Be careful of current year top performing mutual funds

Don’t judge a book by it’s cover…

Is it current year performance that you see while investing in mutual fund? Do you chase current year’s top performer mutual funds? Read on.

For common non finance person, first thing to look in mutual fund at is performance of that fund. Generally mutual funds publish 1 year, 3 year, 5 year and since inception returns. Is it good idea to make selection based on these numbers. Let’s see…

You must have heard or read this at multiple places that we should not look at short term performance but unknowingly we do make decisions generally based on performance in a year or two. See what is happening here is that, at the time of investment, all the performance numbers are influenced by latest returns and it gives illusion that fund is performing well even in long run.

Let’s understand with an example

Let us say you had invested in ICICI Pru Bluechip Fund in beginning of 2014. Today is 15th Jan 2020. In last one year, performance of fund is not very good. One year returns are 11.62. Your friend suggests you to switch to Motilal Oswal Focused 25 Fund. You compare the performance stats of these two funds. You can see from below image, Motilal Oswal Focused 25 Fund is better performing than your fund in most years. 1,2,3 and 5 year returns are higher than ICICI Pru Bluechip Fund.

Returns comparison of both funds

Now based on this comparison, you may tend to conclude that Motilal fund is much better than ICICI fund. But hold on. What has happened here is that one year performance has influenced all the figures. If you see NAV movement of both funds for last f years in below image, you will see both funds performed almost neck to neck.

NAV  movement of both funds

We are not discussing here which fund is better but I am just trying to show how just 1 year performance is giving us a false impression for even 5 year performance.

Are return figures not correct then?

No. That’s not the case. But what happens is that when you are trying to chose a fund based on performance, you need to be aware that these numbers get influenced by even one good or bad year. Now let’t take an hypothetical example. Say there is one really good year for a fund where fund manager strategy clicks and returns jump to 75%. Should you then invest in that fund. Say fund returns are like 75%, -15%, -15% percent in last three years. Due to averaging, you will see even 3 year returns as 15%. It has hidden poor performance of earlier two years.

How to compare returns then?

Good question. In my personal opinion, if you do not have a financial advisor and your decision is going to be just based on performance then use discrete returns of the funds. Discrete returns are absolute returns in each year. Below are discrete returns of both funds for last five years.

Year ICICI Pru Bluechip Fund(G) Motilal Oswal Focused 25 Fund-Reg(G)

Now this will help you understand performance of both funds in each separate year. In 2014 and 2017 both funds performed very similar. 2015 was better for Motilal Fund where as 2016 was better for ICICI fund. 2018 saw ICICI fund holding its principal better than Motilal Fund. 2019 year is where Motilal Fund performed much better but should you decide to switch just based on last one year? That’s question you need to answer and then take the decision. Most probably you will stick with your existing fund and give it one more year to bounce back.

I feel this returns comparison will help you little better compared to 1/3/5 years return as that tend to hide underlying inconsistency in the returns.

Where will you get these data?

There are multiple websites that can help you get these statistics. I use rupeevest for comparing various ratios and returns. Value Research can help you get discrete returns of each fund. Once you navigate to specific fund, you can go to Performance Tab and then check Discrete Return tab.

Is returns comparison correct way to select fund?

Certainly not. One need to also look at various ratios like alpha, beta , standard deviation, Sharpe and Sortino ratios. One needs to consider his or her risk profile, other funds in portfolio, asset allocation etc before deciding on fund to invest.

Purpose of this article was just to make you aware of likely bias of just one year good or bad performance spilling over other years.

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