Can you get better returns by investing in last year’s winning mutual funds?

Investing in last year’s best-performing mutual funds may seem like a logical strategy at first, but it isn’t. As a mutual fund investor, if you look at the last 1-year returns of equity funds, you will notice that, almost always, there is a new fund topping the return charts each year. It will be some sectoral fund one year, a small-cap or a large-cap fund the next year, and so one. In another year, it might be a large-cap or even a mid-cap fund. And while everyone wants the funds they have invested in to top the return charts, that doesn’t happen often.

I recently came across a couple whose mutual fund portfolio had around eight tax-saving ELSS funds. They told me that their strategy was to invest in the top two ELSS funds of last year. As a result, over the last 5-6 years, they had 8 ELSS funds between them! ELSS is short for equity-linked savings schemes.

The often-quoted disclaimer that ‘past performance is neither indicative nor a guarantee of future performance’ is one thing. But a lot of investors, for lack of better words, do run after past winners. This is often seen at the AUM (assets under management) levels as well. If a fund does well for a year or two, it starts attracting fresh money and the AUM grows.

If you are in the process of portfolio construction, never make the mistake of selecting funds solely on the basis of recent performance. There have been numerous instances where a fund that was high-flying for a year or two suddenly received lots of fresh money but found it difficult to even deliver average returns over the next few years.

So, if relying on past performance isn’t advised, then what should one do?

Please do note that past performance should not be ignored totally. But it shouldn’t be the only factor in picking funds.

When it comes to a fund selection, here is a list of factors to assess: rolling returns of 1, 2, 3 and 5-year periods and the ability of the fund to outperform benchmarks and average within its category; fund’s risk parameters, volatility of fund in both directions; consistency related factors; how the fund does across different market cycles or phases; impact of AUM changes on fund’s performance, etc. In addition to these, one should also look at slightly subjective factors like the fund manager and team’s track record across market cycles or years, the stated mandate of the fund and whether there is a style drift regularly or the fund remains consistent in its approach.

I know what you are thinking. Who has the time to do all of this? And you are right. Analysing mutual funds, if done properly, also requires time and effort. But that is how it is.

You may trick your brain and ‘choose to believe’ that a good shortcut is to just pick last year’s winners. And this may work too, given the randomness of market returns at times. But this is not a sustainable strategy. And shouldn’t be relied upon.

Generally, mutual fund performances tend to have cycles. And different categories do well (and not so well) at different points in time. So, if you pick a table-topper of last year just when its upcycle is completing, you are set to have a poor return outcome.

Very recently, small-cap funds started showing good returns over the 2-3 year period given the recent run-up. This attracted small investors like bees to flowers and a major chunk of fresh money is flowing into these categories. But most such investors don’t understand (or choose not to) that while these small-cap funds can give very good returns occasionally, they also have long periods of mediocre return immediately after the good periods.

So, unless ‘things are different this time’, chances are that new money flowing into these categories will not have a great time over the short-medium term.

I know it’s extremely tempting to latch on to table-toppers but please don’t get blindly carried away by recent returns. Pick funds and categories which have a reasonably long-track record of good returns and have delivered consistently across various market cycles. Also, build a portfolio of funds which have optimal exposure to different market-cap segments and style diversification.

Dev Ashish is a Sebi-registered investment adviser and the founder of Stable Investor.