How important is mutual fund selection?

Published: October 29, 2015 at 1:58 pm

Last Updated on

How important is it to select a ‘good’ mutual fund for investment?  Although I have written step-by-step guides to select equity and debt mutual funds, ‘does fund selection matter at all’ is a question that has often bugged me.

What if I chose funds randomly for investment?!

In this post, let us consider the effects of such a random investment.

Using the automated mutual fund and goal tracker, SIP investments in all(*) mid and small cap mutual funds (as defined by VR online) are tracked from April 3rd 2006 (the earliest date in AMFI nav history) onwards.

* all funds that existed at the time except Kotak Mid cap and IDFC Premier Equity for which I could not access NAV history.

The returns (CAGR)  and corpuses as on 21st May 2014 are tabulated below

1-SIP-CAGR

Monthly SIP: Rs. 1000. Total Investment: Rs. 98,000

Here is the CAGR bar chart

SIP-CAGR

 

Now, there are two ways to interpret this data. I will present both and let you be the judge

 Fund selection is crucial!

 Look at the huge variation in CAGR and corpuses! The percentage difference between the maximum and minimum CAGR is an astonishing 296%!! The corresponding number for the corpus is 89%!!

If you had chosen the wrong fund, you could have gotten only 5% returns with a corpus 89% lower than the best fund!

The ‘average’ return is a healthy 14% but along with it is tagged a high standard deviation of 3.5%

So this means approximately 68% of funds would have returns between

14 – 3.5% = 10.5%

to

14 + 3.5% = 17.5%

Indeed 15 funds out of 21 (71%) fall in this category.

This variation is too large for comfort.

Therefore, fund selection is crucial!  You had better choose the ‘right’ fund!

Fund selection is not crucial!

All very well to mark a fund as ‘best’ or ‘worst’ in hindsight.  Unfortunately, such luxuries elude real world investors.

All one can do is to set a reference – a reasonable return desired to achieve a financial goal

Assuming for the purposes of this post that 8 years (Apr 2006 – May 2014) is long-term, the goal of long-term investing is to obtain returns that are above inflation.

So let us set inflation as the reference and let it be equal to 10% (neither too low nor too high. Should be close enough to ‘average’ inflation for everyday expenses. Thanks to members of facebook group, Asan Ideas for Wealth for inputs). Of course what matters in the real world is if the net portfolio returns beat inflation and not just the equity component.

How many funds have CAGRs greater than 10%?

A good 17 out of the 21 funds studied. A good ~ 81%.

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This is the probability an investor would have obtained inflation beating returns had he/she invested randomly.

Now, I do not know about you, but that I will take those odds any day!

It all boils down to expectations!

Had I expected 10% returns for an 8 year goal, 17/21 funds would have delivered.

Had I expected 9%, 20/21 funds would have delivered!

Those are very healthy numbers.

Had I expected 14%, only 12/21 funds would have delivered.

Lower my expectations, lower the importance of fund selection.

Data updated to Oct. 28th 2015

Mutual-Fund-Selection-2015-list

Monthly SIP: Rs. 1000. Total Investment: Rs. 1,15,000

HSBC Progressive themes has now become an infrastructure fund and is not part of the  list.  Could not update for ING Midcap.

Mutual-Fund-Selection-2015

I have now drawn the line at 12.5% !!  The way I see it, the arguments that fund selection is not important have gotten stronger.

So am I saying one can choose fund randomly?

NO. All I am saying is,

  • Lower our expectations, lower is the importance of mutual fund selection. The calmer we can be wrt its day-to-day performance.
  • we have no guarantee that a good performer will continue to do so in the future.

So instead of focussing on best funds and taking star rating seriously, let us choose funds with consistent performance and good downside protection.

Yes, yes this would mean choosing the best at the point in time! Nothing wrong with that!

It is important to recognise that there is no need for the best to remain so forever!

My point is if the funds ratings drop, don’t panic! A 3-star fund can also beat inflation if one has the discipline to stay invested.

After all, staying invested is the key assumption in this analysis!

Staying invested is far, far more important than fund selection.

When it is time to redeem your holdings, the only thing that matters is,

do you have enough to meet your expense?

And not,

Did you choose the best fund?

Bottom line: Choose wisely with low expectations.  Keep calm and stay invested. There is a pretty good chance you will have enough to attain your goals.

Choose mutual funds confidently with a plan and invest in direct mutal fund plans   Read more:  Direct Mutual Fund Option – The Second Anniversary Report

A simple definition of portfolio strategy (check out minimalist portfolio ideas for young earners). that is a clear idea of which fund categories to choose is  more important than fund selection.

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