500) over the long run!
Investment research worldwide has repeatedly shown that stocks with specific, well-defined characteristics often outperform popular market-cap-based benchmarks like the Nifty 50 or Nifty 500 over the long term. These characteristics, known as factors, have demonstrated enduring success, consistently delivering performance over time and proving effective across diverse equity markets.
To date, seven key factors have been identified and validated globally.
Based on the historical performance and portfolios of these different styles, we found that
- ‘Dividend Yield’ hasn’t worked well in India.
- ‘Low volatility’ portfolios have a very high overlap with ‘Quality’ portfolios
So we will avoid these two styles.
Do these investment styles outperform over the long run in India?
As seen below, most styles have been able to outperform the passive index (Nifty 500 TRI) consistently over different 7 year periods.
What is the catch?
Different time tested Equity Styles while they outperform over the long run, go through intermittent periods of underperformance…
While these investment styles have consistently delivered strong results over long periods (7+ years), they do not perform equally well in the short term. Each style experiences its own cycles, with phases of underperformance followed by periods of significant outperformance. However, over the long run, the gains from outperformance more than make up for the lean phases of underperformance.
This underscores an important reality: all styles will inevitably face periods of temporary underperformance as part of their natural cycle.
Focusing solely on funds that have performed well in the recent past can lead to a portfolio heavily concentrated in one or two investment styles. When these styles fall out of favor, your entire portfolio may experience prolonged underperformance for years.
This is why relying only on past performance is an unreliable strategy for predicting future winners!
Can we identify the styles that will perform well in the next few years?
As seen from the above table, investment styles rotate every year and it is extremely difficult to predict when these styles will be in favor or out of favor.
How to build a good equity fund portfolio?
Despite this, we can build a simple and effective portfolio using the time tested magical tool – Diversification.
Instead of trying to predict which style will work over the next 5-7 years, we prefer to diversify across these five styles. We will also be adding ‘global’ exposure to provide global diversification.
Our belief – Time in the style is more important than Timing the style!
Presenting ‘5 Finger Framework’ – Your All Seasons Equity Portfolio Strategy
Just as we need all five fingers to perform daily activities effectively, a well-constructed equity fund portfolio requires a balanced representation of five key styles:
- Quality
- Value
- Growth at a Reasonable Price (GARP)
- Mid/Small Cap
- Global Exposure/Momentum
Our Select Funds are carefully chosen to ensure these styles are adequately represented, leveraging the expertise of the best fund managers. Under our 5-Finger Framework, the equity portfolio is evenly distributed, with 20% allocated to each style.
To maintain this balance, the portfolio is rebalanced annually if any individual fund’s allocation deviates beyond ±5% (i.e., falls below 15% or exceeds 25%). This disciplined approach ensures the portfolio remains diversified and well positioned to navigate different market environments.
The performance of any strategy is as good as its underlying funds. You can invest in one or two funds under each style. But it is important to pick the right funds under each style. You can refer to our FundsIndia SELECT Funds list where we identify good funds and experienced fund managers to play the particular styles.
What is the logic?
- High likelihood of individual styles outperforming over the long term.
- Different cycles of outperformance and underperformance ensure that when some styles lag, others excel, making overall portfolio performance consistent.
- Helps you stay invested in underperforming funds, as strong overall portfolio returns provide confidence and conviction.
We launched the strategy in January 2020 after conducting extensive back-testing from January 2010, which delivered impressive results. Since then, we have tracked the strategy’s actual performance over the past five years.
How did the strategy perform since its launch over the last 5 years?
Superior Performance: 22% per annum vs 19% per annum benchmark returns -> 3% outperformance
5 Finger Strategy multiplied your money 2.7 times over 5 years (vs 2.3 times for the benchmark)
Was the performance consistent?
The outperformance is not attributable to a single exceptional year but has been consistently strong across multiple years
And even for longer time frames i.e. across all the 5-year periods since 2010 this framework has worked well consistently
- Average 5Y Rolling Returns at 18% vs Nifty 500 TRI at 13%
- 5 Finger Framework has outperformed Nifty 500 TRI, 100% of the times on a 5 Year rolling return basis!
- 62% of the times the 5 Finger Framework has outperformed Nifty 500 TRI by more than 3% per annum over 5 Year time frames
- 91% of the times the five finger strategy has delivered >12% returns over 5Y time frames
Did the diversification across styles work?
Low overlap across funds…
Led to different styles out/underperforming at different time periods – helping in a more consistent performance at an overall portfolio level.
What about risk?
Majority of the time, 5 finger strategy fell lower than Nifty 500 & Nifty 50…
The 5 Finger portfolio had a Downside Capture Ratio of 62% against the Nifty 500 for the last 5 years i.e. it roughly captured only 62% of the falls suffered by the broader market. A ratio less than 100% indicates strong risk management ability of the portfolio.
As seen from the intra-year declines (maximum falls faced by the broader market within a year), the portfolio using the 5 Finger framework has generally fallen less than the benchmarks. Except for 2 out of the last 15 calendar years (2016 & 2022), the intra-year declines for 5 Finger strategy was lower than Nifty 50 TRI.
We can also see that this approach has been resilient during the major market declines in the past 10+ years resulting in low falls.
Were there changes in the funds?
There was only 1 change in the last 5 years and this was made last year in 2024.
For the quality style, we transitioned from the Axis Focused 25 Fund due to a dilution in its investment style. Interestingly, instead of following the typical approach of switching from an underperformer to a top performer, we chose another quality fund which was also underperforming at the time.
This decision was consistent with our portfolio design philosophy, which recognizes that all investment styles experience periods of underperformance. Among the quality funds available, we selected one whose underperformance closely aligned with the characteristics of the quality style and relevant indices.
This new fund has also performed well over the past six months, as the quality cycle shows early signs of recovery.
Summing it up
We also launched another version of the 5 Finger Strategy with only India exposure where we have replaced Global style with Momentum style. This strategy has also done well in line with our expectation (CY24 Returns: 23% for 5 Finger Domestic vs 16% for Nifty 500 TRI)
Our Learnings
- Every investment style experiences phases of underperformance and outperformance. By combining these styles, the 5 Finger Framework has proven to be an effective behavioral solution, helping investors stick to the overall strategy and remain invested, even during periods of underperformance within specific styles.
- This strategy is also tax-efficient due to minimal portfolio churn—we have made only one fund change, prompted by a change in the fund management team that diluted its investment style.
- Different investment styles excel in varying market conditions. By blending these styles within the 5 Finger Framework, periods of underperformance in one style have been offset by outperformance in others. This approach has delivered consistent performance with lesser declines compared to benchmark indices.
Is 5 Finger strategy right for you?
The 5 Finger approach is best suited for patient investors with a long-term horizon of at least 5 to 7 years. Some investment styles may experience relative underperformance for extended periods, but staying invested despite this is crucial to fully benefit from diversification, as it’s impossible to predict when styles go in and out of favor.
Please remember that at any point in time, one or two styles may lag, but these underperforming styles rotate over time, creating a balanced and resilient portfolio.
As always, happy investing!