During a rising market phase, so-called ‘high return’ mutual fund schemes tend to capture media headlines and investor conversations.
Your fund might have returned substantial gains in a short period and look unarguably tempting when compared against seemingly lower returns offered by FDs or debt schemes.
However, not all top-performing funds are the right addition to your portfolio in the long term.
In fact, the way it works for most investors is they end up buying the fund at the wrong time.
As history has shown, high returns and high sustainability are not the same. The attractive investment may neatly package structural risks that are yet to show their faces.
Investors must go beyond just the hard facts and look to the level of returns and the underlying risks taken to earn those returns.
Before investing any capital into a high return mutual fund, the following critical warning signs should be considered…
1. One-Year Performance Obsession
One of the most common mistakes investors make is judging a fund purely on its 1-year return. Markets move in cycles, a fund that has benefited from a sharp rally in small caps, a PSU theme, or a manufacturing boom may show extraordinary returns in the short term.
But short-term performance does not reveal how the fund behaves during volatility or corrections. A truly strong fund demonstrates consistency across cycles — not just in bullish phases.
If most of the fund’s outperformance is concentrated in one specific year, it may indicate that returns are cyclical rather than structural.
Investors should review multi-year CAGR, rolling returns, and performance during previous market corrections before taking a decision.
2. Concentrated Portfolio Risk
Some high-return mutual funds achieve performance through concentrated bets. While conviction investing may generate alpha, overconcentration increases risk significantly.
If the top 5–10 holdings account for a large percentage of the portfolio, even one underperforming stock could sharply impact NAV.
Similarly, if sector exposure is heavily skewed toward a single theme, volatility may rise dramatically when that theme cools off.
Diversification is not just about holding many stocks. It’s about balancing risk across sectors and businesses. Investors must examine if the fund’s concentration aligns with their own risk tolerance.
3. Style Drift from the Mandate
A fund categorised as large cap should primarily invest in large-cap stocks.
However, in pursuit of higher returns, some fund managers may increase exposure to mid or small caps beyond what the category typically allows.
This style drift alters the risk profile of the fund. Investors who selected the fund expecting stability may unknowingly be exposed to higher volatility.
Analysing market-cap allocation trends and comparing them with category norms could reveal whether the fund is sticking to its mandate or taking aggressive bets.
4. Excessive Valuation Risk
In a strong bull market, valuation discipline often weakens. Some high-return funds may be heavily invested in stocks trading at stretched valuations.
Returns driven by valuation expansion rather than earnings growth are fragile. If earnings fail to justify high multiples, sharp corrections may follow.
Investors should evaluate whether the fund manager discusses valuation comfort in factsheets and commentary. If portfolio stocks are significantly above historical averages in PE or PB ratios, future return potential may already be priced in.
5. Very High Portfolio Turnover Ratio
Portfolio turnover ratio reflects how frequently the fund buys and sells stocks. An unusually high turnover ratio may indicate aggressive trading rather than long-term conviction.
While tactical shifts are part of active management, excessive churn could increase transaction costs and reduce consistency in strategy. It may also signal reactive management, chasing momentum rather than following a disciplined process.
Long-term wealth creation typically benefits from stability in portfolio construction.
6. Sharp Inflows After Performance Spike
When a fund delivers exceptional returns, inflows surge. A rapid jump in Assets Under Management (AUM) could create challenges, especially for mid and small-cap oriented funds.
Deploying large sums into relatively less liquid stocks becomes difficult. The fund may either dilute performance by spreading capital thinly or take liquidity risk by accumulating large positions in limited stocks.
Investors should examine whether AUM growth has been gradual or sudden. Scalability matters, particularly in niche or thematic strategies.
7. Weak Downside Protection
High returns during rallies are attractive, but the real test of fund quality lies in how it performs during corrections.
If a fund falls significantly more than its benchmark or peers during market declines, it indicates higher beta or poor risk management. Large drawdowns not only reduce capital but also require higher subsequent gains to recover losses.
Evaluating maximum drawdown history and downside capture ratio may provide insight into the fund’s resilience.
8. Risk-Adjusted Returns Are Ignored
Absolute return figures often overshadow risk-adjusted metrics. However, two funds delivering similar returns could have very different volatility profiles.
Standard deviation, Sharpe ratio, and beta help measure whether returns were achieved efficiently relative to risk taken. A fund generating slightly lower returns but with better risk-adjusted metrics may be superior for long-term investors.
Ignoring risk-adjusted parameters is a serious red flag.
The Psychology Trap: Return Chasing
Historically, investors tend to enter funds after strong performance and exit after corrections. This behaviour erodes long-term returns.
If enthusiasm around a fund feels widespread and media coverage is overwhelmingly positive, it may be a sign that expectations are already elevated. Entering at such points increases the probability of short-term disappointment.
Disciplined investors focus on process, valuation comfort, and allocation discipline rather than short-term excitement.
Conclusion
High-return mutual funds could play an important role in wealth creation. However, strong performance should trigger deeper analysis not blind allocation.
The key question is not just how much a fund has returned, but how it generated those returns and whether those drivers are sustainable.
In investing, sustainability matters more than speed. A disciplined, risk-aware approach will always serve investors better than chasing the highest recent return.
Invest wisely.
Happy investing!
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