Should I rely on past returns while investing in mutual funds?

Mutual funds are the type of investment that have a huge variety of options for every class of investors. Investors having a high or low-risk appetite can easily find mutual funds options relevant to them. But with so many options available in the market, how can the investors choose the right type of fund that meets their needs? Many investors rely on the past performance of the fund as an answer to this question. Past performance of the fund is one of the leading parameters influencing the decision-making of the investors. 

Let us discuss further details of this contributing factor to understand its importance and limitations.

Importance of past performance of a fund

Past performance of a fund is often considered to be one of the first indicators of its health or its profitability. A fund that has been consistently performing well and providing decent returns in market highs or market lows will have good quality underlying assets that can withstand the market trends. Such a fund also indicates the competence of the fund manager to navigate the fund through market volatility and meet the investor’s ultimate goal of increasing their wealth. The other indications of the healthy past performance of the fund are the market conditions, the fund house, and their investment strategy, etc.

These are some of the prime factors that the investors focus on and hence invest in funds based on their past performance. 

Disadvantages of relying solely on past performance of a fund

Tracking a mutual fund and its performance over a period of time is a healthy practice on part of the investors. It helps them weed out such funds that may have given good returns in the recent past but not consistently. However, making investment decisions solely based on the past performance of the fund can be dangerous for the investor.

If a fund has performed better in the past, that does not guarantee its good performance in the future as well. Any shift in the fund manager’s investment strategy or change in the assets of the fund, etc can be detrimental to its potential in generating higher returns. 

Also, if a fund has performed poorly in the past, it does not guarantee that the future performance of the fund is also going to be poor. 

Hence, investors relying solely on the past performance of the fund to make their investment decisions often end up making hasty investments that may not meet their objectives in the long run. It is therefore advisable to look for an inclusive approach that factors in other relevant parameters as well in the decision-making process to ensure that the investors do not lose out on good quality mutual funds.

Factors to be considered while making an investment decision on mutual funds

As discussed above, past performance of the fund cannot be the sole basis of an investment decision as it will be like jumping in a ditch with your eyes closed without knowing how deep it is or what is in there. Many other factors have to be considered by the investors to make sound investment decisions. Some of such factors are mentioned below.

1. Fund manager details

One of the most important factors that are often ignored by many investors is the fund manager’s details. These details include the past funds handled by the fund manager if any, the team of professionals working under them, their investment strategy or investment style, educational qualifications, etc. This information will help the investor in trusting the judgment of the fund manager to generate higher returns to meet the investor’s objectives.

2. Expenses ratio of the fund

Another important factor to be considered is the expense ratio of the fund. Most funds charge an expense ratio up to 2% of the fund size to meet their various administrative expenses including fund manager fees. SEBI has capped the expense ratio for various types of mutual funds to ensure that the investors are not ultimately burdened with the heavy cost of investment. Investors should compare the expense ratio of two or more funds along with other factors to determine a better option among them.

3. Risk parameters of the fund

The risk factors of the fund is another driving force in the decision-making process. Investors should be well aware of the risk involved in the investment to ensure that it meets their profile and risk appetite. The newly introduced Mutual Fund Riskometer is a great tool to understand the risk profile of the fund. 

4. Entry load or exit load of the fund

Most funds charge a nominal percentage or fees as a charge to enter or exit the fund. Such charges are known as entry load and exit load of the fund. While entry load is not charged on the majority of the mutual funds, exit load is quite common. Comparing funds on this basis is also important to make a better and cost-effective decision.

5. Comparing the performance of the fund to its benchmark

Investors can also compare the performance of the fund to its benchmark to analyze its relative performance. If the fund has performed poorly in line with the benchmark it may not be a sign of the health of the fund but simply the current market condition or the market trends.

Conclusion

Past performance has been a leading factor contributing to investment decisions over the decades. However, investors who have solely relied on past performance ignoring other factors have often been disappointed with their investment and excited the market sooner or later. Hence, investors should know to strike a balance in giving importance to past performance as well as other relevant considerations to ensure that they have a sound investment portfolio.

FAQs

1. Is it necessary that a fund giving consistently good results will always provide the same always?
A. No fund can consistently provide high returns without reacting to prevalent market conditions or market trends. Hence, there is no guarantee that a fund that is consistently performing well will provide higher returns in the future too. 

2. Can the past performance of the fund be completely ignored while making investment decisions?
A. No. Just as an investment cannot be made solely based on past performance of the fund, it cannot be completely ignored as well. Investors have to strike a balance between various parameters of decision-making to make a profitable investment portfolio. 

3. How is fund selection done on the Fisdom app for mutual funds?
A. Fund selection on the Fisdom app is done based on a Smart Recommendation Engine which is based on proprietary scientific financial models & historical market data, so you get access to the best funds selected and remember this is customized to your risk appetite and investment criteria.

4. Can a person lose all their money even in a mutual fund that has provided good returns in the past?
A. Yes. Mutual funds (especially equity funds) are highly volatile and have the potential to completely drain an investor’s investment. Any change in the fund’s investment strategy, policies of the government, or tax laws, sectoral changes that negatively impact any industry or sector altogether, etc. can have an adverse effect on the performance of the fund. This may eventually lead to the investor’s song all their money invested even if, in the past, the fund has provided better results. 

5. What are the initial takeaways from the past performance of the fund?
A. The initial takeaways from the past performance of the fund can be information about the fund strategy, investment style of the fund manager, asset allocation, risk-return ratio, cost-benefit analysis of the fund, etc.