Returns expectations from mutual funds: How Important is past performance

I sometimes hear financial advisors saying that, this mutual fund will give 20% compounded annual returns, if held for the next 10 years. I ask them, on what basis are they making this projection and the answer that I often get is that, it is based on their “experience”. In the first part of this two part post, How important is past performance in mutual fund selection: Part 1, we had discussed that, it is not correct to extrapolate historical performance (returns) in forming returns expectations. Some readers may ask, if past performance cannot be relied on, then on what basis will they plan for the future and also, how will they select the best mutual funds? These are perfectly valid questions and we will try to address the first questions in this part of our two part series.

How to form investment returns expectations?

A veteran investment banker once philosophically surmised that, the best results are achieved when you have no expectations. I must admit that, some of my best investments were the ones, where I had no expectation; I invested simply for the sake of investing. Since I had no expectation, I was not monitoring these funds regularly and in some cases, even forgot that I owned these funds. As a result, I remained invested in these funds for a very long time and when I discovered that I had these funds, I was delighted with the results because the NAVs had grown many times in value over the years. But while the philosophical approach of not having expectations worked for me, I do not think it is practical approach.

For the purpose of financial planning, you must have financial goals and return expectations, based on which you will know how much to save and invest in order to achieve your goal. Therefore, you need to form expectations for financial planning. It is impossible to know what your future returns will be, unless you are investing only in risk free assured returns schemes. Therefore, when forecasting returns for market linked investments, you must be prepared for some deviations from expected returns. Deviations on the upside will be a pleasant surprise; it is the downside deviations that you should be prepared for in your financial planning. It is easy to preach an ultra-conservative approach in forming returns expectations, but most of us do not have unlimited amounts of money to invest. In my view, you should have reasonable expectations for purposes of financial planning.

What is reasonable returns expectation?

My experience tells me that, most people lose money in capital markets, because they have unrealistic expectations. Unrealistic expectations can make you do bad investments or exit good investments because your unrealistic expectations were not met. We get a few queries from investors who want double digit returns with no risk. You can want anything, but it does not mean you will get it. Reasonable expectations are the ones, where market risks are factored. For equity investments, business cycle or investment cycle risks must be factored in return expectations.

What is business cycle or investment cycle risk? There are periods of boom (high economic growth) and bust (low economic growth) in a business cycle – both the boom and the bust cycles are inevitable. Similarly, there are bull markets and bear markets in an investment cycle (investment cycle closely correspond to business cycles) – both bull and bear markets are inevitable, no matter how much we dislike bear markets. So any reasonable long term returns expectation should factor in the effect of both bull and bear market.

In the last 3 years, we had both bull markets and a bear market; can the last three year returns be assumed to be representative of long term average returns which include effect of both bull and bear markets? The answer is no. Two bear markets may not be identical, same with bull markets. In some bear markets we see a 20 – 25% fall in stock prices or market crash, but in the 2008 crisis we saw stock prices and market crashing by more than 50%. Some bear markets last for 6 – 9 months (before recovery), while some can last a few years (remember the slowdown at the beginning of this millennium; it lasted for more than 2 years).

Historical basis of returns expectations

If you want to form your returns expectations on the basis of historical returns, you should be looking at historical returns over a very long period. A very long period will have multiple bull market and bear market cycles, comprise of broader mix of different market conditions and therefore, a more reliable indicator of future market conditions (probability wise).

In the US, investment experts usually look at 30 year average historical returns as indicators of a long term average equity returns; some experts even look at 50 years historical returns, but 30 years is more common. In India, there was structural shift in our economy in 1991 with the onset of economic liberalization. It has been 26 years since liberalization began; so, by now, it is also quite a long time period, which had multiple bull and bear markets, and a variety of economic scenarios. When liberalization began in India, the Sensex was at around 1,000 and today it is close to 31,600; the average annualized return of Sensex over this period was, therefore, around 14%.

We must mention here that, we are talking about market returns and not fund returns. The basis of long term return expectations should be, in our opinion, the asset class returns and not fund returns. Investors can layer some alpha (fund manager beating the benchmark in terms of risk adjusted returns is alpha) expectations over asset class returns, but alpha expectations can be tricky (we touched upon this briefly in our post, How important is past performance in mutual fund selection: Part 1) and we will discuss it again later in the series.

