Meanwhile, investors in struggling funds have voted with their feet. In the large-cap segment, just two funds accounted for 75% of the outflows.It turns out they have been among the weakest performers over the past three years. In the mid-cap space, the bulk of outflows are from two schemes. This investor behaviour—latching on to recent winners and dumping the losers—makes sense intuitively. However, investors are only setting up their portfolios for a sub-par performance. Here is why.
Fund performance is cyclical
The basic premise for chasing top performers— the belief that past success will continue into the future—is flawed. Chasing past returns is a futile exercise. Funds, like the broader markets, tend to perform in cycles. The ups and downs in a fund’s life cycle are inevitable. A period of outperformance is typically followed by a period of underperformance, and vice versa. This is particularly evident in funds where outperformance is very sharp, observes Sachin Jain, Research Analyst at ICICI Direct.
It is impossible for a fund to remain a top performer across market cycles. Data from FundsIndia shows that only one out of four top performing funds over a three year time frame continued to remain in the top quartile over the next three years. Over five-year time frames, only one out of five funds could manage this feat. Vivek Banka, Co-Founder, GoalTeller, observes, “Reversion to mean is a fundamental investing axiom, and sooner or later some of these funds and stocks revert to averages.” Jain of WhiteOak Capital Mutual Fund asserts, “It is important for investors to remind themselves that winners rotate. Today’s best performing segment of the market may or may not do well in the future, and vice versa.”Let’s consider a few examples. Axis Bluechip was among the consistent outperformers between 2018 and 2020, topping the charts with 16.6% annualised return. If you had latched on to this fund in early 2021 on the back of this show, it would not have turned out well. The fund has been languishing at the bottom of the charts in its category for the past few years. In the mid-cap space, Axis Midcap and PGIM India Midcap Opportunities were the pace-setters in 2018-20. Anybody hopping on to these funds then would find them lagging behind the rest of the pack. Data from FundsIndia shows that the top three funds of 2018-20 have now slipped to 190th, 192nd and 70th positions, respectively, in the performance charts for 2021-23 (see graphic).Investors gravitate towards outperforming funds…
Table-topping funds have attracted bulk of the inflows.
…even as laggards are quickly discarded
Most of the outflows are from underperforming funds.
Note1:“The winners keep rotating. Today’s best performing segment may or may not do well in future, and vice versa.”
MANUJ JAIN
CO-HEAD OF PRODUCT STRATEGY, WHITEOAK
CAPITAL MUTUAL FUND
Note2:“If you go by past returns, your portfolio will gravitate to the segment that is in favour. When it loses currency, your portfolio will underperform.”
ARUN KUMAR
HEAD OF RESEARCH,
FUNDSINDIA
Past winners may not always be future outperformers
Many leading funds of the past have seen a sharp fall in ranking within a few years.
Note: The number 1 ranked fund of 2018-20 is currently ranked 190. The table shows the ranking of diversified equity funds (large cap, mid cap, small cap, flexi cap, large & mid cap, multi cap, ELSS, value/contra, focused & dividend yield) based on 3-year returns | Source: FundsIndia
Likewise, a fund that underperforms today may not remain at the bottom of the charts forever. It could even become tomorrow’s winner. Many times, after sustained underperformance and redemptions, funds witness a turnaround in performance. Franklin India Bluechip and HDFC Top 100 endured a horrid time between 2018 and 2020. Both funds underperformed their peers miserably, but have emerged among the top performers since 2021. HDFC MidCap Opportunities and Motilal Oswal Mid Cap, among the weakest performers in 2018-20, are among the table-toppers of 2021-24. According to FundsIndia, the funds currently ranked first and third for the period 2021-23 were at 160th and 166th spots during 2018-20.
The cyclicality of returns is also evident at the fund category level. Investors often hop between large-, mid- and small-cap categories, chasing the category that delivered the highest return in the past. This strategy is self-defeating. A study by WhiteOak Capital Mutual Fund shows that an investor who started an SIP in a mid-cap index fund in April 2005 and shifted the SIP every year to the best performing index of the previous year fetched lower returns than if he had simply stuck to the mid-cap category till the end (see graphic).
Why do successful funds tend to lose form eventually? This phenomenon is often down to the particular investing style the fund pursues or even the market-cap bias it takes. Different investing styles and market segments work in different market phases. One style cannot perform uniformly across an entire market cycle. “In different market environments, preferences shift towards a specific set of stocks, captured in the fund’s investing style, market cap or even sectoral bias,” contends Arun Kumar, Head, Research, FundsIndia.
