How to select best performing mutual funds: Importance of past performance

In the previous part of our post, Returns expectations from mutual funds: How Important is past performance, we discussed how to form future returns expectations, without relying on historical mutual fund returns. We based our returns projections on long term asset class returns and macro-economic projections / expectations. Forming mutual fund returns expectations based on long term asset class returns or macro-economic projections may seem a tad conservative, but it is more prudent to be a bit conservative in financial planning rather than falling short of your financial goals.

In our earlier post, we had also discussed that, mutual fund managers are tasked with the objective of delivering above average returns over a sufficiently long investment horizon. The delta (difference) between the fund returns and the benchmark returns, on a risk adjusted basis, is known as alpha. Investors should try to invest in funds, whose fund managers have a consistent track record of delivering superior alphas. In the final part of this series, we will discuss how you can select best performing mutual funds, whose fund managers have a great track record.

Importance of fund manager

In my view, the investment objective of a fund and the fund manager’s performance are the two most important factors in selecting a mutual fund. Understanding the investment objective of a fund will ensure that, you invest in the right mutual fund scheme that are suited to your investment needs and risk capacity. The fund manager’s performance will determine whether you get superior returns that meet or exceed your expectations.

Some people may cite examples of star fund managers of the past who are struggling in recent times, but I can cite many more examples of fund managers who had great long term performance records and are continuing to deliver good returns even now. I am generally slightly on the conservative side in my thinking on investments, but I am a big believer in positivity; negative stories may grab more eyeballs, but positive stories, which are backed up by data, are more beneficial, in my opinion, for investors. Most negative stories point to, short term under-performance, but most positive stories are about long term out-performance, which is far more important as far as fund selection is concerned.

Basic parameters of a fund manager’s performance

It is impossible to predict the future, but a rigorous data driven approach in analyzing, is much better than looking at a fund’s performance in the last 1 or 2 years and developing perceptions of short term returns. We have mentioned a number of times in our blog that trailing returns and point to point returns are biased by the market conditions in the concerned period vis-a-vis the fund manager’s investment strategy. To get a correct understanding of the fund manager’s performance, we need to understand three things:-

• What is the investment strategy of the fund? Is it growth investing or value investing or growth at a reasonable price (GARP)? All three investment strategies can yield good returns, but a good understanding of the investment strategy can help us set the correct expectations.


• How much risk does the fund manager takes to deliver the desired returns to the investors? The risk taken by a fund manager is broadly measured by a metric called beta. Higher the beta, above 1, more is the risk taken by the fund manager. Lower the beta, below 1, less is the risk. We must mention that, just because a fund’s beta is high, it is not a bad fund or vice versa.
  
  

  If some investors are desirous of very high returns relative to the benchmark and the peer funds, they can invest in high beta funds. On the other hand, if you want limited downside risks, you should invest in low beta funds. You can know the beta of a fund, by going to our MF Research section and looking up the fund using our MF selector tool.



• The performance of the fund manager in various market conditions, good or bad. We have mentioned a number of times in our blog that performance consistency should be the most important parameter in fund selection. A high beta fund may do very well in bull markets. A low beta fund may perform well in bear markets, on a relative basis. As a long term investor, assuming you are one, you should be looking for mutual fund schemes that perform well in all market conditions, because over a long term period, you will have both bull markets and bear markets.
  
  

  What can help you determine best performing mutual funds that perform well in different market conditions? There are two analytical measures that are unbiased by market conditions and can help you get a sense, if a fund performed in different market conditions. We will discuss these two analytical measures next in this post.

Rolling Returns

Regular readers of our blog will be aware that, rolling return is the best analytical measure of a fund’s performance consistency. In rolling returns, we look at the annualized returns of a fund for specific investment tenures, on every day over a specified period, over a sufficiently long investment period covering multiple market cycles (both bull markets and bear markets).

In Advisorkhoj, we have developed for the benefit of our readers a rolling returns tool, Rolling Return vs Category. Using this tool, you can get the rolling returns of a mutual fund versus average rolling returns of all the funds in the category. We have also developed another rolling returns tool, Rolling Return vs Benchmark, for looking at the rolling returns performance of the fund versus the benchmark index of the fund, to understand, how the fund manager did versus the benchmark index different market conditions.

