I have already written an article about which mutual fund category to choose, I would recommend you to stick to those categories. But, the question of how to select a fund from a category still remains, so let’s address it.
Choose a Category
Whether you are looking for a fund for your equity portfolio or your debt portfolio, the process of choosing a category should be the first step. The main principle I adhere to while selecting a mutual fund category is to choose a fund category that matches my risk appetite. The categories that I have recommended might appear too conservative to you, but you should not fall for marketing gimmicks and stay away from categories like small-cap, credit risk, etc. You can read the following three articles to have a clearer picture.
- Categories of mutual funds. An article I have written, it is sort of a glossary of all 36 mutual fund categories. The details given in this article are too little to make a decision, but it will introduce you to all the categories.
- Mutual fund categories you should avoid. A brilliant article written by S. R. Srinivasan sir on freefincal.
- Which category of mutual fund to choose. My personal recommendation of categories you should choose.
Once you have finalized the category we can move on to fund selection.
Fund Selection for Equity Portfolio
There are two types of funds for equity portfolio, passive funds (this include the equity index funds like NIFTY/SENSEX funds) and active funds (this includes all the equity funds and hybrid funds which invest mostly in equity). The process of selecting a passive fund and an active fund will be discussed separately.
The biggest advantage of investing in an equity index fund is, there is no expensive fund manager who takes extra risk in the quest of generating extra returns for investors. This is the biggest disadvantage too. It is up to you if you believe that a fund manager can deliver better results and are ready to bear extra expenses and risk for it. Just remember various study shows that most of the active funds fail to deliver better returns than the benchmark.
If like me you have decided to go with equity index fund the fund selection is quite easy for you. So let’s start
- STEP 1: Make a list of 10 funds with the largest AUM.
WHY? This not for the purpose of selecting the funds with big AUM, rather avoid funds with small AUM. Because any big inflow/outflow in funds with small AUM can cause their NAV to move significantly. This should be avoided.
- STEP 2: Choose 5 funds with the smallest expense ratio from the list of 10 funds you get in STEP 1.
WHY? Remember the expensive fund manager, this is to ensure that we choose a fund which is amongst the least expensive. Also, a small expense ratio ensures that fund follows the index even closely, i.e. low tracking error, expense ratio doesn’t guarantee it but surely is a major factor.
- STEP 3: From the list of 5 funds you get from STEP 2, choose the fund with the smallest tracking error.
WHY? The index fund is expected to follow the index as closely as possible, tracking error represents how closely the fund is doing so. But, tracking error depends a lot on the period for which it is being calculated, and the benchmark being used for the calculation, that’s why it can not be the sole parameter for selecting an index fund.
Index funds are really simple to choose from, that’s one of the things I like about them.
Now, for those who want to go for an active fund. What does somebody expects from an active fund, or should expect?
- A return that is better than the benchmark. Let us not kid ourselves, we are bearing extra expenses of a fund manager, what good is it if we can’t get a better return than the benchmark.
- This extra return should be generated by taking the lowest possible risk.
You can expect a mutual fund to make you rich like Warren Buffett but as far as realistic expectations go I think these two sums it up. If we could assign a mathematical value to these expectations and choose a fund according to those our aim would be achieved.
As far as better returns than benchmark are considered, we can use alpha. Alpha is the measure of how much the fund has outperformed its benchmark, higher alpha means higher than benchmark returns.
Now for determining the risk associated with the fund we can use either standard deviation or beta. SD tells us how much the funds deviate from its average returns, while beta tells us how much the fund deviates from the benchmark. I prefer beta because it neglects the volatility of a fund caused by the overall volatility of the market. It is very hard for a fund to keep volatility down when the market is experiencing unusual volatility. Lower beta means lower volatility.
So we need to keep alpha as high as possible and beta as low as possible. Now let’s look at the actual steps.
