Chasing the best performing fund

Are you chasing the so-called "best performing fund"? Are you switching an existing SIP because your current fund(s) are not in the top 5 list? Then read on.

You are having coffee with your colleagues and the financially savvy person in the group says he does SIPs through the direct plans instead of regular plans to save on intermediary commissions. "It is so easy," he says, with the digital platforms – there is a lot of information available. A good intermediary – and by good we mean someone who generates consistent, goal-oriented returns and regular reviews; but more importantly gives the emotional and psychological guidance to avoid costly decisions – will generate better returns than an investor doing their own investments in majority of cases. However, in this post, we are trying to highlight a totally different aspect of the investment process – the selection of the fund or scheme.

How to Analyze Performance Ranking of Funds?

If one looks at the past 10 years’ quartile rank of the current darlings of the fund world, one will notice that the variation is huge. There is movement from the top quartile in one year to the bottom in the next, with few funds going consecutive years in the same (forget top) quartile. There is bound to be movement. That is just how the market cycles work.

During a particular market cycle, there would be a set of funds that perform well. Obviously as all cycles go, there will be a dip at some point in time. This can be seen even in the information that we investors so love. The 10-year annualized returns will always be lower than the 5 or 7-year annualized returns. This is because any 10-year market cycle would see a downturn at some point. Another metric to note is that the top equity funds would show past returns well above 20% even 30%. But still, over a period of 5–7 years, an investor’s portfolio typically gives returns in the 18–20% range. Simply, the mix of funds that an investor has is not going to be in an upward market cycle at the same time—some funds would be outperforming, some would be range-bound, and some might even be underperforming. Nevertheless, a return of 18% is great and possible only if the investor stays invested.

We need to understand that a period of overperformance will be followed by a period of underperformance—and the opposite also holds true.

How Does One Select a Mutual Fund for Your Portfolio?

Generally, 9 times out of 10, the selection is done by looking at a variety of factors. These "parameters" are influenced by online articles, finfluencers, financially savvy peers, etc. Finally, the decision is almost always made on the basis of past performance of the fund. Hope is the overriding emotion here—that the future performance will mirror the past performance. Sadly that has never been and never will hold true. Furthermore, only a few funds receive a lion’s share of the inflows from investors—again showing a tendency to chase the best performers. Once the scheme goes “out” of the best performer top 3/5 ranking, many investors make the mistake of switching to a different fund.

Does Selection Based on Current Top Performing Funds Work?

No, this makes no sense due to the movement in the rankings which we explained earlier. Imagine you go bike racing against Valentino Rossi. You might not win even if you are given the fastest Ducati ever made. However, chances are Rossi would beat you even with a Bajaj Pulsar. It is not about going fast in one lap, it is about staying consistent throughout all the laps of the race. The same way Rossi would beat an average person in a bike race with an average bike; you should be able to beat the benchmarks with a properly selected, average mix of funds—provided you are consistent for a long period of time.

(See also: SIP Explained: How Small Investments Grow Big)

Things About Selecting Mutual Funds You Should Know

1. If something has worked for someone, it does not mean the same format will work for you. Everyone has different goals, incomes, expenses, liabilities, and financial plans for the future. Always keep the investing goal-based.
2. If the financial advice comes from someone who is not a financial expert, however close they may be, avoid this advice.
3. If the financial advice comes from a financial expert, a finfluencer, or your favourite business news channel, be cautious. Use these platforms for gaining knowledge and financial literacy, but avoid taking decisions based solely on them.
4. The only financial advice you really need to heed is what your personal financial advisor or mutual fund distributor gives you (assuming they know your background, financial goals, and have worked out a detailed plan for you).
5. The funds that give enormous returns generally carry large risks. Make sure you have an appetite for fall in NAVs from time to time.

Stop chasing the so called "top funds". Select a right mix of funds based on your needs and requirements.