Mutual Fund Selection: The Equity Midas Approach
Mutual Funds – The Problem of Plenty
There is no doubt that mutual funds represent an optimal investment vehicle for the average investor seeking to participate in equity markets; however, they also present a considerable challenge.
Currently, India boasts large number of mutual funds comparable to the number of listed companies. With over 40 Asset Management Companies (AMCs) offering thousands of mutual fund schemes that encompass a wide array of strategies and asset combinations, it becomes exceedingly difficult to discern the most suitable mutual fund portfolio. Investors are keen to capitalize on the prevailing bull markets while simultaneously avoiding significant declines in their portfolio value.
So, how can this dilemma be addressed? What strategies should a typical investor employ to identify the appropriate mutual funds?
Systematic Investment Plan does solve the problem of timing the market, more importantly matching the investment cycle with the income cycle (read salary) ensures a discipline which is critical. What about the fund selection itself?
One potential solution is to consult with SEBI Registered Investment Advisor for tailored financial planning. Alternatively, one may approach this challenge with a degree of market knowledge and some sound judgment.
We will explain our approach in this document. Please note that this is not our advice or our recommendation; this is just how we do it.
What Works in Stock Markets?
Warren Buffett once said, “Investing in stock markets is simple but not easy,” and this sentiment is particularly relevant today.
With the rise of brokers offering zero-commission trading, we now have the convenience of investing through various platforms such as websites and mobile apps at almost no brokerage cost. The advent of demat accounts, integrated payment systems, and automated reporting has certainly streamlined the investment process and made tracking investments more accessible. However, these advancements do not necessarily simplify the complexities of investing.
Successful investing still requires a blend of knowledge, skill, and the right temperament. Investment decisions are often guided by specific philosophies and strategies that shape an investor’s approach.
Historically, three investment strategies have demonstrated long-term success across different market conditions:
They are:
- Value Investing: This strategy focuses on acquiring high-quality companies at prices below their intrinsic value.
- Growth Investing: This approach involves investing in smaller companies that exhibit significant growth potential.
- Momentum Investing: This strategy entails purchasing stocks that are currently experiencing upward price trends.
Understanding and applying these strategies can help investors navigate the complexities of the market effectively without worrying about the market conditions or trying to time the market. A strategic combination of Value, Growth, and Momentum provides a robust defense against varying market conditions.
In favorable market environments, Growth and Momentum strategies tend to outperform, while during downturns, Value investments can mitigate potential losses. In a raging bull market, the fear of missing out (FOMO) is mitigated, as the momentum component of your investments is likely to yield significant benefits.
Why Mutual Funds?
These three investment strategies are optimally implemented through mutual funds for the typical investor. The rationale is as follows:
Both Value and Growth investing necessitates a thorough analysis of the company, its industry, and the prevailing market conditions, in addition to an assessment of management and the competitive advantages of the business. Mutual funds, equipped with extensive analytical resources and broad market access, are ideally suited to execute these strategies effectively.
The Momentum strategy is particularly advantageous for mutual funds due to the absence of capital gains tax at the fund level. While capital gains are taxed at the individual investor level, mutual funds can adjust their holdings without incurring immediate tax liabilities, thereby enhancing their returns and agility.
Mutual funds, hence, have a definite edge when it comes to investing in stock markets.
Selecting the Right Mutual Funds
Now that we know what strategies work in stock markets, it is also essential to understand which strategies are best suited for different types of companies:
1. Momentum investing is most appropriate for mid-cap stocks. While small caps may experience rapid price fluctuations, they are also vulnerable to “pump and dump” schemes and are generally more volatile, making them better suited for strategies that assess company fundamentals prior to investment. Large caps tend to be slower movers and are therefore not ideal for Momentum strategies, which often overlook quality considerations.
2. Small caps are particularly well-suited for growth investing, where the key criterion for selection is “potential.” Growth investing focuses on identifying high-potential companies, a task best left to experts who conduct thorough analyses of individual firms.
