Mutual Funds past performance matters?

Fundamentally one should not take any investment decision based on past performance or returns. But the bitter truth is technically we do. Therefore, today I have decided to write a blog post on Does mutual funds past performance influence your investment decision? Mutual funds past performance matters?

At the onset, I would like to reiterate that I am not advocating taking any financial decision based on past performance only. But for the last couple of years as Mutual Funds industry has begun to bloom, some unscrupulous advisers just ask their clients to invest in fund houses of their liking simply based on the return criteria.

Mutual funds past performance or statistical records help us in making some technical analysis. Because to make the technical analysis of equity mutual funds we need some information on a particular fund regarding past return number to determine some key factors like Jensen Alpha, Treynor ratio, Sharpe ratio, Standard deviation, Beta, CAGR, Absolute return, XIRR, Expense ratio and etc.

Let us understand some of the key determinant factors that one should consider while investing in mutual funds to just avoid prioritising high past return only which is very much vulnerable from an investment point of view.

Beta

Beta measures the volatility or risks factor of an investment. It comprises of both systematic risk and unsystematic risk. It is used in CAPM method while calculating fund’s expected return based on its expected market return. It primarily denotes how the underlying investment would perform against the market movements. For example, if the beta of any fund is 0.8, it means if the market moves 10% upward or downward, the fund also may move in both ways by 8%.

Standard Deviation

Standard deviation measures the volatility of the fund’s return with respect to the fund’s average return. It basically denotes how much the fund’s return can deviate from the average mean return. If a fund has a 10% average return and its standard deviation is 2%, its return would range between 8% to 12%.

Risk-Adjusted Return

Risk and return have a direct relationship between them and they move together. A fund may have fetched a higher return but at the cost of a higher level of risk. The risk-adjusted return is considered as a tool to analyse whether the fund has justified by taking a higher risk in order to deliver a higher return. Funds disclose risk-adjusted return in the form of Sharpe ratio and Treynor ratio in their fact sheets. Thus, I can say that these two ratios depict the risk-adjusted return delivered by the fund itself for investment decision making.

Sharpe ratio= (Return of the fund-Risk fee rate)/Standard Deviation of the fund

The Sharpe ratio compares the excess return delivered by the fund over and above the risk-free return rate with its risk measured by Standard Deviation. Higher the ratio, the better it is when similar funds are compared for the same period. This ratio is used to rank funds within the same category. Therefore, this ratio plays a significant role in order to compare mutual funds. This helps an investor to evaluate, analyse the performance of a particular fund as compared to other similar types of fund and helps them to take an informed decision regarding investment in the fund.

Treynor Ratio= (Return of the fund-Risk fee rate)/Portfolio Beta

The Treynor ratio compares the excess return delivered by the fund over and above the risk-free return with its risk measured as Beta of the Portfolio.

Now, let’s take an example to understand how to calculate the above two ratios.

Example: A small-cap fund X has earned a return of 25% and its Standard Deviation is 14%. During the same period, another small-cap fund Y has earned a return of 32% with a Standard Deviation of 18%. The Beta of fund X is 1.2 and beta of fund Y is 1.3. The risk-free return is 6%. Now compute using the above two ratios which fund has delivered a better risk-adjusted return?

 First, we need to calculate the excess return for two funds.

Excess Return:

Fund X= 25%-6% = 19%

Fund Y= 32%-6%  =26%

Sharpe Ratio:

Fund X = 19/14 = 1.36

Fund Y = 26/18 =1.44

Treynor Ratio:

Fund X = 19/1.2 =15.83

Fund Y = 26/1.3 =20.0

Fund managers always warn the investors regarding not to take any investment decision completely based on high returns of the funds itself. Unfortunately, majority of the DIY(Do it yourself) or direct investors of mutual funds and also some Mutual Fund agents do solely rely on return scores only without considering the need for investing in different assets classes and different mutual funds schemes such as large cap funds, mid cap funds, small-cap funds,diversified funds and tax saving funds or ELSS.

Again, the bitter truth is that experts also rely on the return scores to some extent to fetch a better return opportunity for their clients.

Evaluate, analyse and compare Mutual Funds past performance

Evaluating risk and return is considered as the first step towards mutual fund performance analysis. This information obviously is given in the fact sheets but one needs to understand and look things beyond fact sheets. One must consider the following key factors while making any analysis of the fund’s performance.

• Return generated by the fund in the past.
• Has the fund been able to generate better returns than the market benchmark return?
• Has the fund ranked among top 25% of funds in its category in terms of returns?
• The risk profile of the fund itself.
• Did the fund assume risks that the investor might not have expected?
• The risk profile of the fund than its benchmark.

Does mutual funds past performance influence your investment decision? What one should do then?

Since most of us do invest in Mutual Funds without making any sound financial goals or a proper investment plan in place. We see Mutual Fund Sahi Hai campaign on TV, YouTube and hear mouth words from colleagues, friends, relatives and start investing spareable money in Mutual Funds. But that’s not ideally one should do. Everyone must ask some questions oneself that is  Why I am investing? , When do I need the money?, How I am going to invest the money like SIP or lump sum?, Where should I invest?, What’s my risk profile?

You may read the following:

• What is Personal Financial Planning
• How to calculate mutual fund returns in excel
• What is BSBD account? Basic Savings Bank Deposit account
• Best Liquid Funds-5 Best Liquid Funds for 2019

If you can put your goals in place and know the basics of financial planning and want to invest in Mutual Funds, you can invest in it based on past performance to some extent. I mean you can also consider the ratings given by CRISIL on a particular fund. At times ratings given by other rating agencies (You started investing based on their 5 rating fund, but after sometimes the fund could not perform well and you ask why your 5 rating funds failed. The answer will be like the fund has growth potential but could not hold onto it. Like the Astrologers say us while we are not having a good time. ) may be biased.

So, the ideal situation is if you can’t visit or afford to visit a Financial Planner or Financial advisor, you can invest in Mutual Funds for the long term, remain invested for longer periods based on above criteria to some extent and keep strong vigilance or periodical reviewing on the funds you are invested in at least twice in a year. After six months if your fund could not beat the benchmark return you may think of switching to another fund.

Again I recommend that only for short term period return performance you shouldn’t consider for while switching to another fund. See what other similar types of funds delivered. What is their performance? If they also could not beat the benchmark returns, then your investment is OK. But if other funds did beat the benchmark returns except for your fund you may seriously think for switching to other better performing funds.

Don’t let mutual funds past performance influence your investment decision

Also, do remember that investment in Mutual funds will bring success for you only if you remain invested for the longer horizon and you know what you are investing for or what are your goals. To accomplish this financial goal systematic investment plan is best suited for you.

Final words on Does mutual funds past performance influence your investment decisions

Disclaimer: I am neither directly nor indirectly associated with any products or institutions. My views are completely of my own. ArthikDisha cannot be held responsible for any investment decision. Readers are requested to be prudent while making some investment decisions. There are several mutual fund houses such as DSP Blackrock, ICICI Prudential, Canara Robeco, Reliance, SBI, HDFC, Kotak, Motilal Oswal, UTI, Aditya Birla SL and many more. Investors can invest any of the schemes of the various fund houses based on some principles discussed above.