Don’t ignore ratings completely but accept them with a pinch of salt
Mr Mehta is a careful investor. He believes in doing his homework before committing any of his hard-earned money. A month before, he had decided to invest Rs 3 lakh in good-quality mutual funds (MFs). Consequently, he started looking up the available performance ranking of various funds, to figure the best bets. A month later, he's still at it, without having come to any conclusion.
If you’ve been investing in MFs, perhaps you will identify with his dilemma. He just couldn’t find any consistency or consensus among rating agencies about the ranking. Given the same set of numbers, different personal finance magazines, websites, broker reports and newspapers came up with differing conclusions.
Essentially, rating methodologies differ from agency to agency. To prove they're more incisive than the next person, the agencies adopt all sorts of esoteric techniques and statistical tools.
Purely performance-based analysis is only available in the minority. Most adopt risk-adjusted ratings which should have been fine. But the only hitch here is that the definition of risk or more precisely, the statistical tool that best defines the concept of risk is not consistent. This too, differs from agency to agency. Some adopt the Sharpe ratio, some use the Sortino ratio, others look at standard deviation, beta and alpha. Then there are others who choose specific parameters such as size of assets, portfolio turnover, tenure of the fund manager with the fund, fund size, expense, ratio and so on. They then proceed to assign weights to each of these parameters to arrive at a composite ranking. While most agencies show transparency in their methodology, some may declare that they use a proprietary system which remains unknown to the public at large.
Strategy
The fact is that most of these arcane rating methods are solutions in search of problems. Don’t ignore these totally, but keep your pinch of salt ready. So no matter, which agency’s ratings you look at, the investor will still have to resort to some amount of research from his own side.
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Second, safely ignore all funds which have not been in operation for at least a year. So, safely ignore one-month, three-month or six-month returns and ranking. one can even go to the extent of saying, look at only those funds that have been existing for over three years. Not only will you eliminate a whole lot of ‘me too’ upstarts, but it will also give you an idea about the sustainability of the returns of the fund.
Now that you have significantly reduced the sample size, try and find the common funds that come up in the top ten lists of the various agencies. In other words, arrive at the lowest common denominator. Remember, it is important you invest with a well-managed fund. Whether it is the top performing one or the second or the fifth matters little. Also, a topper today may come in fourth next year and so on. As long as you have invested in a quality portfolio that has stood the test of time, the particular ranking from any particular agency should matter little.
As an analogy, you know Virendra Sehwag or Yuvraj Singh are good batsmen. You don’t need anyone to tell you that. However, their ranks amongst the leading cricketers will differ with the agency calibrating the performance. So, who cares if Yuvraj is fourth, sixth or 10th? His performance over the years tells me he is a good batsman. Use the same principle while choosing your MF investment. No matter where the ratings are from, funds such as Reliance Growth, HDFC Equity, SBI Magnum Contra and Birla Sun Life Frontline Equity will almost always find a place in the top performers. And, just like Sehwag having a lean patch doesn’t make him a lesser batsman, don’t get swayed by a lean three-month or six-month performance number. Test of time is the only true test.
Last, but not least
Even after having identified and invested in a good MF scheme, another vital thing remains to be done. You need to remain invested. For example, the five-year return of HDFC Equity is 16.8 per cent annually, whereas over a 10-year period, it has returned around 30.3 per cent yearly. To put it differently, Rs 1 lakh invested in this scheme would have grown to Rs 2.17 lakh over a five-year frame. The same investment if held over the last decade, would have grown an astounding 14-fold, to over Rs 14 lakh.
I do not suggest that, going ahead, investors should expect similar returns. But for earning a return - any kind of return - holding the investment over the long term is imperative.
It is as simple to earn healthy returns from your MF investments as it is not to. Just do the basics right, invest with established diversified schemes, with a good track record, let the money work hard and stay away from gimmicks. And, take the following words of Donald Trump to heart: “Sometimes your best investments can well be the ones that you don’t make.”
The writer is Director, Wonderland Consultants, a tax and financial
