The Mutual Fund Show: Do Top-Rated Funds Always Assure Higher Returns For Investors?

A lot of money is chasing short-term performance right now. You see a headline-printed number saying that XYZ fund has delivered an X percent return and you think okay great, let me get into it. I mean that is probably the most common pitfall of investing. Simply because, you don’t know what the construct of that fund was. You’re getting into a fund purely based on returns. You don’t know if I look at an equity fund, was it a large cap, multi cap or a small cap. And there is a standard caveat follows right? Past performance may or may not be repeated. If you’re chasing a return that has been delivered and especially, a lot of that happens over looking at, one, two, three year returns which is extremely short-term into our mind for a category like equities. If you do that, you could probably be getting yourself into a fund and the worst thing is that, you’ll think that they will continue to do that, and you don’t have the patience and after a couple of years you will want to swap the fund around, and you will be chasing performance all the time and that is probably the worst thing to do.

Because you need to get down to dissecting more than just purely looking at performance. Just to start with, is that a category of fund, is that asset class right for you or not? Do you have the risk, return objectives? Do you have the time horizon? If I looked at small-cap funds at the end of 2017, which look extremely interesting and great for an investor who came in purely looking at the returns without understanding what a small-cap fund entails, there would’ve been a blood path in his portfolio. And what they might have redeemed. Luckily, data does not show that people have actually jumped ships so soon but that’s something we would want to tell investors you shouldn’t. You’ve got to get your objectives clear, your investment time horizon clear before you even start thinking about what fund should come in your portfolio.

It is very important to acknowledge that this is what we call the starting point to build a portfolio. Like you said, identify what asset class is, what sub-asset class is. For instance, you identify that I want to get into large cap, a multi cap, mid cap sort of strategy if I am talking about the equity side and say, the corporate bond or the short duration fund or the fixed income side to take some category names. Beyond that, now you want to figure out, which are the funds that I want to get into? Now, if I take, for instance, large cap, there could be 35-40 large-cap funds. How do you really drill it down if you want to do your own research? One way is obviously that you go to an adviser. But in case, you want to devote the time and do it yourself, how do you really drill it down? Even advisers use these tools when they are looking at shortlisting funds?

The first thing you can do is see star ratings. Star ratings help to short-list or make the list more manageable. From 40, you can look at the top-rated funds on the star-rating basis and then you bring it down to a more manageable list on which you can do slightly more research before you make a decision. I will come at what you need to do, which is just delving into star ratings, what they are and what they really stand for.

We have been running this globally since 1984 and in India for almost a decade now and the results have been pleasing in terms of forward-looking. If you were to invest into a four or a five-rated fund across categories you would be better off than investing in a one, two or three-star rated fund. But there are other things, which you need to look at. But if I just think about what the star-rating stands for—they are risk-adjusted returns for a fund within its peer group. We are not looking at pure point-to-point performance, we talk about base effect, inflation, GDP; there can be a base-effect even with returns. Say for funds holding stocks that have been battered so badly over the last couple of years, and from there it moves up. You could do well versus a fund, that has done exceptionally well over a period of time over the last one year. Because we know market cycles can go through its blips; different styles, growth playing out one time, momentum playing one time but the point is that, these star ratings, they are the long-term risk adjusted returns within a peer group. That means, when we are looking at assigning star ratings and this is done within the peer group, we look at three, five and 10-year returns on a risk-adjusted basis.

Now about risk adjustment, the most standard definition like the sharp ratio—where you look at volatility of a fund. Now, volatility if you look at it as that, there’s a normal sort of curve that’s there and the spread that you look at—positive standard deviations, negative standard deviation volatility is on both sides. The biggest pitfall is what we acknowledge of the standard volatility measures is that it doesn’t differentiate between negative and positive volatility... Our model thinks about what an investor would think of. If there are large negative returns, there is a huge downside attached to it. Whereas positive returns to excess positive returns, the utility function as we call it, starts tapering off. So, the two funds could have had the same point-to-point return.

Say they delivered 15 percent of the last three years but one guy was all over the place, minus five to plus 10, whereas, another guy consistent. Now, the guy who has probably been more consistent will actually get a better star rating and the star ratings reflect that because it is more important to acknowledge that investors will come at different points in time—that someone looks at the past returns and comes in, someone came in on a day one, someone came in on day 500 and if it is very volatile, they will not have extremely different experiences, but a guy who is more consistent will have a much more stable experience. This is within the context of a peer group so obviously you would be comparing a large cap fund with the large cap fund rather than comparing the same large cap to a mid cap or a small cap.

In fact, what we call the Morningstar risk-adjusted returns is the primary driver which factors in what we call the expected utility of returns. Its done over a three, five and 10-year basis because we believe that long-term sort of risk adjustment is more useful as compared to looking at very short-term returns.

Star ratings are basically looking in the past. There is no relevance in terms of what the funds are going to do in the future.

I can speak for our ratings. If I invested in a four or five-star rated fund, which is as of today and held for three, five, 10 years, the returns of those on an average have been much better than say had you invested in a one two or three-star rated fund.

It has worked. But again, I will talk about some of the things that could change. Star ratings not really changed categories but say a change of fund manager or change in mandate for instance, a very diversified sort of portfolio suddenly becoming very concentrated portfolio running with value or growth cells. These are things that you need to keep in mind. When we spoke about shortlisting of funds, you need to do a little more. Since you are looking to do this research by yourself, you will need to look at how is that consistency of the mandate been over the past period of time. Is it similar to what it delivered in the past? Is there something that has changed? Or it continues to run as it has?

