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Business News/ Money / Calculators/  Historical returns are not enough for selecting funds

Historical returns are not enough for selecting funds

Instead of performance over the last year or three, look at how a mutual fund performed across market cycles and its objectives and fund manager

Photo: iStockPremium
Photo: iStock

Let’s start with some numbers. Equity mutual fund schemes now receive slightly over Rs5,000 crore a month via systematic investment plans (SIPs). The total assets under management (AUM) for equity schemes now stands at about Rs8 trillion.

As more individuals put money into equity funds, thought has to be given to their selection methodology. When we talk about financial products, it is their performance—or returns—that is most scrutinized.

In case of market-linked products like mutual funds, while there is an estimate that can be extrapolated, their future performance is not assured. What is certain is their past performance, or their track record. However, it is inaccurate to simply assume that these will extend into the future.

So, how does one select an equity mutual fund if not by its past performance? 

Performance should not be seen as a historical number. Analysing historical trends is important to determine consistency.

Analysis done by Mint Money in February this year, to test equity fund consistency on randomly chosen dates, showed that there was practically negligible consistency to rely on. Read about it here

This time, we ran the data for each calendar year (since 2000) for large-cap and multi-cap equity funds. This set too showed a lack in consistency (see graph above).

For example: out of all the large-cap funds, only four appear in the top quartile at least 60% of the time (number of years in top quartile divided by total number of years in existence).  Only two of these funds have had 2 successive years of being in the top quartile. To avoid over-reliance on 1-year return, we also considered 3-year return at the end of each calendar year. The findings were the same: only four funds appear in the top quartile space at least 60% of the time. Whether you re-look your fund selection every year or every three years, if performance is your only indicator, in all likelihood your portfolio will undergo big changes. 

One way to surpass this is to rely more on asset allocation as a strategy rather than on individual fund performance. 

According to Nitin Vyakaranam, founder and chief executive officer, ArthaYantra, “The process has to start with the appropriate asset allocation. Selecting four-five good performing funds is not enough. Once the asset allocation is in place, one has to follow that through to ensure that goal timelines are met." ArthaYantra is a full-service robo-advisory platform. 

You can benefit from access to a financial planner or an investment adviser for fund selection.

While the industry functions in a manner that portrays heavy reliance on past performance, there must be a qualitative overlay on technical performance analysis. Include other factors for analysis, rather than relying on just a single past performance number. Advisers usually have multiple criteria to select funds. 

According to Umang Papneja, managing partner and chief investment officer, IIFL Wealth Management Ltd, “You can’t completely ignore past performance. However, it cannot be looked at in isolation. Analysis of other factors around the fundamental characteristics of the fund is very important. Sometimes there are changes in external factors, which warrant us to reconsider a fund that so far has not delivered good returns. In such cases, looking at past performance doesn’t help." 

Many times, laggards don’t feature in recommendation lists because of poor past performance; or a new fund is not included till there is a sufficient performance track record. However, that by itself does not mean that such funds do not have the potential to outperform in the next one, three or five years. 

Now, with the onset of robo-advisories, the process of fund selection can be made even more nuanced as algorithms are used to run multiple selection criteria. 

Vyakaranam says, “Our definition of performance asks, ‘what period and for what level of risk is the return coming?’ Multiple factors are included. For example, for large-cap fund selection, our algorithm uses 64 different metrics." 

There are many advisers who additionally rely on firsthand interactions with fund managers and their assessment of the funds’ investment strategies going forward.  

Given that the market has moved up steadily, despite lack of any positive triggers, more on expectations rather than actual earnings growth—there is a fear that valuations have moved too far ahead of fundamentals. This in turn could result in a correction if the news flow turns negative. 

According to Prateek Pant, co-founder and head—products and solutions, Sanctum Wealth Management Pvt. Ltd, “Currently, earnings growth does not justify valuations. But geo-politics notwithstanding, economic activity is stable and liquidity for domestic equity market is good."

However, Pant also added, fund selection criteria should not change because of a bull or bear market. Along with performance, his company’s proprietary model also focuses on the fund manager’s ability to capture alpha in an up cycle and limit the losses in a down market. 

If your mutual fund distributor comes to you with a list of top-performing funds for the next SIP you are going to start, it might do you well to check with about the funds’ ability to withstand a market fall.

The data we ran shows that there are some funds that do perform consistently and tend to fall less than others when the market corrects. What you have to be careful about is, whether these funds also perform well in a bull market.

If you look at the years 2015 and 2011, two years when the market delivered negative returns—there were only two funds in each year, from the large-cap category, which were in the top quartile and also delivered top-quartile performance in the year before. What this means is that simply choosing a fund that has demonstrated the ability to fall less in a market correction is not sufficient if performance also lags when the market is rising. Once again, fundamental analysis of the fund portfolio kicks in. 

Papneja says, “Today it is wiser to buy funds whose fund managers are buying stocks with low price-to-earning (P-E) multiples rather than where the fresh buying is done in overvalued stocks." 

If you are a do it yourself investor, don’t do it without sufficiently analysing performance and portfolio information. 

The question, “If not past performance then what?" has a two-part answer.

First, performance of a fund must be analysed in different periods, across market cycles to ascertain consistency and not just for a single period.

Second, where the tools are available, you need to correlate performance data with qualitative factors such as: fund portfolio, investment objective, fund manager, and investment process.

Without both these steps, your approach to fund selection remains incomplete.

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Published: 17 Oct 2017, 05:17 PM IST
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