Did you know what to analyze and ignore when selecting equity mutual funds

Awareness of mutual funds is growing in our country. Financial advisors are now spending a lot of time on research to provide better advice to their customers. There is a proliferation of mutual fund related contents like blogs, research and analysis, fund rating etc. on the web. There are a number of online robo-advisors providing advice on how to construct mutual fund portfolios. Based on the large number of comments and queries we get on our website, I get a sense that, retail investor's knowledge of mutual funds and capital markets is significantly higher than what I saw 10 years back.This is a very welcome evolution of investor maturity in our country.

Too much information

While more information is always empowering, too much information can also cause confusion in the minds of investors. There can be scores of performance parameters for a mutual fund scheme. Let us take trailing returns, the most popular measure of returns, as an example. There can be 1 week returns, 1 month returns, 3 month returns, 6 month returns, 1 year returns, 3 year returns, 5 year returns, 7 year returns, 10 year returns and returns since inception etc.

Then there are mutual fund annual returns, point to point returns, SIP returns, rolling returns etc. Different return parameters may give different measures of absolute or relative performance – which one should you take as a measure of the fund’s performance? Mutual fund disclaimers say that, historical returns should not be taken as indicative of future returns; then what is the point of showing historical returns?

To add to this confusion, mutual fund research websites show parameters like R squared, Standard Deviation, Sharpe Ratio, Sortino Ratio, Beta, Jensen’s Alpha, Market Capture Ratio etc. None of these parameters are easy to understand and we have so many parameters.

Let me now further complicate this confusion and I seek your apology for this. You will see different mutual fund research websites will have different alphas or other parameters for the same mutual fund scheme. This does not mean that, some research websites are showing wrong alphas or other parameters. The computational methodology may differ from one research website to another, depending on the benchmark used (some websites like Advisorkhoj use the scheme benchmark as per the Scheme Information Document, while some may use a standard benchmark for a category), the period used for computing these parameters, risk free rate assumptions etc.

Which scheme belongs to which category?

Then there is the confusion about mutual fund product categories. In some mutual fund research websites, you will fund a mutual fund scheme categorized as a large cap fund, while in some others you will find the same scheme categorized as a multi-cap fund and in yet others, you may find it classified as a diversified equity fund. Some websites put midcap and small cap funds in the same category, while others may put it in different categories.

Categorization of mutual fund schemes has a significant impact in understanding relative performance of a scheme because a top performing scheme in a particular category may not be top performing if its category changes. In December 2017, SEBI clarified norms of mutual fund categorization, which will help bring about standardization across the industry. This is a very welcome development. But the timeline by which the SEBI norms of categorization will be implemented across the industry is still not clear.

Are fund ratings useful?

To cut through this clutter of confusion, many mutual fund investors and financial advisors use fund ratings given by different mutual fund research websites. We all want information, which makes life simpler for us, there is nothing wrong with that. However, investors should understand the difference between information and opinion. Information is based on facts, while opinion is based on an individual or an organization’s interpretation of information.

There is nothing wrong with an expert (individual or organization) giving opinion on stocks and mutual funds. But there is a danger in treating the opinion like a fact. Mutual fund ratings given by research firms, is an example of opinions of the research firms, but many a time investors treat these ratings as gospels of truth. What further confuses investors are conflicting ratings given to the same scheme by different research firms. One research website gives a scheme a 5 star rating, while another research website gives the same scheme a 2 star rating. Which rating will you believe? If you have good experience following the ratings of any particular website in terms of returns, then you will believe the rating given by that website. But what if you had mixed experience or a bad experience? What will you do?

Both the mutual fund research websites will claim that their ratings methodology is scientific, based on defined methodologies and both websites may very well, be right in their claims. But implicit in any methodology of mutual fund ratings are assumptions, particularly related to which parameters to use in fund rating and more importantly, the relative importance (weights) of the different parameters in the final rating.

Investors should try to understand the methodology behind mutual fund ratings instead of blindly going by the ratings. Mutual fund research websites provide some information about ratings methodology, but unfortunately they do not provide the full information about their methodology which gives investors comprehensive understanding of how a particular rating was derived. The research firms may be justified in not disclosing full information on their ratings methodology for the fear of their Intellectual Property being used unethically by their competitors, but from an investor perspective, there are very few options other than to follow the ratings blindly without a comprehensive understanding of methodology used. There would have been no problem if highly rated funds always gave high returns in the future. This is however, not always the case and that creates confusion in the minds of the investors.

Further, mutual fund investors would have noticed that, a fund’s rating can change from year to year. A five star rated fund in one year can be downgraded to 3 stars in the following year. The research firm will justify the ratings downgrade by saying that, they are mechanically following a defined methodology based on certain performance parameters, but what is the investor supposed to do? Will he redeem and invest in a five star rated fund? This can lead to an awful amount of portfolio churning, which is not good in the long term for investors.

Are financial advisors better placed than investors to understand fund potential?

Yes, because financial advisors meet with Asset Management Company’s (AMC) personnel from time to time and can get more information about a fund. Financial advisors, also devote more time than individual investors to mutual funds because it is their profession and therefore, can have more qualitative knowledge. Also financial advisors are likely to have more mutual fund experience compared to the average investor. Therefore, investors can benefit from interactions with financial advisors. In our view, the investors who benefit the most from interactions with financial advisors are the ones who ask the right questions. Financial advisors can provide guidance only if they can fully understand the investors requirements. Hence iInvestors, even if they have financial advisors, should educate themselves more on investments and mutual funds, so that they can have meaningful conversations with their financial advisors and jointly take better investment decisions.

Conclusion

In this multi-part post, we discussed the difficulties in selecting equity mutual funds, despite the plethora of information available online. We also discussed how mutual fund ratings assigned by different websites may not always be the best fund selection criteria and how the role of the Financial Advisor is important. In the next part of this post, we will discuss what information may be useful for investors to analyze mutual funds and what information they should avoid.