Which Mutual Funds are Best for the Long Term

Addressing the shareholders of Berkshire Hathaway in April 2022, Warren Buffett called out Wall Street (the new-age broking companies and hedge funds) for luring investors into speculative activities and turning the stock market into a 'gambling parlour'.

This wasn't the first instance when he warned investors against taking a short-term and speculative view of equity markets. Throughout his career, Warren Buffett has encouraged investors to think long-term when they think of equity as an asset class.

Some of his timeless quotes emphasising the importance of long-term investing deserve a special mention here.

• "If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes."
  
  "My favourite holding period is forever."
  
  "Someone's sitting in the shade today because someone planted a tree a long time ago."

In short, long-term investing offers significant advantages and disproportionate rewards. Hence, whether you are investing in stocks or equity mutual funds, long-term investing is the way to go.

Going by the history of the S&P BSE Sensex, when you invest in equity markets for the long-term, the chances of you losing money reduce.

Between 1979 and 2019, the probability of investors losing money was around 30% if they had a time horizon of just one year against only 3% when investors stayed put for 10 years. For a 15-year time horizon, the chances of losing money dropped to near zero. In other words, time can be your best friend.

If you are investing in equity mutual funds for a time horizon of just 1-2 years, or you are selecting mutual fund schemes for your portfolio based on their recent performance, it's time to change your mutual fund investment strategy.

When you invest for the long-term and stay invested for at least 7-10 years, you give your investments enough time to grow. It alleviates short-term volatility.

Typically, a business cycle lasts 3-5 years. Similarly, stock markets also experience peaks and troughs.

In a developing market like India, the peak of every cycle takes the markets far above the peak of the previous cycle. So staying invested through multiple cycles makes a lot of sense.

If you keep adding the top performers to your investment portfolio frequently, you might end up churning your portfolio unnecessarily. You see, top performers keep changing. Stocks and mutual funds that were top performers in say, a year, may not remain at the top next year.

Hence, what you should look for is consistent performers. In one of our recent posts, we demonstrated why it makes little sense to invest in top-ranked funds on3-year/5-year time horizon.

The most important question investors often face is: 'How can I select the best mutual funds to invest in for the long term?'

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To create a truly winning portfolio of equity mutual funds, analyse the schemes on both quantitative and qualitative parameters.

Here are the parameters you should evaluate to select the best equity mutual fund schemes for your portfolio.

I. Quantitative Parameters

1) Past Performance

Although the past performance doesn't give any idea about the potential returns a scheme might generate in future, it may tell you a great deal about the scheme's consistency.

You should bet on consistent performers across timeframes over 3-years, 5-years, 7-years, and 10-years. Mutual fund schemes that have constantly beaten their respective benchmark indices and the category average returns are consistent performers.

They need not be the top-performers always, as mentioned earlier. If a mutual scheme has only occasionally made it to the list of top-performers, ideally, stay away from it.

2) Performance Across Market Cycles

You may get quite a few schemes that do exceedingly well during bullish market phases. But the true test lies when the tide turns, and the market turns very volatile and begins to correct or get in the grip of bears.

The ability to arrest the downside separates the men from the boys. In the words of Warren Buffett, "It's only when the tide goes out do you discover who's been swimming naked."

If the fund manager holds a quality portfolio backed by robust investment processes and systems, the market downturns could be handled better.

Hence choose a scheme that has fared well across market cycles. At PersonalFN, we keenly monitor the performance of schemes across market phases and portfolio characteristics. It's one of our key parameters in the scheme selection process.

3) Risk-adjusted Returns

Returns should never be considered in isolation. A scheme's returns, no matter how high, unless they are in line with the risks it takes, aren't worth it.

Remember, risk and return go hand-in-hand. Therefore, considering the risk-adjusted returns of schemes is important. Risk-adjusted returns can be gauged using various risk ratios such as Sharpe Ratio, Sortino Ratio, Treynor Ratio, etc.

Analysing lone quantitative parameters is not enough to pick the best mutual fund schemes for long-term investing. You also need to assess various qualitative parameters too.

II. Qualitative Parameters

These involve determining the quality and efficiency with which the fund house and the fund management team manage your, hard-earned money.

Usually, schemes that follow a process-driven approach are expected to generate consistent returns for investors compared to schemes where the investment decisions are guided by the whims and fancies of the fund manager.

Here are the factors you should look into.

1) Portfolio Quality

Since the performance of a scheme depends extensively on the quality of its underlying portfolio, always assess the scheme's top-10 holdings, the top-5 sector exposure, and the market capitalisation bias.

