LiveMint, Nov 5, 2019
Studies show past performance is not a sufficient condition when selecting a fund
• Evaluate the portfolio construction and management to understand the risks in the scheme
Picking a fund with a good track record is one of the cardinal principles of mutual fund selection. While examining track record, advisers and distributors rely heavily on past returns to formulate their fund recommendations. This is not to say that other factors like risk, fund style and fund manager experience are disregarded, but returns are arguably the king. Despite this importance, there have been few studies looking at whether past performing funds do actually perform well in the future. We take a look at three studies that have been conducted separately by Morningstar, S&P Dow Jones and Mobikwik.
Akash Jain, associate director, global research and design, S&P BSE Indices, sought to answer the question of whether past performers are also future performers in a study published on the S&P Dow Jones Indexology blog in July 2019. You can read it here. It looked at fund performances over a five-year period from 2008 to 2013 and divided funds into four quartiles. It then looked at the performance of these funds over the subsequent five years ending in 2018. The study found that 48% of large-cap funds in the first quartile remained in the first or second quartile over the subsequent five years. In case of mid- and small-caps, 43% of the funds in the first quartile remained in the first or second quartile.
The results differ somewhat if you look at how many stayed in the first quartile alone, but such a stringent test may not be a meaningful measure of fund performance. This is because only a small minority of funds remain within the first quartile over successive periods. It is unrealistic for a fund to always be a top performer, but it should ideally be at least a good performer (remain in the top two quartiles). Conversely, just 17.8% of large-cap funds in the fourth quartile (worst quartile) migrated to the first or second quartile. In case of mid- and small-caps, only 28.1% of the funds made this dramatic upward migration. The results show that past performance does matter—picking a fund in the bottom quartiles would have in all probability kept you in the bottom quartiles, while picking something in the top two quartiles would have given you a good chance of staying close to the top. However, past performance is not a sufficient condition—less than 50% of the funds in the first quartile stayed in either the first or second quartile.
Other factors should be looked at during your fund selection, and we will go into this a little later.
Another study was done by Shwetabh Sameer of Morningstar. Sameer used a technically complex methodology (you can read it here). Sameer used returns data over a 14-year period from 2001 to 2015. He divided funds into four quartiles based on their performances in one-year, three-year and five-year rolling periods and looked at how many funds in each quartile beat the median return of that category in the subsequent one-, three- and five-year period. For example, if two funds out of 20 funds in the first quartile beat the median return in the subsequent period, the success rate was 10%. He then compared these success rates with the success rates of the other quartiles and reported the differentials. Sameer found that the difference was 26.80% for large-cap funds for a three-year period and 19.30% over a five-year period.
Note, these figures are not the percentages of funds outperforming their category medians in the respective quartiles. Instead, they compare the percentages of outperformers against the median between four different quartiles. A high positive number shows persistence of performance and a low or negative number shows lack of persistence. For mid- and small-cap funds, the figures were 7.50% and -14.80% respectively. In other words, Sameer found that while there was some persistence of returns among large-cap funds, there was little evidence of this in the mid- and small-cap category.
The Mobikwik study
A recent study done by Mobikwik (which acquired Clearfunds, an online mutual fund investment platform) divided mutual funds into four quartiles looking at data from 2013 to 2019. It looked at three-year rolling periods, rolled forward by one year at a time; so it analysed fund returns from 2013-16, then 2014-17, 2015-18 and 2016-19. In another variant, the study looked at discrete periods comparing 2013-16 performance with 2016-19 performance. This allowed a comparison of performance which had completed a three-year return history rather than one-year of returns rolled forward.
A discrete study is easier to understand since it uses two clearly identified periods, but it can be affected by the selection of start and end points. However, the results do not greatly differ between these variants.
What the study found was that only 38% or around only two in every five large-cap funds remain in the first or second quartile in all the four rolling periods. For mid-caps, this proportion is slightly lower at 33% and for small-caps, it is 36%. In all cases, however, the proportion of consistent outperformers is less than 50%, meaning at least one in every two fund schemes is a consistent underperformer. If we apply the more stringent test of how many funds, stayed in the first quartile, this was less than 10% across all three categories.
If you look at discrete periods rather than rolling periods, the percentages of persistent funds for the three categories go to 35%, 40% and 41%—a slight improvement though there is no dramatic change in the picture.
What it means for you
Although returns are a first filter, mutual fund selection is a lot more complicated than just picking the best performers over the past one, three or five years. Look beyond the returns while selecting the schemes. Evaluate the portfolio construction and management to understand the risks in the scheme. Other qualitative factors like the fund house reputation and fund manager experience must feature in the selection process.
“We look at measures like standard deviation, sharpe ratio and upside-downside capture in addition to just returns. The Securities and Exchange Board of India (Sebi) reclassification of mutual fund schemes has made a lot of past returns redundant and we take this into consideration," said Prateek Pant, co-founder and head of products, Sanctum Wealth Management.
“Investors should look at performance, process and people. In the latter two areas, aspects like being true to the investment objective of the fund, experience of the fund manager and management team, reputation of the fund house make a difference,” said Nithin Singh, managing director and head of wealth management for India, Standard Chartered Bank.
Vidya Bala, co-founder, Primeinvestor, also pointed to the portfolio of the scheme in question. “Look for sharp changes in portfolio. For example, a value fund may have sunk into a value trap. You may need a drastic change in strategy to revive it by pruning exposure to some stocks or increasing exposure to others sharply. This will show up in the portfolio turnover ratio far earlier than returns,” she said. If you are a direct investor, this is particularly important for you as you may not have access to high quality fund research online. Regular investors also face a challenge.
A senior executive at a multinational bank pointed out on condition of anonymity that banks tend to direct a disproportionate amount of investors to their associated mutual fund arms. Try to get unbiased research wherever possible and ensure that you regularly review and monitor your mutual fund portfolio to weed out any underperforming funds.