Active funds and paradox of choices

The number of mutual fund offerings has increased considerably in the last 10 years. This ought to bring cheer to investors; for more funds should essentially mean better investment choices. But more choices are not always better! Here is a simple rule that you can use to select funds.

Paradox of choices

Portfolio management works on simple arithmetic. Collectively, those who outperform the benchmark index do so at the expense of those who underperform it. Suppose there are only three investors in the market- you and two of your friends. Suppose the annual return on the Nifty Index is 10 per cent. If you generated 14 per cent annual return, the excess four percentage points should have come from the collective underperformance of both your friends.

Now, the excess return comes from unique strategies. More unique the strategy, greater the chances that the fund manager can generate excess returns for a longer period. The problem is that a fund's uniqueness is likely to fade faster as the number of active funds increases. After all, these funds are chasing the same universe of stocks and, hence, could end-up with similar portfolios!

The increasing number of active funds, therefore, has two implications. One, the period for which a fund manager can generate excess return is likely to shorten.

We call this the alpha fade rate; alpha refers to the excess return over the benchmark index. And two, generating excess return will become more inconsistent; volatility of the alpha will increase.

Besides, the increasing number of funds makes your fund selection process even more difficult! How should you choose a large-cap fund from a universe of, say, 75 funds?

1/n heuristic

When the Nobel-prizing-winning economist, Harry Markowitz, was forced to decide on how much to invest for his retirement fund, he chose to investment equally in equity and bonds! In behavioural finance, this strategy is called 1/n heuristic. We borrow Markowitz's asset allocation strategy to suggest a simple way for you to choose mutual funds.

We suggest you take two funds in each category. That is, two large-cap funds and two mid-cap funds and, perhaps, two sector funds. You should buy one active fund and passive fund from each style category. Using the 1/n heuristic, you will invest equal amount in all these funds.

Buy one large-cap active fund and one large-cap index fund. Index funds are easy to choose — you simply buy the one that charges low fees and closely tracks the index. Such funds give you average returns.

But how should you choose an active fund? We understand your comfort in choosing funds based on past performance. So, choose an active fund that has figured as one of the top five performers during all of the last 1, 3 and 5 years. You can then apply the second factor- familiarity or name-brand recall. If they are two or more funds based on the performance factor, apply the second factor- buy the product from the mutual-fund complex you are familiar with! We suggest this process because you may be unable to do a clinical evaluation of fund performance.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor learning solutions. He can be reached at >enhancek@gmail.com )

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