Best mutual funds

One of the key lessons for equity investors in 2009 was that the change from a bear market to a bull run can be unexpectedly swift. Buoyed by a series of developments, the markets moved up at a breathtaking pace, much to the bewilderment of even the most seasoned players. In just 21 trading sessions, starting 9 March 2009, the Nifty shot up by 35 per cent. In the next 21 trading days, it rose by another 24 per cent to touch 4,323 on 18 May. This was a 68 per cent rise in 42 sessions and possibly the swiftest growth registered by the benchmark index in recent years. The markets have been on an uptrend since then, with the Nifty rising by 20 per cent.

For the long-term investor, these events are but minor blips in a multi-year journey. After all, the performance of an investment in a single year should matter only to those who are going to liquidate their portfolios at the end of that year. This is the reason that the Money Today-Value Research ranking of best mutual funds is based on a robust statistical model that assesses a fund on several counts, including returns, risks and consistency over the long term. It does not look only at the returns that a mutual fund is generating, but also the risk it is facing to earn those returns.

This also means that the best scheme is not necessarily the one that gave the highest returns. A fund may not even figure in the top 10 list if its performance has not been consistent or if it has taken undue risks. Instead, a fund that has outperformed the category and its benchmark year after year without exposing itself to too much risk will find a place. The UTI Opportunities Fund, for instance, has grown only 67.9 per cent in the past one year compared with the 104.3 per cent growth registered by JM Emerging Leaders. Yet, the UTI offering is ranked 7th, while the JM fund finds no mention. Consistency, not lumpy performance, has been considered.

In the new scheme of things, it is not enough for a mutual fund to diversify only across sectors. In the past one year, mid-cap stocks have outperformed large-caps by a huge margin. The 53.98 per cent growth in the Sensex between 1 May 2009 and 30 April 2010 pales in comparison to the 104.5 per cent clocked by the BSE Midcap Index during the same period. So, diversification across market caps is equally important. Flexi-cap funds, which invest across market caps, have performed better than those with an iron-clad mandate. This year's top 10 diversified equity funds hold a judicious mix of large-, mid- and small-cap stocks. Seven of these have a decidedly mid-cap orientation, while four have more than 30 per cent invested in small-cap stocks. Flexibility is the key to success in this market.

Mid-cap and small-cap stocks are generally riskier than large caps, but investors needn't worry. These funds are unlikely to let you down because they are managed by some of the sharpest minds on Dalal Street, who understand the risks and know how to contain them. An equity fund could face a stock-specific or a systemic risk, while a debt fund could face credit and interest rate risks. Our story looks at the risks that a fund manager faces.

The fund manager is not only the chief investment officer but also the custodian of your trust. When you put your hard-earned money in a fund, you expect him to utilise it in the best possible manner. His money management skills decide whether your investment earns 125 per cent or 34 per cent. These are the returns earned by the best and worst performing funds in the past one year. We take a closer look at the investment strategies of some fund managers to understand how they have shaped the destinies of the schemes under their charge.

Our lists this year have some notable exclusions. None of the top 10 diversified equity funds recommended in 2007 and 2008 have made it to the list of honours. It doesn't make them duds. Far from it. They may not be chart-busters, but these funds continue to make wealth for investors steadily. For instance, the top-rated fund of 2007, HDFC Equity, has given annualised returns of 30.5 per cent in the past five years, far above the category average of 22.5 per cent and only second to the best performing fund. While its three-year annualised returns of 17.4 per cent are lower than those of the best fund, they are nearly double the category average and the broader market. Our story on consistent performers reaffirms the ratings assigned to these funds in the previous years.

Readers should note that the ratings and rankings do not last forever. A fund undergoes changes that may have a bearing on its performance. So an investor needs to keep track of his fund's performance and make necessary changes. This need not be done very frequently, just once in a year. There is no need to worry if a five-star fund slips to four stars. Even a three-star rating should not trigger panic. But when it falls to below three stars, it is time to act. One star, and you know you have the wrong fund.

We have looked at some one-star and two-star rated funds that have consistently lagged behind the category average and benchmark indices. More than Rs 7,000 crore invested in 36 underperforming equity funds earned less than the piffling 3.5 per cent received on the balance in a savings bank account. In some cases, the value of the investment has halved even though the overall market and benchmarks have risen. We look at how these funds have destroyed investors' wealth in the past three years and what they should do to avoid further losses. "Investors often stay put in underperforming funds so that they can get their capital back. This is a bad strategy driven more by sentiment than logic. If a fund underperforms, it is best to exit and move to a better scheme," says Swapnil Pawar, head of HNI Solutions at Karvy Private Wealth.

The removal of entry loads has been the biggest change in the mutual fund space in the past year. We look at how investing has changed following the removal of loads and other measures introduced by the market regulators in recent months.

While investing has changed, the cardinal rules of investing have not. Systematic investment plans continue to be the best way to buy equity funds. There is no need to buy too many funds. A basket of 5-6 funds can give you all the diversification you need. Adding more funds will only duplicate your holdings and increase your paperwork. Investments in equities should be done for at least three years. If your tenure is short, go for debt funds.

This year's package goes beyond a simple ranking of best funds or giving the reader a list of funds to invest in. We have developed four portfolios for different types of investors. The Money Today-Value Research Lifestage Fund Portfolios will invest in a basket of 4-6 funds and have different asset allocations. Value Research has chosen the funds that would require minimal intervention except an annual rebalancing. We will track the performance of these portfolios every month and inform the readers if any change is required.

Ranking methodology
It's easy to get carried away when everything is going your way. The stock market is touching new highs, equity funds have churned out phenomenal returns, and corporate results have been positive. But it is during such euphoric times that investors make their biggest mistakes. This is why the fourth Money Today-Value Research ranking of best mutual funds is a useful guide to help identify the most promising funds across six categories.

Evaluating funds
For equity and hybrid funds, the ratings are based on the risk grade of each fund compared with other funds in the category over the past three years. For debt funds, the ratings look at the 18-month weekly risk-adjusted performance compared with other funds in the category. Value Research does not rate equity or hybrid funds that are less than three years old and debt funds less than 18 months old. A category must have at least 10 funds for it to be rated.

Measuring risk
The Value Research risk grade for funds is different from the conventional risk and volatility measures like standard deviation and beta as they indicate only downside volatility. The fund risk grade not only takes into account absolute losses but also the periods when the fund underperforms a risk-free investment. The rationale: you can always earn a risk-free return from a bank deposit. The risk of investing in a fund not only includes the possibility of losing money but also the chance of earning less than you would on a guaranteed investment.

To calculate fund risk, monthly/weekly fund returns are compared with the monthly risk-free returns for equity and hybrid funds and weekly risk-free returns for debt funds. Risk-free return is defined as SBI's 45-180-day term deposit rate. For all months/weeks that the fund underperforms the risk-free return, the magnitude of the underperformance is added. This gives the average underperformance and how the fund performs vis-a-vis its category average. The relative performance of the fund is expressed as a risk score, which captures the fund's risk of loss.

Star rating
The Value Research fund rating is calculated by subtracting the fund's risk score from its return score. Then the final score is assigned a star rating according to the distribution above.