Past performance is a misleading indicator of future returns

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For many investors, the easiest way to select a mutual fund scheme for investment is to look at its historical returns. Many investors and their advisers use past returns to extrapolate the future performance. Even popular star rating websites give much higher weight-age to past performance for mutual funds rankings. However, this strategy is fraught with danger due to its misleading interpretation.

Historical returns should not be seen in isolation but in the context of the underlying risk taken and other market factors. In isolation, past performance is a misleading indicator of future returns. Changes in market dynamics, macroeconomic variables or management could change future performance that is significantly different from the past performance.

In this article, we discuss the futility of giving too much importance to past performance and also talk about the important parameters to keep in mind while selecting mutual fund schemes for investments.

Past Returns can seduce you to jump a cliff

It is no wonder that more than 80% of investment inflows come close to and the peak of an equity market. Seduced by past returns which appear fantastic on the back of the lower base, many gullible investors jump the bandwagon assuming the party will last forever. Consequently, a majority of these investors face major disappointment when the cycle naturally moves from peak to turf.

Similarly, many take out money when equity markets crash, spooked by anticipation of further fall. This goes against the simple logic of buying low and selling high. Yet many investors time and again since ages shun this basic logic due to emotions of greed and fear influenced by past returns.

This phenomenon is visible in debt mutual funds as well. Rising market interest rates produce poor mark to market returns on historical basis without impacting the returns locked in at the time of investments over the period of holding. Instead of benefiting from the higher interest rates in the market, investors get worried about past returns in the short term and fail to take advantage of a better yield scenario for future returns.

Complacency is not good

One of the biggest enemies of investment returns is complacency or status quo bias. Captivated by the past returns, many investors do not prepare for the future scenario. Markets are highly dynamic in nature and portfolio positioning or asset allocation plays a major role in future returns.

Something that has done well in past is no guarantee that it will do well in future too. It is important to know why something has done well in the past. What were the key factors responsible for the past performance? And if the same factors that resulted in good returns in the past are relevant for the future? 

The process is more important than the outcome:

Past performance of a mutual fund scheme is a function of underlying risk taken by a fund manager and themes that became the flavor of the market, sometimes by chance. Some fund managers like to invest in high beta portfolios which give superior returns in a bull market but significantly underperform in a bear market.

Some fund managers strength lies in value investment strategy, some follow growth and some mix of the both. In a rising market, growth strategy gives superior returns while defensive/value based strategy outperforms in a bear market.

An investment made in hot & popular themes by looking at the past returns close to the peak could produce disastrous returns in the future.

Some classic examples are Investment in:

1.      Tech stocks in 1999-2000
2.      Infrastructure stocks in 2007-2008
3.      Pharma stocks in 2014-2015

All these sectors were the flavor of the market with an exemplary past returns record before they peaked in the mentioned periods. However, any investments done in these sectors by looking at their past returns gave highly disappointing long-term returns to the hopeful but misguided investors.

The investment process followed by a mutual fund house and the fund manager plays a much higher role in relative portfolio performance. Change in the fund manager or investment philosophy of the fund house could also change the course of future returns.

Source: IDFC Mutual Fund

A qualified comparison of past returns:

Therefore, it becomes clear that past returns should be understood in the context of economic scenario, investment philosophy & style of the fund manager and risk parameters. After thoroughly understanding the background for the past returns and analyzing the future economic prospects, experienced and qualified advisers with no conflict of interest can filter out certain schemes for apple to apple comparison.

The past returns are then helpful in identifying consistent performers during a bull and bear market. It can also help in identifying schemes that executed well with a given investment strategy/objective in a particular market scenario. Compounded average past returns could again be misleading as one year of good performance could optically hide poor performance in other years. Therefore, one should look into year on year returns across the market cycle.

In the end, we would like to re-iterate that the bottom-line for any investment success lies in investing in the prices which are lower than the intrinsic value of an asset. This generally happens in the themes which have fallen out of market liking and thus have poor past track record. Contrarian investing may underperform in the short term but pays rich dividends in the long term.

Read: How conflict of interest ruins your investment returns?

Truemind Capital is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at connect@truemindcapital.com or call us on 9999505324.