The capital markets regulator SEBI mandates that all mutual funds (MFs) disclose their track record of performance in a specified format. Ironically (or maybe not), it also requires all MF documents to include a disclaimer that states past performance is not an indicator of future returns. Most advisors and analysts in the industry, as well as reputed industry publications, platforms and databases, use this as a key, if not the most important metric, in evaluating a fund. And why not? If a fund manager has skills to identify trends, forecast estimates and pick stocks better, they should be able to outperform peers reasonably continuously. But, in reality, can we rely on historical outperformance to foretell future returns?
To test this, we carried out an in-depth analysis across large-, mid- and small-cap funds and the findings were incredibly surprising. We used the six largest funds across categories to ensure we had sufficient data for a 10-year period. For every trading day, we ranked the funds based on the performance of the last three years and then performed a Spearman’s rank correlation test with the returns provided over the next three years. The Spearman’s correlation coefficient measures how well the past returns correlate with future performance. A value greater than 0.5 indicates that it is a good predictor, while a negative value means that it’s not.
There were a total of 978 days of data points with both a history and a post-investment period of three years. The distribution of Spearman’s coefficient was as follows:
For nearly 72 per cent of the total days, for large-caps, investors would be better off choosing an underperforming fund compared with an outperformer. For mid- and small-caps, this is even starker (93 per cent and 80 per cent respectively).
If an investor had adopted a daily SIP approach over the last 10 years, her optimal choice would have been an underperforming fund rather than a leader. Suppose an investor had invested ₹1,000 every day over the last seven years (after the first three-year return data over the 10-year period became available) in the worst performing of the six large-cap funds, he would have nearly ₹3.8 lakh more today when compared with the best performing fund. And unsurprisingly, this holds good for mid- and small-cap funds as well.
Performance shift
All this begs the question: Why should there be such dramatic shifts in the performance of different funds? As this phenomenon has been witnessed over time periods and across different segments, there is a high probability that this is not just coincidence but there are causal factors impacting their performance.
One possible reason is that fund managers have different strategies.
And when business cycles and markets turn, different sectors and themes tend to be winners. Therefore, funds which had over owned these winners would have underperformed in the past but would consequently do better in the future.
Another reason, and this can work alongside the first, is that outperforming fund managers generally tend to hold on to their winners a bit too long.
After all, it is very difficult for an asset manager to sell their best stocks after just a quarter or two of unfavourable macro data or poor results.
Especially, if this stock had given them superlative returns over long periods! And this can end up costing these schemes dearly as the stock price corrects.
So, how can investors decide on the optimal fund to invest?
It may be easy to infer from the above analysis that it is better to invest in a fund that has a poor track record recently. Apart from being counter intuitive, this approach completely discards the ability of a fund manager as a factor. A better approach would be to understand the investment strategy and holding philosophy of the manager. This is typically obtained through interactions over webinars organised by these MFs, periodic newsletters and direct communications. Investors can then overlay this on the current holding pattern of the fund and how it has evolved over a period. If investors find this too daunting and time consuming, they can rely on qualified advisors, who would be tracking this.
The author is a SEBI registered investment advisor and is the founder of Investreet Advisors. The views are the author’s and does not reflect the opinion of bl.portfolio