Selecting the right equity mutual fund scheme is not possible!

Mutual fund investing is not like investing in an insurance scheme or buying term life insurance or health insurance. You cannot choose a fund based on past performance and assume that all you need to do is to invest in it from time to time. As mentioned several times before, one should not get married to a SIP! Selecting a fund for SIP is not as important as understanding  how to review mutual Fund SIP performance.

Selecting the right equity mutual fund scheme is not possible! Simply because past performance is not an indicator of future performance - duh!

All we can do is to select a fund with a good track record (returns and downside protection is what I recommend), from a fund house you are comfortable with, and review performance from time to time.

Knowing how to review performance is far more important that choosing a fund based on past data. When you review performance, you are not reviewing the performance of the fund, but the performance of your investment, from the day you started investing.  This will make all the difference when it comes to equity mutual fund schemes.

I write this post because an amusing poll conducted by Moneylife foundation caught my eye on twitter.

Title: "Survey: Selecting the right equity
mutual fund scheme"

Preamble:

Many invest in equity mutual fund schemes to generate wealth over the long term. However, there is a huge difference in the performance of the best and the worst equity schemes. This makes selecting the right mutual fund scheme crucial. Before investing in an equity scheme, you may consider multiple factors such as performance, costs, portfolio composition etc. Moneylife Foundation is conducting a short survey to understand which parameters do investors give the most weightage.

I am amused because of the claim, "However, there is a huge difference in the performance of the best and the worst equity schemes. This makes selecting the right mutual fund scheme crucial".

It is a fact that there is a difference between the worst and best schemes - huge for short durations, and not so huge over longer periods.

Moneylife gives the reader the impression that it is crucial to select the 'right fund'. Regardless of what their intention with the poll is, it is silly to project that kind of impression as there is no way of knowing future performance.

The difference in return between the best and worst fund can only be known in future and it is irrelevant to the investor!

In fact, this is a tactic employed by many 'advisors' to scare wannabe DIY investors - 'how will you know what to select, since there are so many schemes?'

New mutual fund investors must recognise that choosing a fund is a leap of faith. No amount of mathematcial sophistication employed in selecting a fund can make up for the fact that we are clueless about how markets will behave in future.

It is important to have a method while selecting a fund because it is important to have a method while reviewing it! The former aids the latter. I would even say, the former begets the latter.

However, while selecting a fund, many  head straight to - which fund to choose?! This is an incorrect approach.

The objective comes first - why am I investing?

Asset allocation comes second - what asset class am I going to use to diversify my portfolio and reduce risk. Read more: Deciding on asset allocation for a financial goal and Equity investing: How to define ‘long-term’ and ‘short-term’

Financial instruments in each asset class come third:  where am I going to invest - stocks, mutual funds, bonds, fixed deposits etc.

If mutual funds are preferred, what category to choose comes fourth - what kind of equity fund or debt fund am I going to choose from?

Once the above four steps are completed and only when they are completed, should we ask, 'which fund to choose from?' as the fifth step.

Regardless of the method used to select funds, it is important to monitor the performance periodically (for new investors, I recommend doing this after a few years only). But first, one should understand how to review fund performance. I have some example videos on this. It is crucial to evaluate the fund wrt its benchmark over the period in which you have invested.

There is no such thing as 'selecting the right equity mutual fund scheme' unless we get hold of a crystal ball or a Palantir (if you are a LOTR fan)!

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9 thoughts on “Selecting the right equity mutual fund scheme is not possible!

  1. Ravi S Pandey

    It is true that past performance is not a guarantee for future performance.However it is the best evaluating parameter to guess future performance.One should select mutual fund in a given category by evaluating its remote and recent performance and change it if immediate past performance relative to relevant index and peer group deteriorates

    Reply
  2. Sanjay S

    Dear Prof. Pattabiraman,

    The survey clearly states picking the 'right' equity scheme. No where does it mention 'best' equity scheme.

