Finding a Fund House to Trust

Trust plays a key role in the relationship between investors, financial advisors and fund houses.  In this post, I offer a framework for an investor or a financial advisor to evaluate the trustworthiness of a fund house.  Please note, it is not my intention to present readers with my preferred list of fund houses.  I intend to provoke thought on the subject in the hope that it will facilitate a meaningful discussion between investors, financial advisors and fund houses.

To most people that I have spoken to, the performance of a scheme is considered, in itself, a testament to the credentials of a fund house.  Some, on the other hand, believe that the number of investors or the amount of money managed is a great indicator.  “They must be doing something right to attract and retain so many investors,” I’m told. Or, “So many investors can’t be wrong.”   Frankly, neither of these parameters cuts much ice with me.  I regard the achievement of a pinnacle in the number of investors or the money managed as likely a marketing triumph, and I question our ability to accurately analyze performance and distinguish between luck and skill. 

In fact, I do not believe in starting by evaluating results (such as money managed, or performance).  Rather, I believe in assessing fund houses and fund management teams independent of their results, and then expecting good results to be a logical conclusion of the selection process.  I am not alone in this thinking- I have met a few financial advisors who have a similar thought process. Morningstar, as part of its stewardship grading, also follows a similar approach. In India, as far as I know, Morningstar hasn’t released any formal grading of the stewardship of fund houses.  However, as part of their Analyst Ratings for schemes, they do give a brief description of their opinion of a fund house’s stewardship.  At the time of writing, these ratings span 12 fund houses.

While I do not claim to have the thoroughness and structure that Morningstar follows, for whatever it is worth, I present below my framework for fund house analysis:

Tenure

I start my evaluation process by looking only at fund houses that have schemes in existence (and under an unchanged fund management) for at least one complete stock market cycle (for equity schemes) and at least 3 years (for debt schemes).  I am open to investing small amounts with fund houses that do not make the cut on this parameter.  However, for me to invest significant amounts or to recommend to others, a fund house has to meet this criterion.

People

This represents a mostly qualitative assessment of the people hired by a fund house, not just in the fund management team, but across other visible areas such as sales and customer service.  I believe that the competence and personality traits reflected across people in an organization is reflective of the thought process of the top management that drives the firm.  Yes, I lay an extra bit of emphasis on the fund management team and closely look at their experience in fund management, and understand their perspective.  I also attempt to get a sense of what has worked for them and why, and what has not worked for them and why.

Processes

This essentially boils down to an analysis of the logic and investor-friendliness of visible processes.  For instance, the manner and speed in which investor questions and complaints are addressed.  Or the ease offered to investors wishing to invest directly.

Practices

This is a checklist of practices that I would not expect a fund house to follow.  It is a list that continues to evolve as questionable practices emerge.  Here are some key points that I look out for:

• Frequent launches of new funds
• Unjustifiably high expense ratios
• Ambiguity and inconsistencies relating to expense ratios (includes non-disclosure in fact sheets, and frequent changes)
• Dubious representation of fund performance
• Inordinate incentivizing of financial advisors
• Inexplicable changes in investment objectives of schemes

By applying these filters to the forty odd fund houses currently existing, there are only five that I feel comfortable recommending and investing significant amounts with.  To set the record straight, I accept the possibility that I may have a brutal evaluation process.  However, it is one that I have found no compelling reason to compromise on.

Selecting the right debt fund

For all their similarities, debt funds are not all alike.  Ideally, to identify the right fund to invest into, one should have a thorough understanding of the risks involved in investing in debt funds and how to assess these risks.  This becomes all the more important because, in my opinion, the potential heartburn from selecting an inappropriate debt fund can be far more than in the case of any other category of funds.  While, over time, I hope to devote posts to talking about these risks and how to assess them, in this post, I’d like to present a straightforward way to understand the types of debt funds and their suitability.

