“Mutual Fund investments are subject to market risks. Please read all scheme-related documents carefully before investing” is the prominent disclaimer in every advertisement of mutual funds that we come across. While this disclaimer is true, are mutual fund investments only subject to market risks? Over the past 5 years, the S&P 500 has returned 12% per year but the average equity investor has only earned 8% per year (DALBAR 2020). If markets were the only risk factor, then why is the gap between market return and investor return so large?
Return Chasing Behavior
Investor behavior plays a large role in investment performance. Particularly, investors’ propensity to chase returns by jumping from one fund to another based on historical returns. Investors tend to buy funds after a period of good performance and sell funds after a period of poor performance (“buy high, sell low” phenomenon). The underlying assumption made by investors is that past performance can help in predicting future performance. However, is this a good assumption for mutual funds?
Persistence in Mutual Fund Performance: Indian Context
If mutual fund returns were persistent, we could conclude that past performance of mutual funds tells us something about future performance. A recent study conducted by Kuvera.in shows that there is no persistence in mutual fund returns in India.
The study ranked all the mutual funds into deciles (10 equal sized bins) based on 1 year past performance. The returns of these funds were then observed 1 year into the future. The results are as follows:
- Only 13% of the best performing funds (top decile) still remain best performers after a year
- 52% of the best performing funds give above average returns after a year (coin toss, isn’t it?)
- 19% of the best performing funds become the worst performing funds (bottom decile) after a year
This exercise was repeated with a 3 year and 5 year look back period. The results were as robust.
Selecting mutual funds based on past performance might seem intuitive but the data is clear that there is no persistence in performance. The Indian mutual fund industry isn’t an outlier. There have been numerous studies on this topic globally and the conclusion is the same in (almost) every country*. The popular disclaimer “Past performance doesn’t guarantee future returns” holds true and should be taken seriously.
Link to the video – https://youtu.be/UfrfltD-Xwk
Persistence of mutual funds in other countries:
*Greek Context: Babalos V, Caporale G, Kostakis A & Philippas N, 2008, ’Testing for Persistence in Mutual Fund Performance and the Ex Post Verification Problem: Evidence From the Greek Market’, European Journal of Finance, Vol. 14, pp. 735-753