Know what to look for and what to discount while assessing the past performance of a mutual fund
In the absence of rolling return data, look at calendar year performances and trailing returns
The return from a mutual fund is typically the start point of evaluating the performance of any mutual fund. While past performance cannot be a guarantee for continued performance in the future, knowing what to look for and what to avoid while assessing past performance can go a long way in making better investment decisions. Make sure the returns show you the whole picture before you make an investment choice.
As a first step, you may list funds with the highest returns in the asset class you choose, but this list may not suit your core portfolio needs. For example, the funds that generated the highest one-year return as of 8 November were banking and financial services funds in the equity asset class, and gilt funds in the debt asset class—both tactical fund categories. If you invested in these, you may end up with funds that perform well only in a particular economic cycle or situation.
You should consider the returns only after you have identified the category of funds that meets your investment objectives. “Investors suffer from recency bias and would be tempted to select the funds with the best recent returns," said Srikanth Meenakshi, co-founder, PrimeInvestor.in, a personal finance research platform.
“But this may lead to undesirable choices. It is important to compare the performances of funds of similar profile," he added. For example, if you are willing to take some risk for a goal that is 10 years away, then the multi-cap category may suit your needs, and you may consider the returns of funds from this category.
Using trailing returns
Trailing returns, say the return from a fund over the last five years, is sensitive to the level of the fund value at the start and end points of the period. If the markets and, therefore, fund values were low at the start point and high at the end date then the returns will look very good and vice-versa. A small shift in the dates considered for calculating the returns may change the complexion of the fund’s returns.
For example, the performance of large-cap funds in the period before the general election results in May 2019 and post that event will show significant difference with the funds coming to their own as large-cap indices rallied. The investment strategy adopted by the fund, such as value investing or focused portfolios, may also explain the outperformance of some funds in a particular period. But this may not sustain across market cycles.
Use trailing returns over longer investment horizons, seven years and more, where performance history is available, that would have captured different market conditions to get a better idea of a fund’s performance. “Indian equity investors have only seen a bull market since 2013 and they need to go beyond that period to see how a fund has performed in different market scenarios, including bear markets," said Amit Kukreja, a registered investment adviser and founder, amitkukreja.com. “In case of debt funds, the evaluation period can be much shorter since the debt markets have seen credit cycles and interest rate cycles in the last five years," he added.
“The time frame considered for returns should be relevant to the fund category. For debt funds for shorter investment horizons, one month, three months, six months and one year may be more relevant," said Meenakshi.
Once you have identified the suitable category, it is always tempting to select the fund with the highest recent returns. It is more important to consider the consistency of returns and your comfort with volatility. While it is virtually impossible for a fund to be a top performer in every period, consider the ones that have been in the top quartile or at least have been in the top third of all funds in the category during different periods.
Trailing return over a period tends to conceal volatility since it only looks at the fund’s value at the start and end points in the period under consideration. Some funds may see deep drawdowns in performance in the interim that is made up by a steep climb. Other funds may generate more steady returns even though the trailing return numbers over a period for both funds may be similar.
Calendar year returns can serve the purpose of identifying such volatility since you will be breaking down a period into multiple discrete periods. For example, if you were looking at the seven-year performance of an equity fund, apart from the trailing return, you should also consider the returns in calendar years 2012, 2013 and so on till 2019. Since you are looking at multiple periods, any deep fall or steep rise in any calendar year will show up. “Look at the returns generated by the fund and the benchmark for multiple calendar years to get an idea of consistency," said Meenakshi.
Rolling returns are the most effective way to look at return performance in a way that eliminates the biases inherent in trailing returns. This is because it considers the returns of multiple desired holding periods, for example all the seven-year returns possible by moving forward the start date by one month each time in the last 10 years. By doing this, it captures the fund’s performance continuously rather than just over two points of time. In the absence of rolling return data, look at calendar year performances in addition to trailing returns to understand the fund’s performance in different market conditions and the consistency with which they have generated returns.
Take outlier returns as cues to investigate further. If a fund’s return in a period is much higher than that of its peer group funds, then it is a good idea to investigate before investing.
A case in point is the sharp 45% rise in the net asset values (NAVs) of PGIM India Mutual Fund’s ultra-short duration fund in end September 2019 when it recouped the amounts due from the Anil Ambani group companies, Reliance Business Broadcast Network Holdings Ltd (RBBNH) and Reliance Commercial Finance Ltd, which it had earlier written down when the debentures were downgraded. This pushed the fund to being a top performer in the three- month investment horizon, a period that investors in the ultra-short debt fund category would generally consider. The return of the fund in this period was more than double than that of other funds in the category and may seem as an attractive pick. But if you dug deeper, you would find that the fund had 100% exposure to RBBNH paper and the jump in the NAV came as a result of the write-back after the company paid its dues.
A 20% return from an equity fund may be considered good, while 10% may be seen as average. But it is important to see the return relative to the benchmark and peer group for better assessment. A 20% return may be seen as inadequate if markets have in the same period generated 30% returns. “Alpha relative to the index of a fund is an important consideration for selection. There is no point in investing in an actively managed fund and bearing the expense ratio if it is unable to beat the benchmark," said Kukreja.
While it is important to look beyond returns to determine the performance of a mutual fund, returns continue to be the cornerstone of investment decisions. To make the right use of the data on past performance, it is important to interpret it right. Use it along with the risk and portfolio data before making investment decisions.
Reliance Group companies have sued HT Media Ltd, Mint’s publisher, and nine others in the Bombay high court over a 2 October 2014 front-page story that they have disputed. HT Media is contesting the case.
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