Should investors chase past performance of equity MFs? Or is there a smarter way?

As of April 2024, there were 440 equity mutual fund (MF) schemes, as per data from the Securities and Exchange Board of India (SEBI). Equity MF schemes invest most of the money they collect into stocks.

So, how does a new investor choose from so many schemes? Typically, most of us who practise the do-it-yourself (DIY) form of investing end up choosing schemes by looking at their past performance. The same is also true for wealth managers, relationship managers, chartered accountants and MF agents in the business of recommending equity MF schemes to prospective investors.

In many cases, these experts and those practising DIY investing typically look at the short-term performance of these funds and invest in schemes that have done well for the past few years. And some of them tend to bet pretty heavily on short-term performance.

In recent years, a good example of this is Quant Mutual Fund. The equity MF schemes of this fund house have done very well, leading to a huge surge in the assets under management from next to nothing to more than ₹90,000 crore invested in the schemes run by this fund. News reports suggest that the fund house is currently under a SEBI investigation for front-running.

So, the question is should investors chase past performance? Or is there more to it than just that? As John Allen Paulos writes in A Mathematician Plays the Stock Market, “...some stocks, funds, or analysts [end up] doing well over an extended period merely by chance.” He makes this point by offering a very interesting analogy, which I am adapting slightly for an Indian context. Let’s say there are 400 equity MF schemes. I am rounding off 440 schemes to 400 schemes, for ease of calculation. Considering a 50:50 probability, half of these (or 200) equity MF schemes might be expected to outperform the rate of return earned by the broader market. Now, of these 200 schemes, 100 schemes might be expected to outperform the broader market for two years. Of these 100 schemes, 50 might be expected to outperform the market for three years. I hope you get the drift.

So, iterating in this way, by the end of six years, there will be around six schemes that would have outperformed the market for six consecutive years, and would have done better than other schemes. Of course, these schemes will be written about in the media and their managers will be projected as investment geniuses on social media. But as the above example shows, it might be just sheer luck.

As Tom Chivers and David Chivers write in How to Read Numbers—A Guide to Statistics in the News (and Knowing When to Trust Them): “There are thousands of investment funds. A few of them achieve incredible rates of return for a while, so they get attention and lots of investment. But is that because they’re genuinely beating the market or because they’ve got lucky?”

Now, this is not to say that the performance may not be because of the analytical skills of a fund manager. That’s possible. However, prospective investors are outsiders with only so much time and resources available to carry out any detailed analysis of this very important question. Most outsiders are not in a position to figure out whether a scheme’s excellent performance is because of sheer luck, the analytical skills of the fund manager, or a combination of both.

So, how should we go about investing? Not look at past performance? Or as the mutual fund disclaimer reads: “The past performance of the mutual funds is not necessarily indicative of future performance of the schemes.”

It’s important to look at the long-term past performance of a scheme. Ideally, one should look at the past performance of at least a decade. If an equity MF scheme comes on top of the charts on this parameter then it’s been through different stock market cycles and done well. The performance is not simply a bull-market phenomenon, as is the case with Quant MF.

It would be even better to look at rolling returns. These are annualised average returns over a period of time. So, let’s say we are looking at ten-year rolling returns of equity MFs as of May 2024. This would mean looking at the ten-year returns of the scheme as of May 2024, May 2023, May 2022… and up to May 2015, and then calculating the average using ten-year returns at the end of each year.

Of course, this is complicated. First, this kind of data may simply not be available in the public domain. Second, even if one were to pay to access such data, analysing it would take time and some mental bandwidth. Third, the Indian MF industry is relatively new and looking at ten-year rolling returns would require data for twenty years. Most equity Indian MF schemes won’t make this cut-off.

So, where does that leave us? We should try to control the controllable. One way of doing that is by applying the most important principle in investing—diversification—something that has been out of fashion in recent years as stock prices have gone from strength to strength. While looking at past performance one should not bet more than 20% of the money invested in equity MF schemes on one particular scheme. Using such an approach can ensure that if the past performance of the scheme doesn’t continue in the future, the damage can be limited.

The second way is to invest one’s money largely in index funds and exchange-traded funds (ETFs). Index funds essentially invest in stocks that make up a particular stock market index like the NIFTY50. This way, an investor can ensure that they at least earn the return earned by the broader market. ETFs are index funds bought and sold on the stock exchange.

While this may not be the perfect solution, it is indeed an optimum one.