Here's how to pick the BEST mutual funds

In each issue of Outlook Money, we discuss mutual fund (MF) products, strategies and regulation. In the last decade, the MF industry has grown substantially and today you have 1,547 funds from 30 fund houses to choose from.

This is what makes our Annual Mutual Fund Rankings and Star Ratings a definitive exercise in helping you narrow down your investment options in this Rs 3,53,310-crore (Rs 3,533.10 billion) industry.

We certainly believe that MFs are the best-suited vehicles for individual investing. Not only are they fairly well regulated, but they also have some efficient products that compare favourably in investment ease, liquidity, tax impact and variety, among the various investment options.

But as an investor, the final frontier is performance. Of what use is a well-regulated fund house that under-performs the benchmark index and doesn't justify its fund management fee. Performance is best evaluated on an annual or semi-annual basis and not by chasing NAVs.

Outlook Money presents the Annual Mutual Fund Rankings and Star Ratings 2007, the most definitive guide to staying ahead with your investments.

Based on a comprehensive risk-return analysis (See below: Methodology: How the Stars Were Born), we have ranked schemes across all categories and awarded them stars depending on their performance.

Why rating and ranking? MF rankings, based on a detailed risk-return analysis, are meant to guide you on how your scheme has performed. It's good to see your fund as high as possible in the rankings. However, past performance is not a guarantee to future returns.

There's no saying that the number one this year will retain its top spot next year. What happens if the top two schemes switch places within a year? Does it mean that the second-ranked scheme is bad and not worthy of your investment?

This dilemma gets deeper as we move further down in the rankings; how much better is a seventh ranked scheme from an eight-ranked scheme?

In reality, there's little to differentiate between, say, the top five or 10 schemes. Also, certain schemes miss the top ranking because the market segment they invest in may not have performed well, despite the scheme itself being well-managed. In a list of 100 schemes, it would be wrong to say that only the top ranked scheme is worth your money.

The key to avoiding this dilemma is to measure consistency. Enter, our star ratings. We club a clutch of successive schemes and allocate them into one of five parts, denoted by stars -- five stars being the highest, and one star being the lowest. A scheme is consistent if it wins the same set of stars year-after-year -- or even better if it adds stars to its credit.

So while, say, a top-ranked scheme may have fared better than the second-ranked scheme, both these scheme would be awarded five stars. In other words, both these schemes are worth your money.

Watch out for your scheme's star ratings, besides its rankings. Five and four star rated schemes are usually worth investing in. If your scheme has consistently been rated five stars, it makes for a better investment than, say, a fund that has topped the charts this year, but may have performed badly in the previous years.

Throughout the year, Outlook Money will revisit schemes, good or bad, that merit your attention. If a scheme, no matter how it has performed in our rankings, is worth evaluating, we will tell you about it.

The rankings are divided into 12 categories. The broad split is between debt, equity and hybrid, and these are further divided into categories that investors are familiar with.

Equity

If 2004 and 2005 were the year of mid-caps, 2006 saw large-caps staging a recovery. While CNX Mid Cap index returned 30.40 per cent, Nifty returned 40.60 per cent.

Mid-cap funds averaged 37 per cent returns last year as against 64.50 per cent in 2004. Diversified equity funds that had tilted their portfolios to mid-cap scrips in 2004 and 2005 pruned their holdings in this segment and increased their large-cap allocation. While mid-cap scrips accounted for 39 per cent, on an average, in diversified equity funds in the beginning of 2006, they went down to 33 per cent average, by December 2006.

Equity funds mirrored market volatility. The average downside risk went up considerably in 2006. Diversified equity funds under-performed Nifty and returned 35.60 per cent. However, this is not a fair comparison as Nifty consists of only large-sized, bluechip companies, while equity funds hold companies across market capitalisation.

There is an urgent need for the industry to re-look at how the benchmarks are chosen and a new industry standard benchmark needs to be mooted.

Diversified Equity (For the long-term, high-risk equity investor). Managing mid-cap portfolios was the key to this sector this year. Though large-caps outperformed mid-caps in 2006, two of the top three schemes are mid-cap oriented and the top five have over 30 per cent in mid-cap stocks. Schemes that could move in and out of mid-caps profitably managed to stay ahead.

