When it comes to choosing a mutual fund, investors are faced with an enormous task of picking a set of schemes that suit their needs from a large universe of funds in India. At this stage, which comes after assessing their risk profile and evaluating their financial goals, investors are subjected to a lot of noise and often get mired amid investment tips and recommendation based on short term events. A lot of this is a distraction and is irrelevant when it comes to choosing a mutual fund for achieving important long term goals like retirement planning, building a corpus for children or simply creating wealth.
Overcoming Myopia
When it comes to analyzing a mutual fund track record, even a 3 to 5 year performance may not be long enough and can be misleading at times, as several market themes play out over a much longer period. For instance, consider the yearly returns of NIFTY 50 over 5 calendar years as stated below:
Source: MFI Explorer
This was the time of the great bull run in the markets as the equity markets rallied for over 5 consecutive calendar years. These were euphoric times and the toppers of the mutual fund performance chart during the period might not have been the winners in the subsequent period and vice versa. An analysis of 19 equity oriented mutual funds (ones that are currently classified as Large Cap, Flexi Cap and Multi Cap schemes which were in existence then) shows that the top 3 performing funds during the bull run of 2003 to 2007 ended with a ranking of 14, 12 and 11 respectively during the subsequent 5 years. The message is simple – Winners keep changing.
Let’s look another time period in history with a different trend.
Source: MFI Explorer. CAGR – Compounded Annual Growth Rate
The two calendar years of 2018 and 2019 were favorable for Large caps in contrast of Mid and Small caps. During this period, a fund with a relatively higher weight to large caps within a category would likely have outperformed, but may not have continued to do well in subsequent periods. The key message from these data points is that a particular trend in the market or a market cycle could persist for 3 to 5 years or even longer, effectively rendering us myopic while we choose a mutual fund. Another example would that be of growth style of investing outperforming value style, a trend that prevailed over almost entire last decade. So how do we go about when it comes to choosing among mutual funds? One may argue that instead of just looking at returns, analyzing risk-adjusted returns would help. However, it is difficult to overcome the problem of short to medium term trends overstating the potential of a particular fund, even with risk-adjusted returns as most research agencies consider just preceding 3 to 5 year time periods. The solution to overcoming this myopia is to look for really long-term mutual fund performance over the last two decades.
The relevance of 20 or 25 years of track record
To begin with, one must remember that a strong track record over say, 25 years, means a particular fund has successfully sailed through good and bad times, multiple market cycles, geo political events and crisis periods like the Dot Com Event, the Global Financial Crisis and the recent Covid induced volatility. A successful long term track record is also a testimony of the 4 Ps - investment team’s robust Processes, risk management Policies, a stable set of People and a sound investment Philosophy at the core. It is these 4 Ps that enable a fund manager through tough times in reducing the possibility of emotional decision making. It is important to note that these 4 Ps are common for a fund house and not just a particular scheme. Hence, experience matters and it would be advisable to choose a scheme managed by a fund house with long term track record. When your financial goals are long term in nature, select mutual funds based on long term track record. Here long term would signify 20 or 25 years.
Choose not only the scheme, but fund house as well
A better approach as a first step in scheme selection is to consider the fund house. Investing is a life long journey requiring you commit your hard earned money and placing your trust on a capable partner. This is where the 4 Ps – Processes, Policies, People and Philosophy can guide you to make effective decisions when it comes to mutual fund investments.
As depicted above, process of financial planning and mutual fund selection becomes more efficient with the inclusion of the crucial step of selecting the fund house. This approach also helps when it comes to investing in a New Fund Offer, as the Scheme would benefit from the 4 Ps of a fund house with decades of experience. The final step of scheme selection becomes an easier task when we know on whom to place our trust.
Happy Investing!
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