Equity Mutual Fund Model Portfolio

Version 6
Apr’ 23

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Equity Mutual Fund Model Portfolio- Aim

Aim
The aim of the equity model portfolio is to have a basket of diversified equity mutual funds which
endeavours to give an alpha of 2-3% p.a. over and above NIFTY 50.

What does a 3% p.a. alpha mean?

A 3% p.a. alpha compounded over a 10 year period is almost equivalent to the principal value invested.

Principal Value Growth Rate p.a. Value at the end of 10 years Value Addition
10 Crs 12% 31.05 Crs
9.4 Crs
10 Crs 15% 40.45 Crs

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Equity Mutual Fund Model Portfolio – Expectations
The model portfolio should be looked at as one basket and not as individual 14 schemes.

Expectation on outliers:

1. On an average, 35% of schemes have underperformed Nifty 50 each year in the last 22 years.
2. It is natural to anticipate that there would be 4-5 underperformers in the basket of 14 funds.
3. A well thought out selection methodology has the potential to bring down the underperformers
from 4-5 to 2-3 schemes, however, it cannot eliminate the underperformers completely.
4. Moreover, it is not possible to identify today which schemes would underperform in next 1 year.
5. Hence, if someone eliminates few schemes today from the basket, there is a high chance that
such eliminated schemes could be the outperformers. The smaller basket so constructed, could
have few underperformers, which would reduce the probability of alpha generation.
6. Therefore, the best probabilistic answer to get 2-3% alpha is to have a 14 funds basket in its
entirety.

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Equity Mutual Fund Model Portfolio – Sources of Alpha
There are three major sources of alpha generation:

1. Underlying Market cap of the portfolio

Finding the right market cap mix of the portfolio keeping in mind the return potential and risk
associated with different market caps.

2. Category selection
Considering categories which have potential to deliver higher alpha over Nifty 50.

3. Scheme Selection
Finding the right set of schemes with high future potential to deliver alpha is the key.

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Step 1-Deciding market Cap allocation
1. Future return potential of benchmarks:
Benchmark Nifty 100 Nifty Mid Cap 150 Nifty SmallCap 250
Expected Return – 1 Yr 13.67% 12.45% 20.80%
Differential Alpha w.r.t. Nifty 100 - -1.22% 7.13%
Source: Bloomberg Estimates for computation of Target NAV

Key Takeaways:
1. The target return potential is looked at on relative basis and not absolute basis. As can be seen above, on
a one year potential basis, small cap has the highest differential relative to large cap benchmark.

2. Risk comparison of small caps and midcap relative to Nifty 50:

3 Years 5 Years
Beta Mid Cap 150 Small Cap 250 Mid Cap 150 Small Cap 250
Beta with Nifty 50 0.84 0.80 0.86 0.83
Note: Beta is computed basis historical performance, however, actual performance may differ.

Key Takeaway:
Risk comparison with Nifty 50 for mid cap and small cap benchmark, shows that small cap has relatively
lower risk contrary to the popular perception for a investment horizon of 3-5 Years. However, for a shorter
investment horizon, 1 year or less, there could be periods of higher volatility.
Disclaimer: Target NAVs are based on estimates as on date, subject to change and actual performance could differ. 5
 Step 1-Deciding market Cap allocation
3. Change in market caps size over the years:
The table below shows how the market cap has moved over the last 5 years.

Large Cap Mid Cap Small Cap No of Small cap

Total Market companies with
1st 100th 101st 250th 251st
Period Cap Greater than 3000
Company Company Company Company company
(In Rs. Lakhs crore) Crore M-cap

Dec-17 141 548 29.30 29.25 8.60 8.60 233

Dec-22 275 1713 48.90 48.70 16.80 16.50 396
Note: All figures in thousand crores except total market cap
Source: AMFI Data

Key Takeaways:
1. Market cap across categories has changed, however, for small cap it has doubled in the last 5 years
thereby reducing the risks associated with the small cap stocks such as illiquidity, volatility etc.
2. Universe of small cap companies with reasonable market cap has also increased to 400 odd companies.
This increases opportunities for the fund managers to find quality stocks in small cap space while
maintaining reasonable risk.