    Picking the best mutual fund scheme is impossible. Anyone who understands market-linked will know. But does that mean you will blindly go ahead and invest in any scheme, even if the scheme is infamous for its performance?

    So how do you pick the 'right' scheme? Like you have mentioned, "All we can do is to select a fund with a good track record (returns and downside protection is what I recommend), from a fund house you are comfortable with, and review performance from time to time"

    So the above is how YOU arrive at the 'right' scheme. Others will employ different methods. Such as fund manager performance, etc. I personally look at the weightage of stocks in the portfolio apart from other factors.

    I guess Moneylife Foundation is looking to understand what are the various parameters investors give the most importance too.

    Best,
    Sanjay

    Reply
    1. freefincal

      1) My problem with the preamble to the poll is stated clearly enough and I do not wish to repeat myself. You dont agree, you dont agree.
      2) I acknowledge there are different and better methods of choosing funds. I would not call MY process as the one to choose the 'right' fund. And I am inclined to believe that the same applies to the other methods.

      Reply
  3. Sanjay S

    Dear Sir,

    Maybe it is with the language. If they just wrote "How do you pick mutual fund schemes" you would have shared a different opinion or no opinion at all. I don't think the questions in the survey would have changed.

    The moment one goes through a selection process, their objective is to choose the 'best' or the 'right' scheme at that moment in time, with the hope that a scheme will do well in future as well. If it were all random, even you would not have a process. I mean why have a process if you don't believe in picking the right/best/good/top/ equity scheme. You should then randomly pick a scheme and 'review' its performance.

    If you were familiar with the returns of the best and worst schemes over the past 10 years you would be aware that the top 10-15 schemes delivered a return in excess of 14% while the bottom 10-15 schemes delivered a return under 8-9%. You will be aware of how compounding works, right? A few percentage point difference can mean a lot. You certainly don't want to end up at the bottom of the list. Nobody does.

    Reply
    1. freefincal

      Yes, and if the sun rose in the west, we would be calling it east. We can all talk about ifs and buts.

      Reply
  4. baljit

    sir,
    professors are looked up for answers and not for getting irriiii.......
    regards
    ps; may be , sometimes, there are no answers........
    in that situation , what a good professor does, ...... ,

    Reply
    1. freefincal

      1) I am not a professor of finance. Just an investor like anyone else
      2) I intend to bang the drums about inconvenient truths as often as I can.

      Reply
  5. Dinesh Singh

    The title of this post says it all, "Selecting the right equity mutual fund scheme is not possible!".

    You yourself have come up with a number of screeners and each one of them ends up with comments like "I may prefer a Franklin, HDFC or ICICI over Kotak, Tata or DWS" or "Notice that funds with above consistently average SIP returns have pretty good (low) downside capture ratios". Ultimately one sees only what one wants to see. There is nothing wrong with that because it is our money that is involved.

    I tried slight variations of your screeners such as selecting funds having returns in the top quartile (instead of above average, top 10 etc) or computing a weighted average of annual returns and found that there are certain funds which are always there irrespective of the screener used.

    Finally I tried the "Risk Stats" tab of VR Fund Selector and selected funds having "Low" or "Below Average" Risk and "Above average" Alpha and came up with the following alphabetical shortlist for Midcap funds:
    1. BNP Paribas Midcap
    2. Franklin India Prima
    3. HDFC Midcap Opportunities
    4. IDFC Premier Equity
    5. L&T India Value
    6. Mirae Asset Emerging Bluechip
    7. SBI Emerging Businesses
    8. SBI Magnum Global
    which is as good or bad as thrown up by any of the screeners.

    The point is if "Selecting the right equity mutual fund scheme is not possible!", then why not just make use of what is readily available rather than trying to devise a "right" screener.

    Nonetheless, I thoroughly enjoy your posts as they provide deep analysis and insight from a researcher's viewpoint rather than that of an average investment expert. I am sure you will continue to dissect the funds and enrich us with your thoughtful posts.

    Reply

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