Indian mutual fund industry now manages Rs19.04 lakh crore (19.04 trillion). This number has almost doubled when first time in 2014 it reported that assets under management by mutual funds stood at Rs 10 lakh crore! There are approximately 4.60 crore retail accounts managed by these mutual funds as of 31st May 2017. (Click here to find the source of these stats)

If the number of retail investor grows then there is no reason not to believe that in next five years AUM (Asset under management) to double fold. With the industry growing so fast in length and breadth, the challenge now investors face is in selecting investment manager with a superior stock selection process who can outperform over time.

There are many start-ups in India who have seen opportunity to guide investors to invest as per their goal. Businesses that come top of my mind are Nivesh.com and Scripbox.com. Whether you are investing your money through these investment managers with the help of these excellent platforms available or directly in the stock market look for these four important skills in your fund managers or build yourself if you are managing your own funds directly into stock market.

Investment framework

Few weeks back we shared our approach on how we select the stocks and manage our funds (Click here if you had missed out on that post). We found only small number of high flying stocks dominate the market returns or average returns of the market. A rigorous and insightful analysis by the managers can identify those stocks from the index and if you select active investor you can build your portfolio of those super stocks.

It is very hard to find out what is happening inside those four walls of fund managers office. It is hard to judge those strong investment performance is because of selecting super stocks that appreciated in value. However, you won’t believe, there are many drivers of investment returns that you should be mindful of. A key consideration is: to what extent have those investment returns been produced due to luck, as opposed to skill?

For example, let us consider this hypothetical scenario where investment manager X of XYZ fund produces a 30% return in a year. This is a great result! But there is no information available in that 30% return which allow us to determine whether the key driver of that return was luck or skill. This is important to know, and goes to the repeatability of this result. That is, if 30% return was mostly driven by luck then it is unlikely to be repeatable over a long time period.

Michael Mauboussin, a well-regarded investment writer, often talks about luck versus skills in investing and elegantly frames the concept with the following thought: “Ask whether you can lose on purpose. If you can’t lose on purpose, or if it is really hard, luck dominates that activity. If it is easy to lose on purpose, skill is more important”.

Investing is an activity driven by some combination of luck and skill, so it is important to scrutinise the one aspect of investment return that investment manager can control: the investment process. Investors should assess their fund managers in light of how they identify and pick the stocks for investment and have strong investment process and thus are positioned to generate investment outperformance over a time.

1 Investment philosophy

An investment manager should have a sound philosophy that guides their approach, and provide a lens through which the analysis is performed. Investors must decide whether that philosophy resonates with them and whether they agree to that approach.

For example, we believe in value investing where we prefer to buy more stocks when they are trading at cheap price and vice versa (although there are also other ways). We also focus on investing into quality companies (looking for super – stocks) with bright prospects that can earn higher returns on their capital. Investors should avoid managers with lack of clarity or whose investment strategy contradicts their stated approach.

2. Quality of the investment analysis

This is the only ground in the process where manager can apply its skills and add value to the process. The investment team should poses those analytical skills that can translate into stock picking edge – that is, generating insights that are being mispriced by the market.

We talk about conviction here, we calculate intrinsic value band of each stock on all the other analysts expectation. We cannot predict what the intrinsic value will be in the future but we know 100% that its value will be sitting within that band somewhere. We use our own analytical skill to slim down that band, but that only helps us to take decision on how much money should we invest into it.

We look for the moat and then the bright prospects of the business. For example, Tech Mahindra, they are specialist in the telecom industry. So, if I am a telco anywhere in the world and I need any kind of IT support for my business, I will definitely short list Tech Mahindra for consultation. Tech Mahindra is also working towards other verticals but will it succeed in those and add value to its business? Looking at the past behaviour management is actually value destroyer. At one stage in the past we valued this business worth of Rs 70 thousand crore and today for just Rs 35 thousand crore.

So we have a mix analysis about Tech Mahindra and only time will be able to throw light on where management will take its business intrinsic value. So our conviction level in this story is only 50%. We update our conviction level every quarter and share few with you.

3. Incentives

Most of the funds do not charge directly to its investors and also debit the fee from their initial investment. It is hard for investors to understand what they had been charged. If the incentives are based on outperformance, make sure that they are driven by right incentives. Also always ask: does the investment team have “skin in the game?” look for managers that have significant portion of their own wealth invested in the fund alongside outside investor.

4. Temperament

Temperament plays crucial role on the performance of fund. It is also very hard to judge from outside for anyone. It is all about how manager manages during adversity. It is all about his decision making skill. How calm face he is when any stock they invested plunges and impacting materially to fund returns. Especially, when the fundamentals are still intact, does he has a conviction in the story to invest more.

If you look at our portfolio that we share with you, we bought many stocks when they were trading close to 52 week low. Hindustan Zinc and ONGC are the biggest laggard on our returns in the first quarter. We might not buy more of them because of our low conviction level but on the other side, Lupin had hit fresh 52 week low and we might invest more to it.

We exactly know the worst case scenario of each of our stocks. Lupin can go as low as Rs 750 and ONGC to Rs 130. Our allocation also considers those levels and we exactly know what kind of negative return to expect during adverse condition.

Conclusion

Many of the elements that are likely to drive a positive outcome for an investor putting money into a managed fund are unobservable and uncertain. This is further complicated by the distorting influence of luck on investment returns, such that looking just at past investment returns when assessing a manager is wholly insufficient.

However, this should not stop investors to do due-diligence on fund managers and hopefully this article provides you framework which can be used to take more informed decision. As they say, past performance is not indicative of future results. With this in mind, the key focus should be on whether the investment manager has developed a superior process for stock selection. This will be the secret sauce behind strong future returns.