Nov 29, 2009

How to Choose the Best Equity Mutual Fund


Sometime back, a reader asked me this question (in the comment section of the post ‘Direct Stock Investing vs. Mutual Funds’): Which is the best equity mutual fund? In fact, every mutual fund investor is faced with this burning question: How to choose the best mutual fund? If you’re investing in an equity fund, then you would like to know which the best equity fund is and if you’re interested in a debt fund, you want to know which is the top most debt fund. So, this post is about how to choose the best equity mutual fund?

The Moot Question: Why this search for Best Equity Mutual Fund?
Before I list down the best / top funds in equity diversified category, the foremost question is: Why is it important to choose the right fund? Why can’t you just invest in any equity mutual fund? How does it make a difference?

The choice is important because there is too high variation in the performance of different mutual funds within the equity diversified category. For example, as per data from Value Research, a mutual fund rating agency, during the last one year (trailing returns as on 27 Nov’ 2009), the best performer in equity diversified category gave a return of 159.48% [Principal Emerging Bluechip –1/211], and the worst performer 14.58% [JM HI FI – 211/211]. The difference is mind-boggling (144.90%). It’s like comparing US with Somalia. However, if we increase the time horizon the gap between the best and the worst equity diversified fund narrows down.



For example, returns from equity diversified mutual funds for a three year period are in the range of +25% to -22% (i.e., a gap of around 46%). Similarly, if we further increase the period to 5 years the return band is 32% to 11% (i.e., variance of around 22%). But the gap is still wide enough to make a substantial difference to our overall returns from equity funds. Besides, due to compounding, the difference between the best and the worst equity fund gets magnified with time.

Let’s see the absolute impact the equity funds return differential can make to your investment returns over time. Suppose that you invested Rs 1 lakh each in ING Core Equity and Reliance Equity about 10 years back. So as on date (27 Nov 2009) while your investment in Reliance would be Rs 14.17 lakh, the total value of ING Core Equity would amount to just 2.20 lakh, a huge difference of about Rs 12 lakh. Put simply, over a period of 10 years the return differential between best and the worst equity diversified mutual fund is 12 times the initial amount invested which is indeed quite significant.

Thus, by not being careful enough to select the right equity fund at the time of investing can really cost you dearly over a long run. Just ask somebody who invested in JM HI FI or Tauras Discovery.

Now we can say for sure that selecting the best / right fund at the time of investing is a crucial factor and can make a big difference in our returns over a long term.


Avoiding the Trap
Second point which I would like to highlight is that a lot many investors make the mistake of comparing the latest short term performance of various funds to arrive at the best performing mutual fund. Actually, the fund which has given the best returns during last 1M/3M/6M/1-Yr may or may not be a good scheme to invest in.

Let me give you an example. First, see the below figures. These are one year trailing returns (as on 27th Nov’09) of a few selected equity diversified funds as per Value Research:

Fund Name-------------------------Rating---1 YR Return---Rank
1. ICICI Prudential Discovery-------3-star---147.73%-------3/211
2. Magnum Emerging Businesses--2-star---120.38%------12/211
3. JM Emerging Leaders--------------1-star---111.00%------29/211
4. UTI Opportunities------------------5-star-----98.08%------67/211
5. ICICI Prudential Infrastructure---5-star-----79.52%----144/211


What do you observe?

Regardless of the outstanding one year returns by ICICI Prudential Discovery, Magnum Emerging Businesses, and JM Emerging Leaders, these schemes are still rated 3-star, 2-star and 1-star respectively. It means that in spite of their short term superb performance, they are yet to prove their long term potential. On the other hand, despite not so good performance of UTI Opportunities and ICICI Prudential Infrastructure, both the equity funds are rated 5-star.

Thus, the lesson to be learnt is that don’t ever try to judge a book by its cover and mutual fund by its short term performance. Put simply, never buy a mutual fund on the basis of excellent short term performance. On the other hand, never sell a mutual fund just because of its recent poor performance.


Theory of Relativity
Another important point you should understand is that the mutual fund rankings are relative and not absolute. Let me clarify the difference between absolute & relative performance of mutual funds.