3. Value investing provides stability (low volatility) to a portfolio, offering steady and reliable growth, making large caps an optimal choice for this strategy.
Together, the strategy of Growth + Value + Momentum, then can also cover the entire spectrum of listed companies, if implemented correctly. Remember, investing options exist across all market segments and no investor wants to lose out on such opportunities.
In addition to these three strategies, numerous mutual funds are marketed under labels such as “emerging,” “focused,” or “contrarian.” These funds may incorporate one or more of the strategies discussed above. Furthermore, some mutual funds may blend strategies and asset classes, such as combining Debt and Equity or including Gold alongside other assets.
Asset mix is crucial yet highly individualized consideration. Mutual funds may not always be the optimal vehicle for achieving the desired asset allocation, and it is advisable to consult a registered investment adviser for personalized guidance.
Here are the steps to identify the right mutual funds:
- Prioritize the investment strategy, followed by the selection of the fund manager, and finally, the specific fund.
- Choose funds that have successfully navigated various market cycles, organizational changes, ownership transitions, or other significant disruptions while maintaining their core investment philosophy.
- Ensure that the selected funds exhibit minimal overlap and, more importantly, no correlation in performance.
- Aim to encompass the full spectrum of market opportunities, as potential exists across all market segments.
- Align the fund’s investment philosophy with your overall strategy.
- Assess the fund’s resilience in adhering to its strategy, even during unfavorable market conditions.
- Review the fund’s performance during the decade from 2010 to 2020, a period characterized by diverse market conditions, including both exuberance and downturns, which serves as an effective benchmark for evaluating fund performance.
- Additionally, opting for a DIRECT investment in mutual funds eliminates the 0.5-1.0% fees typically associated with distributors or agents. Platforms such as mfcentral.com offer excellent opportunities for individual investors.
Based on these strategies, we identified the following mutual fund options that align with their philosophies and have a strong track record. These are merely examples, and other similar mutual funds may also be worth considering:
- Value Investing: Parag Parikh Long Term Equity, HDFC Flexi cap
- Growth Investing: Nippon India Small Cap Fund, SBI Small Cap
- Momentum Investing: Quant Mid-Cap Fund, UTI Momentum Fund
These are funds that are leaders in their respective categories with a long-term performance history. Since they employ diverse strategies there is a minimal overlap in their holdings and hence a potentially low correlation in performance.
Each of these funds has demonstrated effective management and commendable returns over the past decade.
Note: There are just a few options, the key is to align the fund with your strategy. Some effort from individual investors is necessary to finalize the mutual fund combination.
To Summarize
A strategic combination of Value, Growth, and Momentum provides a robust defense against varying market conditions.
As an individual investor, it is crucial to develop a personalized investment strategy, which should be the initial step in mutual fund investing. Typically, mutual fund advisors begin with the AMC/fund and its historical performance, often leading investors to overlook this critical factor.
Once you have redefined your mutual fund investment strategy, it is advisable to review your current mutual fund holdings to ensure they align with your newly established strategy. If discrepancies are found, it may be the time to make some adjustments.
About Equity Midas Capital
Ashish Arole, the proprietor of Equity Midas Capital, is a SEBI Registered Research Analyst. We offer quantitatively curated stock recommendations for subscription.
Our proprietary quantitative model, “Expectations Value Model” (EVM) uses the combinations of company’s financial performance, derived market expectations and quantitative assessment of company’s ability to meet these expectations to identify stock recommendations.
We DO NOT offer personalized financial planning, nor do we engage in distribution of any financial products. Building quantitative models is our passion and subscription to our research/recommendations, our only business.
Our Registration & Contact Details:
| SEBI Registered Name | ASHISH AROLE PROPRIETOR OF EQUITY MIDAS CAPITAL |
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| Website | https://equitymidas.com |
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