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Why picking a mutual fund that gave 100% in one year may be dangerous for your portfolio

23 equity mutual funds gave more than 100% return in past one year period. That is not necessarily good news if you are about to invest in any of them. Flashy returns from some risky funds may be one-off.

mutual funds,investment,equity funds,thematic funds,small-cap funds / June 05, 2021 / 10:29 PM IST

When people ask about returns that can be generated from equity mutual funds, usually, investors say 10-15 percent. Some adventurous and ill-informed ones might even dream of getting 18-20 percent average annual returns in the long term.

But what happens when the past one year’s returns of many equity funds are more than 100 percent, and a few even in excess of 150 percent?

Going by recent returns

Many investors make the mistake of picking schemes based on one-year returns or look for table-toppers. Investors shouldn't make the mistake of picking funds by extrapolating high returns of the last one year.

If you were to look at the one-year data near the end of March 2021 (more specifically around  March 22-24), it would have shown some eye-popping one-year returns for many MFs (mutual funds). The reason is that Indian markets crashed heavily exactly a year back in March 2020 to make multi-year lows. The recovery from that point onwards, as we all know, has been stellar.

Close

As a result, many MF schemes rode the recovery wave over the last one year and are now showing super-normal returns. And that is what can mislead many new investors.

Broader markets themselves have delivered 80-90 percent returns during the said period. So it’s not like that the performance of these high-flying funds is totally because of good stock-picking skills. It’s more about how a rising tide lifts all boats. And just that some of the boats rose higher while others rose a bit less.

Sector and thematic funds fly

Most of these triple-digit returning schemes were from the sectoral stable. And many were small-cap focused or small & mid-cap funds.

But sector funds aren’t suitable for all investors. In fact, these are best avoided by most. I know it might sound foolish to say that when sector funds have given 100-150 percent returns in one year. But that is a fact of proper mutual fund investing. Sectoral funds have concentrated sector-specific portfolios and, hence, carry a lot of risks. Sophisticated investors who understand the risks involved (and the need to properly time the entry and exit) may still invest a small 10-20 percent portfolio in sector funds. But for the rest, it’s best to avoid them. Some sectors will do very well occasionally and deliver better-than-market returns in the short term. But this won’t happen every year.

Small-cap funds, too, are not suitable for everyone. And even though these funds can give very good returns occasionally, they also end up with large cuts when economic conditions become unfavorable for smaller firms. So, the return fluctuations are quite large in these funds. Invest only if you fully understand the real risks and the probability of downsides. And since most people overestimate their ability to digest negative returns, it’s best to avoid these funds.

I have earlier also written about why sector funds and small-cap funds are among investment products to be avoided.

Consider rolling returns

And it is not just for this year that looking at one-year returns doesn’t make sense. Looking at point-to-point one, two or three-year returns is never enough. It’s far better to base your decisions on rolling returns, among other factors. Looking at the point-to-point return (in which even one event can skew the data) can mislead investors.

It is very important to remind us of the often-quoted MF disclaimer here: Past returns are not an indicator of future performance. Remember, short-term returns for mutual funds too can be very high or very low – more than 100 percent in 2020-21 or -50 percent or even worse in 2008-2009. Do not make the mistake of using one-year returns to set your long-term return expectations from your mutual fund portfolio. And if you are a newbie to MF investing, please don’t pick funds based on the last one-year returns. It’s better for you to get yourself some professional advice on picking the right mutual funds in line with your risk appetite, goals, time horizon and other requirements.

We investors keep looking for multi-baggers in stocks. But when more docile mutual funds pick up the pace to give 100-150 percent returns in just a year’s time, then it is bound to excite many. But one-year returns are not the best way to judge and pick schemes for your long-term portfolio.
Dev Ashish The writer is the founder of StableInvestor.com
first published: Jun 4, 2021 10:06 am

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