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Past performance is not everything
If you are a type of investor who goes through the fact
sheet or offer document, in order to study a particular scheme before
investing in it, you would have come across a disclaimer (below the
scheme’s historical returns) stating, “past performance may or may not be
sustained in future and should not be used as a basis for comparison with
other investments”. According to SEBI (Securities and Exchange Board of
India) guidelines, fund houses must state this disclaimer explicitly
whenever they mention the past performance of a scheme. As usual, this
guideline came into force because fund houses were mis-selling their
schemes based solely on the past performance.
However, disclaimers apart, as a practice investors
continue to make investments based on a scheme’s past performance. To make
matters worse, fund houses are only too pleased to toe the line by
actively advertising the past performance of their schemes leading
investors to conclude that it is the single-most important parameter (if
not the most important one) to be considered while investing in a mutual
fund scheme.
The marketing tactic of playing the ‘past performance
card’ at frequent intervals inevitably raises the question - is past
performance the only parameter to be considered while investing in mutual
fund scheme? In our view – No. Let’s see why at Personalfn we are so
adamant about this point.
Relevance of past performance
Past performance of a particular scheme simply informs you, the
investor, how much return the mutual fund scheme has generated over a time
frame. However, there are certain critical points that the past
performance numbers in isolation do not tell. We discuss these points
below:
a) The risk the investor has been exposed to in the
mutual fund’s quest for growth. In a rising market, it is not altogether
difficult to clock higher growth if the fund manager is willing to take on
higher risk (we have seen this on several occasions like the tech rally in
1999-early 2000, the mid cap rally in 2003-05). In that case, the past
performance numbers in isolation will be inaccurate because they do not
give investors any inkling of the higher risk they have been exposed to.
At Personalfn, we believe that before investing in any investment, it must
be evaluated based on the risk-return criterion; evaluating it across any
one of them (risk or return) will not serve the purpose as the investor
will ultimately end up investing in avenue that is not completely suited
to him.
b) Even while showcasing past performance, funds are
careful to show the compounded annualised growth rate (CAGR) numbers over
longer time frames (3-5 years). Over this extended time frame, a CAGR
figure is not entirely representative of the ups and downs (which could be
considerable given the extended time frame) witnessed by the mutual fund
over that period. This is because the CAGR number tends to even out the
fund’s performance over the long-term and the bad times (based on wrong
investment calls) are not that easily discernible.
A statistic that underlines, how much a mutual fund has
fallen during a particular market slump (as compared to the benchmark
index and peers) or how it has performed during a particular calendar
year, is far more illustrative in our view as opposed to just a CAGR
figure; after a market rally, a CAGR figure looks much better than it did
before.
c) Another reason why past performance is not entirely
representative of a mutual fund’s ‘good showing’ is because; it does not
take into consideration the performance of its peers. It is possible that
a fund has performed reasonably well (across relevant parameters) by
itself, but hasn’t quite made the mark when compared to its peers. In
other words, some of its peers that have outperformed it deserve to be
considered by investors before the mutual fund under question. At
Personalfn, we compare an investment (be it a mutual fund, fixed deposit,
unit-linked insurance plan – ULIP, among others) with its comparable peer
group before giving a view on whether or not you should invest in it.
d) Past performance fails to highlight the investment
processes and approach pursued by the fund house. It does not give the
investor an idea whether the past performance is the result of 1) good
fortune/luck 2) a star fund manager 3) a team-based investment approach
that takes decisions based on well-defined processes that are not
over-dependent on a particular individual (like a star fund manager). At
Personalfn, our preference is for Point 3); unfortunately the marketing
campaign doesn’t help us with that information, this we learn after
constant interaction with fund houses and their investment teams.
e) Past performance often ignores the change in guard
or mandate. Fund houses first talk of a star fund manager who was
instrumental in sprucing up their performance. They get a lot of money
based on this star fund manager. The performance numbers that are
advertised are attributed to the ‘brilliance’ of the star fund manager.
When the star fund manager quits (which in many cases is often a matter of
time), the fund house continues to use the performance attributable to the
ex-fund manager to draw fresh monies under the new (star) fund manager!
Investors however, are clueless as to whether the performance being
advertised is the result of the existing team or an older team.
On the same lines, a mutual fund that revises its
mandate/investment objective continues to use the performance figures
under the older mandate/investment objective. Again, investors have
absolutely no idea whether the performance numbers correspond to the
revised mandate or an older mandate.
In an article we wrote earlier, we had addressed this
particular issue in detail and had recommended that fund houses either
stop using older, irrelevant performance numbers or mention that the
performance came under the previous fund management team or an older
investment mandate.
f) Of course, last but not the least, past performance
is no guarantee of future performance. While this is adequately mentioned
in the advertisements, we wonder why it needs to be advertised in the
first place. It’s a bit like advertising tobacco products freely with a
small disclaimer at the bottom!!
Nonetheless this disclaimer is important; we have
mentioned it right at the end because we believe that the 5 points
discussed earlier are a lot more important.
What should investors do?
Our advice to investors is that they should adhere to the basics of
mutual fund investing. They should evaluate mutual funds across
parameters, including of course past performance, before considering any
investments.
In our view, SEBI, as a regulator of Indian stock
markets, should take note of such campaigns and discourage fund houses
from misguiding investors through such misrepresentative and inaccurate
advertisements.
Till then we can only hope that, unlike on previous
occasions when such one-off cases started trends in the mutual fund
industry, this particular problem is nipped in the bud by the regulator at
the earliest.
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