The Mutual Fund Show: What Investors Must Keep In Mind While Choosing A Mutual Fund

Joshi: Let me start with a piece of statistics. There are close to 2,000 schemes, plans and options in India that the mutual fund industry offers to you. There are probably half a dozen asset classes from equity to debt to gold to international now maybe commodities exposure as well. Since that choice is such wide, and nobody wants to invest in dozens of schemes, so there are certainly certain guidelines or guideposts that you should follow as an investor and I have few points in my mind.

Joshi: I would start from the biggest point. This fund industry is also an industry of faith in the sense that there are certain people who like to invest in a mutual fund that they have their bank account with — bank-promoted mutual funds. So basically we are talking about the fund houses.

My four or five broad points or criteria for fund selection would start with the fund house. Once you have zeroed down on the fund house, you look at the fund manager and what kind of capabilities the fund manager brings to the table.

Then you should also look at asset classes and schemes.

Then all those schemes where do they fit into your overall asset allocation? If a small-cap scheme does very well or has done very well and if you have gold which is six months away, that is not the right choice for you. So scheme fitment in overall asset allocation is probably point number three.

Point number four is the scheme that you have zeroed down on, maybe you want to invest into two schemes and you have shortlisted let’s say four schemes, out of those two, look at how a scheme has been managed over the last few years—something that in the fund industry is very fondly called as ‘staying true to the label’. So if it’s a large-cap fund, whether it is completely large-cap fund or it has a 20% exposure to stocks, we are talking about equity funds, stocks that are into mid and small cap segment.

My point number five is at times treated as point number one and that is nothing but the performance. If all those things, if the previous four things have fallen into place, then you should be able to see into the fine performance as well. But most of the time, performance is taken as ‘be all end all’ of the fund selection. In my opinion, that should be probably be the fourth or fifth point and not the first one.

Belapurkar: I think the philosophy is pretty well-grounded. So, the first thing you should always think of when you’re building a portfolio or picking your fund, is think about your overall asset allocation. That should be another sort of top-down approach that investor would take in terms of understanding—what are the fund asset classes or the fund categories that would be of segment in terms of his/her portfolio depending on their return objectives, investment time horizon and so on and so forth. So that is a very important criterion, really the starting point for picking on mutual fund is when you look at a huge set of funds are available.

So, you’ve decided on your asset classes, what do you think are the suitable fund categories. Now how do you really get down to evaluating which is the suitable fund for me or in which other suitable funds from those buckets and how do I choose? I think Amol very nicely put it that performance tends to be the starting point for investors. We think that should be probably the last thing investors should look at, but one way of looking at performance is using it as maybe a little bit of a shortlisting tool. In no way we’re saying that it should be a point-to-point performance. Clearly not, it should be a risk-adjusted rolling analysis of the performance and there are a lot of tools online that can be used to do that to see how a fund has done from the context of its benchmark and its peer group on a risk adjusted basis which will give you some ammunition to think about that if there is a list of 40 funds, can I drill that down to a list of funds which I’m comfortable doing further evaluation on—by no means should that be the final deciding point. So performance becomes a more efficient tool or you can obviously do a double check at the end of things but we think that is a good starting point when you’re looking to evaluate funds within a category. Then obviously you will get down to greater evaluation in terms of understanding the fund manager, the investing team, the kind of skill sets they bring to the table, obviously the parent which is the asset manager, the strengths that they have and then you would get into understanding the investment style of the fund. And I think that’s very important and very often not enough importance is given to that. We think that the basic pivot around when you’re looking to pick a fund; that you need to think about what is the investing style and how does that speak to my overall portfolio, and more importantly, it is not just about style. Has it been consistently applied over time, which gives you conviction that there is a process at the back; that the engine is running smoothly that there is a process in place in terms of the investment process and that’s what is actually going to deliver the returns. Obviously then, you would kind of pack it against the performance and see if the performance is in line with that—like I said consistency.

Then you want to do is building different kinds of funds or different styles of management within your portfolio. I think that’s the additional level of diversification that you can bring in, especially in the equity side which people tend to ignore rather than overloading on one particular style of management. I think that’s something which would be very interesting to look at.