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Step 1-Deciding market Cap allocation
4. Liquidity Analysis of all market caps:

Free Float MF Holdings of open

No. of Total Mcap % Holding basis
Category Mcap ended 584 Equity
Companies Rs in lakh Cr Free Float
Rs in lakh Cr scheme in Rs lakh Cr
Large Cap 100 191.32 83.48 12.43 14.89%

Mid Cap 150 44.03 16.25 3.64 22.37%

Small Cap
(Greater than Rs. 3000 Cr Mcap) 396 28.57 11.04 2.01 18.23%

Small Cap
(Less than Rs. 3000 Cr Mcap)
4426 11.68 3.96 0.22 5.56%

5072 276 115 18 15.95%

Source: AMFI Data
Key Takeaways:
1. As the MFs holding of free float in any of these Market caps is in the range of 15%-20%, there is no liquidity concern.
2. In small cap universe, with reasonable mcap of Rs. 3000 Cr. and above, the free float is Rs. 11 lakhs crore, of which
MFs own only 18%. This provides further opportunities to fund managers to pick quality stocks from this space.
3. Mutual funds manage risk by not significantly venturing into lower tail of small caps universe (< Rs. 3000 Cr mcap).

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Step 1 -Deciding market Cap allocation
Based on these above 4 factors, we have increased the allocation of small cap from 15% to 30% and
reduced midcap allocation from 35% to 20%.

Market Cap Large Cap Mid Cap Small Cap

Old Allocation 50% 35% 15%
New Allocation 50% 20% 30%
Target NAV 13.67% 12.45% 20.80%
Source: Bloomberg Estimates for computation of Target NAV

Portfolio Data Old Allocation New Allocation

Weighted Average Return of the Portfolio 14.31% 15.56%
Alpha Potential w.r.t Nifty 50 0.91% 2.16%*
Beta of the Portfolio w.r.t Nifty 50 0.91 0.91
Note: Beta is computed basis historical performance, however, actual performance may differ.

Key Takeaways:
1. The new market cap allocation has a potential to deliver 2.16% of Alpha as against 0.91% of the old
allocation.
2. The relative risk measured by beta is similar for both the market cap combination.
3. While the alpha potential is computed for the next 1 year period, one should stay invested in the small cap
funds for longer time periods to get meaningful return
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Disclaimer: Target NAVs are based on estimates as on date, subject to change and actual performance could differ.
 Step 2(i) - Deciding the number of schemes in the Model Portfolio
The number of schemes were increased in the model portfolio from 11 to 14. The rationales of the same is
mentioned below:
For the period Aug’22 to Jan’23, we audited 136 client’s portfolios with other distributors to compute their
transaction wise IRR.

No. of Portfolio No. of Portfolio

Total No. of Portfolio Extent of Extent of
underperformed outperformed
audited underperformance outperformance
AR Model Portfolio AR Model Portfolio
136 123 -2.49% 13 0.83%
Key Takeaway:
Out of total 136 portfolios audited, 123 portfolios or 90% of all the portfolios underperformed AR Model Portfolio
and merely13 portfolios have outperformed AR Model Portfolio.

Of the 13 portfolios which outperformed AR Model Portfolio, we analyzed the reasons of the outperformance.
No. of Portfolios Broader Reasons of Outperformance
6 Market cap concentration & sector call mostly contributed to return
7 Average No of Funds-26

Key Takeaways:
1. 6 out of such 13 portfolios outperformed AR Model Portfolio because of sector or M-cap concentration.
2. However, in the balance 7 portfolios the major differentiator was the larger number of schemes, thereby
challenging our hypothesis of having concentrated portfolio of 10-11 schemes.
3. Based on the above, we have decided to increase the number of schemes in the Model portfolio from
11 to 14. This is likely to give us better results than basket of 10-11 funds.
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 Step 2 (ii) – Identification of categories for recommendation
The objective of this step is to have an appropriate category selection which can increase the potential of
alpha generation.
Data of last 5 calendar years is analysed to understand which categories have :
(i) The highest percentage of funds that deliver alpha.
(ii) Large extent of alpha generation over Nifty 50.
The outcome of the analysis is as below:
Large Large & Midcap Flexi Focused Multi Cap Small Contra Value Dividend Thematic
Category Cap Mid Cap Cap Cap Yield

Outperformance against Nifty 50

Percentage of funds 37% 41% 46% 40% 42% 42% 47% 53% 41% 47% 43%
Avg. Alpha 3.02 4.98 6.88 6.04 5.20 7.42 12.81 5.12 3.76 4.48 9.56
Outperformance against their own benchmark
Percentage of funds 33% 41% 42% 40% 42% 43% 71% 47% 34% 48% 47%
Avg. Alpha 2.66 4.32 6.70 5.91 4.32 7.19 9.34 7.29 3.92 5.3 7.59
Final Shortlisted Funds 1 2 1 2 1 2 3 1 0 1 0
Source: ACE MF

