To keep up with the changing times and grow, we adapt to the latest technological advancements, follow popular trends and everyone around us. Most of us follow popular fashion brands, mimic fashion trends of celebrities and icons.
Whilst investing we do the same thing; we look for popular top / star rated funds or blindly follow renowned investors or recommendations from friends and family members.
But if you want to be a successful investor, it is not the right thing to do. In fact, the most popular funds today may not necessarily perform consistently across various market cycles and could lose their star status overnight. Most of the advisers recommend top-rated funds from big fund houses that do research following the passive rating methodology.
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Basically, the passive rating methodology means that they give a higher weightage to quantitative factors such as the past performance and risk-adjusted returns over a period of say 3-5 years and then compare this data with their peers to arrive at the best return generators in the lot.
Table: Performance of schemes having AUM over Rs 10,000 crore
|Scheme Name||AUM (Rs cr)||Absolute returns (%)||CAGR (%)|
|1 Year||2 Years||3 Years|
|Kotak Standard Multicap Fund||25531.08||10.19||10.44||16.75|
|HDFC Equity Fund||23230.66||13.07||10.63||16.26|
|HDFC Mid-Cap Opportunities Fund||22825.43||-3.76||3.45||13.06|
|SBI BlueChip Fund||22754.13||5.38||8.15||11.79|
|ICICI Pru Bluechip Fund||22182.14||7.68||10.70||14.81|
|Aditya Birla SL Frontline Equity Fund||22001.90||5.10||7.43||12.23|
|HDFC Top 100 Fund||17475.32||14.66||11.50||16.29|
|Motilal Oswal Multicap 35 Fund||13634.94||0.84||5.57||15.56|
|Reliance Large Cap Fund||13170.35||10.67||11.49||16.65|
|Mirae Asset Large Cap Fund||13064.85||11.35||11.89||17.15|
|Franklin India Equity Fund||11540.78||2.21||6.11||10.33|
|NIFTY 500 – TRI (Index)||5.10||8.96||13.93|
(Source: ACE MF)
Any mutual fund scheme that has an AUM over Rs 10,000 crore can be considered a popular scheme. From the table above, we see 11 schemes in the diversified equity category. Not all the schemes have managed to outperform the index.
Essentially, these stars are derived from passive numbers at best, which reflects how the fund in a particular category has performed vis-a-vis its peers over the last few years. Moreover, with the change in the performance cycle, the ratings can change dynamically.
While looking at the past performance data of mutual funds is rational, considering the future growth potential and consistency of the fund is oblivious to the majority of mutual fund research houses.
However, when you choose the most popular funds, you tend to lose out on potential opportunities that could earn big returns, something that several lesser-known funds can provide. These lesser-known funds from small fund houses with lesser AUMs have great potential to become the stars of tomorrow.
These are, what we call, Hidden Gems or Undiscovered Funds. Certain funds aren’t talked about much by the IFA fraternity (not promoted or advised), because they aren’t from large fund houses or schemes with large AUMs.
Yet they carry potential to clock BIG risk-adjusted returns and help in wealth accumulation in the long-term.
A hidden gem or undiscovered fund that has not been very popular amongst investors, do have the potential to be star performers of tomorrow. One of the traits of undiscovered funds is that they prove their mettle by performing well across timeframes and market cycles as well as manage their risk well. This is because they are more actively managed by fund managers and hold a liquid portfolio.
If you manage to identify/spot them early, you can earn attractive returns over the long run, within the next 8-10 years.
If you are wondering how it is possible, let me explain…
The reason being, selecting the right mutual funds irrespective of the size of the fund house is important and can generate wealth for you. So, selection matters!
Selection of the right fund based on the qualitative and quantitative parameters can earn appealing returns. When you choose a fund using these aspects, you will undiscover a hidden gem for your portfolio.
Quantitative parameters form the outer layer of a scheme, while the main core of a mutual fund is formed by its qualitative parameters. It’s more like an iceberg, the top portion that is visible to the naked eye is equivalent to quantitative parameters. And the qualitative parameters are submerged below the water hidden, but those are the foundation of the fund.
Hence, for a holistic view of mutual funds, both the parameters are equally important while selection.
Performance across time periods and risk analysis
This is to analyse if the fund has shown consistency in performance across various market periods with decent risk-adjusted returns. Under this, the fund needs to be ranked on quantitative parameters like rolling returns across short-term and long-term periods such as 1 year, 3 years and 5 years, and on risk-reward ratios like Sharpe Ratio, Sortino Ratio and Standard Deviation over a 3-year period.
Performance across market cycles in comparison with peer and index
You need to ensure that the fund can perform consistently across multiple market cycles. Compare the performance of the schemes vis-a-vis their benchmark index across bull phases and bear market phases. A fund that performs well on both sides of the market should rank higher on the list.
Adequate Diversification – The scheme should not hold a highly concentrated portfolio. The portfolio should be well diversified and the exposure to the top 10 holdings should be ideally under 50%.
Credit Quality – For debt portfolios, you need to ensure that the fund does not hold a high proportion of low-rated (securities rated AA or below) or unrated debt instruments. A fund with a higher credit quality should be ranked higher.
Low Churn – Engaging in frequent churning can result in trading and high turnover cost. Therefore, you also need to consider the portfolio turnover ratio and expenses and penalise funds involved in frequent churning, i.e. those funds with a turnover ratio of above 100%.
Quality of Fund Management
You also need to consider the fund manager’s experience, his workload and consistency of the fund house. Therefore, you could check the following:
The fund manager’s work experience – He/she should have a decent experience in investment research and fund management, ideally over a decade.
The number of schemes managed – A fund manager usually manages multiple schemes. Thus, you need to check if the fund manager is not loaded with many schemes. If they manage more than five open-ended funds, it should raise a red flag.
The efficiency of the fund house in managing your money – You need to check if the fund house is consistent in performance across schemes or if only a few selected schemes are doing well. A fund house that performs well across the board is an indication of sound investment processes and risk management techniques in place.
Remember these are important factors to select the right mutual fund. But before investing, always consider your risk profile, financial goals, investment time horizon, and asset allocation strategy.
For an investor, it would be a tedious task though, as it involves calculations and the data isn’t easily available. So, it’s best to seek professional guidance from an ethical and unbiased adviser from a company who follows a comprehensive research process.
PersonalFN follows a stringent scoring model, which ensures that the scheme is tested on various quantitative as well as qualitative parameters, is compared accordingly and scored vis-a-vis its peers.
Remember all that glitters is not always gold, so do not focus only on popular funds. Consider the road less travelled which leads to beautiful destinations; a path that usually needs more research and exploration. Similarly, certain lesser-known funds do have the potential to provide better returns and accumulate wealth in the long run, if you select the right mutual fund based on qualitative and quantitative parameters.
Editor’s note: If you think that picking undiscovered funds will be a tough task or you do not have the time and skills to pick the hidden gems of tomorrow, don’t lose heart.
PersonalFN’s brand new research report: 5 Undiscovered Equity Funds – With High Growth Potential is meant just for you.
Author: Aditi Murkute
This article first appeared on PersonalFN here.
PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.