A worker uses a measuring tape. (Photographer: Taylor Weidman/Bloomberg)

The Mutual Fund Show: How To Rightly Gauge A MF Scheme’s Performance

Performance of a mutual fund scheme should be determined based on its long-term track record instead of the short-term returns generated.

That’s according to Tarun Birani, founder of investment advisory firm Thinkingman.in. “A study shows small and mid cap as a category needs at least seven years of history to classify as an underperformer or outperformer,” Birani said on BloombergQuint’s weekly series The Mutual Fund Show. “Large caps need four to five years, while the multi-cap category requires five to seven years of track record.”

Kunal Bajaj, founder and chief executive officer of Clearfunds, agreed, but added investors should be aware whether the scheme fulfills the purpose of their portfolio. “If a small-cap scheme returns are in line with the small-cap universe of stocks then there should be no reason to worry,” he said. “The small- and mid-cap space is probably correcting the outperformance of the last few years.”

Here are edited excerpts from the conversation:

Should investors be concerned about the underperformance of some funds?

Tarun Birani: The whole exercise of identifying underperformance and outperformance need to have some fundamental logic behind it. I can see year-to-date data to review a fund’s underperformance or over performance. But according to me that is not the right way to look at it. The objectives with which these categories work need to be understood before making any comment. We did a small research internally wherein we need a minimum horizon of seven to 10 years to meaningfully make a statement on mid caps or small caps as a category. Large caps as a category require a minimum four to five year kind of track record and for multi caps it is between five and seven years because that is the time horizon where we have seen the top 20-25 schemes where the return gap is hardly two to three percent between them. Rather than getting into the last six months or one to two year exercise, I think the objective and the suitability part of an investor is much more important.

Do some schemes only have a market impact, or do they have a specific reason because of which they are underperforming?

Tarun Birani: This is more on the behavior side and like a hard mentality bias. Just because markets from last three years have been doing so well, a lot of investors got caught, felt left out and then invested. That’s where they have not done the suitability exercise well for themselves. They just did because somebody has said, or media is highlighting some good performance. So, the basic exercise has to be done more about your suitability. If that is done correctly and you know that in 10 years you don’t want that money, I don’t think one to two years underperformance will matter. Our regulators have done a great job in figuring out as how to educate investors over a regular period of time. I don’t see much problem around it.

Do your thoughts differ significantly?

Kunal Bajaj: I agree with Tarun, but we have to recognise that most of the investors we are seeing at this point of time are first-timers. The inflows have been fabulous and the benefits of systematic investment plans have been explained all over the media, but have they understood the concept of risk properly or has that been explained to them? We are not sure about it. If someone is asking that whether they need to change their asset allocation or whether they should come in or out of a scheme, it is an important to question the answer. It is important to address that does those schemes fall within the purpose that it is meant to perform in their portfolio. For example, if a small-cap scheme performs in-line with small-cap returns, then there is nothing to be concerned about. But if it was meant to fulfill a particular goal, for example, offer stability to your portfolio, but it is behaving erratically then that is something which I will look and say this is something which is not right for you.

Can you explain the chart provided by you?

Kunal Bajaj: This is the most popular tax-saving scheme which people tend to get at the end of the year when they are rushing to pay taxes and for good reason. Even in equity schemes people tend to expect that when we advise and tell them to look at longer returns and then say Rs 10 invested 20 years ago is now worth the Rs 1000. The returns are not in a straight line. There are variabilities. There are years when you will get 3 percent and you will wonder should I be holding this because I make 6-7 percent in the bank. This is not like Dravid taking a run in every single ball. There will a few big pinch-hitting years where you will find people hitting the ball out of the park. There will be years when nothing happens, and you need to be prepared for that volatility. If you are not prepared, then this product is not for you.

In small and mid caps is the bout of underperformance that we are seeing in 2018 is the result of a significant bout of outperformance of the previous four years?

Kunal Bajaj: There has been a craze to buy small caps, particularly because of the kind of returns we are seeing. The year 2014 was a staggering one. The year 2017 was another great one after positive returns of 4 of the last 5 years. We have an online advisory and transaction platform. We have noticed on our platform that people come in and sort by three-year returns and want to buy the best performing fund. That is human nature and we strive to nudge people against. You need to realise that tall trees don’t grow to the sky. Just because the small caps have underperformed large caps for certain time periods, it doesn’t mean it will continue indefinitely. You will see some amount of main reversion. At the beginning of this rally in 2011-2012, the price-to-book, or how expensive small cap was versus large cap, the differential was the largest ever. In the sense, small cap was ridiculously cheap. That differential has largely gone away in the last few years. So, will the large-cap companies just roll over and die or will the cyclicality in the Indian economy go away? No, it is not. We have seen 2013 has been repeated in 2018 in form of a twin deficit, current account and capital account and fiscal deficit. Investors need to recognise that and not just change momentum. Unfortunately, it is easier said than done. We see that in every market cycle and that repeats yet again.

Tarun Birani: On the small-cap side, it is very clear that it is high risk, high-reward kind of product, which requires a much longer horizon. In one year you could see a 100 percent return and in 3 years you could see a negative return. Unless the investor is not ready with that kind of performance, I think they should not venture into something like that. In the last five years, the returns on CAGR (compounded annual growth rate) basis you will always see annualised returns of 15-20 percent, but nobody talks about those four bad years—2008 or 2013—where they have seen a 30-40 percent erosion, too. Next one year, despite all these good data, some event can happen and result in the same situation. That’s where investors should be very clear about the mid- and small-cap category. Unless you have a 10-year horizon, we would recommend against that category. Otherwise, wealth creation as an objective will go away. It would be too transactional a motive. We would rather look at wealth creation as a bigger objective. With suitability, right exercise done and a good fund identified, you will achieve the wealth creation goal.