Musings of a (Financially) Illiterate Father
Page 11
So as far as the methodology of awarding star ratings to a fund is concerned, it is based on the ‘risk-adjusted returns’ that the fund has given in the past 3, 5, and 10 year periods. As a result, “the previous two years’ performance alone accounts for 35 percent of the rating of a fund (with at least 10 years of history) and 66 percent for a fund (with three to five years of history), a heavy bias in favour of recent short-term returns77.”
Similarly, a fund with average return of 10 percent in last ten years but with standard deviation of 1 percent (meaning returns between 9 to 11 percent) will be rated higher than a fund with same returns but standard deviation of 2 percent (meaning returns between 8 percent to 12 percent.)78
The star ratings then follow a sliding scale as under79:-
• 5 stars Top 10 percent funds.
• 4 stars Next 22.5 percent funds.
• 3 stars Middle 35 percent.
• 2 stars Next 22.5 percent.
• 1 stars Bottom 10 percent.
The takeaway for a common investor from the star system and fund selection, in general, is that a 4 or 5-star fund is likely to give more steady returns in future as compared to a 1 or 2-star fund. However, having invested in a 4 or 5-star fund one should monitor its performance on a half-yearly basis. As per Dhirendra Kumar of Value Research, if a five-star fund slides to a 4 or 3-star rating after six months, it should trigger caution but no exit. However, if in the next half-yearly review the fund has slid to a 3 or 2 star, one should stop investment into this fund80.
SELECTING EQUITY MUTUAL FUNDS – II
MUSING 25: GO FOR THE LOWEST COST
We have already established that the star rating system is at best prognosticative—based on past performance and consistency of returns. There is another issue, however, which can be very accurately ascertained and factored in while choosing our fund—the cost of owning the mutual fund.
All the mutual funds are mandated to offer two kinds of plans, regular and direct. The costs charged by ‘regular plans’ of any mutual funds are higher than ‘direct plans’ which just means that the investments are not routed through a distributor. This significantly lowers the costs to the investor which could be as much as 1 percent.
To fathom how significant this 1 percent difference in cost could be, we will revisit Anshreya and HoneyCool. Anshreya invested ₹10,000 per month in an index mutual fund with an expense ratio of 0.2 percent. She started to invest at age 25 and continued till age 60 and in this duration, the fund returned 12 percent CAGR. This took her corpus to ₹6.1 crores. Had she instead invested in a direct plan of an equity mutual fund with an expense ratio of 1.5 percent, her corpus would have been only ₹4.3 crores.
HoneyCool also went in for the same equity fund but a “regular plan” with an expense ratio of 2.5 percent. His final portfolio value, with all other parameters remaining the same, would be barely ₹3.3 crores. The above example once again shows the rupee-draining power of costs. Hence one should always prefer an index fund or ETF (subject to parameters covered in the relevant musings) or else an active mutual fund with the least expense ratio.
Expense ratio is not the only factor which will raise the costs for an investor. The portfolio turnover (buying and selling shares) by the fund manager will incur costs in the form of Securities transaction tax (STT) and brokerage fee. Obviously, the higher the portfolio turnover, the higher are the costs. “The average turnover ratios till 1960s were around 17 percent but post-1997 are in the range of 85 percent with average holding of a stock in mutual fund being only slightly more than a year81.” This is the pitfall of the most active mutual funds and can be significantly reduced with index funds, which buy or sell very rarely. One should always look at the turnover ratio of the mutual fund and should go for the one with least turnover ratio, other factors being common. The recommended sites, Morningstar and Value Research give this data upfront.
The other way to reduce costs is to sell the mutual fund (if at all, and never before the goal for which one was saving, is achieved) only after 1 year to avoid paying short-term capital gains (STCG) tax which is levied at 15 percent. After one year of holding, one has to pay Long-Term Capital gains (LTCG) tax which is at 10 percent (only if profits in the year exceed ₹1 lakh.) So even if one realises that one has made a wrong investment choice in a mutual fund, don’t sell it before 366 days. Be especially careful while making investment through SIP as each SIP has to complete its cycle of one year to avoid STCG tax. Most mutual fund houses levy a ‘redemption fee’ to deter the investors selling before one year of his investment. Remember these rules are applicable for equity funds and not debt funds, which will be covered in a separate musing.
