Past Returns Dont Guarantee Future Performance

Hemant Rustagi
Chief Executive Officer, Wiseinvest Pvt Ltd.

It is quite common to see investors picking funds off-the-shelf solely on the basis of their past performance. This applies to both equity as well as debt funds. The general belief is that best performing funds can’t go wrong and are most likely to replicate their past performance even in the future. The reality, however, is that mutual funds offer a variety of funds for investing in both equity as well as the debt market. For example, equity funds take a varying degree of exposure to different segments of the market i.e. large, mid and small-cap stocks. 

Then there are funds that either follow different investment philosophies i.e. growth and value or look for investment opportunities in a particular theme or a sector. Hybrid funds have a varying degree of exposure to equity and debt instruments. Since different segments or philosophies perform differently at different times, relying mainly on past performance can compel investors to either invest heavily into aggressive funds which can take them beyond their risk-taking capacity as well as make the portfolio returns quite erratic or make them miss out on opportunities that may emerge from segments or philosophies not doing well at the time of making the investment.

Similarly, considering that there is an inverse relationship between interest rate and bond prices, a rising interest rate scenario will reflect subdued returns from debt funds investing in medium to long-term securities and very attractive returns during lower interest rate regime. Therefore, relying on past performance alone can compel investors to invest in these funds at the wrong end of the interest rate cycle and experience disappointment in terms of performance as well as volatility in returns.

The question, therefore, is whether one should ignore past performance completely? If not, to what extent can one rely on it? In reality, while relying solely on the past performance can be risky, ignoring it completely can also be detriment to an investor’s decision-making process. The key, therefore, is to focus on longer term track record rather than short-term performance. In other words, one must avoid those funds that are showing very high past returns because of a very big but isolated period.

Besides, the performance shouldn’t be the first step in the selection process. The suitability of a fund for an investor must hold precedence over everything else. Once it is determined what kind of fund would be suitable for a particular investment goal, the key would be to opt for funds that have a consistent performance track record. Therefore, the aim should be to build a portfolio with funds that have been providing better returns than the average of their peer group on a consistent basis.

Asset allocation plays an important role in deciding the suitability of a fund for an investor. The right way to decide asset allocation is to consider the time horizon and the goal for which one looks to design a portfolio. For example, the safety of capital should be a priority for a short-term goal. Similarly, for a medium-term goal, the focus should be on a combination of safety and growth and for longer duration the priority should be staying ahead of inflation. Therefore, while building a portfolio for retirement planning or for child’s education, equity funds should be the mainstay of the portfolio. The process must begin with a combination of large-cap, multi-cap and/or large and mid-cap funds. Within a chosen category, the focus should be on funds that have a consistent performance track record vis-à-vis its peer group.

Simply put, the investment goal of an investor must match with the investment objective of the chosen fund. Similarly, while investing in debt funds, the focus should be on managing credit and duration risk. While investing in categories such as low duration, ultra short-term and short-term debt funds is fairly straightforward, choosing an income fund for longer duration can be a bit tricky. Since every debt fund clearly mentions the type of securities and maturity duration it is going to maintain, one must match one’s time horizon with the maturity duration of a fund.