Mutual Funds past performance matters?\u00a0\nFundamentally 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\u00a0influence your investment decision? Mutual funds past performance matters?\n\n\n\nAt 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.\n\nMutual 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. \n\nLet us understand some of the key determinant factors that one should consider while investing in mutual funds to just avoid prioritising\u00a0high past return\u00a0only which is very much vulnerable from an investment point of view.\n\nBeta\n\nBeta 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\u00a0move in both ways by 8%.\n\nStandard Deviation\n\nStandard 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%.\n\nRisk-Adjusted Return\n\nRisk 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\u00a0Sharpe ratio\u00a0and\u00a0Treynor 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.\n\nSharpe ratio= (Return of the fund-Risk fee rate)\/Standard Deviation of the fund\n\nThe\u00a0Sharpe ratio\u00a0compares the excess return delivered by the fund over and above the risk-free return rate with its risk measured by\u00a0Standard Deviation.\u00a0Higher the ratio, the better it is when similar funds are compared for the same period.\u00a0This ratio is used to rank funds\u00a0within\u00a0the 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.\n\nTreynor Ratio=\u00a0(Return of the fund-Risk fee rate)\/Portfolio Beta\n\nThe Treynor ratio compares the excess return delivered by the fund over and above the risk-free return with its risk measured as\u00a0Beta of the Portfolio.\n\nNow, let's take an example to understand\u00a0how to calculate the above two ratios.\n\nExample:\u00a0A small-cap fund\u00a0X\u00a0has earned a return of 25% and its\u00a0Standard Deviation is 14%. During the same period, another small-cap fund\u00a0Y\u00a0has earned a return of 32% with a\u00a0Standard Deviation\u00a0of 18%. The\u00a0Beta of fund X is 1.2 and beta of fund\u00a0Y\u00a0is 1.3. The risk-free return is 6%. Now compute using the above two ratios which fund has delivered a better risk-adjusted return?\n\n\u00a0First, we need to calculate the excess return for two funds.\n\nExcess Return:\n\nFund X=\u00a025%-6%\u00a0= 19%\n\nFund Y=\u00a032%-6%\u00a0\u00a0=26%\n\nSharpe Ratio:\n\nFund X = 19\/14 = 1.36\n\nFund Y = 26\/18\u00a0=1.44\n\nTreynor Ratio:\n\nFund X = 19\/1.2 =15.83\n\nFund Y = 26\/1.3\u00a0=20.0\n\nFund 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,\u00a0small-cap funds,diversified funds and tax saving funds or ELSS.\n\nAgain, the bitter truth is that experts also rely on the return scores to some extent to fetch a better return opportunity for their clients.\nEvaluate, analyse and compare Mutual Funds past performance\nEvaluating 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.\n\n\tReturn generated by the fund in the past.\n\tHas the fund been able to generate better returns than the market benchmark return?\n\tHas the fund ranked among top 25% of funds in its category in terms of returns?\n\tThe risk profile of the fund itself.\n\tDid the fund assume risks that the investor might not have expected?\n\tThe risk profile of the fund than its benchmark.\n\nDoes mutual funds past performance influence your investment decision? What one should do then?\n\n\nSince 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\u00a0\u00a0Why I am investing? , When do I need the money?, How I am going to invest the money like SIP or lump sum?,\u00a0Where should I invest?, What's my risk profile?\n\nYou may read the following:\n\n\tWhat is Personal Financial Planning\n\tHow to calculate mutual fund returns in excel\n\tWhat is BSBD account? Basic Savings Bank Deposit account\n\tBest Liquid Funds-5 Best Liquid Funds for 2019\n\nIf 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.\n\nSo, 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.\n\nAgain 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.\nDon't let mutual funds past performance influence your investment decision\n\n\nAlso, 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.\nFinal words on Does mutual funds past performance influence your investment decisions\nDisclaimer: 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.