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How does following an objective investment process help the fund manager, and in turn, you?

Investment process at the asset manager’s level are over and above regulatory guidelines. How do these processes help and what can be some of the risks?

When it comes to managed funds like mutual funds, its critical to have a defined process which is followed by portfolio managers. The process needs to be clear not only about security selection guidelines but also about portfolio construction. 

In the Indian context, the capital markets regulator also has laid down guidelines around portfolio construction in an attempt to limit excessive risk in individual mutual fund schemes. Investment process at the asset manager’s level is over and above regulatory guidelines. 

How do these processes help and what can be some of the risks? 

As a first step, defining the universe limits individual fund managers from picking stocks purely on the basis of qualitative analysis and gut feel. These are subjective factors which may be useable in personal portfolios, but even if they result in a positive outcome, are avoidable when it comes to managed funds. 

Checking individual bias and acting as a filter

Every asset manager begins with a filtered universe of securities from which the fund manager can pick and choose to construct a portfolio. As a first step, the regulator requires each scheme to have a relevant benchmark, which, typically is a listed index. 

This gives a fund manager the broad universe of securities to choose from, internal processes followed by asset managers further reduce this universe further into select stocks that the investment team will research further. 

While a market index filters stocks on the basis of market capitalisation, internal processes essentially filter out further on the basis of defined financial and quantitative criteria designed by the investment team. With this limited universe, now each fund manager can choose which stocks to add to a portfolio.

In case of debt funds however, the universe may not begin at an index level and usually gets defined by other criteria like credit rating and visibility of cash flows, depending on the type of debt fund scheme.  

As a first step, defining the universe limits individual fund managers from picking stocks purely on the basis of qualitative analysis and gut feel. These are subjective factors which may be useable in personal portfolios, but even if they result in a positive outcome, are avoidable when it comes to managed funds. 

The second hurdle can come at the point of portfolio construction, where once again a positive qualitative analysis might lure a fund manager to add a proportionately higher amount to one or two stocks. This too is checked first at a regulatory level and then internally thanks to fund house processes. 

How rigidly the internal processes are followed, will differ for each fund house and asset manager. 

Where it can sometimes go wrong

Despite checks and balances, the influence of an individual will creep into a scheme’s portfolio. For example, be it debt or equity funds, there is no cap on the number of stocks or bonds in a portfolio. While some fund managers prefer tight, concentrated portfolios of 30-40 stocks in an equity fund, other fund managers can go up 60-80 stocks. Impact on long term return is debatable, but differing strategies will alter returns in near term market cycles. 

The problem arises when a fund manager leaves the fund house and another takes over. The scheme(s) being handed over will undergo a revamp if the two fund managers have vastly differing styles for qualitative analysis.

One may argue that the difference in fund management styles is what contributes to the excess return or performance of a scheme against its benchmark, hence, we need this to generate above index long term returns. 

While this is true, one has to be aware that you can just as easily pick a winner when it comes to individual fund manager’s qualitative style as you can an underperformer. Moreover, it's not unheard of for ‘winning’ styles to run into rough weather and underperform benchmark returns for long periods. 

While investment processes are necessary to standardise the approach to portfolios in managed funds and also for institutions to distinguish their products from others, processes are only a part of fund management. Beyond the process itself, the individual fund manager and their style have a big impact too. 

This means you have to constantly ensure that you are able to analyse your fund manager’s capability through what you see in their portfolios and their risk-return parameters. This is not an easy task, hence, better outsourced to an advisor. 

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