The Mutual Fund Show: One Mistake Investors May Be Making While Picking Schemes
When making investments in mutual funds, investors often try to predict future returns. And while doing so, they naturally look at how the schemes have performed most recently—also called recency bias.
But do best-performing schemes of the past remain so in the future?
According to Gaurav Rastogi, founder and chief executive officer at Kuvera.in., they often don’t. The online mutual fund platform, he said, has conducted studies across multiple time frames but the results showed little persistence in past performances of schemes. What that means is the best funds in the past may not be the best funds one or two years later.
For instance, “There are 1,000 funds. We pick the 100 best-performing funds and then hold them for one more year. In the next year, out of those 100 funds, 13 still remain the best performing but 19 now has become worst performing. On an average, only 52% of the best-performing funds do better than average,” Rastogi said on BloombergQuint’s special weekly series The Mutual Fund Show.
Prableen Bajpai, founder, FinFix, cited “chasing return strategy” to explain the relationship between returns and investor behaviour. According to the study, chasing returns in equity mutual fund investing cost investors around 2% every year over the period 2000 to 2012. In contrast, the buy-and-hold strategy outperformed the return-chasing strategy by up to 5% during the period, she said.
Watch the full show here:
Here are the edited excerpts from the interview:
Gaurav, is it a good idea to buy into the best-performing funds—the normal argument is that maybe it is not but I have some very interesting data too.
Rastogi: I think one of the things that most investors look at when selecting a mutual fund and a stock or a PMS, by the way this is not just restricted to mutual funds, is they look at past returns and somehow we think that a fund that is consistent, a fund that has done well in the past, there is somehow some information content there which will help us and make more money in the future. Like it’s rightly said, money is always made in the future. The past is just the data points you have that you can use to get whatever insight you can. So, we did this study where we went to AMFI, a treasure trove of data, and we downloaded returns of all the mutual funds going back to 2003. So, from 2003 till 2020, that’s our data set and the way we set up this study was that we said okay let’s look at one year, look at all the funds and their performances and find the top decile funds — that have the performance in the best 10%. Why 10%? It’s just a measure. So, effectively we are saying these are the best-performing funds based on a one-year look back, and that’s when the fun starts. Then what we do is, we look at the next year’s returns. Then we say okay how these funds did in one year after being in the top decile of the best-performing funds for that year. So, intuitively you would think that there is something good about these funds that’s why they did well, so maybe it will continue—that’s what’s called persistence in returns. What we found is and what a lot of other people have found in mutual funds, in stocks, in PMS is that there’s actually no persistence. In fact, if you look at the data I shared with you, this one-year, one-year set up—the best performing funds in one year, how did they perform one year down the line—only 13% of those funds remained the best-performing funds or in the top decile.
So, you are saying that all funds that have done well over the past one year, you’ve broken them into top deciles and the top 10% of the funds are taken for the study. And from that set, only 13% of those best-performing funds ended up outperforming in the next year or doing better or being in the top decile?
Rastogi: Ended up being in the top decile of the best-performing funds next year as well. What’s more interesting is that 19% of the best-performing funds, they were in the top decile, now are in the worst decile one year down. So, for instance, there are 1,000 funds. We pick the 100 best-performing funds and then we hold them for one more year. In the next year, out of those 100 funds, 13 still remain in the best-performing funds but 19 now has become the worst 100 performing funds. On an average, only 52% of the best-performing funds do better than average. The data we have looked at — one year, we have looked at three years. We got questions saying hey why don’t you look at consistence performance and look at five-year time horizon. We said sure and we looked at five years, the data doesn’t change, the implication doesn’t change.
Prableen, you want to come in on this? You have been advising your clients on various media platforms as well about funds which are doing well and normal instinct would tell that if something is doing well, it is doing well for a reason and it probably makes sense to side with that, but the data is really interesting.
Bajpai: Of course what Gaurav has mentioned is absolutely true and that is why we have the disclaimer on all investment documents that past returns are not an indicator for what will happen in the future. We’ve all read it but probably superficially because somewhere deep down we find comfort in picking a scheme or an asset class where we’ve seen good positive returns. And the same thing actually has been given up by a few other studies as well. There was a study by the chief economist of the Federal Reserve Bank of St. Louis and he compared the buy and hold strategy in equity mutual funds. He called it the Chasing Returns Strategy, where he said that those investors who were chasing returns were actually losing about 2% each year, and the outperformance of the buy and hold was about 5% more overall during the time period 2000 to 2012.
