How to select a mutual fund scheme - (Part 2)

 

Selecting a Mutual Fund Scheme – Part 2

 (Continued from Part 1, which highlighted the need for asset allocation before choosing a scheme)

“Hi Arnav, welcome back. How did your week go? Is your financial plan ready?”

“Yes, I have an outline ready, which we can discuss. It will take some time before I complete it.” Arnav showed his plan, which he scribbled on a piece of paper.

“Good. I did not expect it to be ready for action. It will need some fine-tuning,” I commented while reviewing Arnav's plan.

“I must add that I enjoyed the financial planning exercise. It was the first time in my life that I thought about my family's needs and aspirations. Tell me if whatever I have jotted down aligns with your expectations.” Arnav showed his plan.

Financial Goal	When	Amount
Car	3 years	Rs.15 lac
Children Education	10 years	Rs.30 lac
Children Marriage	15 years	Rs.25 lac
Retirement	25 years	Rs.5 Cr.

 

I was pleased that Arnav followed the guidelines I suggested in our last meeting. Before the last step of selecting a mutual fund scheme, he did his homework on financial planning.

“Yes, you have listed your financial goals with their period. You have also mentioned your asset allocation to achieve these goals. It is 80% equity, 15% debt and 5% gold. Excellent job.”

“I have also decided to use mutual funds as my vehicle for the journey. I neither have the time nor the knowledge to make investments on my own. What will be the next step?” Arnav asked.

“Among the Equity portion of your allocation, you must decide the percentage of large-cap, mid-cap and small-cap schemes in your portfolio. Suppose you decide to allocate  50% to large-cap schemes, 25% to mid-cap schemes and 25% to small-cap schemes. After this, you must select suitable schemes for investment.”

“Please tell me how to select appropriate mutual fund schemes.” Arnav asked.

Choosing a mutual fund Scheme

“Capital market regulator SEBI (Securities & Exchange Board of India) has categorized mutual fund schemes according to the asset classes. There are five main categories, eleven Equity fund categories, sixteen debt fund categories, and six hybrid fund categories, which are a combination of equity, debt, and gold. The risk and return grades of these categories are different, and you can choose them to suit your asset allocation.” I showed him the SEBI list.

“I guess I can choose Flexi Cap, multi-cap, Mid-cap and small-cap schemes. In each of these categories, I will select the top-performing scheme. I see a list of top performers whenever I open my mobile app. It should be easy to pick from that lot. Isn't it?”

“No. You are simplifying it too much. No doubt that past performance matters in selecting a scheme, but it is not the only one. Further, it is also important to see how the past returns are calculated.”

“I am surprised that it is not the way I thought. Moreover, I also do not know about different methods of calculating returns.”

“These are two methods of calculating.

1.       Point-to-point return. This means the scheme's Compounded Annual Growth Rate (CAGR) over the last 3, 5, or 10 years. This data is available in various applications and websites. However, the other method is more relevant for selecting the scheme.

2.       Rolling Return: It is a series of returns taken at regular intervals over a long period. For calculating 3-year rolling returns during 5 years ending on 30th April 2025, the first rolling return observation will be for 1st April 2020 to 31st March 2023, the next will be from 2nd April 2020 to 1st April 2023 and so on, with the last observation for the period 1st May 2024 to 30th April 2025. As you get a significantly high number of observations, rolling returns show if there is a consistency of the returns.

This is a better measure than point-to-point return, as in point-to-point returns, importance is given to entry and exit points.

“Do I need to calculate these rolling returns?” Arnav asked.

“No, they are available on websites. We gain meaningful insights from these observations, making them more useful. As an illustration, please see this tabulation giving data of one-year rolling returns of five large-cap schemes' performance from 1st May 2021 to 30th April 2025,”

Scheme	Average Return	Median Return	-VE Return%	Greater than 12%	Capture Ratio		Sharpe
Large cap					Downside	Upside
LC 1	22%	20%	0%	72%	92%	91%	0.99
LC 2	19%	17%	3%	62%	92%	88%	0.82
LC 3	17%	10%	17%	62%	73%	105%	0.97
LC 4	13%	11%	21%	46%	100%	114%	0.59
LC 5	10%	8%	37%	40%	95%	94%	0.39

 

 “This means there would be more than observations during this period.” The data is interesting. Can you explain it?”