So, finally, how much of the costs could be considered reasonable in a portfolio? “To escape the fee factories, you must lower your total annual fees and associated investment costs to 1.25 percent or less, on average82.” This is the total cost of your entire portfolio which will include equity (including index funds) and debt instruments both.
SELECTING EQUITY MUTUAL FUNDS – III
MUSING 26: FUND LIFETIME
“Purchasing the past five or ten year’s best-performing investment invariably reflects the conventional wisdom, which is usually wrong. Recognise that the returns data for an asset class of less than two or three decades are worthless,” William J Bernstein opines in ‘Four Pillars of Investing.’
The bull markets exponentially raise the expectations of common investors who presume that the current joyride will continue forever. Alas, each bull phase must be accompanied by a bear phase which tests the investors and most flee the market. It is not only important to stay in the market for a long time but also to look at the long time returns of the asset class before one takes the plunge of investing.
You will find that most mutual funds and websites will readily provide returns of last one, three or five years upfront. If you need to find out the returns of last ten or fifteen years or longer, you need to dig deeper. Quality websites like Value Research and Morningstar have this data. But how far back should one go for data mining? The answer lies in the prophetic quote given in the beginning of this musing: I would recommend study of data of at least last 15 years before one decides on investing in a particular mutual fund. What if the fund is not 15 years old? Go for last 10 years data. What if the fund is not even 10 years old? Avoid that fund and limit your research in funds which have at least 10 years lifetime. Let me give you the reasons for this selection criterion.
We have earlier learnt of the concept of ‘survivorship bias’ meaning that any non-performer fund will be quietly buried by the mutual fund company and its assets merged with a successful fund. Any fund which has a life cycle of at least 10 years has passed this litmus test meaning it is considered worthy enough by the mutual fund company not to be extinguished.
The second issue is that a successful fund must see both a bull and a bear market in its lifetime and yet come out a winner. We know that the last bear market (remember the definition) occurred in 2008. So any fund which is not yet 10 years old or just about 10 years old has only seen a rising market and its performance in a bear market is not yet tested. Any fund which is 15 years old has obviously seen both kinds of market and yet logged good returns (it has not been given a quiet burial by the company) and hence needs to be considered for investment.
SELECTING EQUITY MUTUAL FUNDS – IV
MUSING 27: SIZE DOES MATTER
As a mutual fund does well, it attracts more investors and inflows towards it and in the process increases in size (Assets Under Management or AUM increases.) Prima facie, this should be good news for the fund manager and the investors but it is actually not so. The rising asset size of the mutual fund comes with its attendant pitfalls especially in funds called ‘Jumbo Funds83’ meaning funds managing assets more than ₹10,000 crores. Let’s dig deeper.
The average fund size of various mutual funds in India is as follows; Large Cap: ₹1644 crore, Multi-Cap: ₹2202 crores
, Mid-Cap: ₹2188 crores and Small Cap: ₹1691 crores. We know that a large percentage of investment of these funds has to be in stocks whose market capitalisation corresponds to the mandated fund capitalisation. Hence, a large-cap fund will have to pick mostly stocks of large capitalisation in the market and so on. What is the number of corresponding stocks available for investment by these funds? Not very large (refer table below. The data set is of September 2017.)84 To take an example, all the small-cap mutual funds will have to invest only in these 677 stocks (at least 65 percent of their portfolio.) This obviously makes this universe very crowded. Very clearly there is too much money chasing too few stocks.
