How we choose our ‘Select’ equity funds

Last week, we had discussed why you should not pick an equity fund based merely on its 1-year returns record. You can click here to read it.

In this week’s article, let’s see how we sift and sort hundreds of schemes to arrive at the handful that we present to you as ‘FundsIndia Select Funds’ – our own list of schemes we deem ‘investment-worthy.’

First, a disclaimer of sorts – while what we do is not rocket science, it is not quite as simple as picking out a pale blue shirt for office wear either. We use a full database of mutual funds that provides historical data for NAV, returns, and portfolios, apart from various derivative details such as risk ratios. We rely on our past experience to figure out what parameters to consider and what red flags to watch out for. This essay, hence, is more of an exercise in transparency, than an effort to provide a ‘how-to’ manual to investors.

With that caveat aside, here are the key factors we look for:

Consistency scores – We are neither too excited by a fund moving into the top 5, nor are we disturbed when they move out. For us, consistency scores.

We measure this by rolling the returns every single day over 3- or 5-year periods (or longer, depending on the fund’s track record) to see how consistently the fund had been able to beat its benchmark, i.e., the number of occasions it outperforms its benchmark, and by what margin and so on.

A fund that performs exceedingly well in a year and slips in the next will be out in the open when we run this test.
This exercise will also throw a fund’s best and worst performance over different time frames as it is rolled every single day. This provides a good idea of how well a fund can perform or how badly it can slip.

Returns commensurate to risk – While whether a fund scores in terms of consistency is a litmus test for most peer comparisons, risk-adjusted return measures such as Sharpe ratio and Treynor ratio, and volatility and risk measures such as standard deviation beta (the lower the better) become vital to assess performance.

You may see a fund scoring in terms of point-to-point returns; but when measured against a unit of risk it may score low. That means, it does not deliver sufficient returns that compensates for the risk it undertakes. Similarly, standard deviation suggests whether a fund’s performance is too volatile and how much it deviates from its mean returns.

Performance over market phases – It is one thing for a fund to shine in a bull market and another when it goes into oblivion in a bear phase. And if your goal was closing in during a bear phase, you certainly don’t want the fund to destroy much of the wealth you had created till then. This is why checking performance across market phases is a must to know whether a fund is worthy enough for a long-term portfolio.

The above three are few of the many quantitative metrics that we look at before we choose a fund. Besides, factors such as asset size, expense ratio and minimum period of track record are considered.

Also, a number of qualitative factors such as the fund’s stated mandate versus what it actually does, the fund manager’s track record, the fund’s ability to stay invested in equities, and so on also go into our choice of funds.

But then, all of the above is more like an ‘audit check’ to assure oneself of the quality of the fund. Beyond all this, the fund’s strategy in different markets, its exposure to sectors and its stock specific calls and moves – all ultimately decide the future prospects of a fund. All this, of course, within its stated mandate.

This is where, studying sector prospects, whether the fund has taken a contrarian call or not, how its stock moves delivered, etc., matter. And often times, this decides whether a fund can do well prospectively. For instance, a fund such as HDFC Top 200 or Franklin India Prima, which took exposure to cyclical sectors ahead of the up move benefited when such sectors came into the market radar. The call, which seemed an uninspiring one in 2013, worked well later.

On the other hand, a fund such as Franklin India Bluechip, that cannot go much beyond the blue chip universe and also therefore, missed out on some of the cyclical rallies (since a number cyclical stocks are emerging large caps or midcaps) cannot be written off for poor performance, when the fund did what it could, within its mandate. These qualitative factors start mattering more, especially when you choose a fund for a specific, stated quality.

Even with all these tests, there does remain some possibility of a fund not performing up to its mark. All we try to do is keep that error in your portfolio to the minimum. Our regular reviews also help weed out such funds.

On another occasion, we shall discuss what goes behind choice of funds in the debt category.