“Yes. I will explain to you the first Scheme, LC1, in the table. The explanation is the same for other schemes. The second column is labelled “Average,” which shows a 22% average return across all observations. Third is the median, which is 20%. It means that more than half of the time, the return is 20% or more. In the fourth column, pf  -ve return, it shows the percentage of the less than zero (negative) return. Since it is zero, it shows that the scheme has not given a negative annual return at any time. The fifth column shows the percentage of achieving an annual return above 12%. It is 72% of the observations. The next two columns show capture ratios. They indicate the scheme's relative upside or downside performance compared to its benchmark index. If the downside ratio is less than 100%, it indicates that the scheme's decline is less than that of the index. An upside capture ratio above 100 indicates that the scheme outperformed the index. The last column displays the Sharpe ratio, which indicates the level of risk taken to achieve the return. It is calculated by dividing (scheme's return – risk-free return) with its standard deviation. The higher the Sharpe ratio, the better the scheme. What would be your choice, Arnav?”

“I would prefer the scheme L1, as it has the highest average return with no -ve return. Also, its Sharpe ratio is the highest, showing more consistency.” Arnav gave his opinion after studying the table.

“Great! You are now conversant with the basics of rating mutual fund schemes. As rolling returns show consistency and mitigate recent performance bias, they are preferred over point-to-point returns. Apart from the returns, other qualitative parameters are used to evaluate a scheme,” I continued, explaining the rationale behind the scheme selection.

•  Portfolio Concentration- How much is the scheme diversified? Is too much diversified or too much concentrated?
• Fund house's processes - How are the mutual fund company's risk management and research processes followed?
• Fund manager's track record – How do they adhere to the scheme's mandate and perform across the market cycles?
• Liquidity Analysis – How many days will it take to liquidate the scheme's portfolio in a crisis?
• Investment style -  Growth or momentum or Value?

Apart from these parameters, some analysts also consider factors like AUM Size. However, there is no  evidence of correlation between AUM size and performance.” When I stopped, Arnav looked confused.

“There are many things to check. I was wrong to focus on the recent performance. I realize it is not so.”

“Yes, because a good scheme may not be the best performing. Today's top performance may not be sustained next year. And you should not shuffle your portfolio to chase top-performing schemes since you are a long-term investor.”

“I understand that such an exercise will disturb my portfolio, and I will drift from my goals.”

“You said it right. Maintaining a balanced mutual fund portfolio to meet goals is a basic quality of a good investor. You should prefer consistency of the performance over the short-term results.”

“Any other thing you want me to follow?” Arnav asked. “Do not allow your portfolio to bloat. You need a manageable number of MF schemes to build your solid investment portfolio. Though there is no standard number, 8 to 10 MF schemes would be sufficient.”

“Thanks for your guidance. It has busted my misconception that top-performing schemes are best. I will now analyze schemes on trailing returns and other qualitative measures you suggested.” Arnav seemed happy to get this new insight.

(This article is for general information only and not be treated as financial advice. Readers are advised to consult their advisers before taking any decision.)

*****  

How to select a Mutual Fund Scheme - (Part 1)

Selecting a mutual fund Scheme – (Part 1)

 

Arnav, an investor, calls me on the phone and speaks,

Can you recommend a good mutual fund scheme?

"What do you mean by a good scheme?" I ask him.

"I do not know exactly. But I guess it should be a top performer with the highest returns," Arnav replies.

"Yes, surely, I can suggest. However, selecting a scheme based only on returns is not in your interest." I try to warn Arnav.

"Then what more is needed? I want to get maximum returns." He pressed.

"Hold on and let us meet so I can explain it. Choosing a some from the list of top performers popping up on the internet is not correct method. You must follow a process to select a scheme." Arnav agreed to meet the following week.

Arnav is among the many investors who believe they should invest only in the top-performing mutual fund schemes. Sadly, this is a common misconception, as the recent track record is not the only parameter for selection. They are unaware that good or bad performance is often due to a specific situation, and no scheme remains on top for long.

When Arnav came for the discussion, I began,

"Many investors like you choose schemes with a five-star ranking without understanding their rating methodology. You may get it right for a short time, but soon you will realize that the scheme you chose does not stay at the top. Keep in mind that this is not a way to build your portfolio. You need a deeper thought process to arrive at a proper selection of the schemes."