- STEP 1: Make a list of 10 funds that have given good 3 years, 5 years, and 10 years returns. You can choose funds based on how they rank for 3Y, 5Y and 10Y return, choose funds which have been at least among the top 15 in all 3 categories. If you have too few funds or too many funds you can broaden the criteria like amongst the top 20 for all three periods, or you narrow down the criteria. Just shortlist around 10 funds
WHY? Because you are going after active funds for better returns, if not than you should go for passive funds, they are less expensive.
- STEP 2: Choose 5 funds with the lowest beta from the list of 10 funds you got in STEP 1.
WHY? Better returns are good but these should not be generated by taking an unnecessary risk, so we keep beta as low as possible
- STEP 3: Choose a fund that has the highest alpha amongst the 5 funds you selected in STEP 2
WHY? If you have no desire for returns that are better than the benchmark/index go with passive funds. Alpha measures how better are the returns of the fund in comparison to the benchmark
And, you are done you have chosen an active fund for your equity portfolio.
Fund Selection for Debt Portfolio
One thing you should always remember when choosing a debt portfolio, credit risk and interest rate risk are not mutually exclusive, i.e. they do not work separately debt mutual funds have both and you should keep them as low as possible. As you might remember I said the first step is to finalize a category, this is also true for a debt fund. But, in case of debt fund there are a few things that confuse a beginner, let’s have a look at them first.
- Gilt Funds: They have the least credit risk as they invest only in government securities. But, the interest rate risk affects them the most. SEBI has only mandated two categories for them, one with no restriction on maturity duration and one with only long-duration bonds. This has made the funds of this category highly volatile and thus I recommend you stay away from them. And, if you want to go for them only do so for the long term.
- Categories based on portfolio duration: There are a few categories that have a restriction on the Macaulay duration of their portfolio. That means these funds can even invest in long-duration bonds until they maintain the portfolio Macaulay duration.
- Interest rate risk: Average maturity and modified duration should be used to measure the interest rate risk of the funds and not portfolio durations.
- Credit risk: Average credit rating can be used to judge the credit risk of a fund.
- When selecting a liquid fund, do check the percentage of cash the fund hold, a fund that mostly holds cash can be avoided.
The simplest way can be to select a liquid fund and if your goal is long term and you can take more risk you can go for money market funds.
After you have decided on the category let’s move on to selecting a fund.
- STEP 1: Shortlist the funds whose average maturity is less than 1/5 of the term of your goal. For example, if you have a 10-year goal choose only those funds whose average maturity is less than 2 years. If your selected category has no fund satisfying these criteria, change your category.
WHY? Longer the average maturity more is the time required for the fund to recover from downfalls in NAV due to interest rate change. So it is desirable to keep the average maturity as low as possible.
- STEP 2: From these shortlisted funds select the 4 to 5 funds having the lowest modified duration, and best average credit rating.
WHY? Modified duration is a good measurement of how much an interest rate change will affect the NAV of the fund. The average credit rating tells us about the credit risk of the fund. You have to take both into consideration.
- STEP 3: Out of 4 to 5 funds you selected in STEP 2, choose one with better returns in the last 3 years, 5 years, and 10 years.
Who Should Not Follow This Method?
I am not going to lie to you, this is not a very brilliant method, and this stand on the principle that things you do before fund selection are more important than selecting the fund. This principle can be proven and you should consider this as a hard fact. So if you satisfy the following condition this method will not work.
- If you think selecting the best fund and pumping a lot of money into it is a strategy, this method is not for you.
- If you have no target amount and/or time period, this method is not for you.
- If you haven’t decided an asset allocation suiting your need, or your asset allocation is 100% equity, this method is not for you.
- You will not get your dream 18% returns from equity, the matter of fact is higher you go from 10% for equity the more unrealistic your plan becomes. If you expect unrealistic returns, this method is not for you.
- If you treat debt mutual funds just like equity mutual funds and have high return expectations from debt mutual funds too, this method is not for you.