Top dog. The year undoubtedly belongs to SBI Mutual Fund. It rules the equity category with three of its equity schemes in the top four slots. From a sleepy fund house with a poor track record (SBI Magnum Global Fund was 36 out of 41 in 2005), it has morphed into a lean mean fighting machine.

The exit of its star fund manager (Sandeep Sabherwal left in 2005), increasing competition, or choppy markets, did not hold back some outstanding schemes of this fund house. The winning scheme this year is the mid-cap oriented SBI Magnum Global Fund (SMGF).

The mantra for the win. Apart from overall good practices, the fund now holds around 50 to 55 stocks consistently, as against 30 to 35 stocks a few years back.

"We also had relatively unknown holdings in our portfolio before. We removed them," says fund manager Sanjay Sinha. Some of SMGF's biggest success stories of 2006 included Tulip IT, UTI Bank, and Gujarat State Petronet. Also, its exposure to large-cap scrips went up from four per cent in January 2006 to 27 per cent in December 2006 and this flexibility has worked to its advantage. The bloating corpus (154 per cent rise in 2006) could be a drag on the nimbleness of the fund, but Sinha seems unfazed.

And the rest. A new entrant to the top of the pops is the Sundaram BNP Paribas Select Midcap (SSM). On account of its superlative performance in 2004 and 2005 (36 per cent growth in assets and 62 per cent returns) on the back of the mid-cap mania in the market, SSM has held cash of up to 30 per cent of its corpus.

This reduced its volatility in 2006. But before you rush to buy, here are a couple of caveats: the scheme has as many as 112 stocks in its portfolio with no scrip accounting for more than 2.5 per cent of the total corpus. Marginal holdings across a bloated portfolio might strain its future performance.

Also, its star fund manager, Anoop Bhaskar, recently quit. So, how the fund would fare in 2007 remains to be seen.For last year's topper Franklin India Prima, 2006 was a bad year as it dropped 14 places this year to end at 15. While CNX Midcap index and the category average returned 30.4 and 35 per cent, respectively, Franklin Prima returned 24.1 per cent in 2006.

For a mid-cap fund, these short-term blips are normal, but you should watch the future performance of the fund carefully.

How to pick this year's winners. Other than Reliance Vision (which was at the top in 2003 and 2004), no other scheme has retained the top spot for more than a year. Don't chase the top performer, but the consistently good performer. A scheme that remains in the top quartile (top 25 per cent of all the schemes in the category) can be called a good performer.

A look at Outlook Money ratings of the past five years shows that Reliance Growth, Franklin Prima, HDFC Top 200 and HDFC Equity have been in the top quartile each year, since 2003. Franklin India Prima Plus has been in the top quartile in three of the past four years. A fresh set of fund houses are making it to the top in the last two years, such as Sundaram BNP Paribas, Birla Sun Life and DSP Merrill Lynch.

If you own schemes in the top two quartiles, it does not make sense to redeem them, there is a reinvestment cost of the entry load of 2.25 per cent in another fund house's schemes. If your funds are not making the grade in the top two quartiles, look at a split between consistent past performers and some hungry new entrants. Choose from the five star rated schemes and split your money between broadly diversified and mid-cap schemes.

Equity-Linked Savings Scheme (ELSS) (For the long-term medium-risk equity investor who also wants to save taxes). SBI Magnum Tax Gain Scheme 93 (SMTG) has topped the charts for the second year running. While its returns are miles ahead of competition (in 2006, while SMTG returned 17.2 per cent, HDFC Tax  Saver, ranked second, returned 3.6 per cent). SMTG has managed to curtail its risk profile. From being a mid-cap oriented fund till 2004, it has now become a multi-cap  scheme. Says fund manager Sanjay Sinha: "A multi-cap strategy is more suited in today's environment. A mid-cap holding of around 30 per cent gives the fund enough  scalability."

