MC30: The methodology behind the curated basket of mutual funds

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MC30 is a curated basket of 30 investment-worthy mutual funds (MFs). The foundation of MC30 is built upon an internally developed mutual funds (MF) rating and ranking system. Called the MC MF rankings and star ratings, it hand-holds the investor in getting into the finer aspects of every scheme – risks, returns and fund strategies.

MC30 must be the starting point for every investor and not an end in itself to be blindly replicated in full.

Select categories make the cut

Despite SEBI having rolled out 37 categories, we decided to limit MC30, and therefore the MC MF rankings and star ratings, to just 11 categories. The idea behind MC30 is to recommend only simple, diversified and easy-to-understand funds. Thematic and sector funds are out because they are too risky for a common investor. We also left out Value and Contra funds because the definitions are too subjective. We have also left out the Large & Mid-cap category since one scheme in this category can look very different from another. A flexi-cap category is a better alternative as it gives a fund manager the freedom to choose stocks.

Similarly, on the debt funds side, we have kept things simple. Since this is an investment basket, we will only recommend short-term, corporate bond and Banking & PSU Debt funds. In our opinion, they are good enough for your fixed income allocation. Liquid, overnight and similar funds are more parking vehicles for the short term than being investment avenues. Hence, we’ve left such categories out. Long-term bond funds and government securities can be volatile; a sudden interest rate reversal can wipe out an entire year’s gains. They are excluded from the MC30.

There are six types of Hybrid funds. But MC30 has just one – aggressive hybrid. These schemes invest 65-80 percent of their assets in equities and the rest in debt. These funds come with lesser volatility on account of their fixed income exposure.

In MC30, five spots will be permanently reserved for passively-managed index and exchange-traded funds (ETFs).

We chose a mix of index funds and ETFs based on their tracking error, expense ratio and liquidity (in the case of ETFs). Given a choice, our preference is an index fund because of ease of buying and no requirement of a demat account. But if there isn’t an index fund alternative, we will suggest an ETF.

Size has its importance

From within the shortlisted categories, all equity and hybrid schemes of less than Rs 100 crore corpus or those not in existence for at least seven years are left out. Tiny schemes can fall sharply when there are withdrawals. Similarly, in debt categories, all schemes of less than Rs 500 crore or those in existence for less than five years were ignored. All schemes that have changed their categories or portfolios significantly after SEBI’s 2018 re-categorisation exercise have been ignored. Focused funds have been included even though the category is a mere three years old, as returns have been encouraging and risks well-managed.

For ranking and rating of equity funds, we looked at their rolling returns. One, three and five-year rolling returns of schemes over a seven-year period were analysed.

Rolling return is a series of returns, taken at regular intervals, over a long period of time. This is a better measure than point-to-point return because the latter doesn’t take into account different entry and exit points. Rolling returns also demonstrate consistency better. A minimal, yet adequate, weightage has also been given to short-term returns to catch trends that are current. If a fund is slipping, it’s something for investors to watch out for.

Quantifying risks

We looked at the Sortino ratio of funds. It’s a popular risk-return measure that accounts for a fund’s return over its downside risk. The higher this ratio, the better a fund is.

Cash holdings (average cash balance over the past three-year period) beyond 10 percent are penalised. Tactical cash allocations are fine, but holding too much cash is something we do not prefer. Portfolio concentration is penalised even for focussed funds, beyond a point.

For our debt fund categories, we have again considered rolling returns and the Sortino ratio. Allocation to securities that are rated AA and lower have been penalised, depending on the proportion held by a debt fund. The maximum penalty was reserved for those schemes that invested more than 40 percent of their assets in such securities. Excess exposure to a single group has also been accounted for. Our threshold is 10 percent to a single group, as opposed to SEBI’s limit of 20 percent, given how swiftly things can go wrong.

In the end, schemes across various categories were ranked as per the final score. The top 10 percent of the schemes get a 5-star rating; the next 20 percent is given 4-stars; the subsequent 40 percent are accorded a 3-star rating; the next 20 percent get a 2-stars and the remaining 10 percent of schemes get 1-star rating.

Looking into the future

MC MF rankings and star ratings is merely a report card. It tells us how a scheme has done in the past. MC30 aims to see their future and curates the schemes we think are most likely to do well in future. From among the 4-star and 5-star rated schemes, we then pick and choose funds that are is likely to deliver better and stay consistent.

No scheme enters MC30 without a detailed discussion with the fund manager. The fund manager’s philosophy plays a crucial role in deciding our comfort levels with the scheme.

Only schemes that have a 5-star and 4-star rating can enter MC30. But if an existing scheme’s rating falls to 3-star, then we would typically recommend a ‘hold’ for fresh investments. But if the rating dips to 2-stars or below, the scheme exits MC30 and is replaced with a better alternative.

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