How to select an equity mutual fund?

Ever tried to choose a mutual fund scheme to invest in? There are over 30 asset management companies, each offering variety of mutual fund schemes to choose from. For the larger AMCs, the number of schemes offered can run into a number in excess of 100. Additionally, there are equity fund schemes, debt schemes, hybrid funds, gold funds, fixed maturity plans, fund of funds etc. There are sub-classes within the aforementioned broader classes. For instance, within equity funds, you can have index funds, large cap funds, multi-cap funds, mid cap and small cap funds, sector funds etc. Debt mutual funds can be classified into liquid funds, ultra short term funds, income funds, gilt funds etc. Each type of fund serves a different purpose in an investor’s portfolio. So, there is a lot to choose from. Don’t worry much. We provide you a checklist you need to follow to identify the right mutual fund for your portfolio.

In this article, we discuss various parameters that will help you identify the best equity funds for your portfolio. Though the selection criteria for other types of funds do not change much, we shall suggest the minor changes you need to make to your selection process in a separate article.

Asset Allocation comes first

Do remember you reach this stage once the process of asset allocation is over i.e. based on financial risk profile and financial goals, you have decided to allocate a certain percentage, say 60%, of your assets to equities. Let’s assume for now that you have further decided to take entire exposure to equities through mutual funds. Within equity mutual funds, you have decided to invest 45% of your corpus (to be allocated towards equities) to large cap funds, 30% to multi-cap funds, 15% to mid and small cap funds and 5% to sector funds (for that extra mileage).

Remember asset allocation is an extremely important step. Your search for the right mutual fund is an exercise in futility if your asset allocation is not right. We will try to explain with the help of an example. Mr. Goyal is 62 years old and retired from his government job 2 years ago. He relies solely on income from his investments to take care of his monthly expenses. Since Mr. Goyal depends on his investments to provide for his monthly expenses, his ability to take a hit on his portfolio is much less than, say, a 30 year old person. Hence, based on his age and overall risk profile, Mr. Goyal would have been better advised to stick to a portfolio with significant allocation to debt and only a small portion to equity. However, based on advice from a friend and seeing the current run-up in equities, he decides to shift his entire investment portfolio to equity mutual funds. Let’s assume further he chooses the best mutual funds that are available.

Well, Mr. Goyal may still get lucky and reap the benefits if the equity markets appreciate further. However, what if the equity markets tank suddenly and go down 15%? Always remember mutual funds do not perform in isolation and their returns are correlated with the benchmarks (S&P BSE Sensex, CNX NIFTY, S&P BSE 200, CNX Midcap etc). Hence if the markets and the benchmark indices underperform, mutual funds underperform too. Hence, if markets do fall as mentioned, Mr. Goyal will then be sitting on a significant capital loss. Not only that, his corpus will shrink further since he will have to provide for his monthly expenses from that very corpus. This will put an additional strain on his finances. It is not that having his asset allocation right would have avoided him losses in his equity portfolio but the quantum of loss would have been less and possibly in line with the risk taking ability.

You may seek help from a SEBI registered investment adviser or a financial planner to get your asset allocation right. We shall discuss about the process of asset allocation in a subsequent article.

Coming back to the topic of discussion, after the asset allocation process, you know your allocation to equity funds and decide that you need to invest Rs 10,000 each in two large cap funds. We recommend you compare funds on the following parameters to select the best funds for your portfolio.

