The mystery of short term past performance versus future equity fund returns

10 minute read

In our earlier posts, here and here, we found to our dismay that, our natural inclination to choose the top mutual fund performers of the past 1 & 3 years hasn’t worked too well.

That leaves us with the obvious question..

What actually goes wrong when we pick the top funds of the past few years?

 The rotating sector winners..

Below is a representation of the best performing sectors year over year. What do you notice?

Sector wise calendar year performance.png

The sector performance over each and every year varies significantly and the top and bottom sectors keep changing dramatically almost every year.

Sample this:

  • 2007 – Metals was the top performer with a whopping 121% annual return
  • 2008 – Metals was the bottom performer with a negative 74% returns & FMCG was the top perfomer (-21%)
  • 2009 – The tables turned! FMCG was the bottom performer (47%) while Metals was the top performer (234%)
  • 2010 – Oops! Metals reversed to become the bottom performer (1%)
  • 2012 – IT was the bottom performer (1%)
  • 2013 – Reversal of fortunes – IT was the top performer with a huge 55% return

Now if you want to seek some pattern/connection out of this I am afraid it might be a futile attempt. It’s just our pattern seeking brains at work!

Image result for pattern seeking

The simple takeaway is this: Sectoral winners and losers keep rotating randomly and drastically across short time frames

Thus, when we start picking funds based on their last 1 year return, for the fund manager to get into the top yet again, he/she has to exactly know which will be the new sectors which will be on top for the next year and has to rotate back into them.

This in my opinion, unless the fund manager has some supernatural ability to predict the future, is impossible to pull off consistently year after year.

Going by this, it is natural to expect fund rankings to be extremely random in the short run and hence we must not give too much importance to short term performance.

This brings us to our next question:

If the sector performance of the short run is anyone’s guess. And logically since the long run is nothing but the accumulation of the short run, is selecting funds a huge gamble. How in the world do we evaluate fund managers then?

Understanding Market Cycles

Let us turn to one of the most experienced Indian fund managers for some possible answers.

Now for those, who are running short of time, the gist of what Prashant Jain has to say is:

  • Indian stock markets historically has moved in 6-8 year cycles
  • Sectoral leadership in the market changed with every cycle
  • In every cycle, one or more sectors that were often correlated with each other assumed leadership and vastly outperformed the broad market
  • The next cycle then brought with it new leadership 
  • Between 1995-2016, markets have witnessed 3 broad cycles
    1. 1995-2000:
      IT sector was the leader (stocks up by 96-97x); S&P BSE SENSEX (Sensex) moved from 3,000 to 4,000
    2. 2001-2007:
      Capex/Banking/Commodities/Auto led the market (stocks up by 8 to 30x) (; Sensex moved from 4,000 to 20,000
    3. 2008-2015:
      Pharma/FMCG/Auto were the new leaders (stocks up by 3 to 15x); Sensex moved from 20,000 to 26,000

Sector Performance across cyclesSource: HDFC Equity Fund presentation

You can also read his interview on the same topic here

A similar view is also echoed by another experienced fund manager Sankaran Naren of ICICI Prudential Mutual Fund

“Whenever we raise a toast to outperformers, we tend to forget the role of market cycles. Companies become outperformers because of the sector becoming an outperformer. That part is forgotten by people very often.

In the 1990s, we were in an export cycle. After that, there was a very strong boom in technology. Between 2001 and 2003, there was a lull phase and then from 2003 to 2006, there was a mid-cap cycle, followed by an infrastructure cycle that went on till 2008. Post that we had a consumption rally.”

“When the cycle is on an upswing, it doesn’t really matter if a company is great or not — companies in the sector outperform because of the upturn in the business cycle.”
Source: www.outlookbusiness.com

Now before all this goes over our head, let us try and make some sense out of this..

While it is impossible for the fund manager to get the sector calls right year after year, reasonable long term outperformance can still be provided by fund managers who can broadly position their portfolios for sectors which lead the cycle but at the same time not get carried away by the euphoria and can reasonably transition portfolios  across cycles.

Now what does that mean for us?

Short time frames end up capturing only a small part of the cycle and hence it is difficult to evaluate if the fund performance is sustainable as an when the cycle turns.

For past performance to make sense, we need to increase our evaluation periods to cover an entire cycle (i.e not just the bullish phase or bearish phase in isolation). The more the cycles over which we can evaluate the fund manager’s performance the better.

Great..but is it just the sectors that tend to move in cycles??

Even investment styles tend to exhibit cycles..

Investment Styles & Cycles

As seen above, historically in India (and also in other global markets), different investment styles tend to perform at different periods and go through similar cycles as seen in sectors.

You can learn more about this from this video

The other way to look at this is in terms of moat, growth without moat etc.

In the period between 2004-07 moat investing (popularized by Warren Buffet and Charlie Munger) did not work, but instead growth-without-moat worked brilliantly. So naturally funds which did not have growth without moat style, would have suffered.

However, in the period between 2008-13, moats were back in fashion and funds which followed moat based strategies outperformed everything else.


So in addition to evaluating returns over a complete cycle, we also need to place in context the investment style of the fund manager and ensure that our evaluation period covers an entire cycle from an investment style perspective too.

The large cap vs mid cap cycles..

