How to select an equity mutual fund – Creating a shortlist

Any selection process should have three components: (a) an objective; (b) a method to create a shortlist and (c) a method to finalize with the shortlist.

Yesterday we discussed the objective. Today we shall consider how to create a shortlist from which an equity mutual fund can be selected.

If you have not read yesterday's post, I strongly urge you to do so before reading this any further:

How to select an equity mutual fund -preamble

Creating a shortlist

Note:  The description of the shortlist may appear long. In practice, you should be able to create one in under 150 minutes on your first attempt and in under 10 minutes later.  So please hang on.

Creating a shortlist is as important as it is difficult. The criterion used to create one is arbitrarily chosen and is based on personal comfort. It can neither be too broad (meaning too many funds to analyze deeper), nor too narrow (if only a few funds satisfy us, then they are likely to fall out of favor soon). F0r example, the rating of a five-star fund can only go down!

We need to cast a reasonably broad net to create the shortlist.  Peer comparison is a necessary evil to create the shortlist. I prefer to abandon all peer comparison once the shortlist is prepared.

The primary reason for that is simple: before selecting a fund, we are analysts. After selection,  we are investors. Analyst and investors will have very different numbers (returns/risk metrics) to stare at when the asset class is volatile.

Once I invest, I take decisions based on the health of my portfolio tagged to a specific goal. Many make the mistake of worrying about peer comparison, view their holdings like analysts instead of viewing it as investors.

I will discuss two methods of creating this shortlist: with value research online and with Morning Star. It is easy to extend this method to other portals.

Shortlisting with Value Research Online

This is the method discussed in the previous version: Step-by-Step Guide to Selecting a Mutual Fund

Since the time it was written, VR online made a crucial change: It removed the "last seven years trailing return" entry from the category listing.

Trailing return simply refers to the CAGR for the last 1/3/5/7/10  (etc.) years at any given point in time. If I am not wrong, VR updates this each month.

Removal of the 7Y return has made the shortlist a bit longer.

Let us know go through this process, step by step. Click on the images to enlarge them if you wish.

1) Go to https://www.valueresearchonline.com/

Skip the annoying ad, go to the main page and scroll down until you see 'research tools'.

We will be working with the 'Fund selector'

fund-selection-guide-1

2) Leave the fund house  entry alone.

In the fund category entry (left image bel0w), uncheck whatever is checked and check "Equity: large cap" (we assume that is the category we are looking to invest in. The process for other equity categories is the same).

In the exclude entry (right image below),

a) check plans suspended for sales

b) check direct plans (adding them will only clutter the process. The folios and relative performance for regular and direct funds is the same).

c) check closed-ended

Scroll down and uncheck 3 star, 2 star, 1 star and unrated (optional).

fund-selection-guide-2

When ready, click "Get Data".

3) You will be taken to this sheet. Click on returns.

fund-selection-guide-3

4) You will then be taken here.

fund-selection-guide-4

We will now discuss two methods of shortlisting consistent performers.

A) Anchor the search with 5-year returns. Click on 5-years returns (red box above) once or twice until the fund are arranged in ascending order.  Then you need to decide the cut-off rank.  Suppose we select funds which were ranked in the top 25 over last 3 years, 5 years and 10 years, we will get something like this (partial list).

fund-selection-guide-5

 

Invariably we have shortlisted many (not all) 5-star or 4-star funds which are less than 10 years old.   If you are fine with this, then you can proceed.

By removing the 7-year entry, VR forces us to rely on its star rating more. Who are they to tell us (at least me) that it is enough to review only 5-year and 3-year histories?

I prefer a fund which has consistently been in the top 25 for 3, 5 and 10-year periods. So I would like to click on the 10-year returns until they are arranged in ascending order and then create the short list.

Top 25 might sound too broad.  Narrower the net, higher the expectation and sooner the fund is likely to disappoint.

