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How not to look at mutual fund returns

August 13, 2020

Investors care about their MF returns. Naturally. They care about returns from their portfolio; they care about returns of the funds they are holding; and importantly, they make decisions about their portfolio by looking at returns data.

There are several ways to look at returns data, and not all of them are correct. And investors – novice to seasoned – often make mistakes in this regard. Many a time, they look at wrong data or look at right data and draw wrong conclusions.

MF Returns data

There is a popular website in US called FiveThirtyEight.com. It analyses data across politics, sports, and other social arenas to provide useful insights. They are particularly widely followed in US election years, such as this one. They have a segment called ‘Good use of polling or bad use of polling’, in which they look at data from opinion polls and judge whether people are interpreting it correctly.

Along those lines, let me list the ways in which investors look at returns data and identify ‘bad use of returns data’ and ‘good use of returns data’ or. I have split this into 2 articles.

This article (wrong ways)  is for investors who have been in the market for less than 5 years and are still learning how to interpret fund returns.

The second one on right ways (link at the end of this article), will be for both discerning investors as well as relatively new investors wanting to get the facts right when it comes to MF returns.

#1 MF returns of 1-3-5 year periods

And more specifically, the 1-year return. Using these returns to make decisions, to set return expectations, and to choose funds by going for the funds that score at the top of the charts will leave you with sub-par funds more often than not. Here’s the thing about the returns – they are the returns from one particular date to another, on a given day.

What you should be looking at is the consistency of the returns. If a fund is able to stay above average, i.e, in the top two quartiles across timeframes at different times, then it’s a good one and one that you can rely on

These returns:

  • Ignore what has happened in the market in the period between those two dates. Not much may have happened in 1 year. But take a 5-year period. Multicap funds’ latest 5-year return averages about 6%. Between 2015 and 2020, markets went through a strong upswing (2015-2017), a sliding 2018, a volatile 2019 and 2020. A fund would have navigated each of these phases in a different way, and knowing how it has pulled through these cycles is important.
  • Are influenced by what is happening either on the start date or the end date. This is a derivative of the point above – if, 5 years ago, equity markets were on an upswing and now they are in a correction, it is going to pull returns down. For multi-cap 5-year returns in 2019 at 11% were much higher than what they are today.
  • Change, and on a daily basis. This leads from the two points above. What the 1-year or 3-year returns are today will be very different from what they were yesterday and what they will be next week.

And for these reasons, you cannot use the 1-3-5 year returns alone to make an investment decision or set return expectations. HDFC Equity, at this time last year was in the top quartile on a 1, 3, and 5-year basis. Now, it is in the bottom quartile. So going by the ‘top’ fund in the charts today will be misleading.

What you should be looking at is the consistency of the returns. If a fund is able to stay above average, i.e, in the top two quartiles across timeframes at different times, then it’s a good one and one that you can rely on to deliver market-plus returns. And what returns would this be? Well, we’ve covered it here and here.

#2 Going by fund return without looking at the market

When looking at fund returns, you also need the context of what the market is doing.

If liquid funds returns are low today, it’s not because the funds are performing poorly. It is because interest rates are low. If your multicap equity fund’s 5-year SIP is 6.25% (the average IRR for multi-cap funds), markets have gone through two years of flat to volatile to falling returns. The Nifty 500’s SIP return is not very different at 6.39%.

Therefore, to either prevent yourself from worrying about low returns and exiting or being carried away by high returns and entering, first look at the market itself.

#3 Going by return without looking at nature of fund

This leads from the point above. While the returns are a factor of the market, they are also a factor of fund strategy and where it invests. Using the return numbers alone – even if you looked at consistency and all the other metrics discussed above – can still push you into incorrect decisions unless you understand the fund itself.

Consider gilt funds or dynamic bond funds. These funds have been steadily clocking double-digit 1-year returns for over a year now. Their 3-year and 5-year returns are also reasonably strong in the mid-to-high single digits. The interest rate cycle turning down and the resultant bond rallies have helped gains.

But both gilt and dynamic bond funds are extremely volatile by nature and can see losses even in 1-year periods, as bond prices react to changing interest rate dynamics. They therefore suit only the longer-term. If you did not understand this aspect, you may have invested for the wrong timeframe or you would be worried when returns fall.

Similarly, in equity, consider categories such as focused, multi-cap or large-and-midcap. The allocations towards mid-caps, large-caps, and small-caps will vary, influencing both return and risk.

#4 Looking at market return to time investments

Or, trying to use metrics such as PE ratio to time investments. Both market troughs and peaks are known only in hindsight. Markets may remain elevated for months on end before moving into correction zone. When a turnaround from a market fall happens, it can catch you equally unaware – the rapid rise in the past two months attests to that. So trying to time an entry or exit, or rebalancing your portfolio based on market moves is impractical. We’ve covered PE-based investing and market timing in detail in an earlier article.

The best thing you can do is to run a normal SIP, and use market falls to add equity exposure as explained in the linked article. Then, rebalance your portfolio based on how far it has deviated from your original allocation in order to book profits in the rallying asset class and redeploy into the under-valued asset. This is covered in our rebalancing article.

#5 Comparing lump sum and SIP return

It’s all a question of time. Say you’re looking at a 5-year return. If you made a lump-sum investment, that entire amount is invested at a single point and compounds over the full 5-year period. When you invest through an SIP, you have smaller amounts invested at different price points and working for different, and shorter, periods. When the timeframe covers a rising market, each SIP instalment would be at higher prices which takes average costs up and vice versa.

Therefore, the two cannot be directly compared. Lump-sum investing is all about getting the timing right in the medium term and will almost always work whatever be the timing of entry, for the very long term (say 20 years or more). A SIP is all about making disciplined investments to reach your goal. You can always top up an SIP with lump-sum investments on market falls to drive up returns.

Also read our article on – Using MF returns data – the right ways

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