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. Even financial advisors are prone to stick to this past performance benchmark while recommending mutual funds.
Why everyone seems to be obsessed with the past mutual fund returns despite the disclaimer in the offer document of every fund saying clearly, ‘Past performance is no guarantee of future results?’
Studies abound showing 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.
Old habits die hard is what we can say. However, we must caution you against this practice.
The approach to judge a mutual fund on its past returns is fraught with danger. Here we list the reasons why chasing the past returns of mutual funds is a bad idea.
Mutual Fund Returns when Fund Managers move out or are changed…?
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 of the fund resigns or is replaced, the performance of that fund is bound to be affected.
The new mutual fund manager may not be able to yield 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.
Risky Mutual Funds tend to yield stupendous returns in times of bubbles and booms
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 booms and bubbles.
Recall the internet bubble of the late1990, many internet funds looked lucrative for investors and they rush to invest in those funds but when 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 major stake in these high-risk assets looked like they had incredible returns until the bursting of bubble happened. What gets proved 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.
Huge Assets restricts the Mutual Fund Returns
If a mutual fund is performing well, investors scramble to pour money into it. This increases the volumes 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.
For example, 1,000 crore mutual fund could yield better returns than 10,000 crore mutual fund could.
In the investment space, the size of the asset has a definite role to play. A mutual fund is restricted by law to invest only up to 5% of the networth of a single company. Hence size of fund’s capital if bigger 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 smaller assets can invest in a focused portfolio and generate more returns.
If you can’t rely on past mutual fund returns, what are other ways to go for?
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:
In addition to the past mutual fund returns, looking at the above parameters will help you choose a right mutual fund.
The author is Ramalingam K, an MBA (Finance) and Certified Financial Planner. He is the Director and Chief Financial Planner of Holistic Investment Planners (www.holisticinvestment.in) a firm that offers Financial Planning and Wealth Management. He can be reached at firstname.lastname@example.org