Should You Select The Top Ranking Funds Of Today?   Jul 11, 2019

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Mr Vijay selected a multi-cap fund for his portfolio based on the top rank a famous finance portal had given it. After three years, the fund gave negative returns and was one of the worst performers in the category. And because it was consistently performing poorly, Mr Vijay had to sell his investment at a loss.

A top rank does not guarantee good performance in the future. The most important reason why you should not consider a fund's rank for selection is that a top ranking fund of today may not remain so after few years. Very few funds have managed to stay top rankers in the short-term as well as long-term.

With a plethora of schemes available from numerous fund houses, the schemes to be selected for ranking are mainly chosen from large fund houses, while the schemes belonging to smaller fund houses remain undiscovered. These schemes could have better wealth creating potential than the top ranking schemes.

Further, you will find that there are variations in rank allotted by different organisations which can make selecting funds a very confusing exercise.

To allocate a rank, high weightage is given to historical returns. However, that does not make it the right approach to select a fund. This could be one of the reasons why your scheme/s may be underperforming. A fund may not remain a top ranker or low ranker in every market phase. To understand this, take a look at the table below.

Table: Performance over 1-year, 3-year and 5-year period had you invested in July 2014

Returns Rank
Scheme Name July2013 - July2014 July2014 - July2015 July2014 - July2017 July2014 - July2019 July2013 - July2014 July2014 - July2015 July2014 - July2017 July2014 - July2019
Reliance Small Cap Fund 98.01 34.92 29.52 16.98 1 31 4 6
Sahara Star Value Fund 91.16 2.43 13.71 6.37 2 115 93 112
HSBC Small Cap Equity Fund 90.77 33.80 22.58 10.41 3 36 27 87
ICICI Pru Midcap Fund 83.35 35.19 20.40 12.69 4 29 41 54
Canara Rob Emerg Equities Fund 78.05 44.77 27.99 18.10 5 9 9 4
Sundaram Small Cap Fund 75.79 45.29 27.02 10.63 6 8 13 85
DSP Small Cap Fund 75.65 53.37 32.99 15.51 7 3 2 13
UTI Mid Cap Fund 72.45 44.45 22.25 12.03 8 10 28 68
Mirae Asset Emerging Bluechip Fund 68.01 44.22 30.74 20.81 9 11 3 2
L&T Midcap Fund 67.17 38.25 28.93 15.96 10 23 6 11
(1 year return-annualised, 3 year and 5 year return compounded annualized)
(Data as on July 10, 2019)
(Source: ACE MF)

The table above shows top ranking funds of the period July 2013 to July 2014 and its performance over the next few years. If an investor invested in July 2014 based on the ranks of the last one year, here is how the portfolio would have performed:

The top ranker of July 2013-2014 was Reliance Small cap fund. Its rank declined to 31 in the next year. However, it was able to make a turnaround and managed to remain in the top performing category in 3-year and 5-year period. L&T Mid cap fund too showed similar trend.

Schemes like Canara Robeco Emerging Equities Fund, DSP Small cap Fund and Mirae Asset Emerging Bluechip Fund were able to sustain top 10 rank in all three period.

On the other hand, many schemes were not able to sustain their performance and their ranks plunged sharply over the period. Sahara Star value fund, HSBC Small cap equity fund, ICICI Pru Mid cap fund, Sundaram Small cap fund, and UTI Mid cap fund were the schemes which saw the most drop in rank.

Markets are prone to volatility, that's why selecting funds based on rank can be misleading. A fund with poor ranking in the short-term may make a turnaround and become a top performer of tomorrow. Similarly, a top ranking fund may not be able to sustain its performance in the future.

This highlights the importance of choosing a fund based on consistency instead of rank. The fund should be able to outperform the benchmark in the bull phase, while its decline in the bear phase should be lower than the benchmark in a majority of the market cycles.

The fund should be selected based on its consistency in quantitative and qualitative parameters. Checking the fund's historical returns is important, but it should not be the sole basis of selection.

Along with past returns, the fund's risk-reward trade off, portfolio characteristics, and other qualitative parameters must be compared to select winning mutual funds

Here are the parameters you should consider to select winning mutual funds:

Quantitative parameters

The schemes rolling returns over 1-year, 3-year, and 5-year period should be compared with its benchmark and peers to determine how well the scheme has performed in the various market cycles.

Higher the risk of the investment, higher is the return potential. However, not every risk pays off well for the investor. Therefore, you should compare the scheme for risk-adjusted returns. For this purpose ratios like Sharpe, Sortino, and Standard deviation can be compared.

[Read: Why Comparing Returns to Risk Is More Meaningful!]

Portfolio characteristics

This is one aspect that is both quantitative as well as qualitative in nature. Investors should pay close attention to the portfolio characteristics mentioned below when selecting any mutual fund scheme.

  • Asset allocation

  • Market cap bias

  • Sectorial allocation

  • Rating preferences

  • Portfolio concentration

  • Portfolio churning

  • And the expense ratio

[Read: Why Portfolio Characteristics Of A Mutual Fund Are Very Important]

Other qualitative aspects

If the fund follows sound investment process with adequate risk management systems in place, this will be a better parameter during the selection process compared to ranking. Check the following points to determine the efficiency and quality of the fund manager/house.

  • Fund manager's experience

  • Performance pressure on the fund manager

  • Reliance on a handful of star fund manager

  • NFO launches and their frequency

[Read: Why Qualitative Aspects Are So Important To Pick Mutual Funds]

Furthermore, it is crucial that the scheme is suitable for your needs and selected after considering your investment objective, risk appetite, and time horizon to goal. Apart from this, timely review of the fund's performance will help you weed out any non-performing schemes from your portfolio.

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Author: Divya Grover

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