Mutual Funds: Past Performance is not everything

Apr 21, 2011

Many a times your agent / distributor / relationship manager tries to push you some mutual fund schemes by enticing you with a typical sales pitch..."Sir, this scheme has generated 20% returns in the past one year." And this sales pitch often gets louder when the market conditions have been favourable. Some of the agents / distributors / relationship managers have another unique way of luring you. They say, "Sir / madam this scheme has been awarded the best scheme award in the past by a leading business channel"... And hearing all these sales talks you investors very often get attracted and sign a cheque in favour of the respective scheme.

But please ask yourself do you hear these sales talks when the capital markets turn turbulent? Why is it so that your agent / distributor / relationship manager avoids talking to you during turbulent times of the capital markets and doesn't boast about returns generated by the respective funds or awards being conferred on them?

Remember dear investors, past performance may or may not be sustained in the future!

The capital market regulator - Securities and Exchange Board of India (SEBI), has also thus made it mandatory for mutual fund houses to mention at end of every marketing exercise a disclaimer which states, "past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments."

But despite such a disclaimer you still get enticed by what your agent, distributor or relationship manager boasts (about past performance and awards).

Please recognise that past performance will merely enable you to assess the historical returns of the fund over various time frames, but when you are judging how the scheme would perform in the future, a lot more research and analysis is required (which your agent / distributor / relationship manager may be incompetent to handle).

You need to delve deeper into the following critical points, because just studying past performance numbers in isolation would be meaningless:

1. The risk you are exposed to

The Net Asset Value (NAV) of a mutual fund scheme will never tell you as an investor how much risk you are exposed to. For instance in a rising market, it is not altogether difficult to clock higher returns if the fund manager is willing to take on higher risk (we have seen this on several occasions like the tech rally in 1999-early 2000, the mid cap rally in 2003-05, 2009-10 and 2010-11). Hence, the past performance numbers will prove to be incapable to show how much risk you are exposed to.

So the next time you think of making any investment, remember that it must be evaluated based on the risk-return criteria. Evaluating any investment option based on any one of the two i.e. risk or return on a standalone basis may prove to be a fatal exercise. By doing this you might land up with a scheme which just doesn't suit your needs.

2. Individual vs. peer performance

Another reason why the past performance may not entirely represent a mutual fund's 'good showing' is because it does not take into consideration the performance of its peers. It is possible that a fund has performed reasonably well (across relevant parameters) by itself, but hasn't quite made the mark when compared to its peers.

Remember, you should always compare an investment (be it a mutual fund, fixed deposit, unit-linked insurance plan - ULIP, among others) with its comparable peer group while assessing whether or not to invest in it.

3. The reputation of the fund house

Past performance fails to highlight the investment processes and approach followed by the fund house. It does not tell you whether the past performance is the result of:

• Good fortune/luck
  
  
• A star fund manager
  
  
• A team-based investment approach that takes decisions based on well-defined processes rather than being dependent on a particular individual (like the star fund manager)

Before we move further, it's important that you are aware of the benefits of a team based investment approach. Always keep in mind that a team based investment approach is far more superior as compared to a single fund manager. Under a team based approach the mutual fund scheme is exposed to brilliance and expertise of many like-minded individuals.

Whereas a mutual fund scheme managed by a single fund manager may not be able to sustain its performance in the future if one fine day the fund manager quits.

Unfortunately, all this information is not revealed under the marketing campaign adopted by fund houses by way of the literature they print. It is something that can be learned only after constant interaction with fund houses and their investment teams.

Past performance often ignores the change in investment mandate. Fund houses first talk of a star fund manager who was instrumental in sprucing up their performance. They get a lot of money based on this star fund manager's name and fame. The performance numbers that are advertised are attributed to the 'brilliance' of the star fund manager.

But if the star fund manager quits, there is no guarantee that the mutual fund scheme will continue its good performance further.

4. No Guarantee of future performance

Of course, last but not the least, past performance is no guarantee of future performance. While this is adequately mentioned in the advertisements, we wonder why it needs to be advertised in the first place. It's a bit like advertising tobacco products freely with a small disclaimer on tobacco possibly causing cancer written in fine print at the bottom of the packet!!

So remember, while investing always asses all the aforementioned critical points and take a holistic view. This will help you to invest your hard earned money in a prudent way and help you create wealth in the long-term.