Fund selection - Dos and Don'ts

There are more than 2,500 hundred mutual fund schemes across 45 fund houses in India. Fund schemes are grouped in 35 distinct categories consisting of 10 equity, 16 debt, 7 hybrid, and 2 solution-oriented schemes. Additionally, there are ETFs, Index funds and Fund of Funds (FoF) schemes.

Fund selection choices are quite overwhelming. But will there be a significant difference in portfolio performance due to fund selection? Or any random selection of funds can perform in line with the category average?

Let’s find out for equity funds.

Comparison of returns within a category

Let’s consider 3 most popular equity categories based on AUM size:

• Large Cap Funds

• Flexi Cap Funds

• Mid Cap Funds

Large Cap Funds:

Performance data for 5-year trailing returns is as follows:

​Fund name	Return (%)
Axis Bluechip	21.01
Canara Robeco Bluechip	20.21
Mirae Asset Large Cap	18.65
JM Large Cap	14.20
DSP Top 100 Equity	13.35
Taurus Large Cap Equity	11.95

The average return of the top 3 funds and bottom 3 funds is 19.96% and 13.17% respectively. Overall category average return stands at 16.57%.

Flexi Cap Funds

Performance data for 5-year trailing returns is as follows:

Fund name	Return (%)
Parag Parikh Flexi Cap	23.97
PGIM India Flexi Cap	22.91
UTI Flexi Cap	22.60
Motilal Oswal Flexi Cap	13.57
LICMF Flexi Cap	12.08
Taurus Flexi Cap	11.97

The average return of the top 3 funds and bottom 3 funds is 23.16% and 12.54% respectively. Overall category average return stands at 17.59%.

Mid Cap Funds

Performance data for 5-year trailing returns is as follows:

Fund name	Return (%)
Axis Mid Cap	24.90
PGIM India Mid Cap	23.88
Quant Mid Cap	22.38
Franklin India Prima	17.10
ABSL Mid Cap	15.84
Sundaram Mid Cap	14.19

The average return of the top 3 funds and bottom 3 funds is 23.72% and 15.71% respectively. Overall category average return stands at 19.26%.

The difference between top-performing funds and non-performing funds is 6 to 10% for a 5-year period. In the case of lower holding periods, the difference is much higher. For instance, if we consider the last one year data, the difference between the top-performing fund and bottom-performing funds in the large-cap category is a staggering 23%.

How much impact on portfolio value due to difference in returns?

Let’s see how much impact 6% and 10% in returns have on portfolio value over a period of 5, 10 and 20 years for an initial corpus of Rs. 1 crore.

• The difference in corpus value for shorter time periods is relatively less. Longer the investment horizon, higher will be the difference in portfolio value at varying levels of returns.

• At 10% CAGR, Rs. 1 Cr will become 6.72 Cr in 20 years’ time. If return increases to 20% p.a., the same initial investment will grow to a staggering Rs. 38.34 Cr which is more than 5 times.

We can see there can be a huge difference in portfolio value over long periods of time depending on how your mutual fund selection has panned out. The difference is much more than one would have imagined.

What should investors do?

• It makes sense for investors to try and pick better-performing equity funds. Some points to be kept in mind if the investor decides to achieve such a feat:

• Do not blindly go by picking top performing funds of last year. In fact, it rarely happens that top performing fund of previous year will perform again.

  • In YTD-2021, top performing large cap fund is Nippon India Large Cap. It was the worst performing large cap fund in 2020.

  • Top performing large cap fund in 2020 was Canara Robeco Bluechip Equity. In YTD-2021, its stands at 20th position.

• Do not blindly select funds based on ratings mentioned on various websites. At best, ratings can be used as one of the inputs for fund selection. Due diligence and analysis is important to build conviction for long periods of time.

• Fund selection is to be done based on in depth analysis of fund’s investing style, portfolio composition, portfolio concentration, fund manager track record, fund’s vintage and past performance (on rolling returns and risk adjusted basis), fund AUM, expense ratio, and average holding period etc.

• Once a fund is selected, give at least 3 years’ time for fund to perform until unless there is some specific reason such as change in fund manager/style or change in fund mandate etc.

• Thematic funds need much more active management and churning as these are highly depended on market cycles. Thematic funds are akin to picking cyclic stocks and need similar strategy.

• Do not churn mutual fund portfolio on frequent basis. Frequent churning has tax implications which reduces portfolio returns.

• It is difficult to pick top performing funds every time. If you are able to consistently pick up funds which are in top quartile, this should result in superior outcome in long run.