Every analytical tool, no matter how robust or sophisticated, is only as good as how the investor puts it to use. It is the same with rolling returns. The two most important parameters in any rolling returns tool are the start dates and the rolling returns period. The start date of rolling returns should be sufficiently old to include multiple market cycles. Using a start date, one year or two years prior to the current date defeats the purpose of rolling returns, because it fails to cover a large variety of market conditions.

In our view, a start date of at least 5 years prior to the current date, covers a variety of market conditions, because historical data shows that, we usually have a bear market in every 5 years. However, you can use a longer period (more than 5 years prior to current date) if you want. The only thing, that you may want to ensure when using an old start date for rolling returns, is the tenure of the fund manager. If the fund manager changes in the period in question, then the rolling returns may give misleading results.

The other important parameter in using rolling returns is the rolling returns period. This is the period, over which rolling returns are measured. In the case of equity funds, fund managers are mandated to deliver superior returns over a sufficiently long investment period. When using our rolling returns tool for equity funds, we recommend that, investors choose a rolling return of at least 3 years, because in our view, investors should have at least 3 year investment tenures. If you want, you can choose longer investment tenures; however, very long investment tenures like 10 years may not be relevant for scheme selection because many things may change in 10 years, like fund manager of the scheme, AMC merger and acquisitions, evolving market place dynamics etc.

Usually, the results are shown in a graphical (chart format). You can see the rolling return performance of an individual scheme versus the category, using our tool, Rolling Return vs Category. You can also compare rolling returns performance of multiple schemes by clicking on the link Add another fund; you can compare up to four funds. In Advisorkhoj, we also show summary of important rolling return analytics in a tabular format. In the table below the chart, you can see the important Rolling Return analytics like Average Rolling Returns, Median, Rolling Returns, Maximum Rolling Returns and Minimum Rolling Returns. We also show Return Consistency in the table; i.e. how much percentage of times in the chosen period the rolling returns of the fund were in the specific rolling return ranges.

Market Capture Ratio

Market Capture Ratio is, in our view, one of the most important performance metrics of best performing mutual funds. This metric tells us how a fund performed in up market and down market. This metric provides very useful insights on the risk taken by a fund manager and also how the stock selection of the fund manager performs in both up market and down market. You can see market capture ratio of any scheme by using our MF Research tool, Market Capture Ratio.

There are two important parameters in Market Capture Ratio - Up Market Capture Ratio and Down Market Capture Ratio. Up Market Capture Ratio measures the percentage of market gains captured by a fund manager when markets are up. If Up Market Capture Ratio is more than 100%, it means the fund manager was able to beat the benchmark index in market upturns. If Up Market Capture Ratio is less than 100%, it means that the fund manager was not able to beat the benchmark indexin upturns.

Down Market Capture Ratio measures the percentage of market losses suffered by your scheme when markets were down. If Down Market Capture Ratio of a scheme is less than 100%, it means that the fund fell less than the benchmark index in market downturns. Down Market Capture Ratio can sometimes be negative. Do not worry if it is negative because negative Down Market Capture Ratio implies that, the fund NAV went up when the market fell. Negative Down Market Capture Ratio, in fact, shows great bottom up stock picking skills of the fund manager.

Investors should look at both the Up Market Capture Ratio and Down Market Capture Ratio for true evaluation of fund performance. You should select schemes which have high Up Market Capture Ratio (more than 100%) and low (even negative) Down Market Capture Ratio.

Conclusion

In this three part series, we discussed the importance of past performance of mutual funds, in determining selection of best performing mutual funds for financial planning. In the first part of this series, we discussed why historical returns may not be good indicators of future returns. In the second part of this series, we discussed how to form returns expectations without relying on historical fund returns. In the third and final part, we discussed some analytical tools, which can help you analyze more deeply the fund manager’s performance in different market conditions and the fund manager’s performance consistency.