HDFC Taxsaver (HT) and HDFC Long Term Advantage (HLTA) round up the five star rated ELSS schemes. Though HT is a large-cap oriented fund and HLTA focuses on mid-caps, both have a presence in large as well as mid-sized companies. Vinay Kulkarni, who joined HDFC MF in November 2006, has managed both the schemes so far. He has aimed at pruning stocks whose core strategy does not contribute much to its earnings.

On 1 April, fund manager Chirag Setalvad re-joined HDFC MF after a gap of two and a half years. Setalvad has a good track record at HDFC MF. While Setalvad will manage HLTA, Kulkarni will manage HT. The team, led by chief investment officer Prashant Jain, is a formidable one. Watch out for its schemes in 2007.

How to pick this year's winner. Do not fall into the trap of buying a new ELSS fund every year for saving taxes, however much your agent pushes you to buy this

brand new 'New Fund Offer' (NFO). We have reliable star performers in this category, with HDFC Tax Saver in the top quartile consistently. HDFC Long Term Advantage too has been in the top quartile since its debut last year in our rankings. Other consistent performers are Prudential ICICI Tax Plan and Principal Tax Savings Fund.

Look at topping up your existing holding if you own any of the five- or four-star rated schemes. If not, redeem (if your lock-in is over) and invest in any of the top three five-star rated schemes. New money can flow into any of the top rated schemes.

Sector Funds (For the very high risk medium to long term equity investor). Technology and fast moving consumer goods (FMCG) funds performed well on a three-year basis. Tata Life Sciences and Technology Fund (TLST) topped the technology funds for the third consecutive year. As it can diversify into the pharmaceutical and healthcare sector, TLST has the flexibility of investing in multiple sectors. Franklin India IT fund finished last on account of a concentrated portfolio; 69 per cent of the portfolio was invested in its top three scrips.

Among FMCG funds, SBI Magnum Sector Umbrella-FMCG deployed its previous year's cash into equities, but still finished at the bottom of the heap. It returned a mere 7.40 per cent in 2006. Except for SBI Magnum Sector Umbrella-Pharma (SMP), the three-year returns of the other two pharmaceutical funds were disappointing. Although SMP had concentrated holdings, it finished at the top on account of superior returns.

SMP's three-year returns as on 31 December 2006 were 33.40 per cent. Reliance Banking Fund (RBF) is the new sector fund in our rankings this year. Although the fund gave moderate returns, it was one of the most volatile sectoral funds from our set of funds. Apart from aggressive fund management, it also holds a concentrated portfolio and has invested 74 per cent in the top 10 scrips.

Outlook for 2007. Bankers feel that interest rates should peak out around May-June 2007. If interest rates start falling, banks should do well. If you have a view that this scenario could play out, pick up a banking sector  scheme, or Bank BeES (a bank-based exchange traded fund) if you want to eliminate fund manager's risk. FMCG sector is expected to be defensive and some companies may do well. FMCG funds are for you, if you have a view on this sector.

HYBRID

Like in 2005, hybrid funds (schemes that invest in equity and debt) rode the crests of the equity markets to give high returns this year too. In fact, hybrid schemes,  including monthly income plans (MIPs), increased their exposure to large-cap scrips in 2006. As they are more stable than mid-cap scrips, the holding of large-cap scrips bode well for monthly income plans as these schemes aim to pay monthly income.

This year, we rationalised this category. We split the MIP category into two -- equities -- significant exposure and equities-marginal exposure. All schemes that can invest up to 20 per cent in equities are clubbed under equities-marginal exposure. All schemes that can invest up to 40 per cent in equities are clubbed under equities-significant exposure. Rest went to the balanced funds category.

Balanced (For the medium to long-term medium-risk equity investor). Balanced funds got riskier, thanks to Budget 2006. Effective April 2006, equity-oriented funds

 were mandated to hold at least 65 per cent (up from 50 to 60 per cent that they used to hold) in equities to offer exemptions from long-term capital gains and dividend  distribution taxes.

Now, in order to chase the zero per cent tax status, many balanced funds are more tilted towards equity than they were earlier.

HDFC Prudence Fund (HPF) tops the balanced funds charts for the third consecutive year. In fact, surprisingly, it is the only balanced fund that has outperformed the  Sensex in each of the past five years, even though it held only 60 and 65 per cent of equities for the larger portion of that period. Although HPF didn't give the highest  returns in its category last year, it made it to the top on account of its low volatility.

HPF's portfolio is well diversified across equity and it doesn't churn its portfolio  frequently. Towards the latter part of the year, the fund increased its allocation towards mid-caps. Says fund manager Prashant Jain. "We are seeing relatively better value in smaller sized companies. And even the smaller companies in our portfolio are in very good positions. A vast majority amongst them are industry leaders."

SBI Magnum Balanced Fund (SBF) holds on to its second position. Despite topping its category on a three-year return basis, it missed the top spot due to its volatility.

SBF is one of the most aggressive schemes in its category. Though the fund is actively managed, it hasn't increased its exposure to equities. Says fund manager Sanjay Sinha: "Our view on equity was positive. But being a balanced fund, we want to give the best of both worlds to our investors. Two-thirds in equities and one-third in debt, I feel, is appropriate."

SBF invests significantly in large-cap oriented stocks. Like HPF, SBF's debt exposure boasts of high-quality securities.

Outlook for 2007. With at least 65 per cent equities in balanced funds, their performance hinges on the equity markets. Well-managed balanced funds will continue to shine.

Equities-significant exposure (For the medium to long-term low-risk equity investor). With the category's highest three-year (19.70 per cent) and one-year (26.50 per cent) returns as on 31 December 2006, UTI Mahila Unit Scheme (UMUS) tops the charts in this category. This is a specialised scheme that is targeted towards  women investors. It manages its equity-debt allocation aggressively.

So even if the month-end equity allocation went down from 30 per cent in May 2006 to 6.25 per cent  to June 2006 and 2.53 per cent in October 2006, UMUS took aggressive equity calls in the middle of various months to prop up its returns.

"Concerns on global liquidity, fund flows into emerging markets and interest rate volatility amid high oil prices had indicated continued volatility ahead of May 2006. Hence we pruned our equities. Currently, though, it stands at 18 per cent," says fund manager Amandeep Chopra.

The scheme invests in quality debt scrips to ensure that the portfolio does not unnecessarily suffer from a credit rating or default. On account of its aggressive equity fund management style, it boasts of the highest expense ratio (2.30 per cent) in its category. But, you don't feel the pinch of the expense ratio here because of the high returns generated by its equity portfolio.

HDFC Monthly Income Plan-Long-Term Plan comes second. It aims to pay monthly dividends to investors. Like UMUS, it also gave good returns on the back of the bull run in equity markets. But fund manager Prashant Jain does not take much risk with the portfolio, given the conservative nature of the scheme's investors. He says: "We prefer large-cap stocks because they are liquid. We avoid over-exposure to mid-cap scrips in this scheme."

Outlook for 2007. Don't expect great results this year as the overall performance of equity is expected to be less exuberant.

Equities-marginal exposure (For the medium to long-term very low-risk equity investor). Yet another SBI scheme tops the list; this time it is SBI Magnum MIP (SMMIP). SMMIP can go up to 15 per cent in equities. It has a well-diversified equity portfolio and has significantly invested in large-caps throughout 2006. SMMIP also cut its exposure to government securities (4.80 per cent average in 2006, down from 14 per cent average in 2005) to shield its portfolio from excessive volatility.

"We tried to visualise the interest rate cycle and took a hit-and-run exposure to government securities to generate trading income. Till there is clarity in the interest rate direction, it's prudent to be invested in short duration securities," argues fund manager K. Ramkumar.

SMMIP also boasts of one of the lowest expense ratio in its category at 1.40 per cent. A lower expense ratio also helps boost the scheme's performance, especially if it invests significantly in debt instruments. Two hybrid schemes, which stayed away from equity, suffered. While Templeton MIP -- monthly dividend finished last, Prudential ICICI Cautious Plan stood 22nd among 25. Concentrated portfolio in both these cases worsened their cause.

Outlook for 2007. Expect returns that are slightly better than debt funds, the equity kicker of just 20 per cent in a sluggish market won't do much in terms of returns.

DEBT

Rising interest rates continued to take a toll on long-term debt funds as prices of debt securities, and therefore the NAVs of debt funds, fell. The bright spot was the rise in short-term interest rates. Due to the liquidity crunch in the banking system in the past few months, short-term rates moved up significantly.

While banks offered fixed deposits with interest rates as high as 9 per cent, MFs launched Fixed Maturity Plans (FMPs) that offered the equivalent, or in some cases, better and tax-efficient returns. Small wonder then, FMPs collected over Rs 90,000 crore (Rs 900 billion) in 2006-07 -- their highest collection so far, up from Rs 40,000 the year before -- according to Value Research, an independent provider of investment information. However, bond funds with higher maturities felt the heat and returned 4.90 per cent on an average.

Bond (For the conservative investor who wishes little volatility and steady returns). As interest rates steadily rose in 2006, bond fund managers found it difficult to  make money. Apart from actively managing their average maturities, smart fund managers spotted trading opportunities, though they were few and far between. Our topper  for the second consecutive year, UTI Bond Fund, managed to do just that. After drastically reducing its exposure to government securities, thereby its volatility, in 2005,  fund manager Amandeep Chopra preferred to trade in government securities in 2006.

"There were around three such trading opportunities. If bond fund managers caught at least two of them, it was good for their funds," he says.

Reliance Income Fund-Retail climbed one spot to finish second. Birla Sun Life Income Fund moved up 10 spots to rest at third. As against 4.19 per cent returns in 2006, the scheme returned 7.50 per cent in 2006. Bond funds that behaved like liquid funds and reduced their average maturities a bit too much, were penalised. For instance, BOB Income Fund (BIF) has had an average maturity of one day since October 2005 because it has put its entire corpus in cash and cash equivalents.

Outlook for 2007. Avoid bond funds in 2007. Longer maturity bond funds will get hit on the back of consistent interest rate hikes. The direction of interest rates looks uncertain, though bankers feel they should peak by mid-2007. Once interest rates begin to fall, bond funds would become attractive -- the inverse relationship between interest rates and prices of debt securities at play here. We'll keep you posted, until then, stick to liquid funds and FMPs.

Short-Term Bond (For the aggressive, short-term investor). Principal Income Fund-Short Term Plan (PSTP) jumped seven places to finish the year at number one.

 Armed with its new fund manager, Sandeep Bagla, PSTP enhanced its returns last year by spotting trading opportunities. Bagla actively managed PSTP's average maturity to suit the market mood. For instance, from an average maturity of 368 days in May, it dropped to 250 days in June and jumped back to 349 days back in July.

"This was the only change that has happened in the scheme so far since I took over. Rising interest rates merited a reason to generate a little bit of trading income to add to the overall portfolio returns," says Bagla. PSTP doesn't invest in scrips rated below AA credit rating, thereby ensuring a high credit quality portfolio.

Kotak Bond Short Term Plan and HDFC Short Term Plan finished second and third, up from seven and 15, respectively. LIC Short-Term Bond Fund's corpus went down from Rs 5.08 crore (Rs 50.8 million) in January 2005 to Rs 91 lakh (Rs 9.1 million) in December 2006. As a small size limits portfolio diversification, it held cash between September and December 2006 and bagged the 11th position. Sahara Short-Term Plan wound up in June as the fund house found it unviable to run the fund. It had a corpus of Rs 10 lakh (Rs 1 million).

Outlook for 2007. For a one-year tenure, short-term bond funds have an outside chance to give six to eight per cent returns on account of active fund management.

However, FMPs offer a better alternative. With much less risk, FMPs have been able to offer more than 10 per cent returns.

Liquid (For the very short-term investor who wants cash in a hurry). 2006 was a good year for liquid funds. Rising short-term rates benefited liquid funds as

they invest in securities with maturities of one day to three months. On an average, they returned 6.40 per cent, up from 5.25 per cent in 2005.

Ranked at 22 last year, UTI Money Market Fund (UMMF) finished at the top this year. Helped by a bigger corpus, the fund managed to reduce its concentration risk by better diversification than last year. It also reduced its expense ratio to 0.22 per cent in 2006, down from 0.50 per cent in 2005, the lowest among all the liquid funds we considered. Fund manager Amandeep Chopra keeps a significant chunk of UMMF's portfolio, based on his view on the long-term trends and a small portion to spot trading opportunities.

He adds: "We achieve consistent performance by avoiding extreme swings in either maturity or duration."

Outlook for 2007. Good. With call money market rates hovering high because of the liquidity crunch in the banking system, liquid funds are an ideal way to park your idle cash.

The Outlook Money annual MF review is a good time for investors to rebalance their portfolios, weed out the non-performers and invest in top rated schemes. While MF data is easily available on websites and in newspapers, there is no one place to get information across schemes and categories on entry and exit loads, annual fund management costs and the minimum size of investment. The next part of this package will prove to be a reference point over the year for these information elements.

The last story in the package will examine a little known vehicle in the industry: the systematic transfer plan. Volatile markets make this a great way to invest for those with a lump sum.

Inputs from Sunil Dhawan and Shruti Kohli

Methodology: How the stars were born

Based on their investment objective, we classified schemes into 12 sets: equity (diversified, tax-saving and sector), debt (bond, short-term plans, gilt, liquid, short-term floating rate and long-term floating rate), balanced funds, marginal equity exposure (up to 20 per cent equity) and significant equity exposure (up to 40 per cent). Only schemes whose minimum investment stipulation up to Rs 30,000 were considered, except for liquid funds where we increased the threshold to Rs 50,000.

Returns. The cut-off date for our analysis was 31 December 2006. Equity and balanced funds were evaluated on a rolling return of one year over the past three years;  growth plan NAVs were also considered.

For bond, gilt, marginal equity exposure and significant equity exposure, we took one-year rolling returns over the past three years. For marginal equity exposure and significant equity exposure schemes, we also took one-year rolling returns over the past two years.

For short-term plans, we took six-month returns over the past year and one-year rolling returns over a period of two years.

For liquid, short-term floating and long-term floating schemes, we took one-month rolling returns over the past six months.

Data source was MutualFundsIndia.com.

Risk. We have quantified seven kinds of risk.

Downside risk. A statistical measure, 'targeted semi-variance', showing the number of weeks a fund earned less than the risk-free rate and the quantum of shortfall, was used.

Strategy risk. Going for returns, funds may stray from their objective. We penalised balanced funds with over 80 per cent in equity, debt funds with over 10 per cent in equity, and equity funds with less than 65 per cent in equities.

Concentration risk: Investments: Funds holding a security (other than government securities, where there's no risk of default) in excess of 10 per cent of their corpus were assigned a concentration risk. We also penalised gilt funds holding more than 30 per cent of their assets in a single government security and more than 40 per cent in their top five holdings for funds other than gilt funds.

Average maturity. We also penalised bond and short-term bond schemes that had maturities disproportionate to their objective. In bond funds, for average maturity between one and 180 days, we added 12 penalty points; for average maturity between 181 and 365 days six points; for average maturity between 365 and 540 days three points; for average maturity between 540 and 730 days two points; and none for average maturity more than 730 days.

In short-term plans, for average maturity between zero and 90 days, we added 10 penalty points; for average maturity between 90 and 180 days five points; for average maturity between 180 and 270 days one point; and none for average maturity greater than 270 days.

Expense ratio. Actual and latest available expense ratios for debt funds, equities-marginal exposure and equities-significant exposure schemes have been added to the total risk.

Credit risk. Funds with low-quality paper (rated below AA) have been penalised.

Non-disclosure risk. Funds that don't disclose portfolios or other data critical to analysis were penalised by assigning them the highest concentration risk in their category.

Rankings. The values for the seven types of risk were clubbed to arrive at the total risk figure. Next, we computed the risk-adjusted return by dividing the return by the  measure of risk. The funds were ranked on the basis of the final score.

Ratings. Since the variance between two ranks can be statistically insignificant, we assigned star ratings. The top 10 per cent of the schemes get five stars; the next 22.5  per cent get four; the middle 35 per cent get three; the next 22.5 per cent get two; and the bottom 10 per cent get one star. Given their small set size, sector funds have  not been given star ratings.