How important is mutual fund selection?

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%.

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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50 thoughts on “How important is mutual fund selection?

  1. Sanjiv Singhal

    Hi Pattu,

    Simple but powerful insight. Great analysis and thank you for reinforcing the idea of focusing on the goal amount rather than percentage return.

    Having a reasonable expectation of return is not just key to a peaceful existence but also to being a better investor. Just as you're unlikely to get a long term return below inflation with equity mutual funds, you're also not likely to get a long term return of 100, 50 or even 30%. Investors who recognise this are able to resist temptation.

    Therefore, "mutual fund selection" is less about getting maximum returns, and more about trying to ensure that your return is at par with the average for the chosen asset class to justify the risk taken. And as you keep reminding your readers, it's worth the effort and not too difficult either. We've proven that a disciplined selection and investing method can provide pretty decent returns. (https://scripbox.com/pages/mutual-fund-portfolio-performance-track-record/).

    Sanjiv

    Reply
  2. Sanjiv Singhal

    Hi Pattu,

    Simple but powerful insight. Great analysis and thank you for reinforcing the idea of focusing on the goal amount rather than percentage return.

    Having a reasonable expectation of return is not just key to a peaceful existence but also to being a better investor. Just as you're unlikely to get a long term return below inflation with equity mutual funds, you're also not likely to get a long term return of 100, 50 or even 30%. Investors who recognise this are able to resist temptation.

    Therefore, "mutual fund selection" is less about getting maximum returns, and more about trying to ensure that your return is at par with the average for the chosen asset class to justify the risk taken. And as you keep reminding your readers, it's worth the effort and not too difficult either. We've proven that a disciplined selection and investing method can provide pretty decent returns. (https://scripbox.com/pages/mutual-fund-portfolio-performance-track-record/).

    Sanjiv

    Reply
  3. Shan

    I am of a similar thought. I don't want earth shattering returns at the same time I want to beat inflation over long term and want a lot of peace of mind. So I invest almost entirely in index funds. About 80% mutual funds can't beat the index. Further, over the long term there's no guarantee that a particular fund will continue to do well. Today's star fund managers won't be around 20-30 years from now. But the index is guaranteed to beat inflation over the long run of 20-30 yrs. case closed. Why bother with the multiple confusing mutual funds out there and keep tracking them?

    Reply
    1. pattu

      Index investing is certainly simpler and guaranteed to beat inflation. To do this, one must have the maturity to ignore the outperformance of active funds. Personally I wouldn't mind a little alpha 🙂

      Reply
      1. Alex

        What outperformance? Active funds on average underperform their respective indexes. Moreover, index funds outperform close to 80% of actively managed funds, mainly due to lower expense ratios, lower trading costs (low turnover) and low transaction costs, let alone the tendency of active managers to chase past returns, style drift, etc. Diversified index fund investing with periodic rebalancing will beat any other strategy in the long term for the vast majority of investors.

        Reply
  4. Shan

    I am of a similar thought. I don't want earth shattering returns at the same time I want to beat inflation over long term and want a lot of peace of mind. So I invest almost entirely in index funds. About 80% mutual funds can't beat the index. Further, over the long term there's no guarantee that a particular fund will continue to do well. Today's star fund managers won't be around 20-30 years from now. But the index is guaranteed to beat inflation over the long run of 20-30 yrs. case closed. Why bother with the multiple confusing mutual funds out there and keep tracking them?

    Reply
    1. pattu

      Index investing is certainly simpler and guaranteed to beat inflation. To do this, one must have the maturity to ignore the outperformance of active funds. Personally I wouldn't mind a little alpha 🙂

      Reply
      1. Alex

        What outperformance? Active funds on average underperform their respective indexes. Moreover, index funds outperform close to 80% of actively managed funds, mainly due to lower expense ratios, lower trading costs (low turnover) and low transaction costs, let alone the tendency of active managers to chase past returns, style drift, etc. Diversified index fund investing with periodic rebalancing will beat any other strategy in the long term for the vast majority of investors.

