Mutual fund past performance and consistency

In India, the mutual fund scheme selection is not easy. There are nearly half a century mutual fund houses that offer a plethora of schemes. Among the fundamental principles of mutual fund selection, one is picking a fund with a good track record.

Is it necessary to evaluate past performance, and look for consistency?

You know mutual funds are subject to market risks, and its past performance does not guarantee future performance. The returns of mutual funds schemes are also linked to market performance. There are many factors like risk, return, fund style, and fund manager’s experience, however, returns are arguably the king and advisers and distributors depend on past performances heavily to recommend funds.

However, studies show that past performance is not a sufficient condition while selecting a fund. The fund that has performed well in the past may not perform well in the future. Therefore checking the consistency is a crucial step for selecting the winning funds that will help you to achieve your goals.

In the case of persistence of mutual fund performance, there are instances that fund managers beat the benchmark delivering outstanding returns on a reasonably consistent basis by taking more risks (higher beta) in rising markets. However, the same fund underperforms in falling markets. If you analyze mutual fund schemes carefully, you will find that among the thousands of available schemes, only a handful has been consistent performers.

How to assess the performance?

A top-performing fund in shorter time frames like three months, six months, one year, two years and three years period, may not perform well in longer time frames such as 5-year and 10-year period. A better way to check consistency is to choose the top five performing funds matching with your selected investment objectives across longer time frames and not for shorter ones. It demonstrates their ability as a consistent performer.

The factors of consistency in performance

Checking performance consistency is a crucial step to select winning funds to achieve your goals. A fund does not necessarily need to be a top performer or high-star rated to generate consistent returns. There are specific quantitative and qualitative parameters, and all the parameters should be given adequate weightage.

Quantitative Parameters

1. Historical Performance

The historical data of a scheme helps to track its performance across the different time horizon and market conditions. Rolling returns for one year to five year time durations can be analyzed to determine how consistently the scheme performed in each of those years.

Apart from that, specific risk-reward ratios like the Sharpe ratio, Sortino ratio, and Standard deviation also need to be analyzed to track the performance of the scheme over a period of years.

2. Performance vis-à-vis benchmark or peers

Another way to determine the consistency of the scheme is by comparing the fund’s performance with its benchmark and peers. In the mutual fund industry, no scheme can outperform its benchmark every time due to the volatility of markets. However, comparing the scheme’s performance relative to the benchmark and its peers will give a better idea about how the scheme is managing its portfolio.

When returns of a scheme fall lower than the returns compared to benchmark or peers in a market crash, and it is higher compared to benchmark/peers during a bull market phase, the scheme can be termed as a consistent performer.

3. Performance Ranking

You can look at the ranking of any scheme among its peers in recent times or the past. It is based on quartile ranking that shows how the fund has performed quarter on quarter among its peer group. You may select the scheme which has remained in the top quartile most of the time. These rankings are available from the factsheets of various AMCs and also on some websites researching mutual funds.

Qualitative Parameters

1. Quality of Portfolio 

Investors get the benefit of diversification when holdings of the scheme not concentrated on a particular stock or sector. Ideally, the top ten holdings of the portfolio should not form more than 50% of the total assets.

While in debt funds, the fund manager needs to take care in case of having high-quality debt papers in the portfolio, the exposure to low-rated debt instruments must be lower to reduce the credit risk.

The churn ratio of the fund should be low as excess churning increases the overall expense of the scheme that impacts the returns. The analysis of portfolio turnover ratio and expense ratio helps to find out if the scheme has a high churning rate.

2. Quality of fund manager and fund house

The performance of the scheme is directly related to the quality of the fund manager and the fund house. It is an important criterion to track the performance of the scheme.

Firstly, the manager should have decent experience in investment research and fund management. It is highly essential to check that the fund manager is not managing more than five schemes at a time. If the fund manager is overburdened with schemes, it becomes unmanageable and the performance of the scheme is likely to suffer.

Similarly, a fund house that performs well across schemes is efficient. Choose a fund house that follows robust investment processes and has adequate risk management systems in place.

What is Alpha? Is it skill or luck?

Alpha is the excess portfolio returns above the benchmark, for the same amount of risk. It is an exact measure of value added by the fund manager. When a fund manager can deliver high alphas in different market conditions, in both up and down markets, the fund will outperform the benchmark and the peers.

However, as we know that there is no certainty in equity markets, according to some, delivering high alpha consistently, relative to their peers is simply a matter of luck. But the study of academicians and researchers suggests, this cannot merely be a matter of luck in the Indian context. There are many top-performing funds in India displaying steady performance persistence over a number of years.

The fund management expertise and experience of the fund manager significantly matters in this case. However, investment discipline, research capabilities, risk management, and governance mechanisms of the fund house are also contributing factors in persistent outperformance. As an investor, you may lack the competence to evaluate the schemes on all the parameters mentioned above. Therefore, it is always perfect to consult an investment adviser who will be able to select the right fund matching your financial goals and needs.

That’s why Comparte Investment team asks do you have “Nivesh Ki Aadat”.

With this one can say “Mutual Fund Sahi hai”,  so let me do Nivesh