It is a widely-acknowledged practice to invest in a mutual fund that has yielded good returns in the past believing it will do well in future as well. Why does everyone seem to be obsessed with past returns despite the disclaimer in the offer document of every fund saying clearly, ‘Past performance is no guarantee of future results’?
Studies show that many mutual funds with good past returns have yielded poor results in the future. There is no close correlation between high performing mutual funds in one period with high performing funds in the subsequent periods. Regardless of this fact, investors harp on past mutual fund returns while investing in the fund.
Here we list the reasons why chasing the past returns of mutual funds is a bad idea.
Performance of a mutual fund is also due to the manager managing it. If a mutual fund manager who is responsible for the brilliant returns resigns or is replaced, the performance of that fund is bound to be affected. The new mutual fund manager may not be able to ensure the same performance. If you’re not aware of the change in the fund management, betting on past mutual fund returns won’t be safe.
High risk, high reward
A mutual fund that entails high risk often clocks spectacular returns. In such cases, figures don’t betray the propensity of risk involved. This can be noted during periods of booms and bubbles. Recall the internet bubble of the late 1990: Many internet funds looked lucrative for investors and they rushed to invest in those funds but when the bust happened they suffered huge losses. In many instances more than 90% loss was recorded. The same holds true with the real estate boom. When the going was great, none expected that it would crash but it did and made many investors in real estate company shares bankrupt.
In each case, mutual funds having a major stake in these high-risk assets looked like they had incredible returns until the bubble bursted. What gets proved is that the criterion of judging a mutual fund is not reliable. Give a second thought before you pick a mutual fund solely for its past returns.
If a mutual fund is performing well, investors scramble to pour money into it. This increases the volume of money the fund manager has to spin into business. While it increases the management fees for the mutual fund company, it entails problems since with the increased cash it is harder to earn a good rate of returns.
In the investment space, the size of the asset has a definite role to play. A mutual fund is allowed to invest only up to 5% of the networth of a single company. Hence a bigger sized fund capital makes it difficult to invest in a focused or concentrated portfolio. A mutual fund with huge assets is forced to over-diversify. A mutual fund with fewer assets can invest in a focused portfolio and generate more returns.
Now you’ve learned the perils of looking at past mutual fund returns alone while investing. You must be wondering how to evaluate a mutual fund worthy of investment. You will be close to the mark judging mutual funds on the following parameters :
* Match your investment objective with that of the diversified equity fund
* Evaluate returns across diversified equity funds within the same class
* Check diversified equity fund returns against the benchmark index
* Evaluate the consistency of the diversified equity fund
* Check the costs associated with the diversified equity fund scheme
Ramalingam K is director and chief financial planner, Holistic Investment Planners. Extracted from Tax Guru