As far as I am concerned, I will not repeat this exercise unless the selected fund is a laggard in my folio after giving it at least 3 years to perform. Laggards are not identified by peer comparison (drop in star rating etc.) but with respect to net XIRR of the equity portfolio. See more here: How to review a mutual fund portfolio

B) Anchor the search with 10-year returns. Click on 10-years returns once or twice until the fund are arranged in ascending order.  Then you need to decide the cut-off rank.  Suppose we select funds which were ranked in the top 25 over last 3 years, 5 years and 10 years, we will get something like this (partial list). Funds marked in red have done well in the past but not in the recent future  relatively.

fund-selection-guide-6

 

We now have more 10-year old funds and the dependence on star rating is lower. The shortlist also is a bit smaller.

I am more comfortable with this. Now that we have a shortlist, we are ready to analyze further. Before that AMC bias may shorten the list further (we are humans, not machines).

I may prefer a Franklin, HDFC or ICCI over Kotak, Tata or DWS. I may already have an account in one of the amcs!

Had we shortlisted only 4 and 5-star funds, we will end up with 19 funds. This way (with 5-year or 10-year anchoring) we only have 9-10 to choose from.

We will take up further analysis in the next post on this series. I would now like to discuss a faster way to shortlist with Morning Star.

Shortlisting with Morning Star Screener

Morning Star India has a nice screener which can automate the above shortlisting and reduce it down to minutes.

However, it has only large cap and mid/small cap categories. Unlike Value Research which distinguishes among large cap, large and mid-cap, mid and small-cap and multi-cap.

This can present a considerable problem unless we look at the folio carefully.  When I tried out a large cap short-list I end up with many large and mid-cap funds.  If you can handle this, this is a smart way to create a shortlist.

1) Go to

http://www.morningstar.in/tools/mutual-fund-screener.aspx

First make the following choices. The total results  will vary according to the choices. If it is zero, it means you will have to change the choices.

fund-selection-guide-7

 

Inc stands for dividend option and Acc stands for growth.

Scroll down  to further make the following choices

fund-selection-guide-8

 

 

First choose 3-year, 5-year and 10-year returns above the category average.

As you set the option for each year, have an eye on the total results at the top. It should not become zero.  If it does, you will have to change or relax your options.

With the above choices, 15 funds to choose from.

Play around with the morning star risk rating  ( low, below average, average, above average, high) and

3-year standard deviation to see if you can reduce the shortlist.

Low --> 0 results

  • Avg (below average) --> 3 results

Avg --> 6 results

-Avg and Avg --9 results  (I like this)

You can choose what you like.

Further modifications can be done with the so-called Morning Star Syle Box.

For large cap funds choose:

Large and Growth (stocks with substantial earning, high PE, high PB)

fund-selection-guide-9

 

A good 14 out of the 15 shortlisted funds belong to this category. One to large and a blend of value (underpriced stocks with low PE and low PB) and growth.

If you don't understand this, you can ignore the style box for a start or read more about the difference between growth and value stocks or about the morning star style box.

Don't worry about AUM of a large cap fund. For a mid and small cap fund, it is not a terrible idea to choose the fund with smallest  AUM after further analysis.

Mid and small cap funds with large AUM (say more than 5000 Crores) tend to have more large cap stocks for liquidity.

Reducing the expense ratio even by one step makes the total results count go to zero!

Finally, hit search  to get this  shortlist.

fund-selection-guide-10

 

Do not jump to conclusions that the shortlist has only 4/5-star funds and that could have been the lone criterion.

If you tried that you will have 43 funds to contend with instead of just 14.

Out of this 14, you will need to weed out the large and mid-cap funds in consultation with Value Research if you are not looking for one!

We are now ready to analyze further.  This is equally simple. I will take that up in a different post.

Was this not easy? Anybody with a little common sense can do this.

DIY and go direct. Do not trust anyone who says that mutual fund selection is hard.  They say so because they have a  business to run.

