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Do not invest in last Year’s Top Performing MF’s! Here’s Why!

One of the criteria based on which many investors pick their investment schemes is past performance. In this article, we will discuss why you should not invest in last year’s top-performing MFs.
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Whenever a mutual fund scheme displays its performance in terms of returns given in the past, it will always display the message: “Past performance is no guarantee of future results”. In spite of this message, one of the criteria based on which many investors pick their investment schemes is past performance. Many investors choose last year’s top-performing mutual fund schemes. In this article, we will discuss why you should not invest in last year’s top-performing MFs. 

Winners keep rotating

If you study the history of investments, you will notice that winners keep rotating at various levels:

  1. Winners rotate among asset classes: Different asset classes like domestic equity, international equity, fixed income, gold, etc., outperform in different years. You will observe that in most years, a different asset class will be an outperformer.
  2. Winners rotate among the same asset class: Within the same asset class also, winners rotate. For example, in domestic equity, you will see that large-cap, mid-cap, and small-cap indices will take turns to outperform each year. Accordingly, mutual fund schemes investing in large-cap, mid-cap, and small-cap stocks will take turns to outperform each year.
  3. Winners rotate among sectors: Even sectors like banking, IT, pharma, etc., will take turns to outperform each year. Accordingly, sectoral mutual fund schemes investing in these sectors will take turns to outperform each year.

While the winners will keep rotating, even the fund manager will not know whether large-caps, mid-caps, or small-caps will outperform next year. Even the fund manager will not know which sector (banking, IT, pharma, etc.) will outperform next year. Due to this reason, you will observe that it is difficult for a particular mutual fund scheme to consistently appear in the top-performing mutual fund schemes year after year. Hence, mutual fund schemes always display the disclaimer: "Past performance is no guarantee of future results".

Performance of top 3 mutual fund schemes from 2011 to 2020

A study was done to check the consistency of the top 3 mutual fund schemes from 2011 to 2020. The mutual fund categories selected were large-cap, large and mid-cap, multi-cap, and ELSS. Only those mutual fund schemes with Assets Under Management (AUM) of minimum Rs. 500 crores and at least ten years of performance history were selected.

Based on the above criteria, the top 3 mutual fund schemes in 2011 were:

  1. SBI Focused Equity Fund
  2. Canara Robeco Bluechip Equity Fund
  3. Axis Long Term Equity Fund

Following was the performance of these three funds in the next nine years (2012-2020):

  1. SBI Focused Equity Fund: It was ranked number one in 2011. The fund ranked the top-performing fund in the next year (2012) also. After that, for the next 8 years (2013-2020), the fund did not appear in the top 3 funds in any of these years.
  2. Canara Robeco Bluechip Equity Fund: It ranked number two in 2011. After that, for six years (2012-2017), the fund did not appear in the top 3 funds in any of these years. It ranked number three in 2018. After that, in 2019 and 2020, it did not appear in the top 3 funds.
  3. Axis Long Term Equity Fund: It ranked number three in 2011. After that, in 2013, the fund ranked number one. For the next seven years (2014-2020), the fund did not rank in the top 3 funds in any of these years.

As seen in the above table, 

  1. Canara Robeco Emerging Equities Fund is the only fund that has ranked in the top 3 funds for 5 times in the 10 year period (2011-2020). 
  2. Apart from the above fund, no fund has ranked in the top 3 funds for more than 3 times in the 10 year period (2011-2020)
  3. Out of the 17 mutual fund schemes, 9 of them could rank among the top 3 funds only once in the 10 year period (2011-2020)

The above study shows there is no consistency of top performance among mutual fund schemes. The only exception was Canara Robeco Emerging Equities Fund, which ranked in the top 3 funds for 5 times in the 10 year period.

This is why you should not chase top mutual fund schemes. You should not invest in the previous year’s top-performing mutual fund schemes.

Reshuffling your fund portfolio every year has cost and tax implications

If you observe the above study, you will see that during the 10 year period (2011-2020), there were only two instances when the same fund was ranked number one in back to back years:

  1. SBI Focused Equity was the number one performer in 2011 and 2012
  2. Axis Bluechip Fund was the top performer in 2018 and 2019

So, suppose you followed the investment strategy of chasing top-performing mutual fund schemes every year. In that case, there is a very high probability that you will have to shuffle your fund portfolio every year. Shuffling your fund portfolio every year has various implications such as:

  1. Cost implications: Portfolio shuffling is a time and effort-consuming activity and comes at a cost. You will have to spend time and effort researching the top-performing mutual fund schemes every year. You will then have to redeem the existing schemes and re-invest the redemption proceeds in the new schemes. The redemption process may involve exit loads.
  2. Tax implications: Frequent portfolio shuffling will have tax implications. If you sell your equity schemes before one year, you will have to pay short-term capital gains tax.

Considering the above cost and tax implications, it is not advisable to chase top-performing mutual fund schemes every year. So, what should you do then?

Identify mutual fund schemes that can help you fulfill your financial goals

While investing in mutual fund schemes to achieve your financial goals, you will be having an expected rate of return in mind. Accordingly, you should look at schemes that consistently match or give higher returns than your expected rate of return. As long as the funds in your portfolio are giving returns higher than your expected rate of return, you will be able to achieve your financial goals. And, as long as you are able to achieve your financial goals, you need not chase the top-performing mutual fund schemes every year.

Look at the consistency of performance rather than just last year’s performance

While selecting a mutual fund scheme, you should look at the consistency of performance rather than just last year’s performance. Look at the compounded annual growth rate (CAGR) of the last 3 years or 5 years and compare that with your expected rate of return. If the CAGR is higher than your expected rate of return, you may consider that fund.

You should consider mutual fund schemes that have been in existence for a long time, say ten years or more. If the fund has existed for that long, it has gone through one full economic cycle of boom and bust. You should check how the fund performed during an economic down-cycle and whether it could keep its losses lower than its benchmark and the overall market. You should look at how consistent the fund's performance was during the entire economic cycle.

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