Arnav was a professional auto consultant with a thorough knowledge of the automobile industry.

Before discussing selecting a mutual fund scheme, can you suggest a good car for me?"

"To answer your question, you will have to answer my questions. Selecting the right car involves evaluating several factors to ensure it meets your needs. After I know your response to these questions, I can suggest a suitable model." Arnav gave me a list of attributes with the options.

1. Primary purpose for using a car - Daily commute to workplace/long distance drive/family/casual travel

2. Your budget - Below 10lac/11 to 15 lac/ above 15 lac

3. Transmission - Manual/ Automatic

4. Type of car - Hatchback/Sedan/luxury car/SUV/MUV

5. Choice of fuel - Petrol, Diesel, EV, or CNG.

In addition to these questions, you should also tell me about your preferences for brand, new or used car, fuel efficiency, parking facility, safety features, availability of service set up and expectations about resale value."

"Arnav, you have asked me many questions I have never thought about. "

"Yes. However, you must consider all these factors before you decide which car to buy. Unless you give me your requirements, I cannot suggest a model. Opting for a top-selling model will not be the right choice."

"I agree, Arnav. I should buy a car that meets my requirements after a careful thought process. Similarly, when selecting a scheme, you must follow a process linking your needs to the scheme's specifications."

"Do you have a list of parameters as well?" Arnav asked.

"Yes, by addressing these questions, you can make an informed decision that aligns with your creative goals and practical requirements. Arnav, please remember that scheme selection is the last step in your investment process. The mutual fund universe is vast, with three asset classes, thirty-nine categories (as per SEBI circular), more than forty-five mutual fund companies, and more than 1,500 schemes. Before I suggest a scheme to you, here's my list of questions." I provided my list.

1. Have you done your financial planning, including your family members?
2. What are your financial goals? Have you classified them into short-term, medium-term, and long-term goals?
3. What is your risk profile? What type of investor are you? Aggressive, moderate, or conservative?
4. What is your asset allocation to reach your goals? What percentage of equity, fixed income, debt, and gold/silver do you want in your portfolio?
5. Are you aware of the categories of mutual fund schemes?

"Honestly, as you have not thought about cars, I know little about these financial matters. They seem to be more complex than deciding on a car." Arnav confessed.

"Not really. Being conversant with the basics is your advantage. It will be easier if you do your homework and think about what you want from investments. Please start with financial planning and decide on your financial goals. The next step will be doing your asset allocation. Only after this can you properly select a mutual fund scheme."

"I believe financial planning is only for rich people. I do not have time for all these things." Arnav commented.

"Don't worry. Financial planning is not difficult or time-consuming. It means knowing financial needs and aspirations. Your financial plan and asset allocation will be a guide for your life. Mutual fund scheme selection follows your asset allocation, which means allocating your money across multiple asset classes, such as equity, fixed income, debt, cash, etc. After considering your financial goals, return expectations, and risk profile, you can decide where to put how much money. Your asset allocation is the most crucial factor in determining your investment's return and risk. You cannot jump over scheme selection without asset allocation."

"Yes, I got it. I can follow these steps."

"Arnav, one more concept you should understand is correlation. More schemes or securities of the same asset class do not mean diversification. Including diverse asset classes with low correlation of returns and risk is the ideal way of investing. For example, returns on gold, debt, and equity tend to move differently. The mix of asset classes helps to get an optimum return performance. So, a well-thought-out combination of investments is desirable. Of course, this is not easy, but it should be attempted."

"It's like having a balanced meal with sweet, sour, and spicy elements," Arnav remarked.

Yes, something similar. As market volatility affects returns, having a cushion of low-volatility investments is crucial to reduce risk. Including multiple asset classes improves the chances of earning better returns.

"I got it. I should identify asset types where I should put  money to reach my goals. We will meet again after my financial plan is ready,’ Arnav promised.

“Great, Arnav. Today’s discussion was the first part of the selection process. After you do asset allocation, we will identify the category of mutual fund schemes. E.g. Large cap equity scheme. After this  further analysis is necessary to select suitable scheme from the available schemes in the category. So, let us meet next week with your financial plan.  Meanwhile, have a look at this chart to help you understand the investment process."

(This article is for general information only and not be treated as financial advice. Readers are advised to consult their advisers before taking any decision.)