THE MYTH OF THE BEST PERFORMING FUND

Imagine choosing a car based solely on the fact that it was the fastest on one particular stretch of road. But what happens when the road changes? A car that performs exceptionally well on a smooth racetrack may not necessarily perform best on rough terrain, steep hills or wet roads.

Or imagine a batsman who has scored centuries in three consecutive matches. Would you confidently assume that he will score another century in his next innings? Probably not. One should not. Every match brings different conditions, opponents and challenges.

Yet, when it comes to Mutual Funds, investors often make a similar assumption. A fund that has delivered exceptional returns in recent years attracts attention, receives high ratings and often sees a surge in investments. However, historical data suggests that predicting future winners based solely on past performance is far more challenging than it appears.

UNDERSTANDING PERFORMANCE CHASING

Investors often look at a mutual fund's recent performance before deciding where to invest. A fund that has delivered exceptionally high returns, earned a high rating or secured a top position in the rankings can naturally appear more attractive than its peers. However, making investment decisions solely on the basis of such recent success is known as Performance Chasing.

In simple terms, performance chasing occurs when investors choose, invest in or switch to a mutual fund primarily because of its recent returns, ratings or rankings. This often leads to decisions based on thoughts such as (gathered):

• “This fund delivered a 50% return last year, so it must be an excellent investment.”
• “It has a five-star rating, so it seems like a safe choice.”
• “It is currently among the top-performing funds, so it will continually perform well.”
• “Fund B performed better than Fund A last year, so I should switch my investment.”

The key issue with this approach is that it relies heavily on “Past Performance”. While historical returns can offer valuable insights into a fund's journey and investment strategy, they cannot reliably predict its future performance. Market conditions change, investment cycles evolve and yesterday's top-performing fund may not necessarily remain at the top tomorrow.

past performance is not indicative of future results

WHY DO TODAY'S WINNERS OFTEN CHANGE?

One of the most important characteristics of financial markets is that leadership changes over time. A particular category or investment style may perform exceptionally well during one market phase and significantly underperform during another.

For instance, small- and mid-cap strategies dominated performance tables during certain periods, but subsequent market corrections dramatically changed their rankings. Similarly, funds that were among the top performers in one year often slipped into middle or lower rankings over the following years.

This happens because markets, investment categories and styles move in cycles. Different market conditions favour different types of investments. Growth, value, quality and momentum strategies may each outperform at different points in time. Therefore, a fund's strong performance may sometimes reflect favourable market conditions rather than a consistently superior ability to outperform.

DOES LOOKING AT LONGER-TERM PERFORMANCE SOLVE THE PROBLEM?

Many investors may believe that one-year returns are too short a period for evaluating a fund and that three-year performance offers a more reliable indicator. However, scouring various data presented in various studies suggest that even this approach has limitations.

A market analysis (sourced) tracked funds that were in the top 25% based on their three-year returns and then examined whether they remained in the top quartile during the following year. The results showed that:

• Of the top performers during 2014–2017, only 12.5% remained in the top quartile in 2018.
• Of the top performers during 2015–2018, only 8.3% remained in the top quartile in 2019.
• Of the top performers during 2018–2021, only 11.1% remained in the top quartile in 2022.

These findings suggest that simply extending the period used to measure past performance does not necessarily make future performance easier to predict.

EVEN WITHIN THE SAME CATEGORY, WINNERS ROTATE

The tendency for winners to change is not limited to different market-cap categories. Significant variations can exist even among funds within the same category.

Let us take the example of mid-cap funds in 2024 (sourced). The best-performing fund generated a return of approximately 56.7%, while the worst-performing fund delivered around 11.2%, compared with a category average of approximately 28.8%. This substantial difference demonstrates that belonging to the same category does not mean that all funds will behave in the same manner.

One important reason for this variation is investment style. A fund may have a greater exposure to growth-oriented, value-oriented, quality-focused or momentum-driven investments. When a particular style is favoured by market conditions, funds with greater exposure to that style may outperform their peers.

when market conditions change, the leadership can change as well.