        Reply
  5. Manish

    Hi Pattu

    Great Analysis .. However I think we should consider the question - "Can one choose a random portfolio ?" . The real life case with most of the people is that one chooses around 3-4-5 funds randomly (based on the ratings etc) . I guess in that case in most of the cases, the random selected portfolio would not do so bad ! ..

    I will also do a study on this 🙂

    Manish

    Reply
    1. pattu

      Thanks Manish. Yea that is indeed a good question to ask. I think only decent funds houses get 5 star ratings. So even if one went only start ratings they should be doing well, provided they stay invested.

      Reply
  6. Manish

    Hi Pattu

    Great Analysis .. However I think we should consider the question - "Can one choose a random portfolio ?" . The real life case with most of the people is that one chooses around 3-4-5 funds randomly (based on the ratings etc) . I guess in that case in most of the cases, the random selected portfolio would not do so bad ! ..

    I will also do a study on this 🙂

    Manish

    Reply
    1. pattu

      Thanks Manish. Yea that is indeed a good question to ask. I think only decent funds houses get 5 star ratings. So even if one went only start ratings they should be doing well, provided they stay invested.

      Reply
  7. Jatin Visaria

    Really nice article.

    It is rightly said that investment should be goal based and not only return based. Sadly most of the investors look at only average returns and not SD. As said by one of the reader “Shan” in second comment, in long run index is going to beat inflation with relatively more certainty then alpha generating funds.

    I believe comparing these funds with respective appropriate Indexes & not the benchmark chosen by fund manager will give clearer picture. Also analysis on yearly average alpha generated by each fund as compared to respective appropriate Indexes and standard deviation of that alpha will help in taking much more confident investment decision.

    Reply
    1. pattu

      Thanks Jatin. I have looked at a few old funds from this angle. If you look at 1Y rolling returns all of them resemble index funds. However, at some points in time, they outperform and that carries through in the NAV history. If we look at the past, active funds will always win. We will have to check from now and see how they perform. I think there will still be some alpha but the quantum would have gone down.

      Reply
      1. Jatin Visaria

        Yes Pattu, as you rightly said there always will be outperformer. The question is if we can predict FUTURE outperformer. Secondly, my point is not related to 1Y rolling return. My point is to check yearly alpha and std deviation of alpha (not the returns.) Hope i am able to convey my point.

        Reply
  8. Jatin Visaria

    Really nice article.

    It is rightly said that investment should be goal based and not only return based. Sadly most of the investors look at only average returns and not SD. As said by one of the reader “Shan” in second comment, in long run index is going to beat inflation with relatively more certainty then alpha generating funds.

    I believe comparing these funds with respective appropriate Indexes & not the benchmark chosen by fund manager will give clearer picture. Also analysis on yearly average alpha generated by each fund as compared to respective appropriate Indexes and standard deviation of that alpha will help in taking much more confident investment decision.

    Reply
    1. pattu

      Thanks Jatin. I have looked at a few old funds from this angle. If you look at 1Y rolling returns all of them resemble index funds. However, at some points in time, they outperform and that carries through in the NAV history. If we look at the past, active funds will always win. We will have to check from now and see how they perform. I think there will still be some alpha but the quantum would have gone down.

      Reply
      1. Jatin Visaria

        Yes Pattu, as you rightly said there always will be outperformer. The question is if we can predict FUTURE outperformer. Secondly, my point is not related to 1Y rolling return. My point is to check yearly alpha and std deviation of alpha (not the returns.) Hope i am able to convey my point.

        Reply
  9. Deep

    3-4 funds would ensure u r around the category average.What one should understand the impact of a single fund in the portfolio is not worth the time to do over analysis. The key thing is "asset allocation" .Spending too much time on the choice of instrument to achieve correct allocation is a common problem.The reasons are obvious.Instruments are marketed but asset allocation is not.

    Reply
    1. pattu

      Agree about asset allocation but I don't see the need for 3/4 funds just to get close to category average. That would increase the management effort.