This will provide you with insights on whether the scheme is well-diversified, its market capitalisation, its sector exposure, the style of investing followed, etc. Ideally, a scheme should not be churning its portfolio too often, yet be agile and hold the securities with conviction.

2) Efficiency of the mutual fund house

While assessing the performance of mutual fund schemes, pay close attention to the overall efficiency with which the fund house manages investors' hard-earned money.

In other words, check the proportion of the total Assets Under Management (AUM) actually performing and generating wealth for investors.

The fund house should not be a mere asset gatherer (by launching New Fund Offers) but an efficient asset manager achieving the stated investment objectives of the respective schemes it offers.

3) Experience of the fund manager

Besides the fund house's philosophy and fund management approach, the experience of a fund manager greatly impacts the performance of a scheme.

Therefore, check his/her past track record and the number of schemes managed simultaneously. Ideally, the fund manager should not be managing more than 4 or 5 schemes, or else it may prove to be a burden. It could weigh down on the fund manager's efficiency, and possibly impact the scheme's performance.

Ideally, avoid investing in schemes that don't follow robust investment processes and systems and the ones that excessively depend on their star fund managers.

Here's a strategy that every long-term investor should follow...

Given that the bellwether index has corrected over 15% since the lifetime high (and more in the case of mid-cap and small-cap indices), the current levels and valuations offer a decent margin of safety.

The trailing 12-month P/E of the S&P BSE Sensex is down to around 22x (as of 13 July 2022). Likewise, for smaller companies that have been battered relatively more (nearly -20% since the peak), the P/E multiples have come down significantly.

At present, when there is fear and panic around, investing in a market selloff provides you with value-buying opportunities.

If you have a fairly long-term investment horizon of 7-8 years or more, have long-term financial goals to address, and the investment objective is wealth creation by taking calculated high risk, this is a good time to invest by devising a 'Core & Satellite' strategy.

This is the time-tested investment strategy followed by many successful long-term investors to make the most of opportunities available in the market without taking unwarranted risks.

The term 'Core' applies to stable, long-term holdings of the portfolio. The term 'Satellite' applies to the strategic portion that attempts to maximize your returns across market phases.

Typically, your 'Core' holdings should be 65%-70% of the equity portfolio and consist of equity funds such as Large-cap Fund, Flexi-cap Fund, and Value Fund/Contra Fund.

The 'Satellite' portion should comprise up to 30%-35% of the equity portfolio and include worthy Mid-cap Funds and an Aggressive Hybrid Fund. If your risk appetite is very high, maybe you could add a small-cap fund in the satellite portion.

To build a 'Core & Satellite' portfolio of worthy equity mutual funds, here are a few fundamental rules to follow.

1. Consider equity mutual funds with a strong track record of at least 5 years and have been among the top performers in their respective categories.
2. The schemes should be diversified across investment styles and fund management.
3. Ensure that each equity mutual fund selected scheme abides with its stated objectives, indicated asset allocation, and investment style.
4. You should not only invest across investment styles (such as growth and value) but also across fund houses.
5. The equity mutual fund schemes should be managed by experienced and competent fund managers and belong to fund houses that have well-defined investment systems and processes in place.
6. Not more than two equity mutual fund schemes managed by the same fund manager should be included in the portfolio.
7. Not more than two equity mutual fund schemes from the same fund house shall be included in the portfolio.
8. Each equity mutual fund scheme that is to be included in the portfolio should have seen an outperformance over at least three market cycles.
9. You should restrict the count of equity mutual schemes in your portfolio to seven or eight.

If this strategy is correctly applied, it can help you get the best of both worlds, that is, short-term high-rewarding opportunities and long-term steady returns. Besides, the 'Core & Satellite' investment strategy shall help you...

• Keep emotions at bay
• Take advantage of the higher margin of safety and stability of largecaps
• Capitalise on the potential high growth opportunities of small and midcaps
• Reduce the need of churning the portfolio, especially the core portion
• Potentially earn higher returns over the long-term
• Mitigate downside risk

Here are some of the best equity schemes for your 'Core & Satellite' portfolio.

