The curious case of the “Top 5” fund investor

A 5 minute read

In our earlier posts here and here we had explored the reasons why going only by past returns is not a great way to pick equity funds.

However despite all that being said, there is still a strong inherent instinct in all of us (that includes me as well) to lean towards funds which topped the charts in the recent times.

Most of the times in the past, our instincts have stood us well in other areas.

So should we trust our instinct in fund selection as well?

Image result for In God we trust. All others must bring data

Err.. Ok Mr Deming. As per your wish, I will bring the data 😦

The Intuitive Fund Portfolio

How do most of us select our equity fund portfolios?

Simple just select the top 5 funds of the last 1 year!

But this keeps changing. No worries. We seem to have sorted that out as well.

After every 1 year (no tax..hurray!!), we will change the funds to the top 5 funds of the past 1 year. Simple!

So here is the exact plan:

Image result for new year party

On every new year after our parties are over and we become sober, we shall select the top 5 diversified equity funds (no sector, thematic, etf, index, international, balanced blah blah) based on their performance for the year and let it run for a year till the next new year party. Eg On 1-Jan-16 we would have selected the top 5 funds of 2015. On 1-Jan-17 we would replace it with the top 5 funds of 2016. And so on..

This will be our Intuitive Fund portfolio strategy

Image result for intuitive investing

How do you think this strategy would have performed in the last 10 years? (i.e between 01-Jan-2007 till 01-Jan-2017)

Let us check.

The Intuitive Fund Portfolio gave 10.8% compound annualized returns

But is this bad, good, ok-ish. How do we judge ??

Lets add 1 more data point..

Nifty gave 8.1% compound annualised returns

Wow!

Intuitive Fund Portfolio’s 10.8% significantly outperforms Nifty’s 8.1%

So case closed.

But hang on.. What about the performance vis-a-vis other funds?

The 10Y returns of the 95 diversified funds that existed for last 10 years is 10.8%

Oh Shit. That means our Intuitive fund portfolio’s performance is not awesome.
It’s rather barely OK-issh.

Some more sad news.

Out of the 95 funds, a whopping 50 funds outperformed our Intuitive fund portfolio 😦

Its not over. Here is the final  nail in the coffin..

Image result for nail in the coffin

Now instead of picking the top 5, let us assume you were a little high post your new year party and by mistake ended up picking the 5 performers from bottom pile instead of top pile every year (In this case I have assumed you chose funds that were ranked from 76-80 every year).

Believe it or not. This strategy actually beat our Intuitive fund portfolio.

You heard that right – the portfolio of 76-80th ranked funds gave a 10Y return of 12.5% vs 10.8% for our Intuitive portfolio

To put that in perspective..

10 lakhs invested in the portfolio of 76-80th ranked funds would have become 32.4 lakhs vs 28 lakhs for our Intuitive portfolio.

That is a staggering difference of  4.4 lakhs!!
(A foreign trip + Royal Enfield Classic 350 + Iphone 7 + Bose speakers + some lavish weekend outings..Phew)

Image result for vacation baliImage result for classic 350 wall paperImage result for apple iphone 7

Phew..So the next year when you see the top performers of 2017 article in the newspapers – you know what to do about it.

Yawn and move on!

Now, one thing is pretty clear – selecting the top funds every year based on performance and changing them every year is definitely not a great strategy

But I am sure, your pattern seeking mind is upto something. (if not..then here is the hint – didn’t I mention that the funds ranked 76-80 every year outperformed the intuitive portfolio)

Eureka!! How about following this strategy of picking the bottom funds instead?

Interesting. So let us test this out against all combinations i.e funds ranked 1-5,6-10,11-15 and so on.

Here are the ten year returns for the different strategies:

All strategies Performance -1.png

The top 5 strategies have been highlighted in blue. The best performing strategy was picking the funds ranked 46-50 every year. It gave around 13.4%.

But if instead you had picked the funds ranked 41-45 every year, you would have been the worst performer in the last 10 years.

So for all those, who were looking to derive some insights from past short term performance, I have some disappointing news.

The performances across the strategies as seen above are simply random. So neither the bottom 5 or top 5 is a fool proof strategy (or for that matter any “position of ranking” strategy).

Fund Selection is hard work

All these, point towards a simple conclusion:

Fund selection, whether we like it or not, unfortunately is hard work.

