FundsIndia’s Mutual Fund Ratings – post SEBI’s categories

Post AMCs moving to SEBI-defined categories, we have seen different rating agencies as well as ‘top MFs’ list by media houses following various methods to deal with comparison of different categories. Some of these methods have conveniently kept away from certain categories; for example, the Mint 30 list decided to do away with focused funds are they are ‘specialised’. Morningstar too does this. A fund with a sound track record like Aditya Birla Sun life Focused Equity (earlier called Top 100) is unrated.

Among other categories, there isn’t much attempt to group funds and rate them appropriately. For example, Morningstar has 1 to 5-star ratings of large & midcap and multi-cap funds separately. That would leave you wondering which top-rated funds between these two categories you should choose. Both categories have a mix of large-caps and mid-caps, after all. Or should you go with the top-rated value fund which is again a separate category by itself?

Let us take the case of another popular rating website Value Research. You have debt funds under the corporate bond category rated separately. There is also a medium duration fund category in which many of the funds look like corporate bond funds in terms of strategy. So which ‘best fund’ should you choose between these categories?

In our view, the complexity of choices has only gone up with SEBI’s categories and none of the popular websites seem to have solved the ‘problem of plenty’ in the choices an MF investor faces.

At FundsIndia whether it is with our ratings or with our researched list ‘Select Funds’ our objective is simple:

• Compare funds that are comparable in terms of risk and time frame, because these are the 2 factors that really matter when it comes to choice of funds for an investor.
• Club fund categories where they are comparable and do the quantitative rating so that an investor is not left with too many top funds from different categories.
• Make sure the marginal differences that arise in clubbing funds from different categories is normalized by providing appropriate weights. For example, we assess large & midcap funds and multi-cap funds under the same bucket. But we’ve provided a weight to a fund’s marketcap to ensure a mid-cap tilted fund does not get undue advantage over a large-cap tilted fund.

We cannot eliminate fluctuations in ratings over the next few quarters. But our ratings system can make comparisons and choices more appropriate and simpler for investors who wish to choose funds based on their goal, risk profile or time frame.

We’ll now move to some of the changes we have made in terms of ‘clubbing categories’ and also in terms of the metrics used in assessing performance and risk.

Equity funds

Dropping peer comparison: The first thing that has changed across our equity rating methodology is that we dropped peer comparison – i.e., we have stopped comparing a fund’s return against the performance of its category as a whole. Instead, we have taken cognizance of consistency in beating benchmark and the margin of outperformance of benchmark. This was done for two reasons:

One, some of funds coming into new categories had a different history altogether and could not be compared with their new peers. Consider UTI Equity. The fund was predominantly large-cap oriented and thus has a history of delivering like a large-cap fund. It has moved to the multi-cap category in the new system. Then consider Invesco India Multicap, which was a mid-cap fund earlier and has now moved to multi-cap. If we were to compare performance against the category as we have been doing thus far, UTI Equity would have been compared to a stiffer standard than its past warrants and Invesco India Multicap would have an easier average to beat. To avoid such unfair comparisons, we’ve done away with category comparisons.

The best way to measure ability to deliver returns was to compare them with benchmark. To ensure that a fund’s category move did not give them an undue advantage or disadvantage, we used the relevant benchmark of their earlier category until March 2018. We will continue to use such a blended benchmark until all funds spend enough time in their new categories and build up the track record that relates to that category.

Two, we’ve begun using the total returns index for all benchmark comparisons. TRI indices are harder to beat. Consistent outperformance of benchmark is therefore a good enough metric to measure a fund’s ability to deliver higher returns.

Clubbing fund categories: A major drawback of SEBI’s categorization is this – it has brought in a mix of market cap criteria and strategy-based categorizing. However, there will be an overlap of the two. A multi-cap fund can be value-based in strategy, for example. This brings up the second noteworthy point of our ratings, which is the way we have clubbed fund categories.

The large-and-midcap category is an entirely new introduction. This category has seen funds shifting into it from various market caps (large, mid, multi-cap). This category along with multi-cap are essentially funds that can take a good chunk in mid-cap stocks as well. We combined the large & mid and multi-cap categories as essentially their strategy is to have exposure across market cap. However, the challenge was that this set now had funds from the erstwhile midcap, large cap and multi-cap spaces. For example, the large-and-midcap category has Prinicipal Emerging Bluechip, Mirae Asset Emerging Bluechip, and Canara Robeco Emerging Equities, all of which were mid-cap funds. Then there is Aditya Birla Sun Life Equity Advantage and DSP BR Equity Opportunities both of which were multi-cap funds. Reliance Vision and HDFC Growth Opportunities were large-cap funds earlier.