Market Cap Range Number of Stocks Listed on NSE Remarks
More than one lakh crores 26 Large Cap Universe
₹50,000 to ₹1 lakh crores 47 Large Cap Universe
₹25,000 to ₹50,000 crores 82 Large Cap Universe
₹10,000 crores to ₹25,000 crores 153 Large Cap Universe
₹5,000 to ₹10,000 crores 242 Mid-Cap Universe
₹2,500 crores to ₹5,000 crores 766 Mid-Cap Universe
Less than ₹2,500 crores 677 Small Cap Universe
As the fund size increases, the universe of stocks that is available for investing shrinks. To take an example, suppose a fund with an AUM of ₹1,000 crores holds equal amount of 50 stocks in its portfolio for diversification hence each holding equalling to ₹20 crores. Normally, a fund manager will try and restrict his holding of a company to not more than 5 percent of its total market capitalisation due to requirement of easy liquidity85. Hence, he will pick stocks in companies with market capitalisation of more than ₹400 crores (5 percent of ₹400 crores = ₹20 crores.) Suppose the fund size increases to ₹10,000 crores as more and more investors pump in money due to fund’s good performance. Now, the fund manager will have to look for companies with market capitalisation of ₹4,000 crores plus, thus automatically reducing the universe of available companies.
The other option with the fund manager with an increasingly large AUM would be to increase the number of companies from existing 50 if she wishes to keep upper limit of holdings to 5 percent86. As we have seen in our musing on risk-reward paradigm, this does not reduce the portfolio risk but instead may dilute fund’s performance. A larger fund is also likely to incur higher transaction costs (the larger the number of stocks, the more is the transaction.) To make matters more complicated, a fund’s mandate or style like mid or small cap, growth and value and dividend payment etc. may further restrict the investible universe.
So, for a common investor, what should be the take away from this musing? In general, large-cap funds, index funds, ETF and debt funds are not constrained by their fund sizes as the universe of stocks in which they can invest is large enough to accommodate rising inflows. The real problem lies with the multi-cap (with significant exposure in mid and small-cap stocks,) mid and small-cap funds who, if successful, may invite ‘winner’s curse’ due to increased inflows87.
SELECTING EQUITY MUTUAL FUNDS – V
MUSING 28: INVESTMENT STYLE
We are now reaching the end of our journey to understand the selection criteria for equity mutual funds. Most of the major issues have already been taken care of but a few important ones remain. The first is the style of mutual fund.
Market Capitalisation Style: The Securities and Exchange Board of India (SEBI), has defined large-cap, mid-cap and small-cap as follows:
o Large Cap: 1st – 100th company in terms of full market capitalisation.
o Mid-Cap: 101st – 250th company in terms of full market capitalisation.
o Small Cap: 251st company onwards in terms of full market capitalisation88.
o In general, stocks with market cap of more than ₹10,000 crores can be termed as large cap, between ₹2,500 to ₹10,000 crores as mid-cap and below ₹2,500 crores as small cap. So how does this impact a common investor?
o In short, the large-cap stocks are blue chip stocks, the proven performers who have been on the growth treadmill for long and reached a mature phase of their growth. The mid-caps are somewhere midway between a rookie and fully-grown stocks and hence have the major growth period ahead of them. The small caps are just starting off the block with limitless possibilities of growth or bust.
o As a corollary, large-cap stocks are likely to give steady but safe returns, small-cap stocks yield either spectacularly good, or bad returns and mid-cap somewhere in between. The annualised 10 years returns for large-cap funds are 8.9 percent, multi-cap 10.5 percent, mid-cap 13 percent and small-cap 14.8 percent89. An astute investor must mix various market cap funds for optimising and steadying the overall returns. A mutual fund company is mandated to define its fund capitalisation so that a common investor gets a clear idea about his likely investment returns and volatility.
o SEBI though has given sufficient leeway to mutual funds to mix not only equity and debt funds but also various capitalisation stocks within the overall umbrella of above-mentioned categorisation as given below90:
Serial Category of Scheme Scheme Characteristics Remarks
1 Multi-Cap Minimum equity investment 65 percent Can invest in large, mid and small-cap stocks
2 Large Cap Minimum equity investment 80 percent Predominantly in large-cap stocks
3 Large and Mid-cap Minimum equity investment 35 percent each in Large and Mid-cap Both Large and Mid-cap stocks
4 Mid-Cap Minimum equity investment 65 percent Predominantly in Mid-cap stocks
5 Small Cap Minimum equity investment 65 percent Predominantly in Small-cap stocks
6 Dividend Yield Fund Minimum equity investment 65 percent.
Scheme should predominantly invest in dividend yielding stocks
Predominantly in Dividend Yielding Stocks
(Refer our musing on stock market primer where this investing strategy was discussed.)
