Due to their ability to deliver attractive returns, mutual funds are becoming a popular investment tool among many investors. However, with over 8,000 mutual fund schemes in the market, how does one decide which funds to invest in? Many mutual fund investors, both beginners and experienced, have a tendency to judge a scheme by its performance over the years and usually pick the one that has delivered good returns in the past. Is that a wise thing to do?
When you go through the performance history of a particular mutual fund, you must have read the disclaimer that says ‘Past returns are not indicative of future performances’. What does this mean? Shouldn’t you rely on a fund’s past performance? What factors should you consider while picking a mutual fund scheme? These must be some of the questions that you, as an investor, must be having in mind. Allow us to answer those for you in the sections given below.
What do past returns say about a fund?
The past performance of a fund could be evaluated on the basis of:
- The nature of stocks in its portfolio
- Condition of the market
- The asset management company
- The fund’s strategy
- The fund manager’s skill set
A fund’s historical performance is also a combination of many macro and micro parameters. Past returns of a fund should be used to judge the quality of a fund but not to predict its future performance. The fund’s style of investing, its consistency, its strengths and weaknesses during different phases in the market, its volatility, and how all these factors have helped in delivering optimal returns, can be gauged from the historical performance of the fund.
Why you can’t rely on just the past performance of a fund
Mutual fund experts advise investors not to base their investment strategies on the past performance of a fund as it can easily backfire. Many investors are misled by historical performances of a fund but it has been observed that many funds which have performed well in the past have not yielded satisfactory returns at a later stage. On the contrary, funds that have a history of delivering poor returns have delivered attractive returns in the future.
For example, in 2012, the Reliance Equity Fund had delivered returns of over 41% and was the top performer in the large cap category but if someone had analysed its historical returns in the previous year, they would have discovered that the same scheme was the worst performer in the same category based on its returns over the 1-year, 2-years, 3-years, 4-years, and 5-years period.
The same was observed in the case of the SBI Bluechip Fund which delivered returns of 38% in 2012 when its historical performance till December 2011 had been poor.
So, how can an investor predict the future potential of the fund? Simply by analysing the quality of the portfolio. This can be done by looking at how well a portfolio is positioned under various market conditions such as a bear market, bull market, defensive market, volatile market, etc., to generate returns. How a fund takes advantage of macro events to alter its asset allocation is one more quality to look for. This will help investors understand if a particular portfolio holds potential.
Having said that, a fund’s returns can be determined by the forecasted returns done by analysts by taking market valuations into account and the nature of alpha generation of the portfolio. However, it is better for investors to not over-predict or forecast the returns as there is no sure-shot formula for predicting future returns. Instead, they should diversify their portfolio to minimise the risk on their investments.
What factors should you consider while picking a mutual fund scheme?
As an investor, instead of just looking at the fund’s past performance while buying mutual funds, you should look out for the below-mentioned factors:
- Expense ratio - While looking for a mutual scheme to invest in, always pick one that has a lower expense ratio. Expense ratio is the fees charged by fund houses to manage the fund on your behalf and includes the fund manager’s fee, record-keeping fee, etc. At the time of investing this fee may seem small, but over the long-term investing in a scheme with a lower expense ratio can translate to higher returns.
- Loads - Loads are the fees charged when you enter or exit a scheme. In India, no entry load is charged as per the regulation issued by the Securities and Exchange Board of India (SEBI). However, many schemes charge an exit load if the investor exits the scheme before a specified time. If you are not certain of your investment horizon and do not wish to lose money on paying the exit load, it is best to choose a scheme that has a low exit load or no exit load at all.
- Risk - Before investing in any mutual fund scheme, assess how much risk you can tolerate in order to achieve your investment goals. A fund that is giving satisfactory returns in one year may give fewer returns the next year. Hence, it is imperative to diversify the risk by investing in different types of mutual fund schemes.
- Relative performance to a benchmark - Comparing a scheme’s performance with the performance of benchmarks can help you judge if a scheme is performing well. For instance, if the Sensex is declining, and a fund also showcase equally poor performance, it does not necessarily mean that it is a low-performing fund. Instead, it can mean that the condition of the market is down.
Relying on the historical performance of a fund to steer your investment decision is not the best strategy. Funds which have performed well today may not do the same tomorrow and vice-versa. Hence, it is advisable that you look for the factors mentioned-above, align them with your investment goals, and make an informed decision on which fund to invest.