The Hindu Business Line : Quantitative approach to fund selection

A fund house that specialises in running Fund of Fund products, Optimix, shares its approach in selecting good mutual funds for an investors' portfolio.

The process of fund selection has become increasingly difficult in an environment where volatility is significant, new fund houses are entering the market touting their skills and the number of funds are on the rise. In this environment, it is important to focus on selecting a fund/funds that will generate consistent investment performance.

When making a decision on fund selection, one needs to consider the following:

Investment period or time horizon;

Whether the fund is part of an overall pool of funds selected or a single investment;

Amount of risk willing to be taken;

What is the investment benchmark?

Don't chase performance alone.

Once these questions are answered, one can turn to the appropriate fund selection choices from the available universe.

However, as every mutual fund disclaimer states: "Past performance is not necessarily a good indicator of future returns." Thus, performance analysis on its own can only provide part of the crystal ball required to pick funds that will deliver consistent returns. A trap which investors commonly fall into is that of chasing performance and investing after most of the out-performance has occurred. This may lead to a situation where an investor gets into a fund, when the stocks the fund manager has invested in are taking a breather after a strong rally, with most of the value already unlocked.

To achieve consistent performance, an investor should consider the following qualitative factors as well:

History of the fund and the investment manager responsible for it;

Stated investment process and objectives of the fund in the offer document;

The focus of the Asset Management Company (AMC) offering the product in the Indian market;

Breadth and depth available in terms of research, not only in the investment team but, overall, in the global context;

Look at risk-adjusted numbers.

In addition, quantitative analysis also remains an integral part of fund selection. One must look not purely at investment performance, but also understand the risk taken to generate it. Performance generated is always a function of the risk taken. Some equity funds factor in risk in terms of possible capital loss. Some consider risk relative to the respective benchmark such as S&P CNX Nifty or BSE Sensex. Some of the tools used to capture risk-adjusted performance are:

Tracking error and standard deviation to measure risk;

Returns adjusted for risk taken (referred to as Information Ratio — reflects risk against benchmark);

Returns adjusted for risk taken (referred to as Sharpe Ratio — reflects risk against capital loss);

Performance in up and down markets;

Correlation of performance to the benchmark and other equity funds.

Monitoring performance over short-term periods using the above tools is a poor source of information; hence, a period of analysis of at least a year is generally required to assess the attributes of a fund. Remember this may not mean that one cannot invest in a New Fund Offer. In an NFO situation, one needs to look at the track record of the investment team/fund manager to identify what skills can be replicated in the portfolio and by studying the investment process from the offer document.

How we do it

The Optimix investment process has the benefit of a large database of information which allows us to increase our research capabilities. We study some of the following issues when we select funds:

Qualitative factors

Strength and stability of the investment team;

Stability of the investment process and ability to adhere to it in all environments;

Research backing of an AMC.

Quantitative factors

Style analysis to decipher the style biases of a fund through the portfolio of stocks held;

Attribution analysis to decipher where the core skill sets of extracting value lie;

Risk analysis in understanding which parts of the portfolio contribute to investment performance.

Optimix gives more importance to qualitative aspects as its philosophy to fund selection focusses on trying to identify tomorrow's winners, rather than yesterday's heroes.

In this case, it is only through strategy and a top-down view, in conjunction with performance and risk analysis, that drives Optmix to select funds.

(The author is CIO, Optimix.)

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