      Reply
      1. Deep

        I meant a total of 3-4 funds.The point is adding more fund to the portfolio beyond a point is of little value.Short term debt long term equity thats the only mantra.

        Reply
        1. Tim Embleton

          Hi Everyone, There's a massive amount of research that has been carried out by Dimensional Fund Advisors on this and the have several Nobel prizes in economics to prove it. Their research conclusively points to the efficiency of markets and the effects of size and value. The odds are stacked against you if you use active managers with high fees as top performers don't usually repeat in future years (I'd be interested in a study of bottom performers to see if they outperformed more often in future!!!). Trackers reduce the risk of big underperformance but they will underperform by an amount equivalent to their fees if the are a full replication model. There are however sections of the market that outperform consistently - small and value stocks and by using low cost funds that target these areas you will get more volatility but increased returns over the long term. Therefore choosing the underlying assets and paying attention to costs is much more important than picking the right manager. By investing in this way we can explain around 96% of the return. The rest is down to luck and therefore unpredictable. Trouble is that most fund managers are delusional because they ALL believe they can beat the market and yet simple mathematics dictates that at least 50% must be below average - I cannot possibly be any other way, and when you take fees into account 2/3rds underperform. Don't even get me started on bond and property funds!!! :))

          Tim Embleton
          Time Independent Ltd

          Reply
  10. Deep

    3-4 funds would ensure u r around the category average.What one should understand the impact of a single fund in the portfolio is not worth the time to do over analysis. The key thing is "asset allocation" .Spending too much time on the choice of instrument to achieve correct allocation is a common problem.The reasons are obvious.Instruments are marketed but asset allocation is not.

    Reply
    1. pattu

      Agree about asset allocation but I don't see the need for 3/4 funds just to get close to category average. That would increase the management effort.

      Reply
      1. Deep

        I meant a total of 3-4 funds.The point is adding more fund to the portfolio beyond a point is of little value.Short term debt long term equity thats the only mantra.

        Reply
        1. Tim Embleton

          Hi Everyone, There's a massive amount of research that has been carried out by Dimensional Fund Advisors on this and the have several Nobel prizes in economics to prove it. Their research conclusively points to the efficiency of markets and the effects of size and value. The odds are stacked against you if you use active managers with high fees as top performers don't usually repeat in future years (I'd be interested in a study of bottom performers to see if they outperformed more often in future!!!). Trackers reduce the risk of big underperformance but they will underperform by an amount equivalent to their fees if the are a full replication model. There are however sections of the market that outperform consistently - small and value stocks and by using low cost funds that target these areas you will get more volatility but increased returns over the long term. Therefore choosing the underlying assets and paying attention to costs is much more important than picking the right manager. By investing in this way we can explain around 96% of the return. The rest is down to luck and therefore unpredictable. Trouble is that most fund managers are delusional because they ALL believe they can beat the market and yet simple mathematics dictates that at least 50% must be below average - I cannot possibly be any other way, and when you take fees into account 2/3rds underperform. Don't even get me started on bond and property funds!!! :))

          Tim Embleton
          Time Independent Ltd

          Reply
  11. Anonymous

    Frankly speaking it doesn't matter which fund you choose. Most of the Indian Fund managers consider beating the respective benchmarks such as SENSEX, BANKEX etc as a performance indicator which is improper. Alfa creation has become a challenge after the market cycle of 2005-08. Further the figures of ICICI and others look rosy because you have done the calculations when the SENSEX has probably crossed 25K!!!! Imagine the results of this study had you done it in 2010 or 11 or 12!!!! Statistics show that Lum-sum investment was better than SIPs during this period. And all the AMCs sing the SIP songs with the same lyrics even today. The real problem is that none of the AMCs have ever thought of the benefit of investors else they would have designed a system of accountability to investors. Today none of them stick to the mandates of fund management given in the SID.

