Don't chase the fund that won last year
You invest to earn returns. However, returns are a function of many things. Different banks don't offer the same rate for fixed deposits of similar tenure. Come to market-linked investments like mutual funds, and the differences get magnified. The past 1-year returns for funds in the large-cap equity category ranged from 12% to 36%. If you were invested in a fund that delivered the worst, your portfolio return would look relatively poor. Thus, should you always try to pick the top performer? Even in case of fixed deposits, it's rare that investors pick the one that offers the highest return or even compare the returns. Rather, it is more about convenience of having investment products with the bank one has a savings account in. In case of market-linked investments, rankings based only on returns can change at short intervals, and moving in and out of funds based only on performance can be costly and counterproductive.
If not returns, then how does one choose?
Performance change
We looked at equity funds in multi-cap and large-cap diversified categories and compared 1-, 3-, 5- and 10-year returns on five random days between now and 1 January 2014. Why random dates? Investment decisions are taken on random dates; you can decide to start investing at any point in time and when you want to pick an equity fund, intuitively, the first action is to compare returns.
We found that if you look at the past 1-year performance of funds in the equity multi-cap category in February 2017 and match the top ten schemes in terms of returns in, say, October 2015, it's unlikely there will be any overlap. Similarly, the top ten basket in August 2016 and January 2014 looked completely different from today's basket. Repeat this exercise for 3-year returns, and the chances of finding the same names as the top ten performers are only about 10%.
This trend holds true even if you consider the large-cap diversified category and for longer 5- to 10-year performances. One has to make concessions for new fund launches and fund mergers. But what it means is, if you invest only based on performance, you will end up chasing too many funds.
What you will have for sure is a fund that delivered good returns in the past but with very little focus on its potential. Moreover, every time you invest based on past returns, if there is any slack in performance, you are likely to sell too soon. Performance data by itself only gives you a point to point reference. There are several objective and subjective criteria to pick funds, including consistency of performance and fund management team. The stocks bought are not as important as the knowledge, freedom, security and confidence that a fund manager has. Equity funds from four funds houses and believes that selection can't be automated. Each fund manager is different and investors must assess that.
How to choose
In addition to past performance, looking at the consistency of performance and risk measures like fund beta and Sharpe ratio can give an indication of what to expect. A fund that hasn't displayed consistent performance in the past is considered high risk. A fund portfolio with a beta greater than 1 indicates sharper movement relative to the market. Fund performance up to the first year shouldn't be looked at. If there is a drag, consider calendar year performance for, say, the past 5 years. If only 1 year is bad, you know you have to give it time.
Secondly, while performance and risk numbers will change depending on when you are looking, the fund manager's ability and focus around the fund ideally shouldn't waver.
All funds rarely perform equally well at all times, so diversifying into a few funds, which are complimentary in style and portfolio, helps to balance near-term performance gaps. It is important to remain invested through market cycles rather than just looking at recent returns
A fund manager's stock selection style, the investment process and ability to move from one company to another will eventually result in the returns that a scheme earns.
Each fund manager is different. It's important to assess the freedom and security a manager has to make stock selection choices. Their conviction and integrity is also criticality. But these are subjective factors and an average investor may not be able to evaluate them easily.
For investors, the focus in equity mutual funds should be to build a diversified portfolio, which can be held for at least 7-10 years.
Market dynamics change but fund managers often select stocks based on their earnings conviction for a particular company, which takes time to play out.
An adviser can help you pick funds for the long term and hand hold you through short-term lapses in performance. During portfolio reviews, I spend around 20% of the time on individual scheme performance as the discussion needs to be around financial objectives. Performance tracking is something that should be left to the adviser. We consider many aspects and have interactions with fund managers before suggesting a buy or sell.
Fund selection can't be based solely on performance. A fund at the bottom today can well be a top performer 6-12 months later.
While some objective criteria should be looked at for fund selection, as it establishes a performance track record, a lot of the selection is subjective.
Advisers we spoke to said that interactions with fund managers are important in deciding whether to invest in the funds they manage. For the average investor, who doesn't have the time or the ability to evaluate the softer aspects of individual funds, it's best to take the help of an experienced adviser. The other alternative is to invest in passive funds where risk of fund manager selection does not exist. Here you will earn market returns, as passive funds track the performance of underlying indices.
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