FundsIndia Strategy: Past returns and how much to rely on it

July 28, 2015 . Vidya Bala

‘Past returns are not indicative of future performance’ goes the disclaimer. So, why do we rely on past performance?

For most of you, past returns psychologically influence your return expectations for the future. And when that does not happen, there is disappointment that sometimes leads to the dumping of an asset class (like equity funds).

How most investors view past returns

Here’s how past returns are typically used to choose a fund:
– To pick a fund that has given high returns among peers, typically in the recent past, say 1 year
– To hope that the fund will continue to deliver similar returns in the future as well

If the above did indeed play out, and your call works, then there would be no need to review a fund. You could pick a fund sorting it as ‘largest to smallest in returns’ in your Excel sheet and hold it forever! We wish choosing a fund were that easy!

A fund’s past returns could be based on:
– market conditions
– its portfolio of stocks
– the strategy adopted by the fund
– the skill sets of the fund manager, and
– the fund house

It is an amalgam of a number of macro and micro parameters playing out.

A fund that delivered superlative returns in an upmarket may not be well placed to contain declines in a down market. A fund that went overweight on a sector and did not cut exposure on time may suffer when that sector goes out of favour. Hence, to go on the basis of past returns to set your return expectations would not be the most prudent thing to do.

But then, some of you ask us – “If stock price forecasts can be made, why not forecast fund returns?” Well, the answer is simple:

  • One, a stock has an underlying fundamental and it is not too tough to gauge its performance (other external factors remaining the same). For example, if a company increased its production from say 10,000 units to 20,000 units, you know the impact on its revenue and earnings. If a company increases or reduces its debt, you know the impact on its net profit. That is – the underlying fundamental can be measured or reasonably forecasted. However, an equity mutual fund is a basket of stocks. Yes, the basket’s fundamentals can be gauged (like an ‘index’ – which is a basket of stocks). But how does one know what stocks continue to remain in the portfolio, what is removed, and what is added?

As analysts and as investors, we all have access to a fund’s portfolio at the end of the month. There could be many changes in between, and there could be changes post when we see. To this extent, the dynamic nature of a fund’s portfolio makes it tough for anybody to forecast future returns.

  • Two, and more importantly, the regulator does not permit any such forecasts. The case rests here.

How you need to view past returns

But yes, at research, we most certainly use past returns to assess the quality of a fund. Yes, to assess a fund’s quality , and not to forecast a fund’s future performance.

Take a sports person – a tennis player, for instance. A person may have a record of matches won and lost, and may be top seeded or top ranked. But that is not all.

Dig into numbers and you will see that their winning streak (or losing streak) has a story to tell: whether their strengths lie in clay, grass or synthetic courts; how many sets they’ve won; in how many sets were they broken; how many first serves they got right; how many aces they have to their credit; how many games did they lose; are they serve and volley players; and, what was their success with that style, and so on. The data can be endless.

This is exactly the kind of data and analysis we like to dig up from a fund’s past performance. We try and understand its style, its strategy, its strengths and weaknesses across market phases, its consistency, its volatility, and of course, how all of these finally helped the fund deliver returns superior to the market. We see this in relation to the market, and in relation to peers.

The returns that the fund generated could have been double digits in a good market, and even negative in a down market. That is a fallout of the market’s broad performance. How the fund did in favourable and adverse conditions in relation to its universe is what past data helps us gauge.

From there on, we try to understand where and how these funds fit in. Some funds are good for down markets, some do well in rallies but take a beating in falls, and then there are a few others that remain all-weather friendly. Once we understand this, we try to provide you with a suitable combination of funds that will fit your requirement based on the fund’s performance in various parameters.

Hence, past data is used by us to derive the ‘quantitative metrics’ that help assess a fund’s performance.

So, how do we know the future potential of the fund? This is where ‘qualitative factors’, i.e., the quality of the portfolio comes into the picture.

Given a set of market conditions (bull market, bear market, volatile market, a growth focused market, a defensive market, and so on), we look at how well a portfolio is placed to generate returns. Not only that, we also look at how well a fund is able to take advantage of macro events to position its portfolio.

For instance, what sort of sectors or stocks could benefit if the Iran nuclear deal goes through? It could be those that use crude directly as an input (oil marketing companies), or those that use crude as a raw material.

Let’s take another example. It is now clear that the rural consumption story has slowed. So does that mean a fund with high weight to consumer goods is wrong, or is it doing something contrarian? What if the urban consumption story receives a boost from the 7th pay commission hikes to be announced in early 2016? What sort of a consumption revival can it cause, and which segments of consumption are best placed to benefit from it? Is a fund able to see the early beneficiaries and take positions early on? Yes, this information needs plenty of reading and research, and also discussions with fund managers on their calls.

These help us understand the potential a portfolio holds. The market returns forecasted by analysts based on market valuations, together with the kind of alpha generation that a good portfolio can deliver, is what finally determines a fund’s returns. There is no one-shot formula for this, and it is best to not over-predict or forecast.

As an investor, it would suffice for you to know the long-term returns that equity, as an asset class, has delivered in the near past (5-10 years). To this, a 3-5 percentage point expectation is a fair one to assume for a fund to generate. Anything more, certainly reflects superior fund management, and of course, your own fund choice.

Bottom line? Don’t ride on past returns. Ride on ‘performance’. Performance speaks when it builds your wealth; not when it breaks the charts in a single year. Rest assured, we try our best to go with this philosophy.

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