    Reply
  12. Anonymous

    Frankly speaking it doesn't matter which fund you choose. Most of the Indian Fund managers consider beating the respective benchmarks such as SENSEX, BANKEX etc as a performance indicator which is improper. Alfa creation has become a challenge after the market cycle of 2005-08. Further the figures of ICICI and others look rosy because you have done the calculations when the SENSEX has probably crossed 25K!!!! Imagine the results of this study had you done it in 2010 or 11 or 12!!!! Statistics show that Lum-sum investment was better than SIPs during this period. And all the AMCs sing the SIP songs with the same lyrics even today. The real problem is that none of the AMCs have ever thought of the benefit of investors else they would have designed a system of accountability to investors. Today none of them stick to the mandates of fund management given in the SID.

    Reply
  13. Chandru

    Hi Pattu,
    This is a very informative article. Thank you very much. When it comes to bulk investments, what is your opinion on choosing the fund based on the Market PE, fear greed index and the beta?

    As you have clearly shown, those with low CAGR are the high beta funds. But if they are entered closer to the panic bottom, their returns are higher compared to their more stable counterparts. Potential risk of a further dip in the market and capital erosion exists. However, if one is careful, the returns are handsome.
    For example, I made some investments in UTI MNC fund at the time of panic. The fund had not lost much till then, so I entered but when the market picked up, returns were lesser compared to other large cap funds.
    On the contrary, I entered ICICI Pru Value Discovery when the Sensex PE was about 17 and when it was close to 15 in August 2013, I entered DSPBR Microcap which has given spectacular returns.

    So, is it prudent to progressively change to higher beta funds as the market keeps dipping for fresh lump sum investments?

    Reply
    1. pattu

      Sorry for the late response. This sounds too complicated to me. It is very difficult to pull this off in real-time. Some strategic play is important but we cannot put too much importance to it. Yes in the case of bulk investments, PE and other factors could help but sometimes one tends to wait for many months for the index to fall. Averaging by investing via manual STP sounds like a better option to me.

      Reply
  14. Chandru

    Hi Pattu,
    This is a very informative article. Thank you very much. When it comes to bulk investments, what is your opinion on choosing the fund based on the Market PE, fear greed index and the beta?

    As you have clearly shown, those with low CAGR are the high beta funds. But if they are entered closer to the panic bottom, their returns are higher compared to their more stable counterparts. Potential risk of a further dip in the market and capital erosion exists. However, if one is careful, the returns are handsome.
    For example, I made some investments in UTI MNC fund at the time of panic. The fund had not lost much till then, so I entered but when the market picked up, returns were lesser compared to other large cap funds.
    On the contrary, I entered ICICI Pru Value Discovery when the Sensex PE was about 17 and when it was close to 15 in August 2013, I entered DSPBR Microcap which has given spectacular returns.

    So, is it prudent to progressively change to higher beta funds as the market keeps dipping for fresh lump sum investments?

    Reply
    1. pattu

      Sorry for the late response. This sounds too complicated to me. It is very difficult to pull this off in real-time. Some strategic play is important but we cannot put too much importance to it. Yes in the case of bulk investments, PE and other factors could help but sometimes one tends to wait for many months for the index to fall. Averaging by investing via manual STP sounds like a better option to me.

      Reply
  15. Rajat Chennai

    Hi,

    I was planning to start my SIPS with below 3 SIP's. Let me know how is it?

    BNP Paribas Equity Fund Growth - Direct - Rs 3000 (Large Cap)
    Franklin India Smaller Companies Fund Growth - Direct - Rs 3000 (Small Cap)
    Axis Long Term Equity Fund Growth - Rs 3000 (ELSS)

    How are the above funds?
    Do you suggest any changes then - which 3 SIP's for large cap, small cap and elss funds?

    Reply
  16. Rajat Chennai

    Hi,

    I was planning to start my SIPS with below 3 SIP's. Let me know how is it?

    BNP Paribas Equity Fund Growth - Direct - Rs 3000 (Large Cap)
    Franklin India Smaller Companies Fund Growth - Direct - Rs 3000 (Small Cap)
    Axis Long Term Equity Fund Growth - Rs 3000 (ELSS)

    How are the above funds?
    Do you suggest any changes then - which 3 SIP's for large cap, small cap and elss funds?

    Reply

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