Key Takeaway:
We included 3 new categories namely Value, Dividend Yield and Thematic for further analysis. We have selected more
number of funds in categories which have higher potential to deliver alpha.
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 Step 3 – Process to arrive at schemes for Model Portfolio

3 (i): Applying the AUM and track record filters to arrive at the relevant universe:
The below AUM filters are applied:
i. Fund House to have minimum Rs. 3,000 Cr Equity AUM – To avoid small AMCs where there
could be business continuityconcerns.
ii. Funds to have minimum Rs. 1,000 Cr AUM – To shortlist stable schemes.
iii. Funds with minimum 3 year track record – To have a reasonable period for evaluating the
funds.

Large Large & Mid cap Flexi Focused Multi Cap Small Contra/ Dividend Thematic
Category Cap Mid Cap Cap Cap Value Yield Total

Total no of schemes
post AUM filter 17 21 22 18 15 9 18 12 4 12 148

Note: Few schemes have been added as an exception to above criteria

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Step 3: Process to arrive at schemes for Model Portfolio
Step 3(ii)– Selection of quantitative parameters that can help pick funds that would perform well in
future.
i. Statistical Parameters-10 parameters that have historically displayed strong correlation with
future returns are used for fund ranking.
ii. Futuristic Parameter- Target NAV, which logically helps us arrive at schemes which have a
high return potential in the future.
iii. Active Weights- To understand the extent of active calls taken by the fund manager as against
Nifty 50.
iv. Holiday NAV- Excess return due to active management, to mathematically rank fund manager.

Step 3 (iii) - QualitativeJudgements are applied by the investment committee to check for AMC
stability, Fund Manager views and investment principles.

The above steps help us arrive at a basket of 14 funds.

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 Step 3(ii) - Selection based on Quantitative parameters
The endeavor is to select funds that can perform well in future. Therefore, statistical variables over and
above past performance have been analysed.
• There are 101 statistical parameters based on which equity funds can be evaluated.
• We checked the correlation of each parameter with future returns for last 17 years to understand
which parameter has a strong correlation with 1 year future returns.
• 9 parameters with extreme positive or negative correlations which indicate high interrelation with
next 1 year returns are shortlisted.
• The table below shows correlation data for the 9 shortlisted parameters:
Sr. no. Statistical Parameters Correlation
1 Value at Risk 64%
2 Semi Deviation 52%
3 Covariance 51%
4 Standard Deviation 49%
5 3 Year Return(Point to Point) -46%
6 Efficiency Ratio -52%
7 Down Capture Return -61%
8 Longest Down-Streak Return -66%
9 Average Drawdown -70%
• In addition to these 9 historical parameters, 4 other parameters have been considered:
o 1 year Rolling Return for last 3 years as it brings out consistency in a fund return.
o 3 parameters –
i. Target NAV
ii. Active Weights 13
iii. Holiday NAV
Step 3(ii) - Selection based on Quantitative parameters
The definitions of the two new parameters introduced this year are listed in the below table:

Parameter Definitions

Active weight is the portion of money that is invested by the fund manager
Active Weights outside the benchmark Nifty 50. A higher active weight means more
opportunity for fund manager to deliver alpha.

This helps us measure how much extra return a fund manager has delivered
Holiday NAV -
by taking active calls during a 3 year period as compared to the fund manager
Excess return due to
going on holiday and maintaining his static portfolio of 3 years back.
active management
A relatively high excess return indicates good fund management capabilities.

Note: The definitions of the old 11 parameters are included in the annexure of the document.

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Step 3(ii) - Selection based on Quantitative parameters

All funds are evaluated on the basis of the following 4 criterias:

(i) Funds that appear on the top in most of the 10 parameters.
(ii) Funds which have appeared on the top in the target return potential.
(iii) Excess Target NAV per unit of active weight.
(iv) Excess return due to active management.

Final Outcome:
Based on the above exercise 44 funds are shortlisted on which qualitative judgement is applied.

