Did you know which parameters to ignore when selecting mutual funds

In our previous post, Did you know what to analyze and ignore when selecting equity mutual funds, we discussed the difficulties in selecting equity mutual funds, despite the plethora of information available online. Many investors use fund ratings assigned by different mutual fund research portals to identify schemes for investments. In our earlier post, we discussed that, different research firms use different rating methodologies, which can lead to conflicting ratings and as a result, confusion for investors.

We agree that fund ratings assigned by different research portals is the easiest way to select funds because it is a single data point, but it is not necessarily the best way because of the reasons discussed in our earlier post. The alternative approach is to analyze other scheme data points, but there can be scores if not hundreds of data points for each scheme for investors to analyze. It is not possible for the average retail investor to devote time and effort to study all the data related to a scheme or multiple schemes.

In our view, not all data points are relevant for scheme selection or for getting a sense of the future potential of a scheme. The most important thing which mutual fund investors should care about is future performance. Most investors base their investment decisions on past performance, especially short term performance. However, investors who care to read mutual fund disclaimers would have seen that, past performances may not be indicators of future performance of a scheme. In the next part of this series of blog posts, we will discuss which data points are not relevant for analyzing the future performance potential of a fund.

Net Asset Value (NAV)

The Net Asset Value of a fund is the price at which you buy or sell mutual fund units. Mutual fund NAVs are determined at the end of each trading session by calculating the market value of the scheme portfolio (based on the closing price of each security and number of shares for each security in the portfolio), subtracting the liabilities and dividing by the total number of units outstanding. At the time of a scheme’s inception, the units are usually priced (NAV) at Rs 10. Over a period of time, the NAV of the scheme will change depending on the change in market value of the securities and the activities of fund manager (buying and selling securities).

Many investors look at NAVs in the same way as they look at share prices. Investors should understand that, a mutual fund unit derives its value from the value of the underlying securities. Share prices can be high (expensive) or low (cheap) in relation to earnings per share, but fund NAVs are not be expensive or cheap. NAVs depend on the price appreciation of the underlying securities, accumulated profits of the scheme (through portfolio turnover from time to time) and the power of compounding over time. Time is therefore, the most important determinant of NAV along with the fund manager’s performance over time.

A fund with a high NAV is not expensive and applying the same logic, a fund with low NAV is not cheap. Extending this rationale, Mutual Fund New Fund Offers (NFO), which are priced at Rs 10, are not necessarily cheap. Therefore, NFOs should not be seen as attractive in terms of price – there may be investment features in an NFO which can make it an interesting investing proposition for particular investment needs, but not the price.

As discussed previously in our blog, time and quality are the two most important factors in equity investing. In the context of mutual funds, these two factors translate to the tenure of your investment (longer the better) and the fund manager’s ability to outperform (alpha). As an investor, you are in control of the tenure of the investment. The remaining piece is your ability to select the right fund based on the quality of fund manager. Price or NAV has no relevance.

Short term performance

In the financial media, a lot of attention is given to short term (1 year to 3 years) performance, but in equity investing short term performance is often quite misleading because short term performance is more influenced by prevailing market conditions. The media often feeds us with information and analysis which suits the tenor of their content. In Advisorkhoj, we advocate a DIY (Do it yourself) mindset for investors so that they can educate themselves. For that purpose, we have built an extensive array of research tools and capabilities.

Let us now understand, why short term performance is misleading, through a DIY exercise. Go to our MF Research section. Next, select Top Performing Mutual Funds from the menu on the left. In this tool we list the top performing mutual funds for different categories based on their trailing returns over a period chosen by the investor. You can choose any category or period, but for this exercise choose Diversified Equity Funds category and 1 year period. Note down the top 10 funds.

Next, go to the tool, Mutual Fund Quartile Ranking. In this tool, we assign quartile rankings to funds based on their trailing returns over a period selected by the investor. The top quartile includes the top 25% performers over the period, the upper middle quartile includes the next 25%, so on so forth. For this exercise, select the same (diversified equity funds) category but 3 years as the period. Now see, how the top 10 funds based on last 1 year returns, performed on a three year basis. Though we will not share our findings in this exercise, we encourage our readers to do the same exercise themselves, so that they develop a better understanding. Only 50% of the Top 10 funds based on last 1 year returns figured in the top quartile based on last 3 years returns. You can see that relation between short term and long term performance is inconclusive.