THE IMPORTANCE OF UNDERSTANDING INVESTMENT STYLE

A fund's performance is influenced not only by the category in which it invests but also by the investment style it follows. For instance, within a large-cap, mid-cap or small-cap category, different funds may have different approaches like:

• Growth-oriented funds focus on companies expected to deliver strong future growth.
• Value-oriented funds seek stocks that appear relatively inexpensive compared with their fundamentals.
• Quality-focused strategies favour financially strong companies with characteristics such as higher profitability, lower leverage and stable earnings.
• Momentum strategies focus on securities that have demonstrated strong recent performance.

Different styles perform well under different market conditions. At times, growth investing may lead the market. During other periods, value or quality strategies may outperform.

Therefore, selecting a fund solely because it has recently delivered the best returns may also mean unknowingly selecting a particular investment style that may not be favoured during the next market cycle.

A BETTER APPROACH: TWO-DIMENSIONAL DIVERSIFICATION

Instead of attempting to identify the single “best-performing fund,” investors may benefit from building portfolios that are designed to withstand different market conditions.

1. Diversification Across Categories

Investors can diversify their portfolio across different market-cap categories and fund types, such as:

Market-Cap Categories

• Large-Cap Funds
• Mid-Cap Funds
• Small-Cap Funds
• Multi-Cap Funds
• Flexi-Cap Funds

Other Equity Fund Types

• Large & Mid-Cap Funds
• Focused Funds
• Value Funds
• Contra Funds
• Dividend Yield Funds
• ELSS Funds
• Sectoral Funds
• Thematic Funds

Debt Fund Types

• Overnight Funds
• Liquid Funds
• Ultra-Short Duration Funds
• Low Duration Funds
• Money Market Funds
• Short Duration Funds
• Medium Duration Funds
• Medium-to-Long Duration Funds
• Long Duration Funds
• Dynamic Bond Funds
• Corporate Bond Funds
• Credit Risk Funds
• Banking and PSU Funds
• Gilt Funds
• Gilt Funds with 10-Year Constant Duration
• Floater Funds

Hybrid Fund Types

• Conservative Hybrid Funds
• Balanced Hybrid Funds
• Aggressive Hybrid Funds
• Dynamic Asset Allocation / Balanced Advantage Funds
• Multi-Asset Allocation Funds
• Arbitrage Funds
• Equity Savings Funds

Other Categories

• Index Funds
• Exchange-Traded Funds (ETFs)
• Fund of Funds (FoFs)
• Retirement Funds
• Children's Funds

2. Diversification Across Investment Styles

An investment style reflects the approach a fund follows while selecting investments based on factors such as risk, market capitalisation, and growth or value preferences. Diversification, therefore, need not stop at the category level, as funds within the same category can follow significantly different investment styles.

Risk Tolerance also plays an important role in determining an investor's preferred investment approach, ranging from conservative to aggressive. At Investaffairs, our personal finance experts assess “Risk Profile” (regular risk assessments) to understand an investor’s risk-taking capacity and align investment recommendations or their investment goals accordingly.

Our experts also conduct a thorough research and use tools such as Morningstar et al to understand the characteristics and investment style of a fund before recommending it. Understanding a fund's investment style helps investors set realistic expectations regarding risk and potential performance and align their investments with their financial goals.

For example, an investor holding only one large-cap fund is effectively making two assumptions:

1. The large-cap category will perform well.
2. The particular investment style of that fund will also perform well.

This creates a “double bet”. Diversifying across appropriate investment styles may reduce an investor's dependence on correctly predicting which style will perform best in the next market cycle.

The Key Takeaway

Instead of chasing the latest top performer, evaluate performance over time, consider more than just returns, understand the investment strategy, maintain diversification, and tailor your portfolio to your financial goals and risk tolerance. At Investaffairs, our experts always reiterate that it is wiser to construct a portfolio that is prepared for the fact that market leadership will inevitably change. Aim to build a resilient portfolio for market leadership changes, not just chase winners. Remember, past performance doesn't dictate future results.