Investing for the long term isn't enough. Selecting good funds is more important

As the saying goes, the devil is in the details. So, fund managers and experts who constantly tell investors they should invest in mutual funds ( MFs) for the long term should take note of this: Just half the eight large- cap equity schemes have outperformed their own benchmark indices in the past 15 years.

No wonder U K Sinha, chairman of the Securities and Exchange Board of India, expressed concern at the segment's performance at a recent CII Summit. Without naming the asset management companies, Sinha gave some telling numbers – for three years in a row, nine AMCs' majority schemes are underperforming their benchmarks and another nine have half their schemes doing as weakly.

We will engage with the CEOs, fund managers of these AMCs to find the reason for the poor performance. His numbers mean 18 of 41 fund houses, comprising over half the sector's schemes, underperform their benchmarks.

According to data compiled by Value Research and the Business Standard Research Bureau, over a 15 year period, only three schemes – Franklin India Bluechip, HDFC Top 200 and SBI Magnum Equity – have returned much more than their benchmark indices. One has outperformed marginally; the rest have given lower returns.

A larger sample size of 31 large- cap schemes (including index funds) with a10- year record gives a similar picture.

That is, 14 of 31 schemes underperformed their index. Put another way, invest for the long term" is only half- truth. It is more important to get into good schemes and stay invested. Short- term blips: Staying invested assumes importance because these schemes can go through hiccups in the short term. For example, all eight schemes mentioned at the outset have underperformed their respective benchmarks in the past year. In the larger sample size of 31 schemes, 20 have underperformed, whereas 11 have given better returns. But most schemes that have given better returns have performed marginally better.

According to market experts, such short- term blips should be ignored because the fund manager's call can go wrong for these periods. Especially when the Sensex has been wobbling around 18,000- 21,000 for almost three years, there is little a fund manager can do. Even his best picks might go completely wrong.

Look at long- term historical performance:

A retired commander of Air India, has with MFs is that there are too many. While MFs are simple products, how does one select from so many so- called simple options" in every category? Also, if one has to strictly go by the MF disclaimer of past performance not being an indication of future performance, there is little to go by. So, historical performance it will have to be. But don't look at short- term numbers such as one year or two- year returns. Choose a large- cap scheme or any equity scheme that has been around for one bull and one bear run. In other words, schemes that have existed for at least seven to eight years should be considered.

For a new investor, it is best to go for a well- diversified fund and not an exotic one like sector or capital protection.

Don't chase performance always. Every six months or so, funds in the top quartile will keep on changing and you cannot keep on changing the portfolio accordingly. Also, while building an MF portfolio, it is important to remember that it should have schemes with different caps. But the bias should be towards large- cap schemes. For building a long- term portfolio, one should invest 70- 80 per cent in large cap and equity balanced funds. The latter invest 70 per cent in equity and 30 per cent in debt. The rest should be invested thematic funds. But returns from thematic funds are good for shorter periods of three- four years.

Over a longer time period, balanced funds perform better than actively managed equity funds.

Benefit of doubt:

While experts recommend giving five to six quarters for a scheme to perform, he is willing to give as much as three years. And, he is largely satisfied with his investments. He has a little over 25 schemes in his portfolio and started investing in these after retirement in 2000. But, he says, there are a few duds as well. There are some schemes that have not given dividends for seven to eight years and their returns aren't spectacular either.

The lesson from him:

Don't rush into or exit a scheme in a hurry. Once you have put money in the scheme, forget about it for at least five to six quarters. Of course, forgetting does not mean you should not keep checking the performance. Check the performance every quarter and if it consistently does not do well for five to six quarters, take a call to exit the scheme. If the losses are small, book these or wait to recover the principal. Another lesson for him, according to financial planners, is that one should have fewer funds. For example, if you want to invest in large- cap schemes, have two or three at best because they will invest in similar stocks.

Like any investment, it is important to weed out bad performers.

However, investors need to ascertain that this is not a temporary phenomenon or due to structural issues. For example, a large- cap fund can underperform on a relative basis, if mid/ small cap stocks have rallied much more and vice versa.

The important thing, investors should have a mindset to book losses. The commitment should be to the asset class, which is equity in this case, and not to any particular scheme.

Should you go for index funds?

John Bogle, the father of index funds and retired CEO of Vanguard's — global leader in index funds — famous words that over long periods, index funds will beat actively- managed funds, is partially correct in the Indian circumstances as there are many opportunities for fund managers that could lead to exceptional returns.

What also works in favour is the low cost of these schemes, at one per cent (fund management fees) vis- a- vis over two per cent for actively- managed schemes. Over a long 10- 15 year term, these costs do make a difference.

For example, you invested 15 years earlier in an index scheme with a net asset value of ₹ 10 and an annual expense of one per cent. If the NAV (net asset value) is ₹ 100 after 10 years (16.59 per cent compounded annual rate of growth), after accounting for expenses it will be ₹ 94.58. On the other hand, for a similar growth in an actively- managed fund, if the scheme expense is two per cent, the NAV would fall to ₹ 87.35. Of course, the actively- managed fund might do much better or worse depending on the stock picks. Obviously,. While looking at consistent performance, one should also see if the same fund manager has been managing the money.

Over the past 20 years, since private sector MFs entered the market, the number of MF schemes have gone up to almost 3,000. However, performance for quite a is an issue. Investors should take precaution before investing.

To rephrase another quote by Bogle, "Fund investors are confident that they can easily select superior fund managers. They can go wrong... half the time."