Home/ Opinion / The best way to choose an equity mutual fund

The biggest conundrum in the mutual fund industry stems from: “Past performance is not an indicator of the future". And yet, in the absence of any insights on what to look for, an investor ends up looking at past performance. A word closely associated with performance is ‘consistency’. But what is consistency? More linearity of returns? A narrow range in which returns fall? Consistently No.1 in returns or at least in the top quartile all the time?

Let’s look at practical experience on ‘consistency’ and ‘past performance’. Managing equity mutual funds is all about creating wealth for investors through investing in the stock markets. In roughly the past 10 years, at different points in time, different segments, sectors and components of the market have delivered. From 2004 till mid-2006, it was a secular bull run with mid-caps and value picks leading all the way. May 2006 saw a large correction and from then on leadership was with large-caps, real estate, retailing and infrastructure companies. Year 2008 saw the global financial crisis, and except for cash and gold, nothing worked. In 2009, the S&P BSE Sensex bounced back, doubling in six months. In 2010 and 2011, the banking sector rocked; and in 2012 and 2013, international equities fired while India took a beating, especially in interest rate sensitive sectors and mid-caps. The next two years saw great momentum in high-growth companies and mid-caps, while all positive indicators on value buying misfired.

This tells you how nightmarish investing in equities in the past 10 years has been. And it’s been the same in any 10-year period, with leadership among styles, sectors and asset classes rotating every year, sometimes even every six months. In this kind of a scenario, the only way to perform consistently—in terms of highest returns or being No.1 or in a top quartile—is to be Nostradamus. And this is borne out by the fact that practically every year or two, leadership in equity fund performance has changed.

So, what should an investor do? Past performance definitely helps identify a universe of funds that have done well in a few buckets of time and hence arithmetically they show great compounded average returns. But it doesn’t say anything about your probable investing experience.

Equity investing is a process where one cannot control or predict the outcome. But yes, there are those with average scores that are way above the rest. Considering that we can’t predict outcomes for every quarter, or a half year, or any other plausible investing horizon when it comes to equities, the only thing we can do is to look for fund managers with a distinct style or technique which helps them tide over varying market conditions and macro factors.

Does this show up when it comes to fund management? Do fund managers have techniques or styles? The answer is: they do. So the next time you evaluate funds, you could shortlist by way of brands, expertise and, of course, past performance. But when it comes to performance, ask one question—how did they get it and how do they plan to sustain? If the answer lies in a process, an approach to stock picking, an investment philosophy with an implementation plan, then that’s your pick. But if the answer lies in excellent forecasting skills which keeps them ahead of macros and market movements (basically, everything other than process), then you are dealing with someone who is Nostradamus reincarnate.

The other conundrum in recent times regarding fund selection has been about focus and conviction versus diversification. Are focused funds better or are diversified funds better? While the jury is still out on this one, there are a few things to keep in mind. Financial theory suggests that 20-25 stocks is optimal risk diversification; beyond that, diversification only adds market risk. Investment guru Warren Buffett said that risk doesn’t come from owning more or less stocks; risk comes from not knowing what you are owning.

Most investors end up buying 4-6 and at times even 10 mutual funds. If each of these funds own 50-70 stocks, as most funds do, then the investor eventually ends up owning anywhere in the range of 300-500 stocks. Some diversification that.

If you allow for some de-duplication, an investor would still end up with 200-plus stocks. It’s worth remembering that Nifty 50 and BSE 200 alone respectively account for over 50% and 85% of our entire market capitalisation. So, if you have over 200 stocks in your portfolio, you own the full market. How do you beat the market if you own the market?

Secondly, the Pareto principle, or the 80:20 principle as we know it, is all pervasive. Whether a fund has 20 stocks or 100 stocks, bulk of the return will indeed come from the top 20% or top 8-12 stocks. So why own positions running in decimal points like 0.1%,0.5%, or even 1%? What will an investor achieve if a stock is 0.5% of the portfolio and it turns out to be a multibagger? While high conviction positions can work both ways—there must be an optimal level of diversification and it may just help the investors’ cause to have funds with crisp, concise, one-page portfolios—at least you would be able to see all of what you own and not just the top few holdings.

Aashish Somaiyaa, managing director and chief executive officer, Motilal Oswal Asset Management

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Updated: 02 Feb 2016, 02:46 AM IST
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