To ensure that higher returns merely from exposure to high risk (midcap/ smallcap) did not influence comparison, we provided appropriate weights to smoothen midcap exposure. This threw some pleasant surprises as solid multi-cap/diversified funds were ahead of some of the midcap funds that converted themselves to large & midcap now.  Parag Parikh Long Term Equity and Motilal Multicap 35, both of which are multi-cap funds have scored better than Canara Robeco Emerging Equities.

If you compared the ratings of other fund houses, you will find the usual suspects which were erstwhile midcap funds hogging the top spot in the large & midcap space. This is because their history as a midcap fund is being compared to other diversified/multi cap funds. We have clubbed other categories to facilitate the right comparisons, as we will explain in the next point.

No different treatment for varied strategies: The third noteworthy point is that we did not try to rate unique categories separately. Value funds, focused funds, dividend yield or contra funds were all clubbed into their respective marketcap-based categories. This was done for the simple reason that these are only strategies. Fundamentally, a value fund is either a large cap or a multi-cap fund and has to be assessed for its performance with the rest of the funds. So also a focused fund. They cannot be ignored nor rated separately. A multi-cap fund can well follow a value-based strategy and therefore be comparable to a value fund.

Take Axis Focused 25, categorized as focused. The fund invests across market capitalizations. So does Invesco India Contra, categorized as value. So does Franklin India Equity, categorized as multi-cap. Aditya Birla Focused Equity and Motilal Oswal Focused 25 will focus on large-cap stocks. HDFC Top 100 is a large-cap fund that has a concentration in its top stocks.

So how would you as an investor know whether to go with the top-rated focused fund or value fund or a multi-cap fund? They need to be compared with acceptable parameters – not separated or worse, not rated. The choice should not be between a value fund and a multi-cap fund or a focused fund and a large-cap fund. It should be between funds that invest approximately in the same marketcap segments and deliver superior risk-adjusted returns.

Debt funds

Recognizing credit risk. SEBI’s categories are silent about credit risk, barring the corporate bond and credit risk categories. As different categories of funds taking credit risk is not new, we had long solved this problem by providing appropriate weights to credit. This has been the case with erstwhile categories of ultra short-term, short-term or income accrual. We continue to follow that.

Going by duration. What we decided to do in debt was compare all categories based on their duration rather than rating them all separately based on SEBI’s categories alone. Low duration, ultra-short duration, money market and floating rates funds were all clubbed. Most of these operate within a certain range of average maturity which gives little reason for you to be barraged with top funds from each of these categories. For example, UTI Treasury Advantage and ICICI Prudential Savings are both low duration funds and have an average maturity of 0.7-0.9 years. Aditya Birla Sun Life Savings has an average maturity of 0.43 years and is an ultra-short term fund. Aditya Birla Floating Rate Fund – LTP is a floater fund with an average maturity of 0.56 years. They all service the purpose of holding investments between 3 months to a year.

Banking & PSU funds were clubbed with short duration funds even in our earlier methodology and it has worked. We continued with this.

We also brought together medium duration and corporate bond funds. To our mind, both these categories are accrual strategies and are meant for investment timeframes of over 2 years. Most corporate bond funds have average maturities within the range of medium duration funds. HDFC Corporate Bond Fund, for example, is in the corporate bond category and is very similar to L&T India Resurgent Bond fund, in the medium duration category. The only difference between the corporate bond and medium duration categories is that corporate bond funds cannot invest more than 20% in instruments below AA+. The need is to recognize credit risk, which we always have incorporated into ratings.

Continued with peer comparisons. With debt funds, since most of them are nested in their original strategies/maturities/timeframe (barring a few), we continue to do a peer comparison rather than benchmark comparison. There will of course be some outliers like a formerly higher-risk income fund DSP BR Credit Risk (2-star rated) which suffer as a result of comparing itself with credit funds that had always been credit opportunity funds. With time, anomalies like these should reduce as funds gain history under their new category/strategy.

Hybrid funds

In most of the hybrid categories, we have not had the need to make the kind of adjustments that we had to with equity and debt funds. Hybrid aggressive funds were all mostly balanced funds anyway. The same holds for equity savings funds, which were the same even before. Hybrid conservative funds were MIPs for the most part. They are all therefore in their original categories and perfectly comparable with each other.

We have refrained from rating the dynamic asset allocation/ balanced advantage and the multi-asset allocation categories for now. This is because funds that make up these categories have come from a wide variety of earlier categories across hybrids, debt, and equity. There is no clarity on what they will be from here, either. We’ll wait until this emerges. As a result, funds that were rated earlier that moved into this category may be unrated now.

Across all fund categories, this is what we aim at measuring:

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.