Let me start by suggesting that debt funds can be grouped into three broad categories:

Category A: Closed-end schemes

Category B: Open-end schemes where the fund manager can make significant changes to the average maturity

Category C: Open-end schemes where the fund manager intends to keep the average maturity within a narrow band

This is not a textbook classification but I believe it is the best way to assess the suitability of a fund. To facilitate understanding as to which funds fit in what category, I will be linking these with the categories put forth by Value Research.  You may notice a certain ambiguity to the definitions (what, for instance would ‘significant’ or ‘narrow’ mean?)- but interpreting these will be less relevant once I link these to the categories of Value Research.

Let me now elaborate on these categories.

Category A : This is really the same as Value Research’s category: Fixed Maturity Plans.  Like deposits, these funds have a fixed tenure. Amongst all categories, these carry the highest level of predictability as to the returns one can expect. The returns on such funds virtually mirror the returns of the underlying debt instruments. This is a key reason why a number of advisors strongly encourage their clients to invest in these funds.

On the flip side, these funds typically carry severe restrictions in case we need to withdraw before the term of the fund. It is possible we may not even be able to do so.  For this reason, these are best suited for investors with crystal clarity about the time they would like to stay invested.  The right fund is one whose tenure matches one’s own investment time horizon.

Do bear in mind that at the time of investing, we do not know the exact composition of the portfolio of the fund. Once the portfolio is disclosed, if we don’t like what we see, it may not be easy to walk out. It, therefore, becomes important to get as much clarity as we can, about what the portfolio will look like, before we invest our money. Additionally, at the end of their tenure, these are compulsorily redeemed- we cannot defer exiting the fund beyond that time.  This is important because taxes, if any, become due the moment we redeem an investment.

Category B: This would include funds in the following categories of Value Research: Income, Gilt-Medium and Long Term, and Gilt-Short Term. 

These funds are best suited for investors who are looking for the highest returns (among debt funds) and are willing to take higher risk, and to time their entry into, and exit from these funds.  To put it differently, these funds are an acquired taste- these are not for everyone. These carry the highest level of unpredictability as to the returns one can expect.  Historical 1 year returns show that it is not uncommon to see a double-digit difference between the returns of the best performing and the worst performing funds, particularly in the Income and Gilt-Medium and Long Term categories.  In the turbulence of mid-July to mid-August, 2013, the worst performing funds in each of these three categories had lost between 5% and 12%. 

Category C: This would include funds in the following categories of Value Research: Liquid, Ultra Short Term, and Short Term.  Like the funds in Category B, being open-end schemes, these allow one to defer one’s exit (and taxes) for as long as one wants to.  But because of their targeted maturity being more narrowly defined than those in Category B, there is a higher level of predictability to their returns.

Here is how I look at their suitability, relative to comparable bank deposits:

• For someone with an investment horizon of up to 3 months, funds in the Liquid category can be a good choice and, in my opinion, can be expected to give better returns than a bank deposit. 
• For someone with a investment horizon of over 3 months and less than a year, funds in the  Ultra Short Term category can be a good choice and in my opinion, can be expected to give better returns than a bank deposit. 
• For someone with a time horizon of over a year but less than 3 years, I would recommend going for a bank deposit rather than a debt fund. 
• For someone with a time horizon of over 3 years, and with no taxable income or who is in the lowest tax bracket, I would again recommend a bank deposit over a debt fund. 
• For someone with a time horizon of over 3 years, and in the higher tax brackets, funds in the Ultra Short Term and Short Term categories can be a good choice and can be expected to give better returns than a bank deposit, after adjusting for taxes.

To take all of this further towards deciding which specific fund to select, as I mentioned at the start, it would help to understand the risks involved in investing in debt funds and how to assess these risks.  I hope to dwell on these in detail in future posts.  For now, I would like to close with a mention of one important indicator to consider while selecting a fund: the expense ratio. 

