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How do you evaluate the investment style of the fund manager?

07 Jul 2023

We all know that the fund manager makes a major difference to the eventual performance of the fund. That is why fund managers who consistently outperform the market tend to become stars in the market. How do you evaluate a fund manager? Fund manager performance evaluation is best done by returns but that only tells you one side of the story. You can also look at index outperformance but that also glosses over a lot of facts. The answer could lie in style. Every fund manager has a style of functioning or operating which eventually becomes the style of the fund and reflects upon the fund manager. When it comes to investment style let us understand how to evaluate investment managers and what to look for in a fund manager?

1.  Active versus passive styles

This is applicable to all types of funds but it is more prominent among equity funds. A typical example of a passive fund is the index fund. Of course, if you are going to buy the index then investors are not going to be too impressed. They can buy an index fund at much lower cost from the market itself. When we talk of active versus passive style we are referring to a proactive versus reactive style. There are fund managers deliberately waiting for an announcement and then apply the appropriate strategy. The more proactive fund manager tries to use data and judgment to take a view on which way the macros will shift and positions accordingly. Proactive approach has the potential to generate higher returns but also entails higher risk.

2.  Aggressive versus conservative style

An aggressive versus conservative style refers more to how frequently the fund manager is willing to churn the portfolio. Normally, more you churn the portfolio, the greater the cost in terms of transaction costs and statutory costs. But aggressive approach also helps you to better play the short term trends in the market. Conservative style, on the other hand, is all about identifying quality stocks and then let the stock create value for the unit holders. In conservative style, the focus is more on time rather than on timing. Both have the potential to generate alpha depending on the structure of the market.

3.  Value versus growth style

This is a style comparison that is more suited to equities. What should a fund manager bet on? Should they bet on buying quality stocks at deep discount to their intrinsic value? Should they focus on growth stocks that can generate huge returns in the coming years as the growth catches up with valuations? Normally, fund managers follow a mix of both the strategies. Value approach works very well at a macro level. For example, creating a portfolio in 2002 or 2009 when Nifty P/E ratio was at 11X would have generated tremendous returns over the next few years. A growth approach is the any-time approach. You can buy growth stocks at any point of time and make money out of it.

4.  Credit risk style

This is more applicable to debt funds where the credit risk matters a lot in the portfolio. Normally, the most blue chip of debt is government debt but then returns on these are also the lowest. As you go towards AAA rated corporate debt and AA rated corporate debt, your yield increases. Here is where credit style comes in handy. Some debt fund managers are of the view that many AA stocks are rated AA for reasons that have nothing to do with the credit risk. Hence it is possible to increase yields by buying AA rate stocks without impairing the quality of the portfolio. Credit style is useful in debt funds but the risk and concentration have to be taken care of.

5.  Maturity style

A maturity style shows which end of the yield curve the fund manager is willing to bet on. For example, there are fund managers who prefer to simply align the maturity of the bond held by them with the tenure of the fund. That is a more passive approach. The more aggressive maturity style is about estimating which end of the yield curve is underpriced and which end of the yield curve is overpriced. Then these managers buy the underpriced end of the yield curve and sell the overpriced end of the yield curve to generate alpha.

6.  Allocation style

This allocation style works where the fund manager is willing to temporarily shift the entire focus of the fund to capitalize on opportunities. In case of a balanced allocation fund, the fund manager will try to shift the equity / debt mix depending on parameters like market valuations, outlook on interest rates, outlook on credit etc. This is an aggressive approach and depends largely on the view of the fund manager. While this allocation style has the potential to generate higher returns, it comes with a huge risk of fund manager bias.

When you evaluate the fund from the returns and risk perspective, also spend a few minutes to analyze the style of the fund manager. That is normally evident from the fund manager outlook at the beginning of the fact sheet. Make the best of it!

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