This also brings up to another point that investors often say that we haven’t made money. So the schemes show returns and investors often tend to make lesser returns than what the schemes actually show on their fact sheets because somewhere as investors you and me, I think we like to pick the top performer, we are not happy, we are sensitive to any fund under-performing or not performing that well and then we tend to somewhere shift and get on to another best performer. And in the whole process, we end up losing a lot of our returns. This again has been cited by an Axis Mutual Fund study, which read data from 2003-2015 where equity mutual funds gave about 22% but investors only made about 15% CAGR. Likewise, a Motilal Oswal report that said from 2000 to 2020, the difference between returns that investors actually ended up making was lesser than the category returns in the large-cap funds. The difference was 15X, which is really high. So, it is about if these funds are not getting consistent performance, and it is also a lot to do with these phases of under-performance.
Gaurav, are you saying that even with slightly longer time frames these results stand true, maybe not to the exact decimal, but somewhere around that?
Rastogi: We did a three-year study where we said okay we’ll look at the best performer over the past three years, we will look at the best performers over the past five years and we will look at the best performers over the past five years where the returns are consistent so there is no one outlier here. And none of it actually merits a deeper dive and none of it shows that okay this is a setup that kind of predicts future returns because it does not. Effectively, I think what Prableen is saying is very true. There’s a word for it also, it is called the ‘behaviour gap’. The behaviour gap is literally the amount of money that investors leave on the table because they’re always chasing a best-performing fund. So, effectively what happens is you’re buying high and selling low. You go in, you buy a best-performing fund. Not all of the funds will do well, right? In our study it’s only 13% that have continued to do well, or 48% that have continued to do well. So, there is a 52% chance that your fund will actually underperform the average. Then you will be broken-hearted and you will be like I bought this because you know it was giving 30% returns for the last three years and now it only gave me 5% returns, this is a bad fund now. People talk in those terms, it becomes a ‘bad fund’ just because the returns are bad and it becomes a ‘good fund’ just because the returns are good. A good or bad fund is always relative to your existing portfolio, your goals and what do you want to achieve with that portfolio. But the whole investor mindset is so focused on that returns part, right? Now, this is not true just for mutual funds. Stocks do the same thing. A great stock becomes a bad stock if it’s down 60%. Overnight, it becomes a bad stock. I mean, what’s changed? It is the same business, the same people managing that company, but suddenly they say now it’s not a good stock anymore. This is the same thing that happens with asset class. Prableen made a great point, she said it’s not just an asset class, it is also people chasing entire asset classes with the same kind of expectations and I think the part that really kind of hurts the most is when those expectations are broken; and expectations will be broken. We know that, the data shows that, but by continuously doing this behaviour the investors are actually setting themselves up for disappointment.
Do you by any chance do a study on what happens to the worst-performing funds, and do they come up on the top the next year?
Rastogi: We did because persistence runs both ways and this is the reasoning behind it. Even if we can say with some convictions that avoid these kinds of funds, then at least we have narrowed the choice. So, if I can say something like we should avoid the bottom 20% of the funds, then instead of 100 funds you have 80 funds to look at. It would still be hard, but slightly easier, right? So, we look at the worst-performing funds and I think we did that as a five-year study. If you look at the five-year worst-performing fund, there is a 15% chance that the next year they will be the best-performing fund or would be in the top decile. It would move from the worst decile to the top decile. It’s a coin toss.
Prableen, why do any of the viewers need the show, need Gaurav, need Prableen or anybody else? I might just go throw a dart and pick a fund because it almost is as likely to be successful as a well-researched strategy, maybe?
Bajpai: I’ll just add something here because in the first question you had asked me what my experience from the investor returns was, what I’ve seen. So, a few of my clients who had very old portfolios, I was not even in business then, and they had just shown me or they moved with us and I was so surprised to know that a 13% CAGR, especially in markets in this year, or an 11% CAGR is pretty good. And I was so surprised to see the names of those funds because those themes are nowhere in top performers right now. So it’s interesting to see how the whole dynamic played out of the top performers because equity as an asset class is meant to move up in a non-linear manner. There’ll always be different sectors which are picked by fund managers, different portfolios across these schemes, and something will play out in a certain time period. To just this day, pharmaceuticals has been an underperformer but Covid has just made it like the hit of the year. So, there have been instances where we’ve seen the cyclical trends and that is how the whole pattern of these funds are. They underperform, they are better than the broader markets and the phases are there.
Also, I’m quite a believer of broader rules. So I feel that you have to take a top-down approach. You decide how much you want to put in which asset class. That’s the first thing because I think they spend way too much time deciding what is the timing of my market, entry and exit point, and which is the scheme. I think way too much time is spent on that. We don’t really spend much time on which asset class to buy. So once you’ve decided which asset class to buy, within that are which products or which instruments do you want to buy? So, if you say within equity. I am not going with direct stocks, I’m going with equity mutual funds. Within equity mutual funds you decide, I need a mid cap, I need a large cap, I need a multi cap whatever or an international fund. And broadly I think you can just always use these as filters but you don’t have to pick the top performer for sure. I feel it’s good to go with the middle order. That’s one of my rules.