Fundamental basis of returns expectations

Using very long term (30 years) historical average returns can be used to form long term returns expectations. If you read American investment blogs, 30 year S&P – 500 returns are commonly used. However, investors should understand the difference between a matured capital market like the US and a developing market like India. Therefore, in my view, a macro-economic fundamental basis of forming returns expectations for diversified equity funds in India can be more meaningful in our context.

Returns expectations, on a fundamental basis, is formed based on the GDP growth (industrial production growth) and inflation. If we assume our long term real GDP growth rate to be 7.5 to 8% and inflation to be 4.5 to 5%, then our long term returns expectations should be = real GDP growth + inflation rate = 12 – 13%. This is a economically sound basis of forming returns expectations for diversified equity funds, because at a fundamental level stock price increases are driven by earnings (EPS) growth and EPS growth is driven by economic growth (in real terms) and also price increases (inflation). On top of the earnings driven growth in stock prices, investors can layer on, if they want, some valuation (P/E multiple) expansion, because in a developing market, investors expect earnings to grow faster in the future. How much valuation expansion, you can see in the long term future, is tricky. In the US, valuations did expand over the last 35 years period or so, but in a momentum market in India, especially at a time, when valuations are not very far from their historical highs, predicting long term valuation expansion can be tricky. We have discussed, forming returns expectations, based on macro-economic fundamentals of our country in our blog post, What is the reasonable rate of return from equity mutual funds. We urge our readers to read the post, in case they have not.

Anyway, the 26 year Sensex returns from 1991 (around 14%) is the not very far from the long term returns predicated on real GDP growth and inflation (12 – 13%). Investors can form reasonable returns expectationson the basis of very long term historical returnsand also based on macro-economic fundamentals.

Long term returns expectations from fixed income / debt funds

We must address fixed income (debt asset category) also, because they are an important asset category for many investors. While many investors invest in pure debt funds, many others invest in hybrid funds, which have both debt and equity; therefore, fixed income returns are also very important from a financial planning perspective. Forming long term returns expectations from debt funds is relatively easier, compared to equity funds. Debt funds are subject to two kinds of risk – interest rate risk and credit risk.

We will not discuss credit risk in this post. Suffices to say that, higher the credit risk, more returns, investors can expect; at the same time, if investors want to minimize credit risk, there are many investment options available in the debt funds space. Let us discuss, only interest rate risk for the purpose of this post. Interest rates follow a cycle of increasing trajectory and decreasing trajectory depending on the inflation rate and economic growth needs of the country. For most central banks around the world, including Reserve Bank of India, inflation is one of the most important drivers of interest rates. We see periods of increasing interest rates (increasing or high inflation) followed by a period of declining interest rates. Inflation rates, usually, follow a cycle and therefore, over sufficiently long investment tenures, effects of high or low inflations, neutralize each other in long term interest rates.

The 10 year Government Bond yield is usually taken as the benchmark yield. The average 10 year bond yields over a long period of time can, therefore, be taken as a proxy for fixed income (debt) returns over a long period of time. The average 10 year bond yields, over the last 10 years or so, was around 8%, but we must caution investors that, long term interest rates may be altered by structural changes in our economy and structural factors affecting inflation due to measures taken by the Government. Therefore, for long term financial planning purposes,it may be prudent to be a little conservative about long term returns expectations from debt funds or hybrid funds (which have both equity and debt investments).

Conclusion

In this post, we discussed how to form future returns expectations, without relying on historical mutual fund returns. When discussing returns expectations from mutual funds, we have ignored an important factor, outperformance of fund manager versus the market. By ignoring outperformance, you can be conservative, some may think, even prudent, in forming your returns expectations. But historical returns show that, a few fund managers have the track record of delivering outperformance. You may or may not want to factor in the outperformance in your financial planning, but you should definitely consider the fund manager’s track record in selecting mutual fund schemes for your portfolio. We will discuss how to select funds, based on the fund manager’s track record in the third and final post of this series. Please stay tuned for more.......