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Mutual Funds: Why investing in last year’s winner may prove to be a dud

A fund’s past performance is an inadequate measure. You need to look at other factors to filter and shortlist the funds that you want to add to your portfolio.

February 03, 2023 / 07:16 AM IST
Picking the best fund is a tough task

Picking the best fund is a tough task

If you look at the returns of equity mutual funds (MF) over the past several years, you will find one thing — no one fund will be among the top year after year. That is reasonably good proof for the oft-repeated disclaimer: “Past performance is no guarantee of future results.”

But the fact is that investors chase performance. In any given year, the people who need to pick a fund will quite often pick schemes based on the past year’s returns, or look for schemes which are the table-toppers. They feel that if something has done well last year, it is bound to do well the next few years as well. But that is far from the truth. It is statistically impossible for a scheme (in a given fund category) to be the top performer of the category across market cycles and for several years continuously.

I have come across people who start a 12-month SIP in a fund which has done the best in the past one year. After a year, once the SIP stops, they again pick another fund which did the best the following year and start a new SIP. This is unwise. Fund selection should never be based solely on near-term performance. There have been many instances where a fund that was in the bottom 10 percent in one year shot up to the top 10 percent the next. There have been several cases of the reverse too.

Don’t just rely on past performance

So, if you shouldn’t pick funds just based on past performance, then how to shortlist funds for your portfolio?

Not only should you not only look at last year’s table topper, you should also not rely solely on point-to-point returns for the last one-, two-, or three-year periods. It’s much better to look at rolling returns for all the funds first instead of point-to-point returns.

In addition to rolling-returns, also consider other factors like the fund’s risk parameters, fund volatility compared to markets, how often it beats or underperforms the benchmarks, consistency ratios, the scheme’s performance compared to its category peers across cycles, etc. I would add doing a subjective assessment of the fund manager and the team’s track record, as well as of the processes in place for building the scheme’s portfolio. But that is easier said than done. Not just for retail investors but for so-called experts as well.

I am not saying that looking at past performance is wrong. All I am saying is that it is not enough. You need other factors to filter and shortlist the funds that you want to add to your portfolio.

A winner may not be suitable for you

Quite often, you will see sector or thematic funds topping the returns table. But while these get all the limelight in good years, their good performance comes after years of mediocre-to-poor returns. So, in most cases, sectoral and thematic funds aren’t suitable for most investors. Sophisticated investors who understand the risks involved (and the need to properly time the entry and exit) may invest 10-20 percent of their portfolio in sector funds. But for the rest, it’s best to avoid.

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Similarly, smallcap funds can also deliver long-term returns. But even though these funds can give very good returns occasionally, they also see deep devaluation when economic conditions become unfavorable for smaller companies. As the returns of such funds fluctuate quite wildly, these too are not for everybody.

There is another interesting phenomenon in markets. When a scheme does well for a year or two, it attracts more investors and money. This leads to the growth of the scheme’s AUM. At times, in a some categories, the size of the mutual fund becomes a problem for the fund manager.

It’s something like this. You can manoeuvre a small car very fast. But if you are driving a truck, that’ll be a problem.

When building your MF portfolio, it’s best that you diversify across a few funds which invest across market-cap segments and have different / complementary styles with limited portfolio overlap. That should work well for most investors. If you want to get rid of the whole hassle of picking funds, then go for passive index funds only.

But whatever you do, avoid looking at just the top performers and investing in them. If you are still not sure, then take help from an investment advisor to plan your finances using good and suitable funds.

Dev Ashish is a SEBI Registered Investment Advisor (RIA) and Founder, StableInvestor
first published: Feb 3, 2023 07:16 am