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Are Top Performing Funds Really Good to Invest in? - Outside View by PersonalFN
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Are Top Performing Funds Really Good to Invest in?
Oct 20, 2016

Mr Shah, an active mutual fund investor, has invested huge money in mutual funds over the last 10 years. But he seems to be finding it difficult to manage his portfolio, which now has 38 schemes. Spending couple of hours a week studying about the funds in his portfolio and tracking their performance each day has become a part of his financial planning.

You may be wondering how he managed to identify and build a portfolio of 38 schemes, when even finding 5-10 good funds is difficult.

Well, his strategy was simple. Pick the top 5 equity funds by the returns every calendar year and invest in them. To his surprise the number of funds in his portfolio kept on mounting, with only 14 odd funds now managing to beat the category average, while the remaining 24 have been underperformers in their respective categories over the last 2-3 years. The 3 infrastructure funds that he invested in CY 2007 have constantly underperformed the BSE Sensex since then; while his bets in I.T. and Energy funds cost him a fortune.

His due diligence of investing in funds that once generated the highest return has not played out well. So was his approach right? Was it really a smart and prudent way of investing in mutual funds?

Like Mr Shah, many of us often fall for funds that top the return chart and happily invest in them, without understanding their investment style and suitability. If you really think that investing is serious business, then you should not get lured by performance numbers as you may end up investing in funds that may be a flash in the pan. Rather have a holistic approach to select winning mutual funds for your portfolio.

It is common practice among fund houses to flaunt the returns generated by its top performers, while keeping mum about the underperformers. These flashy numbers many a times help their funds win star points that are followed by many investors, and even by distributors who use them to convince their clients about the merits of the fund. There is nothing wrong with the idea of granting rankings/ratings to mutual funds. However, we believe that the degree of reliance and the utility they offer is certainly worth a debate. The method of computing ratings tends to be largely quantitative. The rating system is automated to rank the funds based on their risk-adjusted returns and their near term performance vis-a-vis their category peers. On the other hand, qualitative factors like fund house philosophy, fund manager's experience, portfolio management style and adherence to the stated investment objective, number of funds managed by the fund manager, portfolio concentration as such are ignored.

Since a fund manager is managing your money, knowing his experience in fund management and his investment style is valuable information. The fortune of the fund will be closely linked to the prudence with which he/she manages; and mind you, this is a function of the experience he/she carries in the field of fund management and equity research. Moreover, one also needs to consider the investment processes and systems followed by the fund house.

As stated above, returns generated by a fund in isolation should not be the only factor that influences your investment decision. A fund might be generating alpha at the cost of compromising the investment norms set ahead by AMC or maybe at high risk levels.

Here are some important qualitative parameters which add to the funds long-term investment objective of wealth creation:

  1. The risk-return tradeoff: While investing in mutual funds, every investment decision that your fund managers take involves a degree of risk. His investment bets may generate phenomenal returns, while sometimes be disappointing. Hence, it is important to understand and appreciate the calculated risk your fund manager takes.

    You should not fall for funds that have been highly volatile, or if its fund manager has a tendency to churn the portfolio quite often to generate extra ordinary returns.
  2. Fund's performance across various market cycles: Like any other player, a fund's fundamental value is put to test when the market runs down the bear phase (a period where markets witness a great fall). As a litmus test, you also need to ascertain how the top performing mutual fund schemes sailed during various market cycles in the last decade (i.e. during bull as well as bear phases).

    Though the fund may not be a great bull market performer, but it should have ability to limit the downside during extreme conditions.
  3. Fund Manager's experience: A fund manager is a skilled professional who's managing your money invested in mutual funds, so knowing his/her fund management experience and management style will be worthwhile. It is noteworthy that the fortune of the fund will be closely linked to the way he/she manages the fund, based on the experience he/she carries in the field of fund management and equity research.

    In some instances, the fund may be managed by a "team of fund managers" along with its primary fund manager. In such a case, it is essential to understand the philosophy and the track record of the fund house as a whole.
  4. Number of schemes to fund manager ratio: Many mutual fund houses frequently launch new schemes in order to garner more Assets Under Management (AUM), despite having similar products in their kitty. At the same time some fund houses do not bother to hire new fund managers on the team. This eventually leads to the existing fund managers being over-burdened in managing these additional funds along with their existing funds. This can result in lower efficiency of the fund managers, thus doing injustice to investors of their existing schemes.
  5. Proportion of AUM performance: Some cash-rich fund houses constantly engage in an exercise of increasing their AUMs, through aggressive sales and promotions. Well, that may be required in a way to grow their business and arrive in top slots in terms of size. But does it mean that a fund house with a larger AUM, is good for you?

    Consider a fund house XYZ MF having an equity AUM of Rs 10,000 crore across 10 schemes. Now, if 6 out of its 10 schemes having a combined AUM of Rs 3,500 crore are performing well, while the other 4 schemes with Rs 6,500 crore corpus are underperformers, then it can be said that only 35% of the fund house's AUM is performing. This clearly reveals whether the fund house is really doing a good job in fund management or is it just an AUM gatherer. But for you, as an investor, if your money ended up in its popular schemes bucket of Rs 6,500 crore and underperforms for a long time, then it may drag down the performance of your overall portfolio.
  6. Duplicate schemes: Frequent product launches by fund houses, with an aim to increase AUM, in our opinion just do not make much sense. The fund so launched has to offer a unique proposition, - otherwise it is simply an "old wine in new skin".

    The more number of duplicate funds with the fund house, more it lacks in terms of innovation, and hence does not deserve your hard earned money.
  7. Investment Systems and Processes: The mutual fund house's ideology is reflected through this factor. The fund's stock / debt picking approach is also a function of the investment systems and processes followed by the fund house, which eventually links to the fortune of the fund.

    You should give high weightage to fund house that has well defined investment process in place, and diligently follows them. Look for a fund house that aims to keep clients interest ahead of its own.

In order to adopt a more holistic approach towards investing, and for effective wealth creation it is imperative that you consider both - quantitative as well as qualitative parameters, while selecting solid mutual funds for your portfolio. It is noteworthy that, while quantitative parameters depict the outer layer of a mutual fund scheme which is visible to everyone, qualitative parameters (which require microscopic analysis) as cited above are inseparable when doing an unbiased and comprehensive analysis of mutual fund schemes.

Merely relying on star ratings (which are illustrated taking into account only quantitative parameters) may not enable you to have long term performers in your portfolio. This is because when quantitative parameters undergo a change, mutual fund schemes will also play musical chairs. A fund with a "5 star" rated today, may easily slip in terms of rating and become a "3 star" in the ensuing year.

Hence, do not get lured by the glossy numbers and do look at the qualitative aspects of the fund as well. Every fund has to pass through tough market phases, but the one that is well managed and has ability to contain downside risks will be a true long-term performer.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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