7 Value Fund Minimum equity investment 65 percent.
Scheme should follow a value investment strategy
Value Investment Strategy. Being covered subsequently
7 Contra Fund Minimum equity investment 65 percent.
Scheme should follow a contrarian investment strategy
Contrarian Investment Strategy (purchasing and selling in contrast to the prevailing sentiment of the time)
8 Focused Fund A scheme focused on the number of stocks (maximum 30).
Minimum equity investment 65 percent
Maximum 30 stocks (mention where the scheme is intended to focus — Large, Multi, Mid or Small-Cap Stocks)
9 Sectoral/Thematic Fund Minimum investment in equity & equity related instruments of a particular sector/particular theme 80 percent of total assets Sector/Theme to be specified
10 ELSS Minimum equity Investment 80 percent An open-ended equity linked saving scheme with a statutory lock-in of 3 years and tax benefits
In addition to the above, equity mutual funds can also offer ‘Hybrid Funds’ (Various mix of equity and debt instruments,) dynamic or balanced asset allocation funds (equity and debt component dynamically adjusted,) arbitrage funds (leverages the price differential in the cash and derivatives market to generate returns91,) index funds or ETFs and fund of fund scheme.
Growth and Value Style
o Growth and Value styles are possible in all market capitalisation of funds. “Growth investing entails looking for companies that have a potential to grow faster than others. The optimism is reflected in the premium valuation commanded by the market price of such companies. A value investor, on the other hand, buys undervalued stocks that have a potential for appreciation, but are usually ignored by the investing community92.”
o So a value investor believes that “Good companies are bad stocks and bad companies are generally good stocks and he is right93.” Most of the mutual funds follow the growth strategy.
o Mixing both the above-mentioned styles (blend style): it is obvious that a large-cap growth fund is likely to give most steady returns whereas a small-cap value fund the most ag
gressive but volatile returns. A blend style will prudently mix both growth and value funds to optimise returns.
And finally, one must compare the returns from the mutual fund against the appropriate benchmark or index. For example returns from a large-cap fund should be compared against the S&P BSE large-cap index while that of the small-cap fund against S&P BSE small-cap index. Similarly, it will be incorrect to compare the returns of a large-cap fund to a small-cap fund or a growth fund to a value fund. The investment styles and philosophies are totally different.
SELECTING EQUITY MUTUAL FUNDS – VI
MUSING 29: FUND MANAGER
Anyone with even the most elementary knowledge of the Stock market or equity investment will not be unfamiliar with names like Benjamin Graham, Warren Buffet, Sir John Templeton, John Bogle, Peter Lynch and Ray Dalio. These are superstar fund managers who managed to give market-beating returns over many decades, trumping many bull and bear markets. They also introduced the concepts of value investing, index funds, global investing, contra investing, buy and hold investing and many others. These legends amassed great fortunes for their clients and themselves which they generously ploughed back to the society in philanthropy.
In India, we are not yet very familiar with names of superstar fund managers though they are the ones who strategise, after their astute study of market and economy, about the best way a common investor’s or a pension or hedge fund money need to be invested. They are the people who we trust to give us steady, market-beating returns year after year. In short, they have to work indefatigably so that we can sleep in peace knowing that our money is in safe hands.
To appreciate how important a fund manager is, just sample this: In India, there are nearly 5500 listed companies on BSE and around 2000 on NSE (with many stocks common) which vie for the attention of the fund managers. How much of stake to invest in how many companies and for how long, how much risk to take, what are the global and domestic economic and fiscal policies that will impact the market (we are in a global village today) and many other factors have to be carefully considered by a fund manager. Their decisions could have far-reaching impact on the financial well-being of investors. A manager with a perceptive sense of the market can consistently generate alpha. To cite an example, the highest and the lowest 10-year annualised returns from mutual funds are as follow94: