5P Process for Investment Product Selection

Process

The first ‘P’ focuses on the process followed by a particular investment product. For instance, there are around 40 mutual fund companies with more than 7000 mutual fund schemes in the market. It is very important to assess if a particular company follows robust process for stock/bond selection. We rank these companies on the basis of the following criteria:

Consistency: Does a company follow its mandate consistently? For example some companies may take higher exposure to mid cap stocks even for schemes that are classified as large cap. They may do it to chase returns. In the bargain they may expose their customers to higher risk. Similarly, some PMS provider may buy stocks that are going up without any fundamental reason. We filter out such companies. Key Metric: % Large cap; % Mid&Small cap.
Compliance: How much do they comply to SEBI guidelines? Do they follow a practice of tweaking SEBI guidelines? For example, even though SEBI mandates a max. 10% exposure in a particular group, some fund houses may find a work-around to increase the exposure beyond 10%, thereby exposing their investors to unsystematic risk. Key Metric: Max. exposure of a particular group.
Quality: What is the quality of bonds that they are selecting? Are they taking low credit bonds to chase returns? For example, a debt mutual fund can invest a significant portion in lesser than AA rated bonds that may increase the investment risk significantly. Key Metric: %AA & above paper.

Price

The second ‘P’ focuses on the price that we are pay for a particular investment product. Just like price is an important factor when we buy any personal product like garments, handset etc., it is important to ensure that we pay a reasonable price for any investment product that we invest in. Following factors enable us to evaluate the fair price of an investment product:

Margin of safety: When we select a mutual fund or any investment product, one of the most important factor that we look for is the margin of safety. More the price that we pay for an investment product, the lesser the margin of safety. Investing into products which are under-valued ensures that the downside risk is limited and the hard earned money of our investors is not getting subjected to undue risk. Key Metric: Price / Earning Per Share; Price / Book Value.
Management cost: Each investment product has an underlying management cost associated with it. We ensure that the management costs are justified and in line with the performance of a particular investment product. Key Metric: Expense Ratio.
Cost of exit: Some investment product charge an exit load if you need to withdraw the investments before the stipulated time. For most of the equity funds the exit load is 1% if redeemed within one year of investments. But some funds put a higher time-frame as well. We ensure that we don’t get stuck with an investment product for a long period of time. We should be free to change the investments if a particular product is not performing well. Key Metric: Exit Load.

Performance

The third ‘P’ focuses on the risk adjusted performance of a particular investment product. Following criteria are considered:

Past returns: We look at long term performance of a given investment product. We filter out products which are not consistent in their performance and give temporary spikes which is generally unsustainable. We like products that outperform in longer duration which should be at least three years. Key Metric: 3 year return, 5 year return, 10 year return.
Volatility: Since a significant part of the portfolio that we create gets invested in equity and equity related investments, the portfolio gets subjected to market volatility. There are innumerable global and domestic events that are beyond our control. As a result the investment corpus may go up or down based on market volatility. Though we cannot eradicate the market based volatility from our investment portfolio, we can choose the investment products which manage the volatility better than the broader markets. Key Metric: Standard deviation.
Comparative performance: A key factor under consideration is the comparative performance with the benchmark and peer group of the respective investment product. Key Metric: Sharpe ratio.

People

The fourth ‘P’ focuses on the management pedigree of a particular investment product. High quality management team is one of the most important factor for any investment product to outperform in the long run. There is significant churn in the portfolio management industry and it is very important to keep a track of the changes in the management team of a particular investment product. Following factors are considered:

Fund manager experience: A well qualified & experienced fund manager who has seen various market cycles is in a much better position to take right investment decisions. She has the wisdom to not get carried away in a bull market and has the courage to buy quality companies in a depressed market Key Metric: Fund manager qualification & experience.
Peer comparison: A fund manager is good if she can perform better than her peer consistently. Using an advanced research tool named “FE Analytics”, we compare the fund manager performance against her peer group. Key Metric: Alpha generated in 3 year and 5 year compared to peer group.
Upside and downside capture: It is the ability of the fund manager to capture more upside when the markets are at an upswing. At the same time limit the downside when the markets head down. Key Metric: % Upside capture, % Downside capture.

Portfolio

The fifth ‘P’ focuses on the investment portfolio for a particular risk profile of an investor. The investment portfolio is a mix of various investment products like MFs, PMS, P2P, Real Estate products etc. Following factors are taken into account to design the final investment portfolio:

Risk profile of an investor: Portfolio creation is based on investor’s risk profile. There are three broad categories of investors viz. Aggressive, Moderate and Conservative. Portfolio composition for each category will be different. The investment portfolio is created in such a manner so as to reduce the investment risk with lesser impact on return potential Key Metric: Risk category.
Portfolio composition: The investment portfolio will comprise of various sectors like large caps, mid caps, credit risk, real estate etc. Care has to be taken to create a proper mix so as to reduce the risk with optimum diversification. When choosing multiple investment products, we need to ensure that there is not much overlap in the underlying holdings of such investment products. Key Metric: % of Large vs mid vs small vs sector, % Overlap in the portfolio.
Return potential: The portfolio has to be created keeping in mind long term return potential based on prevailing market conditions. Eventually, the investment portfolio should deliver higher return for each unit of risk taken. Key Metric: Portfolio sharpe ratio.