The expense ratio tells us how much is deducted as expenses by the fund house from whatever they have earned from their investments.  While this is an important indicator across all kinds of funds, it is particularly crucial in the context of debt funds.  Here’s one way to look at this: if two funds follow identical strategies and take identical risks, the fund with the lesser expense ratio will give better returns.  A note of caution: As important as this is, in my opinion, there is generally a lack of transparency regarding this indicator across the mutual fund industry.  Though, in all fairness, Value Research and Morningstar provide this indicator for most funds, most fund houses don’t disclose this in their monthly fact sheets.

For that reason, personally, I focus only on funds where the expense ratio is disclosed transparently, month after month, in their fact sheets.

Using Past Performance Data to Select a Fund

A number of people analyze the past performance data of funds to determine which funds to buy. If you are one of them, and if your analysis has been working well for you, don’t bother to read any further. If not, here are three guideposts that you might want to use. These are not absolute truths but merely a personal opinion of some of the things to bear in mind.

1. Performance analysis is best done in the context of fund strategy.

Not knowing a fund’s strategy carries the risk of misjudging the fund’s performance. For instance, given their strategy, certain equity funds are expected to do better than market indices in periods when share prices are falling while others are expected to do better than market indices in periods when share prices are rising. Lack of awareness of the strategy may result in giving more credit to a fund manager than is necessary, or less credit than he/she deserves.

2. Be careful of performance snapshots

Most of us use performance snapshots in one form or another. Tables showing the trailing returns (e.g. returns for the last 3 years/ 5 years etc.) are a common example of such a snapshot. Charts showing the NAV movement over a period of time are another common example of such a snapshot. While, these are easily available and appear easy to understand, these have limitations that can also lead to misjudgment of a fund’s performance. Here’s an example. Table 1 below gives the trailing returns of two funds as on 31 Dec, 2010.

Table 1: Trailing Returns (Annualized) as on 31 Dec, 2010

	Fund A	Fund B
Last 1 year	17.9%	14.6%
Last 2 years	54.0%	59.3%
Last 3 years	13.2%	15.3%
Last 4 years	23.5%	24.4%
Last 5 years	24.2%	24.7%

A number of people are inclined to conclude that except for the immediate previous year, Fund B had mostly given better returns than Fund A. The truth is somewhat different. Table 2 below gives the quarterly returns of these two funds from 2006 to 2010. You may notice that other than in the second quarter of 2009, Fund B had never beaten Fund A in any of the remaining quarters.

Table 2: Quarterly Returns 2006-2010

2006	Fund A	Fund B
Q1	14.7%	14.7%
Q2	-11.2%	-11.8%
Q3	15.8%	15.2%
Q4	7.7%	7.7%

2007	Fund A	Fund B
Q1	-3.4%	-3.5%
Q2	20.5%	19.6%
Q3	15.0%	14.6%
Q4	19.6%	18.3%

2008	Fund A	Fund B
Q1	-15.9%	-16.2%
Q2	-12.9%	-13.4%
Q3	2.6%	2.5%
Q4	-18.7%	-18.8%

2009	Fund A	Fund B
Q1	2.7%	2.5%
Q2	52.1%	68.5%
Q3	20.1%	20.0%
Q4	7.3%	6.8%

2010	Fund A	Fund B
Q1	4.8%	2.4%
Q2	0.1%	0.1%
Q3	11.9%	11.5%
Q4	0.4%	0.3%

In effect, one recent month or quarter of good returns or bad returns can have a cascading effect on the trailing returns.

3. Performance is more than just returns

Actual returns represent one aspect of performance. While to some, this may be enough, the fact is that these returns were never assured and that there was always a degree of uncertainty attached to these returns (technically referred to, as ‘risk’). Most experts agree that the actual returns need to be seen in light of these risks. Technically speaking, they refer to this, as examining ‘risk-adjusted returns.’ In my opinion, too, analyzing risk-adjusted returns represents a better way of assessing the competence of a fund manager.

It may appear, from the above, that analyzing fund performance data isn’t as simple as one may have thought. If so, I suggest using the services of a good financial advisor. However, if you would like to understand more on this subject, Morningstar has put together an excellent article that offers multiple perspectives from their in-house experts on how to use fund performance data to evaluate funds. Here is the link.