DIY implies doing everything yourself. Not making a shortlisting and asking others. If you don't have confidence (time is not the issue), get yourself a fee-only financial planner who will suggest direct mutual fund plans.

What do you think? If you liked the post, do share it with the buttons below.

Part 3: How to select an equity mutual fund – Making a Choice!

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57 thoughts on “How to select an equity mutual fund – Creating a shortlist

  1. Supreeth

    Wow! Too good. One of the best MF selection article I have read till date. Pattu Sir, you are doing a really good job by encouraging young investors like us to start planning for their future. Wish you a really long and healthy life ahead.

    Reply
  2. Supreeth

    Wow! Too good. One of the best MF selection article I have read till date. Pattu Sir, you are doing a really good job by encouraging young investors like us to start planning for their future. Wish you a really long and healthy life ahead.

    Reply
  3. Nithin

    Only Kotak 50 in this morning star list is a pure large cap. Rest all are Large & Mid cap. The problem with shortlisting with morning star is that the filter treats Large & Mid cap as a subset of large cap. The universe of Large and Mid cap has grown a lot of late.

    Reply
  4. Nithin

    Only Kotak 50 in this morning star list is a pure large cap. Rest all are Large & Mid cap. The problem with shortlisting with morning star is that the filter treats Large & Mid cap as a subset of large cap. The universe of Large and Mid cap has grown a lot of late.

    Reply
  5. Nithin

    This method is excellent for a first degree level of shortlisting. Though not free from some pitfalls which are mentioned below : I will take example of three funds.

    1. Selecting 10 Year category average filter for shortlisting makes you miss out 2 great large cap funds.
    a). ICICI Pru Focused Blue chip : This is filtered out because it is just 7Y old. But 7Y track record is excellent. So one can keep just 5Y and 3Y filters enabled just to ensure gems like these aren't missed. At a later stage if you find an older fund that has better performance than this fund, you can consider the latter.

    b) UTI equity fund : The irony here is greater ! This fund was launched in 1992. More than 2 decades old. It was renamed later in 2005 from UTI Mastergain to UTI Equity Fund. Because of this the new named fund does not make it to the shortlist since it is just 1 month short of 10Y, considering it was renamed on July 1, 2005.

    2. Under Fund style box, it is better if Large growth is selected along with Large blend. This prevents funds which are on border line between large growth & blend from being missed out. eg. ICICI Prudential Top 100 Fund is a pure large cap which will come through if above is obeyed.

    Point is that it is OK to let some more funds in the shortlist (which can be rejected later after further analysis) instead of unknowingly rejecting good funds right at the start.

    Thanks.

    Reply
    1. freefincal

      Like I said, those who know more about some of these funds can adjust accordingly. This is for those who don't. Whatever criterion you choose, there will always be near misses.

      Reply
  6. Nithin

    This method is excellent for a first degree level of shortlisting. Though not free from some pitfalls which are mentioned below : I will take example of three funds.

    1. Selecting 10 Year category average filter for shortlisting makes you miss out 2 great large cap funds.
    a). ICICI Pru Focused Blue chip : This is filtered out because it is just 7Y old. But 7Y track record is excellent. So one can keep just 5Y and 3Y filters enabled just to ensure gems like these aren't missed. At a later stage if you find an older fund that has better performance than this fund, you can consider the latter.

    b) UTI equity fund : The irony here is greater ! This fund was launched in 1992. More than 2 decades old. It was renamed later in 2005 from UTI Mastergain to UTI Equity Fund. Because of this the new named fund does not make it to the shortlist since it is just 1 month short of 10Y, considering it was renamed on July 1, 2005.

    2. Under Fund style box, it is better if Large growth is selected along with Large blend. This prevents funds which are on border line between large growth & blend from being missed out. eg. ICICI Prudential Top 100 Fund is a pure large cap which will come through if above is obeyed.

    Point is that it is OK to let some more funds in the shortlist (which can be rejected later after further analysis) instead of unknowingly rejecting good funds right at the start.

    Thanks.