So returns over what period should we use for selecting funds? Experienced financial advisors will ask you to use a longer time period for evaluating fund performance when selecting funds for investments. In Advisorkhoj we agree that, investors should use a longer time period for evaluating fund performance, but what if the fund manager changed in the last 3 years? What if the investment strategy, e.g. change from midcap to large cap, change from value investing to GARP (Growth At a Reasonable Price) etc. changed over the last 1 to 3 years? What we are trying to say here is that, while a longer time period is suitable for evaluating a fund’s performance, it may not give you the true picture unless you analyze other factors.

Very long term performance

Financial advisors and mutual fund bloggers often talk about funds, which gave 30 to 40 times returns or even more over the past 20 years or so. Such data points make a great story for mutual funds in general, but they are irrelevant as far as specific funds are concerned. Over a very long period, 10 to 15 years or longer, many things are likely to change, like the fund manager, the investment strategy of the fund, the structural nature of the market (especially here in India) etc. There are quite a few examples of funds which gave terrific returns in the past 20 years or longer, but are struggling to outperform in the more recent past. In fact, some of them are languishing in the bottom quartiles.

If you have been investing for a long period of time, there may be funds in your portfolio which had given fantastic returns in the past, but are underperforming for some time now. I have seen that, some investors grow an emotional attachment to certain stocks or funds. But there is a saying in Wall Street, “never get emotional about stocks” – the same thing can be applied to mutual funds. If there is a fund in your portfolio which gave you very high returns in the past, but is struggling to perform over the last 3 years or so, you should investigate the cause of underperformance. Has there been a change in fund manager, investment style, market cap style etc.? If a fund in your portfolio continues to underperform, relative to its benchmark, you should switch to a better fund, the past performance of your fund notwithstanding.

Expense ratio for actively managed equity funds

This is controversial but in Advisorkhoj, we hold the view that ultimately investors care only about returns. There is a lot of online content which focus on expense ratios; the bloggers / authors argue that, even a few basis points of difference in expense ratio can add up to a substantial difference in wealth creation over a long investment horizon. While we agree with the theoretical argument, these bloggers / authors ignore fund manager alphas in their arguments.

There is a lot of focus on expense ratios in matured capital markets like the US. If you want to focus simply on expense ratios then index funds or ETFs are the way to go, but actively managed funds in India have been able to outperform index funds or ETFs. This is because there are pricing inefficiencies in India, which good fund managers are able to exploit, generating high alphas for investors. High alphas mean high returns and that is all investors should care about – expense ratios in actively managed equity funds tend to be a distraction, adding no significant value to the investment decision. In Advisorkhoj, we studied the relationship between expense ratios and long term (3 years or 5 years) returns; we found no statistically significant relationship between the two (please see our post, How much importance should mutual fund investors give to expense ratios).

In our view, investors should focus more effort on understanding the fund manager’s performance in different market conditions and over a sufficiently long investment horizon, relative to the fund benchmark. Investors should note that, our view on the importance of expense ratio is with relation to actively managed equity mutual funds. For debt mutual funds, especially money market mutual funds, expense ratio is very important because the fund manager’s ability to generate alphas in debt funds, especially money market mutual funds, is fairly limited.

Fund manager tenure in index funds

Fund manager tenure is a very important consideration in actively managed mutual funds. However, it makes no sense to analyze manager tenure for index funds or ETFs. Index funds or ETFs are designed to track a benchmark index with high fidelity (low tracking errors). An index fund or ETF manager does not aim to beat the index; he or she simply aims to replicate index performance. Therefore, it is the process and execution capabilities which are important in index funds, not so much, the fund manager. Though index funds are not as popular in India as they are in the West (e.g. US), there are a few investors who invest in both index funds and actively managed mutual funds. Such investors should be clear about the differences between the two.

Conclusion

My father began investing in mutual funds more than 35 years ago. Back then, forget so much information that we have today, there was only one mutual fund AMC – investors like my father had very little choice. I started investing in mutual funds about 15 years ago – even though I had more choices than my father, I did not have the kind of investment analytics that is available today when I began my investment journey.

The growth in information technology has enabled research and analysis to reach our fingertips today and we are able to make, much more informed decisions than what my father’s generation was able to make. However, amongst the information overload, we must know what to analyze and what to ignore, when making investment decisions. In this part of our multipart blog series, we discussed which data points to ignore, while making investment decisions. In the next part of our series, we will discuss the most important data points to consider while selecting mutual funds. Please stay tuned……