Table 1: Worthy equity schemes to hold in the 'Core & Satellite Portfolio

Scheme Name	Category	Returns (Absolute %)	Returns (CAGR %)
		1 Year	2 Years	3 Years	5 Years	7 Years
Parag Parikh Flexi Cap Fund	Flexi Cap Fund	5.5	28.7	23.4	18.1	16.4
Kotak Emerging Equity Fund	Mid Cap Fund	5.4	38.2	23	14.4	16.1
PGIM India Midcap Opp Fund	Mid Cap Fund	10.1	48	34.5	18.2	15.8
Canara Rob Bluechip Equity Fund	Large Cap Fund	1.9	23.4	16.9	14.3	13
Canara Rob Flexi Cap Fund	Flexi Cap Fund	2.3	25.6	16.9	13.9	12.4
ICICI Pru Value Discovery Fund	Value Fund	13.8	33.5	20.2	13.4	12.3
Mirae Asset Hybrid Equity Fund	Aggressive Hybrid Fund	3.4	20.6	13.5	12.2	-
Category Average of Aggressive Hybrid Funds	-	3.2	22	13.4	10.3	10.6
Category Average of Flexi Cap Fund	-	1.9	26.2	15.2	11.5	11.6
Category Average of Large Cap Fund	-	2.9	23.7	13.2	10.8	10.7
Category Average of Mid Cap Fund	-	4.1	35.1	21.2	12.6	13.4
Category Average of Value Fund	-	3.7	30.5	15.4	10	11.7
NIFTY 500 - TRI	-	3.4	26.9	14.9	11.6	11.7
CRISIL Hybrid 35+65 - Aggressive Index	-	3.5	17.9	12.5	10.7	10.8

Data as of 8 July 2022
Direct Plan and Growth Option considered.
Past performance is not indicative of future returns.
(Source: ACE MF, PersonalFN Research)

As you can see in Table 1, the aforementioned schemes have done remarkably well over 5-year and 7-year time periods.

All of them have refrained from unnecessary churning of the portfolio - a crucial factor that decides the success of long-term investors - and have fared respectably compensated investors for the risk taken.

They have paid close attention to valuations and remained unaffected by market swings. This has resulted in their consistent long-term performance.

For instance, Canara Robeco Bluechip Equity Fund has been buying undervalued large-cap stocks such as ITC and NTPC. It has also picked some of the growth stocks such as ABB and Siemens in the recent market downturn.

Another fund from the Canara Robeco Mutual Fund, Canara Robeco Flexi Cap Fund, has also followed a similar strategy. The fund has been investing in undervalued energy and defence stocks of late.

On the other hand, Parag Parikh Flexi Cap Fund and ICICI Prudential Value Discovery Fund have not only shown a penchant for undervalued and unpopular stocks but have also shown the courage to bet big on their conviction. So far, their bets have paid off.

For example, ONGC and Sun Pharma have been the top two stocks in the portfolio of the ICICI Prudential Value Discovery Fund, which together account for 16.6% of the portfolio.

In the case of Parag Parikh Flexi Cap Fund, it made fortunes by investing in hi-tech stocks listed in the US by taking advantage of a multi-year boom in the US markets.

Kotak Emerging Equity Fund, despite being a midcap fund having the mandate to take very high risk, has adopted a thoughtful approach while investing in midcap companies.

It hasn't churned the portfolio unnecessarily. On the contrary, it held a quality portfolio with conviction. These moves have rewarded long-term investors substantially.

Mirae Asset Hybrid Equity Fund has picked index-heavy large-cap stocks to anchor the equity portfolio. While managing the debt portfolio, it has largely relied only on high-quality sovereign/AAA-rated instruments.

This has made Mirae Asset Hybrid Equity Fund one of the top performers in the category with a consistent performance track record.

Whether to invest via SIP or lump sum route?

Given the fact that the volatility has intensified lately, and equity markets have corrected, you may make lump sum investments. But prefer making staggered lump sum investments rather than deploying all your investible surplus at one go.

Alternatively, you may take the Systematic Investment Plan (SIP) route, particularly when you have long-term financial goals to address.

With the inherent rupee-cost averaging feature of SIPs, you will be able to mitigate risk. It shall eliminate the risk of timing the market and instead, help you remain focused on your goals. Also, when the stock market moves up, it will compound your wealth better.

To conclude...

The success of long-term investors depends more on consistency than massive yet occasional outperformance. Don't forget this while selecting mutual fund schemes for your portfolio.

Also, do not ignore your asset allocation, which is the cornerstone of investing. Your asset allocation and investment choices should be in congruence with your risk profile, investment objective, financial goals, and the time to achieve the envisioned goals.

Your long-term financial success depends on your investment discipline and the approach you follow.

Happy Investing!

Disclaimer: This article has been authored by PersonalFN exclusively for Equitymaster.com. PersonalFN is a Mumbai-based Financial Planning and Mutual Fund research firm known for offering unbiased and honest opinions on investing.