    Reply
    1. freefincal

      Like I said, those who know more about some of these funds can adjust accordingly. This is for those who don't. Whatever criterion you choose, there will always be near misses.

      Reply
  7. வெற்றி வேல்

    Thanks for the nice DIY methodology. The none of the funds that got shortlisted are part of the Morningstar's GOLD analyst rating. Are these vastly different because of the filters each of them use? Is my understanding as a layman correct?

    List as per the shortlist:

    BNP Paribas Equity Fund Growth
    Franklin India Prima Plus Fund Growth
    Kotak 50 Growth
    L&T Equity Fund Growth
    DSP BlackRock Opportunities Fund Growth
    Tata Equity Opportunities Fund Growth
    Tata Pure Equity Fund Growth
    Birla Sun Life Frontline Equity Fund Growth
    Canara Robeco Equity Diversified Growth
    SBI Magnum Equity Fund Growth
    HSBC India Opportunities Fund - Growth

    ANALYST RATING-GOLD MS:

    HDFC Top 200 Fund Growth
    HDFC Equity Fund Growth
    Franklin India Bluechip Fund Growth
    Franklin India Prima Plus Fund Growth
    DSP BlackRock Top 100 Equity Fund Growth

    Reply
  8. வெற்றி வேல்

    Thanks for the nice DIY methodology. The none of the funds that got shortlisted are part of the Morningstar's GOLD analyst rating. Are these vastly different because of the filters each of them use? Is my understanding as a layman correct?

    List as per the shortlist:

    BNP Paribas Equity Fund Growth
    Franklin India Prima Plus Fund Growth
    Kotak 50 Growth
    L&T Equity Fund Growth
    DSP BlackRock Opportunities Fund Growth
    Tata Equity Opportunities Fund Growth
    Tata Pure Equity Fund Growth
    Birla Sun Life Frontline Equity Fund Growth
    Canara Robeco Equity Diversified Growth
    SBI Magnum Equity Fund Growth
    HSBC India Opportunities Fund - Growth

    ANALYST RATING-GOLD MS:

    HDFC Top 200 Fund Growth
    HDFC Equity Fund Growth
    Franklin India Bluechip Fund Growth
    Franklin India Prima Plus Fund Growth
    DSP BlackRock Top 100 Equity Fund Growth

    Reply
  9. Anish Mohan

    Pattu-sir, another work of fine art and precision technique. I have been visiting VR for almost 10 years and never been able to spot such hidden gems of information stored in it. As usual, you are great ! and your mind+brain is amazing !

    Reply
  10. Anish Mohan

    Pattu-sir, another work of fine art and precision technique. I have been visiting VR for almost 10 years and never been able to spot such hidden gems of information stored in it. As usual, you are great ! and your mind+brain is amazing !

    Reply
  11. sangeeta

    Hi Sir,
    I am a regular visitor of your articles. started understanding mutual funds and the behavior with your help.
    Sir I have never invested in stocks/MF's so eager to understand them well even before I step in.
    as I was going though your step by step mutual fund shortlisting process which I could do with VR but was unable to do the same with morningstar. when I first select Acc and then India open end funds it shows zero results and shows me a many more options to choose from like exchange, fund group etc. Not sure why so feeling absurd and lost.
    Am I missing anything?
    your help would be highly appreciable.
    Thanks,
    Sangeeta

    Reply
  12. sangeeta

    Hi Sir,
    I am a regular visitor of your articles. started understanding mutual funds and the behavior with your help.
    Sir I have never invested in stocks/MF's so eager to understand them well even before I step in.
    as I was going though your step by step mutual fund shortlisting process which I could do with VR but was unable to do the same with morningstar. when I first select Acc and then India open end funds it shows zero results and shows me a many more options to choose from like exchange, fund group etc. Not sure why so feeling absurd and lost.
    Am I missing anything?
    your help would be highly appreciable.
    Thanks,
    Sangeeta

    Reply
  13. Deepak Patwardhan

    Wouldn't this data skewed by amazing returns of last 18months. Is there a way the last 5yrs, last 10yrs data is referenced by 18months older data ? Like select a window with end date of Nov 2013 etc

    Reply
  14. Deepak Patwardhan

    Wouldn't this data skewed by amazing returns of last 18months. Is there a way the last 5yrs, last 10yrs data is referenced by 18months older data ? Like select a window with end date of Nov 2013 etc

    Reply
  15. Raghavendra Kalmadi

    Thank you for sharing the process for systematically selecting the MFs. This is really useful and can be used by all.

