How do I know if a mutual fund has beat its benchmark consistently?

Published: January 28, 2017 at 11:10 am

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Each week I try to answer generic reader questions on money management.  Here is this weeks edition.

Hi Sir, I follow your blog regularly – you helped in a great deal choosing the right funds as per goals. Now, my question is – when is a good time for a retail investor to consider portfolio management scheme(PMS) and what are some of the good PMS providers in India? What should be my selection criteria in selecting the correct PMS? Thank you.

Thank you. Mutual funds are way more convenient and tax efficient (stock buy and sells would results in short term and long term capital gains) than a PMS for everyone – retail or high net worth investor. So I would suggest that you do not consider a PMS. Keep it simple.

“If you must go by stars, choose a 3-star fund that has consistently beat the benchmark consistently over 3Y and more.” Can you please elaborate this? What benchmark the fund should be compared against? How can I know if it has beaten the benchmark consistently? – Sachin.

I keep saying this about 3-star funds just to highlight the fact a 3-star fund investor is likely to be calmer than a 5-star fund investor. If you were to track star rating history, you will notice (VR pointed this out) that very few funds stay in 4-,5-star range all their life.

Most 5-star funds are a flash in the pan. So the outstanding performance is typically temporary. If I choose a fund by its stars, I am likely to be disappointed if it falls in rating. Therefore, I would prefer not to look at stars at all.

What benchmark to use? The total returns index (TRI) of the benchmark that the fund uses. The TRI assumes dividends are reinvested and this is harder to beat than just the price index.

How to evaluate performance consistency? Use a rolling returns calculator. Here the duration over which the return is computed is “rolled over” to the next business day.

For example, suppose we wish to analyse the fund from Jan 2006, we calculate the return over 3 years (say) between

Jan 1st 2006 to Dec 31st 2008 and then between

Jan 2nd 2006 to Jan 1st 2009 and then between

Jan 3rd 2006 to Jan 2nd 2009 and so on. That is over every possible 5 year period. Then we repeat this for the benchmark and get a graph like this:

Notice that it immediately tells you that the fund has been consistent in beating the benchmark.

Whether it is a 1-star fund or 5-star fund, as long as it is consistent this way, I will be happy to invest in it.

Readers have two options:

Use this for individual funds and their specific benchmarks: Mutual Fund SIP and Lump Sum Rolling Returns Calculators

Or, use the monthly outperformance screener: January 2017: Equity Mutual Fund Outperformance Screener

What is your opinion on the FundsIndia Super Savings Account which invests your idle cash in Reliance Money Manager liquid fund? – Mahesh

As long as the short term, medium term and long term financial goals are accounted for, the rest of the available must be idle! It can be in a savings bank account or a liquid fund. It does not matter where. If you wish to use the above-mentioned reliance fund, get an account with them and invest directly.

Post my financial audit on Jan 2017, I find that my retirement portfolio has reached the ratio of 50:50 w.r.t equity:debt. My equity return assumption is 12% and Debt 8% and hence my portfolio return expectation is 10%. Retirement is 20+ years away. Though I can take this to 60:40, but it will not bring a significant increase in return expectation. (With 60:40 and 12% vs 8%, return expectation is only 10.40% as opposed to 10% flat for 50:50). I want to stick to 50:50. Till now, I invested only in equity for which I am now at 50:50. Therefore, now on, I would require to invest in Debt MF as well, in addition to EPF, for keeping equity debt ratio at 50:50 levels. For retirement purposes and long term debt investment, what can be the right category of Debt mutual funds ? Till now, the UST category has returned same as other Debt fund categories over a long period of time. But is there any merit to invest in Dynamic Bond or Income funds when the goal is more than 15 years away. How rewarding or punishing can be if someone embraces volatility in debt funds ? Or should I stick to plain vanilla liquid or UST ? – Anish.

The answer is quite contextual. For you, I would say, if it will not clutter your portfolio, you can have some corporate bond or income fund exposure. However, is it really necessary when you can add more into EPF? You still get solid returns there, with same liquidity.

Should the investment in equity arbitrage fund be considered as equity investment? – Abhay

We should consider it as a debt instrument because of its risk profile. The taxman treats it as equity wrt taxation.

I am investor in mutual funds. I started late my asset allocation is equity 30% and debt 70%. I want to increase this to 50-50. Currently investing via SIP 20000 pm for 3 years in each of mirae asset emerging bluechip, franklin india smaller companies and franklin india prima fund. All direct. I will not require this money for 10 years as this is for my retirement. I will retire after 3 years so can invest in this period only. I have income from other sources to take care of retirement expenses initially. But I have option to invest additional amounts in these schemes as I have extra money now in my savings account (INR 1,000,000). What should be criteria for additional investments? Should I see PE of each of these funds or is there some better way? Basically my question is, if someone has additional amount for investing then what should be the criteria? Sandeep Gupta

The PE of a mutual fund has not much relevance to the investor. At best it can provide a subjective insight into the fund managers strategy. You can continue to invest systematically. I would suggest a rethink into your equity allocation. You cannot make up for lost time by having 50% equity for 7 years into retirement. That is quite dangerous.

Suggest that you plan your retirement expenses with this one of these tools:

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I own a small business. My cash flow is erratic so i can’t commit to a fixed SIP schedule. For last few months, I am investing in ICICI Pru, Axis Long Term and HDFC Mid cap every month randomly. Do mutual funds have P/E ratios? Before investing, should i look at current P/E value for that fund? If Yes, where can i find current/ most recent P/E value for a mutual fund .. and what is the good enough p/e range to invest. – Santosh

Yes, mutual funds have PE ratios, but as mentioned above, they are of little use. You can check Value Research or Morning Star for the PE. Most mutual funds change their portfolios frequently. So, there is no value in looking at a funds portfolio PE. Simply invest when you can. No big deal.

There are 7 more questions to discuss. Will do that tomorrow.

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5 Comments

  1. Tax standpoint is wrong for first question. There is no long term capital gain for equities. If there will long term capital gain for direct equities, then there is long term capital gain for equity based mutual fund also.

  2. Nope! Arbitrage investments are not equity investments. They invest in price differentials and not directly in the asset. The fin min can make that alone taxed as debt anytime they want.

  3. Thank you Mr. Pattu for answering my question. I have read somewhere that people in age from 50-60 years can have equty:debt ratio of 50-50. I will retire at 55 years.

    In fact I have read in valueresearchonine.com that retirees should also invest in equity after taking care of 5 years of monthly expenses, emergencies and must do responsible tasks. Remaining they advise to invest in balanced or hybrid funds via SIP only.
    From 6th year onwards one can start SWP from balanced funds as per monthly expenses. Or can sell equivalent of 1 year expenses.

    Your comments on this please.

  4. Since this maybe of interest to many, I will respond to this in tomorrows post, which is a continuation of the Q/A.

Comments are closed.