Image result for hard work

While past returns over long term (say greater than 7 years) may still form an important input for fund selection, we also need to start appreciating other important predominantly qualitative nuances such as fund manager’s investment philosophy, process, investment style, investment strategy, consistency in performance, fund house credentials, behavior during bad times, ability to stick to process, communication etc

To get a glimpse of how to evaluate fund managers you can refer here

In the coming weeks , we will explore on what might be leading to this strange phenomenon of top 5 funds under performing and also if fund ratings (which are primarily based on performance) are a good way to pick funds.

And just in case you like the contents,

Make sure you subscribe to the blog along with the 1300+ awesome people, so that you don’t miss out on the free weekly investment articles & other interesting updates

Annexure:

For the curious ones, these were the funds that went into our intuitive portfolio every year

Top 5 Strategy.png

Source: Value Research

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

 

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Author: Arun

Hey! I'm Arun and I work for the research team of a boutique wealth management firm based out of Chennai. The idea behind this space is to share my learnings/mistakes and hopefully help people in making better investment decisions :)

9 thoughts on “The curious case of the “Top 5” fund investor”

  1. Hi Arun, Great analysis. In your analysis, you have assumed that the investor would redeem the entire units he invested in previous year while making the new investment. Can we tweak it a bit (and may be you could write a new post on it) and here goes what I think. In YEAR1, the investor chooses the best fund of YEAR0 and invests in it (say he invested Rs. 1 lac he saved from his Salary/Bonus in FUND1). Come YEAR2, he invests fresh Rs. 1 lac that he saved from his Salary/Bonus (NOTE, he would not redeem anything from FUND1) in the best fund of YEAR1 (say he invested fresh Rs. 1 lac in FUND2). He will continue doing this for 10 years (without redeeming any of the previous investments as he is able to save Rs. 1 lac each year out of his Salary/Bonus). How will this turn out at the end? Is this strategy of “fill it – shut it – forget it” better than what you had analyzed?

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    1. Thanks a ton Sachin for taking the time to write back. Interesting idea. The concern I have is that by the time you come to the 10th year we will end up with 5*10= 50 funds. Assuming few funds repeat, even then we will be looking at atleast 30-40 funds which I think is too large a number of funds for a single portfolio. What do you think??

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      1. There will not be 50 funds at the end of 10 years. I would be investing in one single best fund of previous year, so in 10 years, I can have maximum 10 funds. Managing 10 funds would not be that difficult. We have MFU https://www.mfuonline.com/ wherein within single login we can manage funds from 27 different participating Fund houses. Also we have “Portfolio Management & Accounting Software” like Perfios (https://www.perfios.com/KuberaVault/login) and MProfit (www.mprofit.in/) wherein we can get to see XIRR at scheme and portfolio level. I would request you to take this strategy (outlined by me in previous comment) forward and write a separate post on it so that it will benefit DIY investor community.

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      2. Got it. My basic thesis was that selecting funds based on their one year return doesn’t work. The success of the above strategy to a great extent will depend on the success of the first 3-5 funds as they will have a longer time frame to compound. Since I couldn’t find any pattern in future returns of the top funds, I am not too sure on how good this strategy would be. Anyways will check it out and send the workings across to you. Cheers 🙂

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  2. Hi Arun. Nice post – made me subscribe to your blog. I just had a quick question regarding your analysis – did you take care of the survivorship bias (funds that closed or got merged) in your analysis?

    If not then your benchmarks might change –
    a) The 10Y returns of the 95 diversified funds that existed for last 10 years is 10.8% -> these are survivor funds, their returns will be higher than the entire sample of diversified funds available for last 10 years. An investor starting in 2007 has no way of knowing which funds will survive till 2017.

    b) the portfolio of 76-80th ranked funds gave a 10Y return of 12.5% vs 10.8% for our Intuitive portfolio -> again these are 76-80th ranked funds which managed to survive the entire sample period – again something which cannot be known in advance.

    Curious to know.

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    1. Glad you liked it, Ankur. As you pointed out rightly, I didn’t have the data of the funds which merged/closed and hence the workings will definitely have survivor bias. However, the point I was trying to drive was that there is no predictive power for 1Y returns in the long term which is evident from the fact that the returns are scattered across top and bottom short term performers. I have also tested it out for all 5 year periods (not included in the post), where the results again point to the same conclusion. Also there were 50 funds out of 95 which outperformed top 5 strategy. My sense is that even if we had included the closed funds the long term returns would still remain scattered and without a pattern across the top and bottom 1Y performers. Thanks once again for reading and writing back 🙂

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