Before zeroing in on a mutual fund scheme, investors invariably examine the past few years’ returns to gauge its future earning potential. Prioritising the past returns over other considerations might look natural for a lay investor – but it is not recommended, advise wealth advisors MintGenie spoke with.
Recently Dezerv, a wealth creation platform, carried out a study of 24 midcap mutual funds and assessed their past 15-year returns. The study made a number of key observations.
One of these is that the past three-year returns are not the correct yardstick to estimate future 3-year returns.
“In our recent study, we found that past 3-year returns have no correlation with future 3-year returns. Further, we found that even past 3-year outperformance has no correlation with the future 3-year outperformance,” says Vaibhav Porwal, co-founder of Dezerv.in.
While encapsulating the above images into words, he aptly points out: “In order to pick an outperformer, it is necessary to look beyond returns and parameters derived using returns. You need to consider the valuation, business growth, and diversification of the underlying portfolio. You also need to know how different portfolios behave under different market conditions.”
Flip of a coin?
Another study was carried out by wealth management platform Kuvera. This study — which looks at the past returns dating back to 2003 — discovered that only a mere 13 percent of the best-performing funds based on past one-year data continued to be part of the best-performing funds one year later. Also, only a slim majority (52 percent) of the best-performing funds continue to be in the top half of the funds a year later.
Gaurav Rastogi, CEO & Founder, Kuvera, says, “Investing based on past returns alone is no better than the flip of a coin. Investing based on past performance seldom works in practice. Using 5-year best performers instead didn’t change the results either putting to rest the consistent outperformer or long-term outperformer myth.”
Amol Joshi, Founder of Plan Rupee Investment Service, echoes the same sentiment. “The simple reason for not relying totally on past performance is that it cannot be repeated in the future. And when valuation goes out of sync, mean reversion is likely to take place,” says Joshi.
So, what exactly is the alternative? On this, he says, “Before investing, you should look at where you are in the market cycle. And whatever valuation criteria you follow – you should follow it consistently — be it P/E ratio, P/B ratio or dividend yield."
Whatever goes up must come down
In 2017, mid- and small-cap funds gave a return of up to 100 percent, following which investors were motivated to invest in them the next year too. Much to the investors' chagrin, the funds in these categories declined by 50 percent the following year, recounts Sreedharan Sundaram, a SEBI-registered investment advisor and Founder of Wealth Ladder Direct.
“The past return is not the criteria to choose a fund scheme. If a category has delivered great returns in the past, valuations are naturally stretched and are likely to correct the following year. For example, mid and small caps corrected around 50 percent in 2018 after rising 100 percent in the preceding year. However, some investors think that if a category has given a return of 100 percent in one year, then next year it would, at least, give half of it, but that is not the right way to look at it,” adds Sreedharan.
And what about the other considerations that an investor can weigh before selecting a mutual fund?
In response to this, Sreedharan says, “Investors can examine the standard deviation and sharpe ratio of fund schemes, among other things.”
Abhishek Dev, Co-Founder and CEO of Epsilon Money Mart, says: “While seeing historical performance is important, it doesn’t necessarily promise future returns. The stock market is dynamic in nature and a lot depends on the current economic scenario. Thus, while some sectors or industries which did remarkably well yesterday might be the one most affected at present.”
“Therefore, it makes sense to invest in funds in line with your asset allocation and which meet your investment objectives, your risk appetite and how the fund manager functions and not just the top performing funds,” he concludes.