Investing in last year’s top performing mutual funds may appear to be a rational approach at first, but it is not. As a mutual fund investor, if you look at the recent one-year returns of equities funds, you will find that practically every year, a new fund tops the returns rankings. It may be a sectoral fund one year, a large-cap fund the following year, and so on. In another year, it might be a small or mid-cap fund as well in the ranking list. And, while everyone expects their investments to outperform the market, this seldom happens.
The frequently used disclaimer that “past performance is neither indicative nor a guarantee of future performance” is a fact. However, many investors seek for past year winners. This is also common at the AUM (Assets under Management) level. If a fund performs well for a year or two, it begins to attract new money and the AUM increases as a result.
If you are constructing a portfolio, never make the costly error of picking funds simply based on their previous performance. There have been countless cases in which a fund that had been performing well for a year or two suddenly got a large amount of new money but struggled to generate even ordinary returns over the next few years.
Please keep in mind that prior performance should not be dismissed completely. However, it should not be the main criteria in selecting funds.
When it comes to fund selection, here’s a list of criteria to consider (not an exhaustive list though):
- The fund’s rolling returns over 1, 2, 3, and 5 years to demonstrate its capacity to beat benchmarks and their respective category average returns.
- Fund volatility in both directions;
- Performance throughout different market cycles;
- AUM changes’ influence on fund performance.
In addition to this, one should consider relatively subjective aspects such as the fund manager’s historical performance across market cycles, the fund’s declared objective, and whether if the fund’s strategy drifts on a frequent basis or stays consistent in its technique.
You may wonder, “Who has time to do all of this?” Analysing mutual funds, when done properly, takes considerable effort and time. But that’s how it is.
Individual investors may be tempted to grab on to table-toppers in the mutual fund chart, but please don’t be drawn into recent results. Picking previous year’s winners is not a long-term strategy and should not be relied upon. As mutual funds pass through different cycles, investing in a table-topper from last year whose up-cycle is about to end, will result in a low return.
So, the final takeaway here is that – Choose funds and categories that have a relatively lengthy track record of strong returns and have performed consistently across market cycles.