Fund Selection Process
Note to: Clients of Yudhajit Financial Service (YFS)
From: Yudhajit Baul, Founder YFS
Date: 14/01/2022
Re: Why Fund Selection Process is so important?
“We have no control over outcomes but we can control the process. Of course, outcomes matter but by focusing our attention on process we maximise our chance of good outcome”- Michael Mauboussin, investor, best-selling author and head research at Morgan Stanley. At Yudhajit Financial Services we firmly believe in this maxim. Mutual funds can be selected based on qualitative and quantitative parameters.
We follow Morningstar’s five pillar research framework that emphasizes on people, process, parent, performance and price. People denotes the depth and breadth of the fund management team, alignment of interests, continuity and tenure of the team. Process denotes security selection, idea generation, value discipline, portfolio construction and risk management. Parent denotes ownership structure, organisation stability, financial strength, culture, stewardship, regulatory and compliance. Performance denotes rolling risk adjusted returns versus style benchmark, downside statistics and attribution analysis. Price denotes expense ratio relative to peers.
Scientific process of selection of mutual funds reduces various biases which otherwise can be detrimental to portfolio construction. One of the most common biases affecting optimal risk adjusted portfolio performance is recency bias. We recommend investors to consider the rolling returns performance of portfolios across various time frames to gauge portfolio performance along with the risk and volatility measures like alpha, beta, Standard Deviation, Sharpe Ratio. We also recommend investors to consider information ratio, up capture and down capture ratios in assessing volatility and performance. Alpha measures the difference between an investment’s expected returns based on its beta and actual returns, Beta measures sensitivity to market movements, Standard deviation measures the range of investment’s performance, Sharpe ratio indicates reward per unit of risk by using Standard deviation and excess returns.
The 5 years, 10 years trailing performance, risk and volatility measures of two large cap funds are as follows
Fund 5-year trailing CAGR (%) 10-years trailing CAGR (%) Standard Deviation Sharpe Ratio
Axis Bluechip fund 17.11 15.28 17.56 0.82
HDFC Top 100 fund 11.78 12.43 23.02 0.51
Source: Morningstar
Clearly Axis Bluechip fund has delivered better risk adjusted returns than HDFC top 100 fund from a 5 years and 10 years perspective but that does not however guarantee future performance. Risk and volatility measures deals only with past performance, a careful study of the portfolio will help investors understand the reason for the performance based on stock composition. To gauge future performance investors must study the prospects of the industries invested and the prospect of the underlying securities invested.
The best performing funds in the large cap category has delivered 16.58% and the worst performing funds has delivered 9.35% in last 10 years. The difference in wealth creation of capital invested of Rs 1 crore between these two funds in 10 years is Rs 2.19 crores therefore sub optimal process and haphazard way of selecting funds would yield sub optimal results.