How important is past performance in mutual fund selection: Part 1

We often read in mutual fund related articles that, one should not select mutual fund schemes based on their past performance because historical performance is not an indicator of future performance. The articles or blog posts advise investors to look to at the investment style, strategy and track record of the fund manager. Investors are also advised to seek professional help from their financial advisors.

A good friend of mine, Anirban, also a long time mutual fund investor, once told me, with a hint of exasperation in his voice that, if past performance of a scheme is irrelevant then, how will a retail investor know which scheme is good? Retail investors like you and I, Anirban said, cannot just pick up the phone and speak with a fund manager to understand the future potential of a scheme. Anirban agreed that, taking professional help from a financial advisor made sense, but he asked me how much insight does an average independent financial advisor (IFAs) has into the fund manager’s investment style or strategy?

Financial advisors usually have more insights than the average retail investors because they have more connect with the Asset Management Companies compared to retail investors, but even a financial advisor’s interactions with fund managers and Chief Investment Officers are extremely limited because of accessibility issues and time constraints of the financial advisor.

So back to Anirban’s question – if historical performance may not be very useful, as is the common refrain of many mutual fund articles, how will an investor select a mutual fund scheme for investment, unless the investor is friends with every fund manager in the industry and has their numbers saved on his or her phone? It is a valid question. In this blog post, I will share my perspectives on this topic.

Mutual fund is a product for the average retail investor. In my view, an investor should not be required to have specialknowledge expertise, unlike investing directly in equity, to select and invest in the right mutual fund. Any mutual fund investor can become a successful investor by knowing what their investment goals are, with some basic understanding of capital markets and how mutual funds work. Our endeavour in Advisorkhoj is to empower you with the knowledge that can make you better investors. Therefore,I urge all our readers to believe that they can become better investors. Let us now discuss on whether past performance is useful or not.

Can historical returns be an indicator of future returns?

By performance most people imply returns. In my view, mutual fund performance has a number of aspect of which return is only one, but for now, let us stick to returns. Our readers know that, mutual funds are subject to market risks. Therefore, mutual fund returns will always be a factor of market conditions. The market condition prevailing in the last one or two years, may not prevail in the next one or two years. Therefore, short term returns can be very misleading and not indicator of future returns.

Some people have asked me, whether returns over a longer period can be indicative of future returns; for instance, can 3 year returns be more reliable as an indicator of future returns? Past returns can be indicator of future returns, only if market conditions in both the past and future periods are similar. Let us now talk about last 3 year (2014 to 2017) returns in the context of our market. 2014 was an extraordinary year because of the Lok Sabha elections, March 2015 to March 2016 was another extraordinary period because of the bear market (the market fell more than 20%, which happens from time to time, but not very frequently) and March 2016 to now has been another extraordinary period when the market bounced back from the low to the all-time high.

You can see that, the last three years had two bull market periods and one bear market period. Let us now look at the three year period from mid 2013 – mid 2016. 2013 was a flat year for the market, 2014 was a bull market year and 2015 / early 2016 was bear market. Market return in the mid 2014 to mid 2017 period was different from market return in the mid 2013 – mid 2016 period. Every 3 year period is likely to be different and therefore, we cannot say that 3 year returns are reliable indicators of future returns.

One financial advisor once asked me, if historical returns over a very long period which has multiple bull and bear markets (e.g. 10 year period) a reliable indicator of future returns. It is a more reliable indicator than a short term period, but again even a very long term return is not a fully reliable indicator of future returns, if the long term period has a black swan event. I explained what a black swan event is in one of my posts, but for the benefit of our readers, a black swan event is an event of very large magnitude, which is a significant deviation from the spectrum of possibilities that one can normally think of. The last 10 years, for example, included the Great Recession of 2008, a black swan event, when the stock market crashed more than 50%. The recession of 2008 was the worst recession since the Great Depression of the 1930s. Such events happen very rarely, but since it happened in the last 10 years, it will skew 10 year returns negatively.