And it becomes very important in the context we saw—the whole SEBI categorisation that happened last year. Obviously funds change categories, while I would say that it wasn’t a very disruptive move. But it is still important to acknowledge, say someone who is maintaining a 70 percent large-cap portfolio suddenly today is now doing a more 60-40 portfolio that still is 10 percent shift away. It is not a dramatic change but there is a change in mandate that has happened, and you need to see how things have moved. That is important.

Change in fund manager is where Morningstar does a lot of deep diving in terms of understanding people. That is important and you know if you can’t do it yourself, you can look at some of the commentary that we write on our own website where we kind of qualitatively analyse some of these funds, where we talk about not just the manager but the team supporting him and the consistency of the investment process.

A classical case would be that someone who is chasing the market rather than having a stable process. In 2017, growth momentum stocks really did well. If you stuck to your value mandate, you would have suffered in that kind of a market cycle, which is fine because that is your mandate and you stuck to it. But you suddenly started chasing growth because that is what investors were looking at, it would be a double-edged sword because you would have missed the last part of the rally and at the same time when the markets crashed in 2018 you have kind of fallen off. So, the consistency of the mandate is important and if you just look at historical portfolios you will get a reasonable sense of how some of these things have moved.

One is if the mandate by itself has changed very dramatically. When the past performance becomes completely obsolete if that’s the case then we suspend star ratings on that altogether.

Yes, we restart. The other thing I didn’t talk about is that we typically wait for a three-year seasoning of the fund. So, if there’s a new fund offer, we will only issue ratings after it has completed three years where it has demonstrated track record because like I said our star ratings are based on three, five, and 10 years... Efficacy is also driven by how stable the star ratings are. If your process by itself does not reward long-term risk-adjusted returns— what is going to happen is that today it is a five-star tomorrow it would be a two star.

If he is a do-it-yourself investor, he will need to spend some time in delving into the portfolio construct, the mandate of the strategy because you cannot be going by the star-rating—if it is a change of margin, the manager has changed, or the team has changed or the process by itself has changed terms of the way the portfolio’s being constructed. You will start seeing a huge style drift in the way. Obviously, it will not come over two, three months but it will start showing up over 6-12 months. That time may be good, but we don’t know what’s going to deliver the same kind of consistent returns and does a portfolio manager have the wherewithal to do it. That is something you will need to take a qualitative call on and that is something we actively do an our own qualitative research.

The other option is national advisers. If you cannot devote that kind of time, national advisers are on top of these things and they know what has been happening and have been tracking some of these funds for a while. They would also be using some of these same tools to start shortlisting and move forward to what funds make sense in an investor’s portfolio.

Definitely say so because otherwise you cannot wrap your head around 40 funds even if you were to put filters like, ‘okay I will choose fund sizes above so-and-so’, you might end up with a lot in your plate. But this is obviously a signaling effect that this is something that has worked in the past but like I said that you need to see that the elements that were helping and worked in the past remained stable or not.

So if you step back to see what has been happening with the liquid fund industry, if you look at the large part of the investors that exist in, largely institutions and corporates and a lot of the asset managers; it is kind of an AUM sort of game because that is kind of flush money that could come in but the biggest problem is that money comes and goes.

Last month SEBI fixed liquid funds to mark-to-market valuation. So, even if there is a huge redemption, it has already been mapped on a mark-to-market basis. It will be a more fairer NAV price realisation for all investors. So, it is not like someone’s disadvantage by large flows coming in. The thing obviously they have done is to address some of those large flows itself. They have put in a graded exit load up to seven days, which is great because now you will have only investors who have at least a seven day investment horizon rather than one-two-day money. You have to hold 20 percent in cash liquid instruments that you can redeem at any point of time even if there’s some large redemptions that come through. All of this is going to make it a much more cleaner price realisation product for investors. The important thing to acknowledge is that still it is like an institution of products— a large part of the money comes in from there. Obviously, we’re far behind in other geographies. If you look at markets like the U.S., money market funds are largely brought in by retailers so, that component of hot money is not necessarily same there.

Direct plans have now been in existence for almost seven years and what they’ve been refining is your various heads of expenses—your management fees and then there’s a distribution fee. Now SEBI has mandated that all fees and expenses in a direct plan in percentage terms under various heads shall not exceed the fees charged under such heads in a regular plan.

Assume that the expense ratio of an equity fund is 2 percent for a regular plan and on an average you paid 0.7 percent of the AUM as distribution commission.
So, the regular plan should ideally be at 1.3 percent + 0.7 percent. What they [SEBI] are saying the direct plan should be on a percentage basis, the same as another regular plan and the only difference should be the distribution. That’s embedded into the commissions of a regular plan, which don’t exist in the direct—that should be the difference. We haven’t done the analysis ourselves but I’m assuming what Mr. Tyagi is referring is that maybe some direct plans are charging a little high.

Yes, that is right.

I will lay out the pros and the cons. One, I’m glad to see that despite a pretty sharp correction in July, the flows remained reasonably rock steady. That’s great because the investors are not panicking or fleeing the market and I hope that continues.

Funds that have say quartile one or quartile two on a pure one-year basis, it suggests that a lot of money seems to be flowing into well-performing funds over a short term, which is something I think investors need to understand because it hits you on both sides—you get into something that has already done a fair bit and the second, if it doesn’t perform to your expectations, you are going to flip it around to something else. That is something I would advise not to do.

There is a new study that we are planning to publish soon that talks about how active managers add alpha in a market. It’s spread across certain number of months— what we call a critical month study. It has been done globally and we look at India data and it doesn’t look any different from global context. If I had a 60-month or a 100-month period, this 5 percent of the months contribute to the alpha. So, if I wasn’t invested in that fund for those five months even though the fund gives an alpha and I was invested in those 95 months, I would underperform the index. The point is that you cannot try to time your entry and exit into a fund, you choose a good manager and just stick with them.