The Mutual Fund Show: This Method Helps Investors To Prepare For Future
Past returns can’t predict the future for mutual fund investors, according to Sunil Subramaniam, managing director and chief executive officer at Sundaram Mutual Fund.
Mutual fund schemes provide data on returns for different time periods like one, three, five years, etc, but these point-to-point returns aren’t very useful as they can’t predict the future and don’t address the issue of market volatility, Subramaniam said in BloombergQuint’s weekly series The Mutual Fund Show.
“If you want to use the past performance, use rolling returns. This will give a reasonable estimate of future and will help investors to prepare for the worst- and best-case scenarios,” he said.
Rolling returns, according to Subramaniam, consider a series of returns over a long period of time and then take an average to see how the fund has performed. It also helps investors to choose the right asset allocation based on the time horizon for investment and risk appetite, he said. “It’s a ‘bullet proof’ method.”
Harshvardhan Roongta, principal-financial planner at Roongta Securities, agreed. Investors, he said, can have an idea of the probability of losing or making money and evaluate the consistency of a fund. It’s qualitative data, provided the investor has the know how of how to compile and calculate the data, he added.
Watch the full interaction here:
Here are the edited excerpts from the conversation:
What is rolling returns and why shouldn’t I just stick to returns of what a particular mutual fund has done for 1-5 years?
Sunil Subramaniam: Most investors are aware that equity markets are risk-reward mechanism. They take risks to deliver reward. The basic cyclicality of economics brings risk to markets and the markets which follow. Investors when they look at past 1-5 years, they are using that to say that the next one year and the next three years will be the repeat of the last. So, they pick the best fund of last three years. Why it is that the fund which have done very well in last three years is not the best? It is not that the fund manager suddenly becomes inefficient. It is because the stock picking they have done in past; the same thing cannot continue in future. So, how do you then use it? This is a flawed mechanism because cyclicality means that past is not the predictor of the future.
That’s where the rolling returns methodology comes into picture. Let us say that you have to test it for 15-year period and you have to test three-year returns over that period. So, on April 1, 2003 you made a three-year investment. It will mature of March 31, 2006. Assume that you have made a three-year investment on April 2, 2003. It will mature one day later. You made one on investment on the third day, so you do this over a period of time, then you will get 4,000-5,000 three-year periods in that 15 year. That 5,000 periods give you a large sample size where the average can be reliable.
In this probability of 15-year time frame, you will see a bull and bear market. So you will know what investments exited a bear market in three years and in bull market made solid returns. You can also see the minimum return which is the worst loss you would have experienced. Also, if you have got the timing right, it could be the best return you would have ever got.
If you have this set of data points, then you will show you 2-3 things. If you see the Sensex, it is stunning for you to know that if you are blind about it, you need a period of 7 years in investment on the Sensex to be assured of not losing money. In 7 years, the worst possible return is 1.5 percent, which means you never lost your capital. There are different investors with different risk appetite. While people are attracted by the rewards of equity many are not willing to take the risk of equity. I am not saying equity market is a no-no. But stretch your time frame in such a period that you don’t have a risk of loss. This is the first help of rolling-return methodology based on investors risk appetite. Whereas in one year, 20 percent of time the Sensex lost your money. Somebody is willing to take high risk and you get 110 percent return in best of times. Tuning yourself to your risk methodology, you can time your investment using rolling return methodology.
Lets assume I am investing in a large-cap fund and rolling-return analysis of that fund suggests that the breakeven point for that fund, wherein I will not make a loss, is about seven years. If I am investing in the fund, I will go with mindset that let me invest for at least seven years because then my capital is protected. Is that the way you approach?
Sunil Subramaniam: Absolutely. You can do this for funds, too. You will find that equity market mutual funds have protected capital over five years which tells that they do better than the index. This could also be the way of evaluating funds to see at what point do they protect capital. It is important to understand your own risk-taking capacity. So, in a way the maximum-minimum and average can be equated to optimistic and pessimistic individual and somebody who is more realistic saying that at an average I will get this but there will be other way.
The key element here is that the past performance is used to predict future. If you want to use the past performance, use the rolling returns past performance which will give you the reasonable estimate of future and will help you to prepare yourself for worst- and best-case scenarios. When you do goal-based investment, when your goal is reached, you get out. You may choose seven-year investment, but your goal was to triple your money. If you reach in five years, this tells you to take it out. The beauty of this analysis is that manages expectations, it’s a more reliable predictor of future and it is a probabilistic tool.
How do I as a retail investor get this data?
Sunil Subramaniam: Most advisors have access to Value research, MoneyControl, NAV India, you get any data points of market or fund. All you need is to go and pick up daily points of Sensex, if you are doing it for Sensex, put in excel sheet, it is like a daily SIP. If you do a one-year investment, it is like you are doing every day. So, it is like a daily SIP.
An advisor would give you the capacity to do this for multiple funds. If the going is good he will maximise the returns most. So, you can play around with the numbers from an advisor’s perspective. You should challenge your advisor and say show me the rolling-return performance, and while you are choosing X fund over Y, is the rolling-return of this fund better than the other one. Then when you go with the choice take a print out and keep it with you, so that at the end of three years you see whether it helped or not. Half the battle is won with preparedness for the outcome.
Have these parameters worked very well across fund sizes and time frames?
Sunil Subramaniam: Even high-risk funds like mid- and small-cap funds over five years have always protected capital. We make most of our investment with a five-year outlook of the stock. So, it is fed into the fund management and into the result. When you buy a stock with a five-year outlook, the volatility in stocks, EPS, price, etc, you keep a level ahead and make your long-term goal because of the assessment and it shows that fund manager’s assessment of five-year performance has turned out to be correct. Otherwise, it could have never protected the capital. It has a very close link. It is something we use all the time in terms of assessing.
There are people who could have already invested in market. In last one year, the mid cap has shown a negative return. If you are invested in mid-cap fund one year back and now you are sitting on a negative return, you will be worried. If I told you for five years, the fund has particular capital, this gives you comfort independent of the past one-year negative return, you are waiting for four more years and you are assured of not losing your capital. It is not that for fresh investment you need to do rolling return. If your return is very high and you look at the average return and you say you will revert to that mean, then you can also decide how long you have to stay invested. It is a very powerful tool. If this is used more often by the investors and advisors, then it will make up for the whole disappointment with equity performance, it will make them say this is the time frame I will wait. Second, they know that in one year this was the probability of return and they are prepared for the outcome. The overall milieu of stock market investing will be much healthier if this is adopted by larger number of constituents.
Do you think that the rolling-return concept will in a period of time will take the shape and form?
Harshvardhan Roongta: If you see the benefits of rolling returns, there is merit in it and there is no question about it. The hard part is we don’t have the data accessible. If you get a trailing return data point from the fund house, it is available as aggregate on website and online medium. If you could have a rolling-return data readily available, then you can do a lot of work around it. One is that you can know what probability is of losing money or making money in equities over a period of time. You can also evaluate the consistency of fund performance, of what is the consistency of giving specific returns in time frame. It is a very good qualitative data. The only issue is where do you get it from. If you want to sit down and get this fair enough, you will see you can do it if you wish to. Just that there are so many data points and comparisons that you want to do which becomes difficult to sit down and do it yourself.