‘The past performance of the mutual funds is not necessarily indicative of the future performance of the schemes.’ The very famous disclaimer often confuses investors who only check for past returns of a fund before investing. The disclaimer clearly states that past performance may not sustain in future. However, that doesn’t mean historic returns do not hold value in investment decisions. Did you know past returns give us noteworthy information about the fund’s performance? But, if these returns cannot tell us how much returns a fund will generate, what else do these returns tell us about?
In this blog, we will understand the past returns of mutual funds in detail.
What does the Past performance of Mutual Funds tell us?
Past performance of the mutual funds sheds light on the ability of a fund to deliver returns. For instance, if a fund has delivered an annualised return of 7%, it shows that the fund has the potential to generate 7% in a year, but it does not promise you that this return will be sustained. Consider the scenario of a company called XYZ Technologies, looking to acquire another business. In this process XYZ tech. conducts extensive due diligence on how much revenue the company has generated to date. However, do you think making the decision to acquire a business solely based on historical financials would be prudent? No, right? Similarly, investors should not rely exclusively on a mutual fund’s past returns.
What Should be the Focus Area?
To better gauge the health of the business before acquiring it, it is crucial to focus on how it managed to deliver returns, not just focusing on the fact that it has. The past performance of mutual funds is no different. In both cases, success depends on a holistic evaluation that considers what the numbers signify rather than unthinkingly following them.
In short, looking at returns as just absolute figures will not tell us the whole story. What we do is dissect the return numbers and understand what the past returns portray– in different markets and under different stress conditions.
Let us try to break down returns into components that are necessary to assess a fund’s actual performance:
Consistency is the Key:
Let’s recall the example of XYZ Technologies, which was planning to acquire a new venture. Do you think the company’s one-year profit is all XYZ Tech should consider before investing their hard-earned business money? No, right! They should consider how consistently the company has managed to deliver profits.
Similarly, when you check for the fund’s past performance, the consistency with which the fund has been providing those returns is one of the vital factors to be looking at. If you are solely considering the returns from the last 1, 3, or 5 years, you will only have insight into how the fund performed during those specific timeframes.
Rolling returns is a valuable matrix for assessing a fund’s performance over various timeframes. Instead of relying on fixed time periods like 1, 3, or 5 years, rolling returns involve calculating returns for a specific period (e.g., one year) at multiple points in time. For instance, you assess the one-year return of a fund today, then one year from yesterday, and so on. This approach helps remove the influence of short-term fluctuations and evens out periods of exceptional returns. By comparing rolling returns to its benchmark and peers within the category, you can gauge how consistently the fund has performed over time.
Performance When the Market is Volatile:
Volatility in mutual funds refers to how much a mutual fund’s returns go up and down. It becomes tricky to predict how the fund will perform in future when its past returns swing a lot. In finance, this uncertainty is what makes a mutual funds investment risky. Think of bank deposits as safe because you know exactly how much money you will get. Similarly, we measure a fund’s volatility to understand how risky it is.
To measure volatility we use a statistic called standard deviation to measure volatility. Consider two funds: one with returns of 15% and 20% in different periods and another with returns of 10% and 30%, for instance. The first fund has less standard deviation because its returns are more consistent. A higher standard deviation means the fund’s returns can be much higher or lower than the average. It adds uncertainty to an already uncertain market.
Risk-Returns Trade-Off:
A quick question! What would you choose: a volatile equity fund or a stable debt fund, given the condition that they both offer the same returns?
The essence lies in the fact that as a reward for bearing higher risk, investors expect higher returns. Knowing how the fund manages the risk-return trade-off is crucial when comparing funds to invest business money. It is better to go for funds that provide average returns and carry lesser risk instead of a fund taking extreme risks to deliver average returns.
To assess how well a fund balances risk and return, you can use metrics like the Sharpe ratio. The Sharpe ratio measures the excess return (returns earned above the risk-free rate) for each unit of risk taken. A higher Sharpe ratio indicates that the fund has generated better risk-adjusted returns, which means it has effectively managed the trade-off between risk and return. So, it is generally better to choose funds with higher Sharpe ratios when comparing funds for business investments, as they provide better risk-adjusted returns.
Potential to Contain Losses
In the volatile finance world, it is crucial to invest business money in funds with the potential to contain its losses. To assess this, negative returns of funds and the maximum loss it has incurred can be compared in different periods. Also, to make the analysis more accurate, the best and worst performance of a fund can be taken into account. You can compare the worst performance of different funds to gain insights into how the funds manage the downsides.
The steeper the fall, the more difficult it gets for a fund to climb up the ladder of profitability. Historically, it has been seen many with robust performance in a bull market have failed to contain downsides. As a result, those funds lost out in the long run. You can check the best and worst performance of funds online and analyse how funds cut back on losses without impacting the profit numbers in the long run.
It will tell us how different funds score on cutting back on losses without compromising on returns in the long run. It is vital because the steeper the fall for a fund, the more difficult it is to climb back. Many funds lose out in the long run because of their inability to contain downsides, despite rallying in bull markets.
The above are just a few parameters that we look at when breaking down the past returns of mutual funds. Before you invest business money in mutual funds, consider these factors while analysing past returns of mutual funds investment to ensure informed decision-making.
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Disclaimer: Mutual funds are subject to market risks. Read all scheme-related documents carefully.
The content of this blog is not intended to serve any professional advice or guidance, and Shootih takes no responsibility or liability in whatsoever manner for any investment decisions made by the readers of this blog or other blogs. Readers should seek independent professional advice before making any investment decision based on the information provided on this website.
