Mutual Funds: Why last year’s returns aren’t enough to choose the right fund?

If investing was as easy as looking at the winners from last year and investing in them, then everyone would be rich. But that is not how investing works.

Just because something has worked in the past year doesn’t guarantee that it will work again this year. And this is also what market regulators like SEBI and financial companies like AMCs keep warning everyone about with their disclaimer -"The past performance is no guarantee of future results and may not repeat."

But time and again, investors do chase funds that have done well in the last one year. They believe that since it did well last year, it will continue to do well over the next few years as well. It may happen once in a while (if the strategy has some inherent momentum around it), but more often than not, mean reversion kicks in and the fund doesn’t do well.

Statistically speaking too, it is highly improbable for any scheme/fund within a specific category to maintain its status as the top performer across various market cycles over multiple years.

Sectoral/thematic funds and their risks

In fact, if one were to look at the top-performing funds of the last 1 year, then it shows that a whopping 12 out of the top-15 funds are non-diversified and sectoral/thematic in nature.

Now this article isn’t about sectoral/thematic funds but let me address it a bit as the table above shows that in the last 1-year, sectoral/thematic funds have done very well and hence, investors may be tempted to invest in many of them. If you zoom out a bit and look at the last several year’s data, it will be clear that there is always a different sector/theme at the top each year. So practically speaking, you can’t be getting in and out of a sector every year.

Also, many sectors (themes) can take years to play out well. So having the patience to wait for good days is another challenge for most. In a way, it’s like trying to ride a wave that you expect to rise soon. So you need to get your timing ride with such concentrated sectoral/thematic bets. If you time your entry well, then you can no doubt make a lot of money. But if you get it wrong, then you will suffer badly. Remember, that once a sector does well and you enter late, it might be years before the sector gets back in favour again.

Hence, most small investors are better off without investing in sectoral or thematic funds. More sophisticated investors, who comprehend the inherent risks and the necessity for precise timing in entering and exiting these investments, might allocate a small portion (10-20%) of their portfolios to sectoral/thematic funds.

How to select funds beyond last year’s performance

That said and coming back, if relying solely on past 1-year performance is not advisable, how should investors go about selecting funds for their portfolios?

While it is crucial to avoid making decisions based solely on the previous year's top performers, it is equally important not to rely exclusively on point-to-point returns from the last one, two, or three years. A more effective strategy is to look at the rolling returns for all funds first rather than focusing on specific time frames.

In addition to analysing rolling returns, investors should consider a variety of factors, including the fund's risk parameters, its volatility in comparison to market benchmarks, its historical performance relative to these benchmarks, and its consistency ratios. Evaluating how a fund performs against its peers across different market cycles is also essential.

Furthermore, conducting a qualitative assessment of the fund manager and their team's track record, along with the processes employed in portfolio construction, can provide valuable insights. However, this comprehensive analysis can be challenging, not only for retail investors but also for so-called experts in the field.

The impact of growing fund size

Please don’t misunderstand me. I am not saying that looking at past performance is wrong. But what I am saying is that it is never enough. You need to look at other factors to shortlist the funds that you may want to add to your portfolio for the long term.

If you have been in markets for long, then you will agree with this - when a fund performs well for a year or two: it tends to attract a surge of new investors and fresh money. This influx can lead to the fund's assets under management (AUM) growing significantly, which can then pose challenges for the fund manager to keep delivering good returns on a larger portfolio.

To illustrate, consider the difference between driving a small car and a large truck on a highway. A small car can manoeuvre quickly and efficiently, while a larger vehicle may struggle to maintain speed and agility. This analogy highlights the potential issues that can arise when the size of a small fund grows too large due to the above discussed reason.

In conclusion, it is crucial to avoid making investment decisions based solely on the last 1-year returns and then gravitating towards the top few funds. When constructing a mutual fund portfolio, diversification across various funds that invest in different market-cap segments and employ complementary investment styles is advisable. This strategy helps mitigate risks and should be effective for most investors.

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