The last bit that I want to touch upon very quickly is costs. Cost can be a very important factor in certain categories of funds; fixed income is becoming more and more important. In categories where you think that alpha generation beating the benchmark can be hard, costs can be a very important factor in terms of picking the right fund but that should not be a factor in choosing a fund, that should be, everything else being the same, can I get a cheaper option within that space?

Joshi: So if you ask me, the way you asked me my first preference would be, my first shortlist would be investment philosophy. Now there are various types of investment philosophies that the fund managers as well as fund houses do employ here in India as well as worldwide. I think for an investor who is starting afresh, even that person probably would know something called as quality or something called as growth or something called as value. Now, value’s typical example, you will remember from five to ten years back, a few value points that did very well and value then became a category in itself. Now what is value? Value by one word itself just does not tell us much. An investor should know what value stands for. Value stands for identifying stocks and sectors that are currently out of favour of investors. In the sense, a company’s fair market value, let’s suppose, is 100 but that stock is currently trading at Rs 30 or Rs 60. Now what happens is when you invest in a value oriented fund, you are looking at a solid performance but not as soon as the next day when you invest. Value funds or value category takes a lot of time for market to appreciate that stock or a sector and over a period of time as the reckoning comes back to the stock and the sector, then the companies that you have picked up at a lower resolution or lower cost purchase price, ends up giving you after a few years gap in between; unless the market recognizes your fix immediately. Now there is other spectrum and that spectrum you can consider as quality. Let’s say for example, companies that are profit or return on capital employed are growing at the rate of 15% or 20% year-on-year. Now, if you invest in such companies, probably your downsides are protected or you get market beating performance, but the thing is those companies obviously by default, by definition, are never available cheaper for you, so you will always end up buying those companies at a higher valuation and higher P/E multiples. So, in an investment philosophy, a fund house or a fund manager, whether the style drift is towards quality or growth or value or growth at a reasonable price, you should pay a lot of attention to this because your returns expectation is on one side but your returns experience is going to depend a lot on these parameters.

Belapurkar: So I think when you look at constructing a portfolio, it needs to be a portfolio approach and I think that’s very important. Like Amol rightly said, you have to think about it from a holistic perspective. So, I would start with the mix of your overall asset allocation and that’s very important because there’s a lot of noise in the market when you look at things. I mean, even in the recent context of things, investors can easily get swayed by thinking that suddenly small-cap funds have started rallying or gilt funds have done exceedingly well over the last you know 6, 8, 12 months. Now, the issue with that is, the returns on a post-facto basis might look very attractive, but the point is does that fund or that asset class will be fit into your objectives or not? I mean just take a simple example; if I’m a five year equity investor, I wouldn’t recommend a small-cap investor to even come in for that period of time. It’s clearly going to be a longer period of time. Similarly with gilt funds, we’ve spoken about it in the past that flows have been increasing in this because the perception that there’s no credit risk, obviously which is a known fact, but the interest rate risk is ignored. So when you look at it in the context of what are the suitable categories in terms of asset allocation and the categories and then kind of look at within the categories what are the different styles of investing. So, like Amol rightly said to you if you want to value style within your portfolio, who are the good value managers who are stuck to that value investing style, who are the growth at a reasonable price or the quality managers? Those are the ones that I would look to differentiate in terms of the investment style and that is how I would start the journey of trying to evaluate for a top-down approach starting from asset class and sub asset class level.

Belapurkar: I’d say do not look at short-term point returns. I think that is a complete no-no. Purely in isolation just looking at returns is something you should completely avoid. It needs a lot more drilling down when it comes to understanding various other metrics that we have spoken about. Even if it’s a fund within the asset class that you want to invest into, do not purely invest based on what the fund has done on a one or three years. That’s something that I would completely avoid.

Joshi: So here I’d be guilty of siding with Kaustubh and I will never be tired of repeating it—we should never chase the performance. Kaustubh elaborated on the technical side and I can probably tell you something on the client side. In the calendar year 2013-2014, you had something like 60% returns in mid caps. Now when an investor sees this kind of a return in a magazine, in a newspaper or in an article, that investor has a mindset that I’m likely to get similar kind of returns in the future. That is as far from the truth as possible and sometimes this is slightly on the funny side, although it is a money matter and there is nothing funny in that, but many times investors say if not 60% even if I get half of that, even if I get 30%, that is good enough, but the risks are completely the opposite. In the sense, after such of a red hot rally, we have seen small caps and mid caps actually correcting. This is not to say ill about a particular category of equity but it’s a risky kind of an asset class and more and more people come to equity with an expectation of making more than what they will usually make in traditional fixed income, you should always remember not to chase the past performance. Exactly same thing with gilts. For gilts, the last one, two or three-year returns are probably in double digits—10% 12% or so. But today the YTM, the yields are probably in the ballpark of 6%. So unless the interest rates go extremely south from here, it is highly unlikely that you will make a 10%+ three-year CAGR from today onwards.

