How to avoid mutual funds (MFs) that are top-rated one year, but run out of steam and become laggards in the next three-four years. For instance, I bought Sundaram Tax Saver and SBI Magnum Taxgain in 2009 and now find them at the bottom of the heap in terms of returns.
MF ratings are purely quantitative in nature. They take empirical data regarding the fund’s performance and risk metrics to provide a rating that is indicative of the fund’s relative ranking within its category. For example, a five-star rated large-cap fund means that the fund was in the top 10% among large-cap funds with respect to the risk-adjusted returns that it delivered over the past few years. In this sense, ratings are “backward-looking” and do not claim to predict future prospects for a fund. Hence, while star rating can be used for filtering out funds that should not merit consideration, it can’t be used as a sole indicator for determining where to invest.
Then, how does one choose funds to invest in? Looking at the big picture, the decision on which funds to invest in should be made in the context of one’s overall portfolio that should have core and satellite segments. The core of a portfolio (60-80%) should be made of funds that have proven long-term record of outperformance. Websites such as Value Research, which provide ratings, also provide information regarding how funds ranked among its peers during different time periods—one, three, five, seven and 10 years. Funds that rank in the top quartile consistently over these periods would be good candidates for the core segment of your portfolio. For example, Franklin India Bluechip fund has ranked consistently among the top five funds in the large-cap category over several time frames. Similarly, HDFC Prudence has been a consistent top-ranker in the equity-oriented balanced funds category. After identifying such funds, ratings can be used as the final deciding factor.
The satellite portion of your portfolio could be made of newer, well-rated funds with less track record but ones that show the promise of good performance in the future. Following this approach has a high probability of yielding a portfolio that yields good risk-adjusted returns and has funds that don’t sag too much in terms of ratings.
However, one should realize that there is no guaranteed method of identifying future top performers and any prediction about the future will necessarily rely heavily on past data. That is the reason why one would need to track a portfolio regularly and rebalance/reallocate as required at least once a year. You may not have been able to do so with your tax-saving funds (since they are locked for three years), but you could definitely do so with the rest of your MF portfolio.
Srikanth Meenakshi is founder and director, FundsIndia.com
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