The curious case of the “Top 5” fund investor

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?

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:

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

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..

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)

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:

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.

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.

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Annexure:

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

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