There is something else as well that I would like to speak about as to what should be avoided. You should also avoid chasing performance and exiting prematurely from your existing schemes.

Belapurkar: There is a very pertinent point that Amol made in terms of not only about entering a fund which is done reasonably well but even exiting some of what you would think are laggards in your portfolio. That’s typical investor behaviour and I think that’s where behavioural sciences become such an important aspect of curbing that and I think advisers are doing a great job in reining back investors from displaying those peculiar or typical behavioural traits. We did a study and I just want to spend just a minute on that, talking about how fund performance comes in. We spoke about different investing styles, value, growth and reasonable price. The one thing that we need to understand is that the market does move in cycles and there will be pockets of the market that will do well at some point of time and then the other part of the market will clearly take over. We’ve seen some sort of that in the last two-three years. We’ve seen that quality growth rally happening but if you just turn back the clock; if you’re a quality and growth manager back in 2015 or 2016 you severely underperform the market. In fact, none of the investors had gone with it at that point of time and only when the performance started tracking in 2017, 2018, 2019 towards the lag end, that sort of rally started coming in. While we’ve seen some outflows happening, some profit-booking happening, the most startling number which doesn’t tell you and if I break that down in terms of equity flows and look at which funds are getting flows, the study showed us that funds that are ranked one in quartile or on a one-year basis of returns get about, in the last one year gone by, 85-90% of the flow which is staggering. I’m not saying that don’t ignore those funds, but you need to know set of expectations about what that fund can potentially do and why is it delivering the returns and are those the only funds you want to invest into. We spoke about polarizing of returns and stocks. I think polarizing of flows is happening in certain funds, in certain fund houses which to be honest is a little worrying for me. If I look at YTD basis, the top three equity fund houses in terms of flows account for about 85% of the overall equity flows which is pretty staggering and I’ll be a little worried that investors are coming with slightly mismatched expectations thinking that look, this is all that’s going to work for me and the rest is not something I want to look at. That’s the word of caution I want to give investors- that you need to diversify across different investing styles.

Joshi: So to elaborate on this point and Kaustubh also touched upon very briefly on behavioural aspects. Now let me again talk about the client side. See this time is kind of different. This crisis or the stock market crash is kind of different than let’s say 2000- that was the last big one because that had everything to do with financial markets. Now this crash or this Covid-19 crisis had something to do with health aspect and hence that makes every person interested; every person a party into whatever is happening around us across the globe. Because of the information overload people are waiting for the much talked about ‘second wave’. Now we do not have any recent pandemic experience or example but from the reading, I have gathered that 1919 or 1920; probably 100 years back was the last pandemic. Within that, in that era after the six-eight months you got a second wave, which was bigger than the first wave. Now this data point is available, rather this information is available to everybody. Now people are expecting that second big wave to hit them and if the health crisis gets bigger from here, then the market is obviously not going to sustain at these levels. What is happening then, in anticipation of that as soon as your Rs 100 which you invested one year back, six months back, two years back as soon as you’re close to that Rs 100 kind of figure, just throwing in the towel you’re cutting your losses, you’re just taking your money off the table and running away as an investor. That’s why you see outflows and as you rightly said, this is actually the second month of outflow. SIPs also, I wouldn’t say SIP flows have completely dried up, but the SIP flows are also reducing by Rs 1,500 crore month-on-month a couple of Rs 100 crore month-on-month. Now, we’ve spoken about the one side as to why the outflows and probably the client side reason of that. Second point is- if you look at the last 10-15 years of data of inflows into mutual funds, this is an excellent contraindication. In the sense whenever the domestic inflows are at their highest, you’re probably close to the market top and whenever domestic flows are topping out or whenever there are negative flows that point is considered to be a good point three-five years hence. Three-year and five-year CAGR have been very robust. So, I thought this behavioural aspect probably was worth discussing.