How do you usually select equity funds for your portfolio? If you simply look at the screen and pick up the top-ranking funds for the last one year, you may be in trouble.

Sample this: Twenty of the top 25 equity funds in 2009 did not figure in the top-25 list in 2010. Worse, at least half of these 2009 toppers either returned lower than the equity category average (19 per cent) or just about managed to beat it in 2010. Short-term return charts don't tell the real story on performance.

Before the long-term investors pat themselves on the back, here's some glum news for them as well. Some of the historic top performers such as Franklin India Prima Plus, DSPBR Top 100 and Sundaram Select Midcap also saw slippages in performance in the last three years. So, should you think long-term or short-term?

The long and short of it is that investors need to have a mixed strategy for optimal returns. And here's how.

Testing times

The years 2008-10, with their up and down stock markets, hold many lessons for equity fund investors. The first is that there are huge shifts in the rankings of equity funds from year to year. This demonstrates the futility of selecting funds for your long-term portfolio based on returns for a year or less.

Two, even after choosing funds based on their longer track records, investors may have to check back and reshuffle their portfolio from time to time. Booking profits may be essential when you hold theme funds and mid-cap funds, to protect returns. Three, nothing works the way SIPs do in a see-sawing market, although the benefits are not immediately visible.

We take a quick look at how the last three years turned out to be a game-changer for mutual funds. The last three years ensured that mutual funds were put through three key testing phases of market – 2008 being a year of onslaught by the bears; 2009 saw a spectacular rally and 2010, a more fluid and volatile phase.

Churn in midcap funds

Midcap funds as a category experienced the most churn in their return rankings over the last three years. While most of them were uniformly beaten down in 2008, the swings in performance between 2009 and 2010 appeared rather erratic. Funds such as JM Midcap that appeared in the toppers' list in 2009 fell to the bottom in 2010. The more established funds such as UTI Midcap, Sundaram Select Midcap or Magnum Global, which bounced back in 2009, too slipped below the top quartile in 2010.

Unfortunately, performance in the last two years were crucial for mid-cap funds' long-term record, especially after the onslaught. The short-term underperformance, therefore, weighed on the three-year scorecard — one half of the mid-cap universe remains covered in red and only a couple of funds sport double-digit returns. Others such as HDFC Mid-Cap Opportunities, IDFC Premier Equity instead, led the rally in 2010 and also rose in rankings over a cumulative three-year period.

Clearly, mid-cap funds are a tricky category to navigate, especially for those building a mid-cap biased portfolio to achieve medium-term goals. Given these circumstances, it may be prudent to stick to a couple of funds and use a profit-booking strategy in exceptional years such as the 2007 or 2009 rally.

A compounded annual return of 25 per cent over a five-year period is reason enough to book profits. SIPs over at least a three-year time-frame appear to be the best option to handle volatility in mid-cap funds. A SIP in the last three years in IDFC Premier Equity Plan A, for instance, would have delivered 26 per cent compounded returns, against a meagre 8 per cent return through lumpsum investment at the beginning of the period.

Unpredictable themes

Sector funds can easily destroy your wealth as easily as they build it. Even funds playing on so-called ‘secular' themes such as power, capex and infrastructure, which notched up good performance in the three years to 2008, slipped up thereafter.

Reliance Diversified Power Sector Fund, for instance, sported a 21 per cent compounded return over three years ending December 2008 and was the top performer in this period. But the fund dismally lagged markets from March 2009 and now sports a 1.3 per cent decline compounded annually over the last three years. Similar has been the case with theme funds such as Tata Infrastructure or Sundaram Capex Opportunities.

The lesson: Unlike diversified equity funds, theme funds are all about timing. Select theme funds only if you have conviction about the theme or sector's performance over the next one to two years and book profits on target returns. A sector fund, once the sector cycle turns, may be an underperformer no matter what its track record.

Commodity, energy and technology funds all come tagged with these risks. Pharma funds and FMCG funds which have had a fairly long run for the last two years now, may be no exception to this rule.

However, banking and financial services has strangely panned out to be more of a secular theme, perhaps being directly linked to economic growth. A strategy of booking profits and holding to capital may be apt for those holding this set of funds.

Rankings change but….

JM Large Cap Fund, which contained declines well in 2008 failed in subsequent years, while the spectacular rally of Principal PNB Long Term Equity in 2009, did not prevent it from finishing in the last quartile of the performance charts over a three-year time frame. This being the case, we have consistently maintained that investors should go for funds with a good long term track record. However, even this has not been easy as some of the noteworthy funds pre-2008 have slipped in the performance charts during this bull market.

A comparison of three- and five-year performance chart suggests that only 9 of the top 25 diversified funds that appeared in the five-year chart, found their way into the three-year top-25 list. However, not much is lost as barring three funds (Magnum Equity, Franklin India Prima Plus and Principal Large Cap) the remaining funds remained in the top quartile.

Resorting to high cash holding in 2008 or inability to quickly reallocate assets to equity in 2009 appears to have cost funds such as Reliance Vision, Principal Large Cap, Reliance Growth and Magnum Contra dearly.

While holding these funds would do no harm, given their still sound portfolio and ability to beat their benchmark, investors running SIPs in these funds may have to take a re-look.

Seen in the light of their less inspiring performance, high return targets in the medium term may be tough to achieve. A switch in such cases may become necessary if funds underperform benchmark for a year and show a lag of 5-10 percentage points during a rally.

This said, there remain some all-season funds that proved their ability to contain downsides better than market during the 2008 correction and also bounce back in style in 2009. HDFC Equity, Quantum Long Term Equity, HDFC Top 200 and Birla Dividend Yield Plus are some of the prominent funds that appear in this list. Surprisingly, these funds were seldom seen in the top of the equity fund score card every year, although they have remained in the top quartile in every one of these years.

Consistency rather than super-normal performance has been the key to their generating long term wealth for investors. HDFC Equity for instance has beat its benchmark CNX 500 80 per cent of the time on a rolling return basis over the last three years.

Balanced approach

In tough times balanced funds have emerged as the more dependable equity-oriented class, thanks to the cushion from their debt exposure.

Funds such as HDFC Prudence, Birla Sun Life 95, HDFC Balanced, Reliance Regular Savings Balanced and Canara Robeco Balance have also remained steady in their medium and long term performance and comfortably beaten broad equity indices over a three-year time frame. They thus, turn out to be best bets for hassle-free investing.

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