Further looking at returns over a very long period means that, you may exclude many good schemes launched within the last 10 years. Also, a lot of things related to a scheme can change in 10 years, like fund managers, investment styles (growth versus value), market cap strategy (large cap versus midcap) so on so forth. Very often you will read articles or product reviews (even on Advisorkhoj) which shows how much returns a fund has given since its launch, which may have been 20 years back.

If you see 25% CAGR or 90 times growth in investment since launch, do not think that you will get similar returns in the next 20 years. The purpose of showing very long term returns is to demonstrate the wealth creation potential of equity mutual funds; it is, however, by no means, indicative of future returns. Looking at returns since launch or inception (which was 10 or 20 years back) is like enjoying a classic cricket match from the 80s or 90s on TV, where you see Sachin Tendulkar hitting Australian fast bowlers out of the park on the way to scoring a big hundred. However, it does not mean that, Rohit Sharma or Shikhar Dhawan will score a century against Australia when we play them next. If Rohit or Shikhar score a century, it will because of their own abilities as a batsman, the nature of the bowling attack and the pitch; it will have nothing to do with what Sachin did in the nineties.

Difficulty in forming return expectations

In the previous section we have discussed that short term (1 year or even 2 years) returns are not suitable for forming future expectations. Even medium term (3 years) returns are not suitable for forming return expectations. For that, even very long term returns are not suitable if they include black swan events of if the fund characteristics have changed over the long term period. Some of readers may ask whether there are any point to point period returns based on which we can form future return expectations.

Well, it is difficult for several reasons. Firstly, the definition of future differs from investor to investor, depending on their financial objectives. For some future means next one year, for some it may mean 3 to 5 years, for others it may mean 10 years or more. Secondly, every 5 year period in our country have a Lok Sabha Election; the market expects a particular outcome and reacts accordingly after results; elections are difficult to guess.

Thirdly, the Great Recession of 2008 was such a seismic event globally, that it’s after effects are lingering even today, after 9 years. The real economic recovery, globally, post the 2008 recession has been very gradual. On the other hand, for many years interest rates globally were very low which fuelled liquidity in capital markets and influenced risk attitudes. Now the Federal Reserve in the United States has started to bring interest rates to normal over the past 20 months, after 7 years of close to zero interest rates. The capital market dynamics of gradual global economic recovery and rising interest rates in the US will be very interesting and at the same time difficult to guess.

Finally, India is an emerging market; our economy is rapidly developing and our capital markets are also maturing. India is a bright spot among the emerging markets, retail participation in equity markets through mutual funds is increasing and our bond markets are also getting attention from global investors. Market inefficiencies which existed in our equity market in the past have been to a large extent reduced. You must realize that, market inefficiencies gave rise to opportunities, which fund managers were able to exploit in giving high returns to investors in the past, but market inefficiencies also caused scams and crises due to which investors suffered. In summary, market dynamics now, are very different from what they were 10 or 15 years back.

Based on all the above reasons, it is difficult to base our future expectations on historical market or fund performance.Instead of looking at performance, it may be wiser to form our returns expectations based on economic growth potential of India (we will discuss more about this later).

Pitfalls of basing expected returns on historical returns

If you base your expected returns on historical returns of a scheme, you can be setting wrong expectations for your financial plan. You can fall short of your financial goals, if you are expecting high returns, when in reality the returns are likely to be lower. On the other hand, if you have reasonable expectations, you will be able to achieve your financial goals, because you will be investing the correct amount to meet your goal.

Your asset allocation may also not be correct if you base your returns expectations on historical returns. If historical returns (over the period you are evaluating) of a particular asset class (e.g. equity, debt) is very skewed relative to the other because of the market conditions prevailing in the period under consideration, you may end up having either sub-optimal or risky asset allocation, if you base your asset allocation decision based on relative returns of asset classes.

Conclusion

In the first part of this blog post, we discussed, why investors should not form returns expectations based on historical returns and how it can be detrimental to their financial interests. If your question is, “how to select a mutual fund scheme if you cannot go by past returns”, then your question has not been answered in this post. But do not worry; we will try to address your and Anirban’s question in the next part of our blog post; past performance, by the way, will still have an important role to play, but in a different way. Please stay tuned......