The official portfolio-based categorisation of mutual funds has triggered investors' interest into a suboptimal way of choosing funds
30-Jul-2018 •Dhirendra Kumar
Investors choose or reject mutual funds according to a variety of criteria. Useful ones are obvious, like track record of returns, volatility, suitability to one's needs and other things like that. Obviously, there are unsuitable ones like brand image or the pushiness of the salesperson, to name just two that, in my experience, are the most common. However, one way of choosing mutual funds that sounds legitimate and yet is utterly wrong is to study and evaluate the fund's underlying portfolio and second guess it.
This approach is based on the idea that investors should choose funds on the basis of the funds' portfolios. Unfortunately, there's no shortage of people who try and do this. The strange thing is that this style of analysing mutual funds is prevalent not just among investors but even among some analysts and in parts of the financial media. Generally, the approach taken by this kind of analysis is to find out a fund's latest investment portfolio and then see if the individual stocks are likely to go up in the near future.
This method has two major problems. One, it will work well only if the investor is a better judge of stocks than the fund manager. The underlying assumption is that the investor or his advisor knows which stocks are going to do well and which are not and that they should evaluate funds on this basis. Often, this is done by investors who have been investing directly in equities and also in funds. Going by what I've seen, this is driven by stock brokerages that have also gotten into the funds business. They just replicate what they've been doing for equity. Their fund reports will actually say something like "HDFC Bank and Maruti are in the top holdings of this fund but our research team says these are overvalued so don't buy this fund". These are equity sales outfits pretending to do research so they just replicate that approach for choosing mutual funds. When all you have is a hammer, then everything looks like a nail.
The other common issue is seen more often in the media. This has been going on for a while now but have become sharper because of social media, conforming to the outrage-led approach to all public issues that is now standard. Someone will pick out a few stocks in a fund's portfolio that has declined sharply and outrage about it, regardless of what the fund's returns have been. I've even had readers who write to me asking if it's possible to sue mutual funds for investing in a particular stock that has lost money. This seems to be implicitly based on the idea that no stock that exists in a portfolio must do badly. This is based on a misunderstanding of what a portfolio is for. Any portfolio is more than a sum of its parts. The central motive in having a portfolio is to diversify, whose goal is to limit exposure and to set off stocks against each other as balancing elements in case some do badly.
The only reasonable way to analyse and then choose a fund is based on the returns that it has generated for investors, in comparison to the benchmarks and its peers. Does the portfolio play a role? Only to judge whether the fund is sticking to its mandate (something that is now ensured by the regulator), and to analyse the past and potential quality of the returns, and that too at an aggregate level. One should ask these kind of questions to be answered by a fund's portfolio: How concentrated is a fund across industries or capitalisation bands? Are the top few holdings a lot larger than the smaller ones? Does the fund change its portfolio a lot in response to market conditions or does it change only moderately or none at all? Studying the portfolio in order to directly judge funds for selection serves no purpose.