Gaurav, if indeed the study shows that it’s almost like a coin toss, how does one go out and choose the right fund? Is it a method of what is apt for the portfolio? How does one forecast whether this fund that I’m choosing will give me X return which might be better than what the benchmark is giving? Is there a way to predict that or it’s almost impossible?
Rastogi: Predicting which fund is going to outperform is very hard. Funds have specific purposes and you have to understand very well why you’re buying into a fund; whether you’re buying into it for as a speculation or you’re buying into it as an investment.
Let’s assume, it’s an investment goal.
Rastogi: If it’s an investment goal, the simplistic way to think about all of this at least in my mind is this — do you have an edge to know better than everyone else that this pharma fund will do better? So, I think what people always conflate is, and especially in sector funds, that first they think that they can choose a better manager. Somehow they have this belief that I can select a better fund manager, which again the data doesn’t show that it is possible. Even when they do that, they will still want to override that decision by saying that I can now make a better sectoral or a better thematic bet. Why did you hire that fund manager in the first place then? Isn’t it the fund manager’s job to place these thematic and sectoral bets for you? So, from an end-investor’s perspective, the question boils down to this — how much time do you want to spend doing this? You want to spend nine hours doing this then you’re a professional investor, and then you might want to build an informational edge or you a behavioural edge where you’re doing things which are slightly different than the rest of us then be my guest, have a portfolio that has multiple fund options and churn it, but it’s based on some thought process. But if you’re not a professional management or a professional investor, then it’s always better to have a really simplistic portfolio that serves your needs and actually prevents you from these behavioural biases because they are they’re going to eat into your returns. So the numbers that Prableen said, there are based on Indian data—Axis Mutual Fund and all. It’s a 5% behaviour gap year-on-year. So, those are pretty powerful numbers.
Maybe it is behavioural bias or maybe not, but do the returns and do the talk of how global markets are doing so well are leading people to invest into international funds? Is that the right strategy and even if it is, are people approaching that in the right fashion? Prableen, you have some thoughts here and are you suggesting this to your clients?
Bajpai: I think if we see the current inflows into international funds we all would just conclude that it’s because of the markets doing better than the Indian markets. So I went back and I saw how in different time periods NFOs were launched in India. So we had the first NFO in 2004, then we had a lot of NFOs in 2007-08, and then it was the global crisis in 2008-09, then we had a few of them in 2011-2012 and 2014. Till then we had lot of these. The maximum number of funds were launched till 2014. In 2015, we just had one NFO, and in 2016 and 2017 we didn’t have any NFOs in the space as far as my information goes. In 2018, either in October or November, Motilal Oswal came up with an FOF for the Nasdaq 100 ETF. Then in 2019, one fund from again a bigger fund house, ICICI, had a global advantage fund, and in 2020 we saw two NFOs in this space.
Now if we look at the inflows, the net inflows into this segment, what does that tell us? I went through the data for 2017, 2018, 2019 and 2020 — the net monthly inflows. So, 2017 onwards, it was people moving out of this space month-on-month, there was a negative figure — starting February 2017 till about April 2018. From May 2018 onwards, the figures were in positive, low figures, and we saw better inflows. There were continuously positive inflows from May 2018 to 2019 and 2020. So it would be wrong to conclude that it’s just 2020. Of course the figures have become slightly more robust during this year, but I think it has also a lot to do with this kind of information and awareness. Not every person is aware about geographical diversification and investing internationally. When these NFOs are launched which we’ve seen in this year and then last year and there is a lot of awareness created by the AMCs around these products. You call them on your shows, there is so much information in print media and these things are discussed. And I think that is one very important point which probably has occurred to a lot of investors who actually feel that okay we haven’t done that till now, we haven’t added an international fund till now and now I would like to believe that they are able to understand the merit of adding an international fund or diversifying geographically and not just based on past returns but are wanting to do it. And that is why we’ve seen good numbers, good inflows. It is really miniscule when you compare with the broader markets. Also, I think Parag Parikh is been really talked about but it’s not an FOF, it is just investing primarily in India. When such funds are also discussed; how is it that Parag Parikh was holding up when all the other Indian equity funds were giving returns in negative. Because it has a part of its allocation to the U.S. and other markets. So, I’m just hoping that now investors who are entering are coming with the mindset that it is for geographical diversification because whether it is Indian equities or U.S. equities or any other markets, the ground rules don’t change.
To high net worth individuals who’ve been around in equity markets and are investing in funds for a long time, a geographical diversification is probably a must do. But for people who are new in this game or people who do not have a very large investment portfolio in funds in any which way, should they start diversifying into global funds from the word go or is it something that you advise should happen after a bit of a lag, after testing the waters and after building some corpus size?
