Predictive Value of Historical Returns in Mutual Funds

Social Media has been a great leveler of things. While getting opinions of a dozen people in real life can be tremendously tough, thanks to Social Media, you know have the opportunity to tap into the opinions of thousands by the mere click of a button.

Polls have always been used to understand and bring out the view of the crowd where the majority may not always be easily distinguishable. The risk though is one of sample size and the kind of people who are surveyed.

As Election Surveys / Polls have shown, it’s never about how many people you polled but the diversity among them that counts and the weights you give to factor in biases that this selective population may have brought about into the poll – knowingly or unknowingly.

A few months earlier, I ran a poll on Twitter (where else can you can get so easy a access to so many smart and sophisticated investors) regarding what drove them to invest in Mutual Funds. The vast majority was inclined to Returns.

Post that poll, I wrote a post Chasing Performance & Behavior Gap. Yesterday, I ran a poll which is kind of following up on that question. If return was a criterion for investing, what was the look-back period investor were most concerned about.

The Options were the same options you can get at ValueResearch since this is one of the biggest sites investors use when researching a fund. While you can also do a point to point comparison, it’s not really simple to measure funds across multiple periods and our brains I doubt are wired to take the “Road not Taken”.

The fact that it’s easy to now get data on what funds are the best performers doesn’t really translate to being better investors. From Survivor bias to Information bias, we fall pretty easily to a lot of biases when looking at data selectively. But given that our options are limited, what we see is what we use to make the choices we make.

Mutual Funds have been in the news like never before but that has also meant that choosing the next big fund is getting near impossible thanks to erosion of competitive advantages the funds enjoyed when they were small.

SEBI’s recent decision to have funds compare performance against Total Returns Index versus the Spot means that almost all funds have suddenly lost a percentage of two of their Alpha.

While advisors preen about how they choose funds taking into account a variety of factors – data seems to suggest that its finally historical returns that can make or break a fund. Of course, even there, funds which don’t pay as much commission as advisors do worse since they are rarely ever advised regardless of performance or other merits.

Take a look at this data chart for example. Among Large Cap funds, excluding Index Funds and ETF’s, AUM is highly concentrated in the top funds. But are current rankings indicative of the funds greatness over time or are they just a random variable that happened to be at the right time and right place?

The best fund among all Large Cap Fund over the last five years is “ICICI Prudential Value Discovery Fund” but as anyone who has spent any time in the area of Mutual Funds knows, this fund was a Mid Cap fund that has overtime graduated to Large cap and hence the results aren’t really comparable.

The Second best fund is Invesco India Growth Fund. But this fund wasn’t known as Invesco for a long time but was known as Lotus India Growth Fund. In 2008, Religare Mutual Fund acquired Lotus Mutual Fund and this fund became known as Religare India Growth Fund. In 2013, Invesco acquired 49% of Religare Asset Management and the fund was from then known as Religare Invesco India Growth Fund. In 2015, Invesco acquired the stake of Religare and the fund since then is known under its current name.

With Asset Under Management of around 300 Crores, this is one of the smaller funds among the large cap Universe. But if you are looking at performance, the AUM should be the least of the worry. A smaller AUM also provides the fund manager to be flexible compared to large AUM’s though there is no correlation between returns and assets under management.

If you were to just invest in the best fund over the last 5 years, you would have ended up with over 5 funds over the last 7 years, such has been the volatility among the top.

HDFC Top 200 fund which was the Best among Large Cap Funds is now a distant 18. SBI Bluechip fund which was ranked 31st out of 38 funds in 2010 is now the 3rd best fund with a huge asset under management to match the upgrade in ranks.

Predictive value of the data is based on how well the data has acted in the past and if the ranking of funds by returns over the last 5 years is anything to go by, this data has very less predictive value than most would assume.

Add to it the fact that 50% of the funds did not beat a simple benchmark like the Nifty 100 TRI, your ability to meet your goals based on assumed returns of these funds will leave a lot to be desired. While active management has worked in India, the odds of funds ability to beat their benchmarks is decreasing by the year. When expectations are set by the historical returns of some of these funds, you are setting up for failure and disappointment right away.

Let Data be your Guide to Investing, not Narrative.

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