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Step 3(iii) – Qualitative Assessment of Funds
The Qualitive Assessment is done by the Investment Committee:

 Committee comprises of 16 members including CEO, Deputy CEO, Director- Product Research,
Chief Economist, Mutual fund Head, 11 Relationship Managers.
 The members have experienced markets behaviour across various market cycles and can
recognize the agility and adaptability of fund managers to restructure the portfolios as per
changing market dynamics and changing regulatory framework over the last 20 years and its
impact on their fund performance.
 The committee has spent more than 1000 man hours over the year, working on the selection
process to arriveat the model portfolio.

Committee members Experience

Cumulative experience
CEO 40 years + of the committee
Deputy CEO 19 years -Over 300 years

Chief Economist 30 years+

Director – Product Research 20 years Total man hours spent
by the committee -
Mutual Fund Head 15 years Over 1000 man hours
5 Unit Heads Average 18 years
6 Team Leaders / Sr. Average 20 years
16
Relationship Managers
Step 3(iii) – Qualitative Assessment of Funds
The Qualitive Assessment is done by the Investment Committee:

 Our Deputy CEO, Director-Product Research, Mutual Fund Research head and the research
team members personally met all the CIOs/Fund Managers of the shortlisted funds to
understand:
(a) Fund Manager optimism about market
(b) Conviction on the future return potential of the fund
(c) Overall fund management environment
(d) Noting changes in the management at fund or AMC level
 The findings of the meetings were presented and deliberated in the investment committee.
 The members presentend their views on funds and finally a unanimous view is taken to
arrive at the model portfolio.
 Moreover, the committee meets on a weekly basis to review the model portfolio and
deliberate if any actions needed.

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Equity Mutual Fund Model Portfolio
The following 14 funds have been selected after running the 3 steps:

Sr No Fund Name Category Allocation

1 Franklin India Bluechip Fund Large Cap Fund 6%
2 SBI Large & Midcap Fund Large & Mid Cap 9%
3 DSP Equity Opportunities Fund Large & Mid Cap 9%
4 Kotak Emerging Equity Fund Mid Cap Fund 6%
5 Aditya Birla SL Small Cap Fund Small Cap Fund 7%
6 HDFC Small Cap Fund Small Cap Fund 7%
7 Invesco India Smallcap Fund Small Cap Fund 7%
8 ICICI Pru Focused Equity Fund Focused Fund 7%
9 Kotak Multicap Fund Multi Cap Fund 7%
10 Quant Active Fund Multi Cap Fund 7%
11 Canara Rob Flexi Cap Fund Flexi Cap Fund 7%
12 HDFC Flexi Cap Fund Flexi Cap Fund 7%
13 SBI Contra Fund Contra 7%
14 ICICI Pru Dividend Yield Equity Fund Dividend Yield 7%

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 Equity Mutual Fund Model Portfolio
1. Alpha potential of the Model Portfolio
Portfolio Data New Portfolio
Weighted Average Return of the Portfolio 16.95%
Target NAV of Nifty 50 13.40%
Alpha Potential 3.55%
Source: Bloomberg Estimates for computation of Target NAV
The target return potential is looked at on relative basis and not absolute basis. As can be seen
above, on one year potential basis, the model portfolio has a higher probability of achieving 2-3% of
alpha over Nifty 50.

2. Risk similar or lower than Nifty 50

Portfolio Data New Portfolio
Beta of the Portfolio wrt Nifty 50 0.86
Note: Beta is computed basis historical performance, however, actual performance may differ.

The portfolio’s risk, as measured by beta w.r.t Nifty 50 in the last 1 year, is lower than Nifty 50 and
we expect portfolio’s risk to be lower than Nifty 50 going forward as well.

Disclaimer: Target NAVs are based on estimates as on date, subject to change and actual performance could differ.
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Conclusion

1. We recommend to implement the new 14 funds basket, in full, in the Apr-Jun Quarter of FY 2023-24.

2. The next selection process exercise is to be carried out in the Apr-Jun Quarter of next FY 2024-25, to
be implemented in the subsequent quarter of Jul-Sep of FY 2024-25.

3. This would help us implement the new selection basket, post completion of 1 year of the schemes in
the Model Portfolio, in case if any changes are made.

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Annexure

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Why certain categories are not considered
• Out of the total universe of 584 open ended equity schemes, 262 schemes meet the category
filteringcriteria mentioned previously.
• Remaining schemes of other categories are not considered for reasons mentioned in the
table below:

Category Name No. of Schemes Reason for Non Suitability

Index Funds/ETF 204 No alpha generation through active management

ELSS Funds 41 Lock in and illiquid nature of the category

Sector Funds 67 Concentration to certainsectors may result in high risk

compared to a diversified fund and also may result in
inconsistentalpha due to sector cyclicality.

