One of the most erroneous methods of selecting equity funds is by only watching the performance of the last one year or two years. Many investors feel that by taking out a few best performing funds from the internet or from some financial journal, they have found the champion funds. But this one sided research usually results in dismal performance. The lure of attractive numbers is so alluring that investors forget that it is just a past return and not yet the actual return for them. Not just investors but many mutual fund advisors and distributors find the easy way selling funds on the basis of past return. This is quite easy for them to show the return of the best performing funds and sell the funds.
But this is not the best way of selecting funds. In fact research shows that mutual funds usually follow what is called the concept of “reversion to the mean”. This concept says that funds which have delivered superlative returns are not likely to repeat their past performance in fact, most are likely to underperform.
So this concept makes the process of selecting the best funds of the year concept on its heels. This is because, by selecting the best performer of the year, you are most likely choosing the potential below average performers. So, what should be the approach of the investors to choose good funds for their portfolio formation?
One may argue that we should then select the most laggard funds of the year because according to this theory they are likely to be the winners in the coming time? Not necessarily! See the fund management is a systematic process, smart anticipation and diligent discipline by the fund manager, his/her team and the entire fund house in unison. There has to be firm conviction on the part of all these components without being swayed by the market movement. Fund’s underperformance due to bad fund management will not help the investors who are hoping to benefit from “reversion to the mean” concept. Many fund managers, when they see that their style is not working, try to imitate others in order to turn things around. But that is not going to be successful in the long term.
So the ideal approach should be to understand the quality of the fund manager, his/her team apart from the philosophy and the process of the fund house. Also, watch out for the consistency of the performance rather than focusing on the recent past returns. If all this looks complicated, then simply invest in index funds.
In the ideal situation, you should select the better fund managers who along with a better team are working under better fund houses. Then, you can select the funds of these combinations which have underperformed in the recent past. They are quite likely to perform well in the coming period. By the same coin, if you have already invested in those funds which fit in the above combination but performed poorly in the recent past, don’t jump ship and move to hot funds. It may be a mistake because good funds generally bounce back with a bang and maintain the long term outperformance.
In the overall analysis, investors are better off choosing the funds with the quality of management and consistency of performance rather than simply investing in funds on the basis of recent past returns. As I mentioned above, by choosing index funds, you can avoid all these complications.
Manoj Pandey
CFP
