Which fund should you choose: A 15% annual return for 10 years or 25% annual return for 3 years?

Dev Ashish
Moneycontrol Contributor

To be fair, both 15 percent and 25 percent average annual returns are pretty decent. And let’s accept that the former is more achievable than the latter in the long run. At least for those who know their fund managers aren’t Warren Buffett. But jokes apart, this is a typical dilemma that investors face.

Whether to pick a fund which has delivered reasonably good returns in long-term or go for the ones which have delivered good returns in recent years.

Here I must say something - when selecting a fund, performance should not be the only criteria.

This might sound strange to many. You invest in MFs for returns, so why shouldn’t the performance be the sole criteria for fund selection?

I feel that the past performance rarely provides enough information to allow fund selection or rejection. And many times, recent performance can be an illusion. I will try to address this aspect with reference to the title of this article:

Should you choose a fund that returned 15 percent annually for 10 years or the one that delivered 25 percent annually over the last 3 years?

A fund which has been there for 10 years must have seen at least one full market cycle, if not two. On the other hand, a three-year period might only be during a good one for overall markets. Or the three-year period might be that of a sector fund that has just delivered its best and isn’t expected to do perform well in the near future as the sectoral cycle turns.

Also, remember that return figures can be skewed by what takes place near the start or end dates. Even non-consistent funds may show spikes in returns, which may attract investors towards them.

So first, you should compare both the funds over similar periods. At least then you will be checking them out in a similar environment.

Another thing to note is that just comparing point-to-point returns of funds is not sufficient. You should check the rolling returns for periods under consideration, which allows you to gauge fund performance across time periods.

Volatility analysis is something that most investors ignore but is exactly what comes back to haunt them eventually. The average returns (of 15 percent and 25 percent in this example) can paint a rosy picture. But the actual volatility that a fund undergoes gets lost in the average figures. For example, suppose the two funds have the following volatility figures:

• Fund A (15 percent returns in 10 years) - Best annual: 35 percent, Worst annual: a negative 12 percent
• Fund B (25 percent returns in 3 years) - Best annual: 52 percent, Worst annual: a negative 27 percent

Chasing the past returns of mutual funds is not a very good idea. I am not saying that you should ignore it. But it should be considered along with other things.

Last year’s winners may not necessarily be this or next year’s winners. If you just focus on past performance, you will continuously be selling existing funds and buying newer ones based on the latter’s recent performance. Such flipping in search of the best returns comes with transactional costs like loads, taxes, etc. Also, you may end up entering a new fund (which is a recent top fund) only after it has completed its best run.

There is no perfect way to pick the right mutual fund or next year’s winners. But here are some points worth considering when picking the same:

• Identify the goal for which you are investing. Only choose equity if it’s a long-term goal. Also, check whether you have the necessary risk tolerance to invest in the chosen fund category.
• Do check the fund’s rolling returns for 3, 5, 7-year periods for both lump sum and SIP investments.
• Compare these with category average and with benchmarks return figures.
• The focus should be on fund consistency. But consistency does not mean that the fund should be a table-topper all the time. A good strategy can have bad years and a bad strategy can have good years.
• If the fund is doing better than the benchmark in at least over 3- and 5-year periods and is consistently among the top quartile (25 percent) of the category, then it’s a good fund to consider.
• If need be, 1- and 2-year performance should also be analysed to see whether there is a turnaround in fund’s performance due to any recent changes or not.
• Evaluation of market-phase performance should also be made. Remember that any fund's historical performance can change dramatically if the major events (like the 2009 bear market, etc.) are taken out of the period in consideration.
• Upside and downside capturing ability of the fund: If the upside capture ratio of a fund is more than 100 percent, it means the fund does better than the benchmark when markets move up. On the other hand, a downside capture ratio of less than 100 percent means that the fund falls lesser than the benchmark if market falls. As you might have guessed, funds having high upside capturing ability and low downside capture ratio are better ones.
• The pedigrees of the fund house and the fund manager, expenses, liquidity are some other factors worth considering.

I know that every investor has his own opinion on how to use performance data to pick funds. But just looking at the recent past performance is not how fund selection should happen. A holistic assessment of the fund performance from various perspectives, its strategy, fund manager ability (track record) and fund’s portfolio is what's required.

Never hesitate in consulting investment advisers if you have doubts about whether your fund selection is right or not.

The author is founder of StableInvestor.com.