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SEBI definition of categories that are considered
Large Cap Funds:
Funds that invest at least 80% of their assets in top 100 companies.
Mid Cap Funds:
Funds that invest at least 65% of their assets in companies ranked 101 – 250 as per marketcap.
Large & Mid Cap Funds:
Funds that invest in both large and mid cap stocks with the minimum requirement of 35%
investmentin each large cap and mid cap stocks as definedabove.
Flexi CapFunds:
Funds that can invest acrossmarket cap without any restrictions.

Multi Cap funds:

Fund has to mandatorily invest minimum 25% of the fund’s corpus in large-caps, mid-caps and
small- caps each.

Small Cap Funds:

These funds need to invest at least 65% of their assets in companies rankedbelow 250th company as
per market cap.
Focused Funds:
Funds with no market cap bias but maximum no. of stocks cannot exceed 30.

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 SEBI definition of categories that are considered
Contra funds/Value Funds:
The scheme tends to follow a value/contra investment strategy. In Contra, fund manager invests mostly
in equities of companies that are not performing well in the short term. The idea is that buying equity at a
low price today will be profitable in the long term when the business problem is resolved and the stock
will witness a strong rally.

Dividend Yield funds:

These are Mutual funds which invest in equity & equity-related instruments of high dividend yielding
stocks.

Thematic Funds
Thematic funds select stocks of companies in industries that belong to a particular theme. It invests a
minimum of 80% of total assets in equity and equity-related instruments of a particular sector or a
particular theme.

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 SEBI Market Cap definitions
In Oct’ 2017 SEBI came up with the regulations defining each category in which a mutual fund can operate
and the market cap rules they need to follow while constructing portfolios.
The market cap definitions stated by SEBI are as below:

Market Cap Market Cap Market Cap Range Name of Company

Details Definition

Maximum - Rs.17.13 Lakh Cr 1st co. - Reliance Ind.

Top 100 companies
Large Cap by full market cap 100th co. –PI industries Ltd
Minimum - Rs. 0.48 Lakh Cr

101st – 250th company Maximum - Rs. 48,700 Cr 101st co. –Tube Investments Ltd

Mid Cap by full market cap

Minimum - Rs. 16,800 Cr 250th co. –Piramal Pharma Ltd
Beyond 250th
Small Cap company by full Below - Rs. 16,500 Cr 251st co. – AAVAS Financiers Ltd
market cap
Data Source: NSE Data as of 31st Dec’ 22

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Ranking Parameters Definition
The 11 shortlisted parametershave been explained as below:
Parameter Definitions
1 year avg. This ratio tells us the average return made by 24 different
Rolling Return investors who invested for a 1 year investment period anytime in
for last 3yrs the last 3 years.

The ratio tells us how the fund has performed in times when the
Down Capture
market delivered negative return.
Return

Historical This ratio tells us the return delivered by the fund for every
Data one percent of risk taken. Risk is measured in terms of standard
Efficiency Ratio
Analytics deviation.
It is the maximum rupee amount expected to be lost over a given
time horizon, at a pre- defined confidence level. For e.g.: VAR of a
fund can be 3% over 3 years at 95% confidence level which
Value at Risk means that one can predict with 95% confidence that a Rs 100
portfolio can experience Rs 3 loss over a 3 year period.
Covariance Covariance measures the directional relationship between the
fund and the benchmark.

Return Return is point to point return of last 3 years.

All 10 statisticalratios are computed for a 3 year period. 26
Ranking Parameters Definition
Parameter Definitions

Semi deviation Semi deviation is calculation of standard deviation of only those

observations which are lesser than the average of the data set.

Historical Longest Down Streak The cumulative return for the longest series of negative monthly
Data Return returns in the last 3 yrs.
Analytics
The average of the yearly maximum Drawdown of last 3 years.
Average Drawdown Max Drawdown is a funds maximum loss in a peak-to-trough
decline before a new peak is attained.

Standard deviation measures the deviation of the return from its

Standard deviation average.

Analyst estimates of target price of each stock is used to arrive at

Futuristic the Target NAV of the fund for next 1 year. Post this, the gap
Parameters Target NAV between the Target NAV and Actual NAV is calculated thus
arriving at return potential of each fund. Funds with higher return
potential are preferred.
All 10 statisticalratios are computed for a 3 year period.
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 Thank You
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