Chasing past glory: Why last year’s top fund may not be your smartest pick

When evaluating mutual fund performance, one must look beyond single-period returns.

Every April, investors scan mutual fund rankings to identify the past year’s top performers. The logic seems straightforward—choose the fund that delivered the highest returns and expect the same performance going forward. However, this approach is not just overly simplistic—it can be dangerously misleading. Mutual fund performance is inherently cyclical. A fund that leads the pack one year can easily fall behind the next, and vice versa. This is because market conditions, sector trends, investor behaviour and even fund manager decisions shift over time. Basing your investment decision solely on past rankings is like driving while looking only in the rearview mirror.

The problem with ranking-based investing

While it’s tempting to invest in the previous year’s No. 1 fund, doing so is akin to selecting a cricket team going only by who the last match’s top scorers were. Just because a player or fund had a great performance once doesn’t mean they will replicate that in the next outing. Market momentum rotates. Sectors that outperform in one cycle may underperform in the next. Similarly, investment styles—whether growth, value or momentum—can fall in and out of favour based on macroeconomic cues.

Also read | Mindful asset allocation the key to investment success

A reality check using real data

Let’s examine a real-world two-year comparison of five mutual fund schemes to understand just how drastically performance and rankings can change:

Scheme 2, once a top-five fund, saw its performance cool off to modest returns in both years.

The remaining schemes also displayed significant fluctuations, proving that past performance is an unreliable predictor of future outcomes.This pattern clearly illustrates the phenomenon of performance rotation, where market dynamics—such as interest rates, inflation or sector cycles—dictate the short-term success or failure of a scheme. Chasing past winners without context often results in disappointment.

Why rolling returns matter more

When evaluating mutual fund performance, one must look beyond single-period returns. Point-to-point returns (like one-year or three-year returns) offer a snapshot, but not the full picture. They only tell you how a fund performed between two fixed points in time—which could have been unusually favourable or unfavourable.

Rolling returns, however, afford a more nuanced and reliable analysis.

- They measure returns over overlapping intervals (for instance, three-year returns calculated every month over a five-year span).

- This approach smooths out temporary volatility and eliminates selection bias.

- Rolling returns help you assess how consistently a fund has performed across various market conditions.

- They show how often the fund has outperformed its benchmark, indicating stability and resilience.

For instance, Scheme 1 in the table above might appear to be a top performer in 2023–24. But a rolling return analysis would reveal that its stellar return was a one-off event, masking a broader trend of volatility or underperformance in other periods.

What investors should focus on

Rather than relying on annual rankings or “best performer” lists, investors should evaluate mutual funds through a comprehensive and strategic lens. Here are the key factors that truly matter:

Final thoughts

Past performance is a rearview mirror—it reflects but cannot guide. Mutual fund rankings constantly shift because market conditions are always evolving. What did well last year might not even be in the top 50 the next. Instead of chasing high returns and names that dominated recent charts, focus on what truly builds wealth—consistency, suitability and discipline. Use rolling returns, analyse risk-adjusted metrics, and select funds that align with your goals and temperament. In the long run, successful investing isn’t about finding last year’s winner. It’s about choosing a strategy that can win across years.

The writer is a certified financial planner and founder, True North Finance, a financial and investment planning firm based in Pune.

Disclaimer: The views expressed by experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.