Mid vs Large Cycles

Mid caps (11x) trounced large caps (7x) during the bull run of 2003-07. But the interesting part came post that. For the same investor, in another 1.5 years, the returns of large caps and mid caps stood similar for the period 2003-09..Call it the power of cycles!!

As seen above, large and mid caps tend to converge over cycles, with mid caps outperforming in bullish phases and large caps outperforming in bearish phases.

This again is extremely important when we look at past returns of a fund manager as we have to make sure that our evaluation period covers an entire cycle and not just the bullish or bearish phase.

This becomes extremely relevant in today’s context as most of us tend to prefer mid cap funds based on their last 3-5 year performance. A casual look at the above graph will indicate the trap that we might be getting into. (this deserves a separate post on its own. so will reserve it for another day)

Summing it up..

  1. The cycles across sector, investment style and market cap segment more or less seem to coincide with the bull and bear phases for most of the periods, as seen from historical evidence

  2. Returns over short time frames are not a great indicator of future returns as most of the times they only represent performance over a small part of the cycle and the true color of the fund manager is known only when the cycle turns.

  3. To derive meaningful evidence from a fund/fund manager’s past performance we need to increase our evaluation periods to cover at least an entire cycle (obviously the higher the no of cycles the better)

  4. Thus while it is impossible for any fund manager to consistently perform over the short term, we can look out for fund managers who are consistent in performing across cycles

  5. When putting up a portfolio of funds together, we also need to diversify across investment styles (value &  growth) and market caps (large & mid caps) as different styles and market cap segments tend to perform over different periods of time.

All this is fine. But how do we exactly define a cycle and how have funds performed across various cycles?

Hang on. We will save that for the next week 🙂

And just in case you like the contents,

Consider subscribing to the blog along with the 1400+ awesome people, so that you don’t miss out on the free weekly investment articles & other interesting updates delivered straight to your inbox.

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

Advertisements

The curious case of the “Top 5” fund investor – Part 2

A few weeks back we had explored the curious case of the “Top 5” fund investor here.

For those who haven’t read the earlier piece, the short summary goes like this –

Typically most of us intuitively tend to select funds based on the previous year returns. However when we tested how an investor who picked funds for his portfolio every year based on the previous year’s top 5 had fared in the last ten years, we found something very shocking. 

The returns of the investor who picked funds based on the past year’s top performers  actually was lower than the one who picked the past year’s bottom performers!!

But before you jump into any conclusion and go after the bottom 5 – the takeaway was that the performances across the investors who picked 5 funds from various ranks (1-5,6-10,11-15 and so on) were actually simply random. So neither the bottom 5 or top 5 is a fool proof strategy (or for that matter any “position of ranking” strategy).

Great. But that leaves us with another question.

Maybe 1 year is too short and is irrelevant. Agreed.

But what if we picked funds based on 3 years instead of 1 year. Will the results be the same??

Image result for investigator

Let us put our investigative hats on and find out..

So here is the new plan:

Image result for new year party

On every new year after our parties are over and we become sober, as usual we shall select the top 5 diversified equity funds (no sector, thematic, etf, index, international, balanced blah blah) but with a small change. This time it will be based on their performance for the last 3 years (instead of 1 year) and we will let it run for a year till the next new year party. And then repeat the same process again. Eg On 1-Jan-16 we would have selected the top 5 funds of the last 3 years (i.e covering 2013, 2014 & 2015). On 1-Jan-17 we would replace it with the top 5 funds of last 3  years (covering 2014, 2015 & 2016). And so on..

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

Take a guess. Will it be better than our 1 year strategy?

The strategy of picking top 5 fund based on last 3 years gave 13.6% compound annualized returns vs 10.8% for the earlier strategy based on last 1 year returns.

Phew. Some good news at last..

Putting that in perspective,

The Nifty gave only 8.1% compound annualised returns in the same period

Further, the 10Y returns of the 95 diversified funds that existed for last 10 years was also lower at 10.8%

And here comes the best part..

Amongst the 95 funds, this new strategy was ranked 15th !!

So at the outset, selecting funds based on a 3 year time frame definitely seems to be much better option than on a 1 year period.

But wait…

Just before we go about jumping “Eureka”, here comes the dampener

The bottom 5 funds strategy (in this case the funds ranked between 41-45) gave a mind blowing return of 15.2%!!

And this bottom 5 strategy was ranked the 4th across all funds in the last 10 years!!

(Now the detective in you must be wondering how can 41-45 represent the bottom as there were 95 funds and hence shouldn’t it be the fund ranked 90-95. Am I upto some data jugglery. Relax. Since I had to use a 3 year past return – it implied we needed to have funds with 13 years track record which came to around 48 funds. So, I took 41-45 for convenience)

But as always,

Image result for the devil lies in the details

So let us check the returns of the other strategies which picked funds across other ranks i.e 6-10, 11-15 and so on..

3year based - All Strategies Performance.png

Oops. Yet again there seems to be no pattern. The top 11-15 fund picking strategy has given 10.0% while the top 16-20 strategy has given 14.3%.

Now based on this data, one thing is for sure. You and I should definitely not be betting our hard earned money on some random top 5 or bottom 5 strategy!

Thus yet again, it leaves us with the same conclusion and the nagging question –

Why the heck does this happen? How in the world do we select funds if we can’t trust the past performance?

Some interesting answers coming soon. Hang on till the next week.

And just in case you like the contents,

Consider subscribing 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 delivered straight to your inbox.

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