If you switch to a fund based on its recent performance, you often risk catching it near the end of its upcycle. For instance, if you latch on to current market favourites— value funds or small-cap funds—it may not be the best point of entry. Likewise, it you exit a fund after a period of underperformance, you potentially risk leaving it near the start of its upcycle. “Before the comeback in 2021, the value style underperformed most other styles of fund management for three consecutive calendar years (2018, 2019, 2020), delivering a poor investor experience,” points out Jain.
In other words, if you simply follow returns, your portfolio will ultimately suffer. Kumar remarks, “We have seen this pattern repeat itself over long periods of time. If you go by past performance, your portfolio will begin to gravitate to one particular market pocket that is in favour. When that segment inevitably loses currency, your portfolio will underperform.”
How to avoid the return trap
To be sure, past performance is a key factor in choosing a fund. Even so, there are better ways of looking at the past than relying on simple point-to-point returns. Rolling returns are a better way to analyse the performance of mutual funds. Trailing returns have a recency bias because they are based on a single point-to-point reading. The market trajectory, and fund’s performance, near the end of the period have undue influence on its entire trailing return. A sharp uptick in recent performance will make returns across all trailing periods— one, three or five years—look healthy. So when a fund’s one-year, three-year or five-year returns look better than others, it doesn’t necessarily imply that the fund has always been better. Rolling returns, on the other hand, capture multiple instances of point-to-point returns over a period of time. They help the investor gauge performance across blocks of time, without any bias towards any particular period of time. It, thus, facilitates a more accurate reading of a fund’s track record, provided the lookback period is reasonably long.
Current winners have often been previous underperformers
Many of the current outperforming funds have been among the laggards in previous years.
Note:The current number 1 fund was ranked 160 during 2018-20. The table shows the ranking of diversified equity funds (large cap, mid cap, small cap, flexi cap, large & mid cap, multi cap, ELSS, value/contra, focused & dividend yield) based on 3-year returns. | Source: FundsIndia
Only one out of four winners remained at the top in next three years
Blindly chasing past winners is a futile exercise because outperformance is followed by underperformance.
Switching lanes can hurt portfolio returns
Moving to the best performing segment will not yield expected outcomes.
These outcomes are for an investor who had started SIPs in the mid-cap index and switched to the best performing index (large, mid or small) of the previous year, every year. The 10-year rolling SIP return period is from 1 Apr 2005 to 1 Apr 2024. Mid-cap index is represented by Nifty Midcap 150 TRI | Source: WhiteOak Capital AMC
Note: “Reversion to mean is a fundamental investing axiom. Sooner or later some funds and stocks revert to averages.”
VIVEK BANKA
CO-FOUNDER,
GOALTELLER
Winners keep rotating as styles & segments perform differently
It is important to diversify across styles and segments to ensure that your portfolio performs consistently.
Avoid fixation on returns
The obsession with past returns leads you to an endless cycle of fund-hopping. Performance alone should not be the criterion for gauging the merits of holding a fund. It is important to add more layers to your fund selection matrix. Try and explore risk characteristics of the fund. Typically, a fund that takes higher risks will be prone to alternating bouts of outperformance, followed by underperformance. A fund that is more conscious of its risk positioning will deliver more consistent outcomes. Ideally, a fund’s risk profile should be aligned with your risk tolerance. “Apart from returns, one should closely look at other metrics like volatility, downside capture ratio and beta to determine how risky the fund is,” says Banka.
Similarly, don’t get fixated on how a fund is doing relative to its peers or index. This leads to disenchantment if a fund starts underperforming. It may not always be a good idea to seek an exit and explore greener pastures. Instead, fix a broad range of expected returns from the chosen fund. If your fund exhibits outcomes within this range, you should remain invested even if it strays from its peers or index intermittently. Likewise, even if the fund is outperforming sharply, anchoring to a specific range will make sure your future return expectations are moderated. “Investors should exercise extra due diligence in analysing and investing in funds that have significantly outperformed,” argues ICICI Direct’s Jain.
To avoid being swayed by extreme outcomes, investors should bring more style diversification in their portfolios. “Always have a mix of different styles with very low overlap,” suggests Kumar. “You can’t build a team with only fast bowlers. You will do great in a few matches, but will miss the spinners in others.” In the past four years, funds leaning on the value style have outperformed, while growth and quality-led funds have lagged. But the tide could turn in the next few years as mean reversion inevitably plays out. It may not be a good idea to junk your growth funds at this juncture.
Instead, spread your portfolio across funds geared towards value, quality, momentum, size (mid/small cap) and global equities. This style diversification will ensure that you not only capture today’s top performing segments but are also positioned to benefit from a turnaround in others. “A balanced portfolio with a blend of these factors can help improve the consistency of performance,” avers Jain.