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??

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

So here is the new plan:

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,

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..

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.

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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