    Reply
  16. Raghavendra Kalmadi

    Thank you for sharing the process for systematically selecting the MFs. This is really useful and can be used by all.

    Reply
  17. Debojyoti Das

    Thanks Pattu for including another Screener tool in order to avoid bias. I am hoping the upcoming post will have more insight on the different parameters needs to be kept in mind before finalizing on the actual fund from the set of 10-15 funds. Appreciate your style of expressing the things so simply.

    Reply
  18. Debojyoti Das

    Thanks Pattu for including another Screener tool in order to avoid bias. I am hoping the upcoming post will have more insight on the different parameters needs to be kept in mind before finalizing on the actual fund from the set of 10-15 funds. Appreciate your style of expressing the things so simply.

    Reply
  19. Aditya Bhargava

    Awesome information pattu sir one more thing do morningstar provide you the ranking as well ??beacuse VR do provide the ranking.Also, is it necessary to check on style box for selection if i have already selected the fund type

    Reply
  20. Aditya Bhargava

    Awesome information pattu sir one more thing do morningstar provide you the ranking as well ??beacuse VR do provide the ranking.Also, is it necessary to check on style box for selection if i have already selected the fund type

    Reply
  21. Ravi Kiran

    Dear Sir,
    Those who follow the Sentences given by you to analyse and select a fund will get the clear picture of chosing an MF for better returns. Excellent Articles. I have been reading them for the past week. Though I have been investing since a long time, the articles n calculators are useful to find the pitfalls in my investments and to recheck. Thanks a lot......

    Reply
  22. Ravi Kiran

    Dear Sir,
    Those who follow the Sentences given by you to analyse and select a fund will get the clear picture of chosing an MF for better returns. Excellent Articles. I have been reading them for the past week. Though I have been investing since a long time, the articles n calculators are useful to find the pitfalls in my investments and to recheck. Thanks a lot......

    Reply
  23. Amri Krish

    Dear Sir,
    Those who follow the Sentences given by you to analyse and select a fund will get the clear picture of chosing an MF for better returns. Excellent Articles. I have been reading them for the past week. Though I have been investing since a long time, the articles n calculators are useful to find the pitfalls in my investments and to recheck. Thanks a lot……

    Reply
  24. Amri Krish

    Dear Sir,
    Those who follow the Sentences given by you to analyse and select a fund will get the clear picture of chosing an MF for better returns. Excellent Articles. I have been reading them for the past week. Though I have been investing since a long time, the articles n calculators are useful to find the pitfalls in my investments and to recheck. Thanks a lot……

    Reply
  25. KARTHIK BHARATHI

    Thanks a lot Sir, before this analysis I have started investing in UTI Equity (G), Franklin India Bluechip (G), and TATA balanced fund in SIP for a duration of 3 years, through SBI demat. Are these funds ok , also is there any hidden charges if I invest through a DEMAT acc. What should be the minimum investment period for a large cap &Small & mid cap fund respcectively. Thanks in advance Sir.

    Reply
  26. Dinesh Shrivas

    Thank you sir!!
    Please confirm if my understanding is correct:
    1. If I am pick any fund from 'All Equity Funds' from value research and invest in it for more than one year, then all the gains will be tax free after 1 year of holding.
    2. These equity funds can't be claimed under 80c, to claim under 80c i have to choose any ELSS fund.

    Waiting for your response. Thank you!

    Reply

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