Suppose you’ve got 97% marks in an examination, but out of, say, a total of 5 persons, three have scored better results than you, say between, 97.5—98% marks. Does it mean that you’re not good enough? Consider another scenario, where all the 5 persons failed in the examination but you scored, say, 25% marks while all others scored less than you? Does it mean you’re the best?

It is very similar dilemma with fund rankings. Mutual Funds are ranked not on the basis of their absolute performance but on the basis of their relative strength as compared to their peers (other funds in the same category). For example, if I tell you that your fund, say, Tata Dividend Yield has returned more than 100% during last one year (1-Yr ending 27th Nov 09), you will be on top of the world but the moment I tell you it is ranked 56 / 211 on the basis of returns (meaning thereby that 55 other mutual funds in the equity diversified category have earned better returns than it), then probably you won’t feel like celebrating it, isn’t it? The handsome returns of over 100% pales down when compared to others.

Do you know that this theory of relativity is also one of the root causes of our unhappiness? Shouldn’t an investor be more concerned with absolute performance rather than relative performance?

Anyway, the point to notice is that the best performance is always relative (i.e., in comparison to others). There are no best absolute returns. For example, a mutual fund can be ranked as top fund in a particular category even by earning a meager return, say CAGR of 3%, if the other funds in the same category are earning less than that. In a similar vein, a mutual fund, say, ABC giving you an annualised returns of, say 40% would still rank much lower if the benchmark index and other funds in the same category are giving better returns than it.

Finally, before I list down the best / top equity mutual funds, understand that while selecting best / top equity funds it is important to consider short term performance as well as long term performance, relative performance as well as absolute performance, trailing returns as well as calendar year returns, CAGR as well as year-wise returns, and returns as well as risk-adjusted returns.

To know the best equity diversified fund, just wait for part two!

Also see:

1. Stock Investing vs. Mutual Funds: Making a Choice
2. How to Choose Best ELSS Mutual Funds
3. How to invest in Gold ETFs

14 comments:

  1. When can we expext part2 please

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  2. Raju: Kindly be patient!

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  3. You are so good in explaining such complicated matters...may god bless you. I will be waiting for your next part before I make an investment decision.

    ReplyDelete
  4. Thank you, Mr. Anonymous.

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  5. "Actually, the fund which is has given the best returns during last 1M/3M/6M/1-Yr may or may not be a good scheme to invest in."
    You put it so well. Do not fall into that trap!

    ReplyDelete
  6. hi fisher,
    i am really impressed with ur analysis.wud like to do some smart decisions in mutual funds kindly guide me as to where or what mutual
    funds i can look a return 0f 30%

    ReplyDelete
  7. Vishal: Sorry, I’m not aware of any such fund.

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  8. Hi
    I have invested in axis equity fund(G).What do you think?? I know its NFO but I think every fund was NFO sometime or the other....no one expected principle emerging bluechip to top the rank.Your opinions are valuable to me.Thanx in advance

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  9. Rehaan: In my view, it is always better to invest in an existing fund rather than a NFO. For more details, see: 12 principles of mutual fund investing.

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  10. Hey Fisher
    I've never come across a blog as informative as you )with an Indian perspective). Most of the financial blogs I browsed were American, so I was left to take what was relevant to me. But I'm glad to have found out about this blog. Please keep up the excellent quality of your work, and keep it as simple and lucid as you always have! God bless..

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  11. Hi, Fisher
    you are explaining everything very nicely and giving good real advice. i like most of your articles.

    i want to ask you is there any relation between fund size and its performance, bcause most of the good funds are of large size.


    Dr Paresh
    drpareshsmesurani@yahoo.com

    ReplyDelete
  12. Dr Paresh,

    Too large corpus size can affect the performance of mid and small cap equity funds adversely by resulting in over-diversification.

    ReplyDelete
  13. ArunprasadApril 15, 2010

    Hi Fisher,
    I have been reading your blog regularly and it is very impressive/informative to read all your blogs. I find your SIP calculators really useful for everyone. I am eagerly waiting for your part two of Diversified Equity Fund. My sincere thanks for your service.

    ReplyDelete
  14. hi fisher,

    may god bless you.you are helping those who are in desperate need of people like you.

    i m eagerly waiting for part- 2. Atleast predict it's time.

    suneet

    ReplyDelete

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