Bajpai: I feel that if you’re coming to even the Indian equity markets, you have to understand the very nature of how equities work. It will always be a non-linear growth... you’re okay with giving a small allocation of your overall portfolio to an international fund even right from the beginning till the time you don’t consider that is totally an insulated part of your portfolio and will never go down or things like that. The basic element remains the same that volatility will be there, it’s equity—the basic nature will not change be it any market.
Gaurav, what’s your experience been at Kuvera. Has the influx of money to your platform into international funds of various geographies really gone up and do you reckon as a behavioural aspect or otherwise that it’s a good thing to do?
Rastogi: Is it a good thing to do? So, I totally agree with what Prableen said is that having international diversification is important. It is a currency hedge. As I think as the country becomes more affluent there will be a lot of people who would want to send their kids for education abroad or for vacations abroad. So, having some of those expenses already being planned for in that currency is not bad.
India is about 3% of MSCI global. So as an Indian investor just because you happen to be born in India for you to have 100% exposure to equity doesn’t make any sense. The question that comes is that what’s happening now? Is this a serious asset allocation play where people are understanding these concepts, people are understanding that there is a diversification benefit or is this something which is purely driven by hey Nasdaq is up by 30-70, 80% whatever it is in the past six to nine months and the truth lies somewhere in the middle. I think there are investors who are realising that there are benefits of international diversification, as Prableen rightly mentioned there are now also tools available. There are low-cost mutual funds, there are direct equity platforms which are also low cost that allow you to do that. So even if you have a small portfolio you can easily have a 10-15% allocation to international equity just by buying that fund of funds or buying that ETF or buying that direct investment fund, and people are getting it.
But is it fair to say that that’s all that is happening? So, we disagree a little bit because some of the behaviour we see on our platform, I mean we have seen flows since we started because our recommended portfolio, starting from 2017, had a 13% allocation to an international fund. But what has changed is in the past two months or so, the top five most watched listed funds; funds that most people are putting into their watch list, that watch list rarely ever had an international fund. In the past three months or in the past two months to be more exact, at least three of those five funds tend to be international. So in a way, discoverability goes up. Even people talk more about sectors and funds that are doing well. Forget returns, right? Say I am totally oblivious to returns, but I have to still make a decision, so if I hear international again and again, if I read about international and even if I don’t know the returns I’ll be like, what is this international fund? Everyone’s talking about it let me go and check. Then I go and check on a site like ours or someone else’s and I’m like the returns are so amazing. Now, suddenly what happens is they are not two different pieces of information you bought but the way you will process it as an individual, is as two different pieces of information. I heard about the fund, and then I found out the fund also gave good returns but it is possible that you heard about the fund just because it gave good returns. I think both of it is happening. It’s only in hindsight that we can be absolutely sure that people are doing it for the proper reasons and for proper asset allocation. But as an asset allocation play we think you should always have something invested abroad—whether through Indian mutual funds or direct equity, that’s your choice.
Prableen, we don’t usually ask about fund recommendations but I’m still just wanting to ask you. You mentioned a fund which is an Indian fund but investing directly into global equities and there are examples of funds which are also fund of funds essentially just mirroring a global index. Are you suggesting both kind of funds to people or are you doing a mix of both?
Bajpai: Within this space, we have varieties. So FOF where you just buy another fund or you buy an ETF which is tracking broader indices and we’ve got different markets as well—we’ve got funds in India which can give you exposure to Brazil, they can give you exposure to China, they can give you exposure to the U.S. and they can even give you a broader exposure to emerging markets. So, I feel if somebody has to choose a fund for himself or herself, the first thing is to know what you are going to do. So let’s say if I’m looking to invest abroad and I have to pick between Brazil, China and America—me and a lot of other people would not even know what is the exchange rate between the currency of Brazil and India. One Brazilian currency is actually about Rs 13 in India. Likewise, a lot of people would not even know the name of the President or the Prime Minister of Brazil. So first of all I think the market that you want to invest in, you kind of need to be aware. So, if I have to put my money, I would go with the U.S. because I think we track those markets way more. The companies which we know will be investing into we’re actually using their products, whether it is Apple, we use an iPhone or whether it is Netflix and other products. Secondly, I think American markets are very transparent, the governance standards and regulatory standards for their companies are pretty good, they are robust and of course it’s one-fourth of the total economy, it is 50% of the global market cap. If I have to invest in U.S., if I’m a beginner then I would just move in for a low expense fund which is probably an FOF into a broader index there like S&P 500, or Nasdaq 100. Nasdaq 100 is up 30%, Nasdaq Composite is up about 25%, S&P 500 just about yesterday I think it was at its all-time high and it’s still just about 5% year-to-date because of the different compositions overweight or technology in some.