Why looking at the 1, 3, or 5-year returns is not enough

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Pick up any equity fund today and the 1-year return looks absolutely uninspiring. 8%? 9%? 11%? Losses? Where is that bumper equity return? But if you had picked up any equity fund this time in 2018, returns were so much better featuring in the double-digits. And in 2017? Why, 1-year returns were well above 20%!

Now think about making any investment decision or keeping expectations pinned to these returns alone. You got it, chances are you’re going to be misled. Here’s why looking at the 1, 3, or 5-year returns is not enough.

Point-to-point only

Today, the 1-year performance of BNP Paribas Large Cap looks high at 14%. ICICI Prudential Bluechip looks much worse with a 2% return. Would you consider the BNP fund to be better? But just six months ago, ICICI Bluechip’s 1-year return was 7.1% against BNP Large Cap’s 5.8%. Both funds sport around a 10.5% 5-year return. Which is the better fund now?

The answer is that you do not go by a single or a few days of the 1, 3, and 5-year returns to make a choice. You do not also set your return expectations against these returns. These returns are called point-to-point returns – that is, they are the return differential between two single points in time. And going by only such point-to-point returns is misleading for the following reasons.

#1 It ignores the in-between period

That is, point to point returns just show the change in NAV from one single day in a year to one single day in another. Therefore, the returns don’t tell you anything about what happened in the months or years between these two dates. They only returns on a particular day. Over the years, equity and debt markets go through phases. Point-to-point returns do not show that these returns have changed or how they’ve changed or the return volatility in the years between the two dates.

The current 5-year return for equity funds, for example, does not show that large-cap indices and funds corrected in 2015, that they didn’t do much in 2018, or that there were some months in 2016 and 2017 where almost all funds clocked losses on a 1-year basis. If you knew that there have been periods of 1-year losses even before and that it evens out over a 5-year period, you may be far more willing to take into stride funds’ current 1-year losses.

#2 It is influenced by events on the from date or to date

By that we mean – if you’re looking at the 3-year return on 3rd October this year, the from date is 4th October 2016 and the to date is 3rd October 2019. If markets were bullish at the time of the ‘from’ date but struggle on the ‘to’ date, the returns look poor. Why? Because your base is high or the recent fall in prices is pulling down the numbers, like the current 3-year returns of many small-cap funds. The opposite is true when markets were down on the from date or up on the to date – the low base kicks returns up a few notches.

The low/high base effect is especially clear in dynamic bond and gilt funds. In mid-2018, with rate hikes on the horizon, bond prices were dipping. Mid-2017 was a time when there were rate cut hopes and bond prices were volatile or rising. As a result, several dynamic bond and most gilt funds were sporting sub-3% returns. Now, at this time in 2019, gilt yields are dropping and bond prices rising as rates drop. Result? These funds’ 1-year returns have jumped to the double digits. Their 3-year returns, on the other hand, are much more reasonable at 7-9%.

So – you have a high base (2017) at the start and falling prices (2018) at the end which results in low returns, and a low base at the start (2018) and rising prices at the end (2019) which spikes returns. The base effect holds true for funds that have begun to slide in performance (which pulls returns lower) or begun to improve performance (which pushes returns much higher).

#3 Returns change every day

Fund returns – the movement in its NAV – are dependent on the way markets move. When markets change every day, so too would fund returns. Consider the same two funds above. BNP Largecap rocketed from 4.9% 1-year return on 19th September to 16.5% just four days later. ICICI Prudential Bluechip moved from a 4% loss to a 4.7% gain. That’s because markets added close to 3,000 points in that time.

The trend of returns keeps changing over time and fund performance keeps changing over time. In a rising market phase, the trend of returns would be upward and vice versa. Most mid-cap/ small-cap funds mostly loss-making on a 3-year basis throughout 2013 but recovered to upwards of 15% by mid-2014.

General market movement aside, events in securities that a fund holds also plays a role in returns. Funds holding heavier weights in Yes Bank, for example, have felt the stock’s 76% plunge much more keenly. Funds holding debt papers of troubled companies such as DHFL, ADAG group and the like were hit much harder than those with small or no holdings. Fund strategies can also play a role – duration strategies can make debt fund returns more volatile, credit calls in debt funds can push returns higher, small-cap and mid-cap exposure in equity funds can prop up returns and the like.

Here’s what the 1-year, 3-year, and 5-year returns don’t tell you.

It does not show whether the fund is always able to do well. It isn’t enough if the 3-year return of an equity fund is higher than its peers or its benchmark today. Was it higher last month? Last December? In other words, has it always been able to deliver market-plus returns? Only this will tell you if a fund’s investment strategy is good – that is, whether it is consistently able to pick stocks/ bonds that generate higher returns.

Remember, returns are past performance, not future. If you are to get higher returns after investing in the fund, that fund’s strategy should be such that it is able to identify the right mix of securities and opportunities going forward. The 1/ 3/ 5 year return on a single date will just tell you the fund did well in the past – rely on this alone, and you may well be getting into a fund that has already generated high returns and is unable to sustain it.

It does not show volatility. Are the fund’s returns prone to swinging sharply higher then crashing lower? Or are they much steadier with limited rise and fall? A more volatile fund requires a higher risk appetite. You’d also need to combine low and high volatile funds to build a balanced portfolio.

It does not show fund strategy. Knowing fund strategy is understanding whether the fund has the capacity to consistently perform, as explained earlier. Fund strategy also sets risk expectations. A fund following a growth-oriented strategy would today show better returns than one with a value-driven one. A fund with a higher mid-cap allocation may be faring much worse than one with a lower mid-cap allocation. In debt funds, both duration risk and credit risk are masked by returns. As mentioned earlier, dynamic bond and gilt funds would show high 1-year returns, but this comes with volatility and higher risk. Funds that take exposure to low-rated credit may show great returns, but would certainly not suit shorter timeframes. Funds that stick to high-rated, safe instruments may pale in returns but would eminently suit most portfolios.

In a nutshell,

  • there are several factors that influence returns and you need to account for these influences.
  • you need to see these returns over a period of time and not just on one day, which will show you consistency in performance.
  • given that returns change every day, week, month, and year, pinning return expectations to the 1/ 3/ 5-year returns will leave you disappointed.
  • don’t compare a 1-year, 3-year, and 5-year returns with each other to conclude how long you should hold the fund.
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3 thoughts on “Why looking at the 1, 3, or 5-year returns is not enough”

  1. Jeetu Gurdasani

    What are the tools that can be tracked to understand a fund’s volatility relative to peers?

    1. Std deviation, downside capture, rolling return, instance of negative returns and tracking error for index funds are SOME of the tools. thanks, Vidya

  2. Shashibhushan Gokhale

    Got the point that considering only 1,3,5 years returns alone could be misleading.

    I think it will be great to have an analytics tool on PrimeInvestor.in having all the factors that you mentioned above as selectable parameters so that members can use it in as per their needs.

    I think having such a DIY (do it yourself) tool would let the platform scale exponentially rather than one-to-one counselling over phone/email/etc which would have limitations of available counseller time.

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