1. Performance against benchmark: At the outset, we want to mention that past performance is not indicative of future returns but it is still the best comparable parameter available. Every mutual fund scheme chooses a benchmark (BSE Sensex, CNX Nifty etc) to compare its performance against. This also gives an idea about the kind of securities the scheme will invest in. We recommend you to go for funds which have consistently outperformed their benchmark index over longer terms (1, 3, 5 and 10 years). Equity mutual funds are conducive for long term investments only. Thus, the focus should be on long term performance than a weekly, monthly or quarterly performance. Sometimes, good fortune can be enough for a fund manager to outperform the benchmark in the short term but outperforming the benchmark over the longer terms requires much more than good fortune. A consistent outperformance over the longer terms is a reflection of excellent stock selection skills of the fund manager and research process followed at the fund house. Hence, go with the funds with a consistent record of outperforming their benchmark index.
2. Performance against peers: Once you have identified the funds which have consistently identified the benchmark index, you need to compare a fund with its peers. To identify the peers for comparison, find out the funds with the same/similar benchmark (e.g. BSE Sensex or CNX Nifty). Remember you cannot compare apples and oranges. Comparing two funds with CNX Nifty and CNX Midcap as their respective benchmarks makes little sense.
3. Fund Manager: The credit for outperformance or underperformance of a mutual fund scheme lies with the fund manager (and his research team). He is the one responsible for taking investment decisions for the fund’s portfolio. Hence, even if the fund scheme has done very well in the last 5 years and ticks all the parameters discussed in this parameter list but a new fund manager has taken charge of the scheme recently, it is better to stay away from the fund scheme and observe new fund manager’s performance for some time before deciding to invest in that particular mutual fund scheme. Alternatively, if the new fund manager has the track record of managing a similar type of fund elsewhere, you can review his/her performance in managing that fund scheme. However, please remember that only experience of managing a similar kind of fund shall be counted. For instance, a fund manager may have performed exceedingly well managing a large cap fund but that does mean he will do equally well managing a midcap/small cap fund because the skills required to manage a large cap fund and midcap/small cap fund are vastly different. In short, pay close attention to how long the current fund manager has been managing the fund.
4. Fund house pedigree: The longer the fund house has been business, the more comfort you can take dealing with them. Similarly, if the fund house is supported by an established financial institution, you can have greater confidence in its research process, systems and resources and ability to sustain performance.
5. Expense ratio: It is the ratio of the amount of money charged by the AMC (asset management company) for managing the mutual fund scheme to the average daily net assets for a particular scheme. The charges are utilized towards fund management charges, distributor commissions, marketing etc. Generally, the expense ratio is higher for actively managed schemes than it is for passively managed schemes such as ETFs or index funds due to lower fund management charges. As per the latest SEBI regulations, equity funds can charge to a maximum of 2.5% as the expense ratio (prescribed limit goes down as the fund size increases). This limit is exclusive of service tax of investment management fees. An additional charge towards investor education and penetration beyond top 15 cities can also be charged from the investors. Lower the expense ratio, higher the money that gets invested in the markets and better the chances of making greater returns. Do not choose on the basis on expense ratio alone. However, everything else being the same, go with the one with a lower expense ratio.
6. Risk Reward: The outperformance of a fund emanates from the manager choosing to deviate from the weights given to a security in the benchmark index. For example, Reliance Industries and ICICI Bank might have a weightage of 7.0% and 8.0% in the benchmark Nifty index, the fund manager expecting outperformance in the banking sector and underperformance in oil and gas may choose to increase weightage to ICICI Bank to reduce weightage to Reliance Industries. He may go for 5% to Reliance Industries and 10% to ICICI Bank. However, in doing so, he has altered the risk of its fund vis-a-vis the benchmark index. Hence, it is pertinent to compare excess return earned per unit of excess risk taken. Alpha is one of the ways to measure mutual fund risk and compares the risk adjusted performance (not absolute performance) to the benchmark index. Without going too deep into technicalities, the higher the alpha, the better the performance of the fund manager.

Let’s go through an example. After asset allocation exercise, you have decided to invest Rs. 10,000 each (from your equity corpus) in two large cap funds. You have to select two schemes for making monthly investments through systematic investment plans.

We have shortlisted all open ended large cap equity funds which have been rated 3 star or higher by Value Research and have S&P BSE Sensex or CNX Nifty as their benchmark indices. Additionally, only regular plans (and not direct plans) have been considered. The difference between regular and direct plans is that, under direct plans, investors bypass distributors and contact AMCs directly for any mutual fund investments. Thus, expense ratio for direct plans is lesser than regular plans (and thus NAV for direct plans is higher). In total, there were 25 such fund schemes (regular plan) as on November 26, 2014.       Source: Value Research

Subsequently, we applied the filter for those funds which consistently outperformed the benchmark index over 1 year, 3 year, 5 year (if available) and 10 year (if available) period. Nine funds were eliminated during the exercise. Among those 16 funds, we picked up top 10 performing funds across each of the four comparison periods (1 year, 3 year, 5 year and 10 year periods) and found that only six funds figured in top 10 in all the comparison periods (for which the data was available).

All the aforementioned funds are excellent funds to invest in and the fund houses have excellent pedigree. Beyond this point, the search process becomes slightly subjective and we will use remaining parameters to finalize the two funds. All the funds apart from HDFC Index Fund- Sensex Plus Plan have similar expense ratios. This is because the fund is closer to an index fund and thus also has a lower alpha. If you want to further narrow down choices, Axis Equity Fund does not have a five year record (even though it has the best 3-year record amongst the six selected funds) and the current manager has been managing for only 1.4 years. ICICI Prudential Focused Bluechip Equity Fund and UTI Leadership Equity Funds don’t have a 10 year record. SBI Magnum Equity Fund ranks low on alpha.

Our recommendations (based on the above exercise):

1. HDFC Index Fund – Sensex Plus Plan
2. ICICI Prudential Top 100 Plan

The similar exercise can be conducted for all types of equity funds for your portfolio. There are good resources available on the internet including Value Research and MorningStar which you can use to identify the best funds for your portfolio. One more thing, invest in the selected mutual funds through systematic investment plans (SIPs). SIPs let you invest a fixed sum into selected funds periodically (weekly, monthly etc). Additionally, SIPs provide the benefit of rupee cost averaging and bring in discipline to your investments.

Hope this article has helped you and you are ready to select the equity funds to select just the right funds for your portfolio.

Deepesh is Founder, PersonalFinancePlan.in