Mutual Fund Selection Guide: Investing in a mutual fund that has delivered the highest returns may seem like an easy way to build wealth. However, a scheme that tops the performance charts today may not retain its position over the next three to five years as changing market cycles, shifting investment styles, and the level of risk taken to generate returns can all influence a fund’s performance, experts told Zee Business.
For investors, this means that past returns alone may not be enough to select the right mutual fund. Consistency, rolling returns, portfolio quality, investment strategy and risk-adjusted returns also deserve attention.
Pankaj Mathpal, MD of Optima Money, and Sandeep Bagla, CEO of TRUST Mutual Fund, explained why investors should look beyond recent performance when selecting mutual fund schemes and how they can avoid common investment mistakes.
6 key reasons why today’s top-performing mutual fund may disappoint you in 3–5 years
Here are six key reasons why today’s top-performing mutual fund may not remain a top performer over the next three to five years:
1) Changing market cycles can impact fund rankings
No mutual fund can consistently remain at the top of the performance charts, irrespective of how good its fund manager is. Different investment styles tend to perform differently under different market conditions.
Explaining this, Mathpal said, “Every fund manager has a style. In different cycles, at different times, different strategies work.”
For instance, a fund following a value-investing strategy may underperform when value stocks are out of favour. That does not necessarily mean the strategy has become ineffective; market conditions may simply not be favourable to it at that time.
Mathpal also stressed the importance of giving equity investments an adequate time horizon. He said investors should ideally have a horizon of at least five years for equity mutual funds, allowing them to experience different market conditions rather than judge a scheme based on its performance over a single year.
2) Recency bias can lead investors to chase returns
One of the common mistakes investors make is choosing a fund because it has delivered exceptional returns recently. This behaviour, known as recency bias, can lead investors to put money into a scheme after much of its strong performance has already occurred.
Mathpal explained that investors often identify a fund that has performed exceptionally well over the recent past and then allocate more money to it, even if it was not part of their portfolios earlier.
He cautioned against making investment decisions based solely on recent performance. Instead, investors should examine the fund’s strategy, portfolio quality and the fund manager’s ability to navigate both favourable and unfavourable market conditions.
A fund that has performed well over the past three or six months may not necessarily continue to outperform over the next three to five years.
3) Sector, theme and investment-style rotation can change the winners
Different sectors, investment themes and market-cap segments do not perform equally well at all times. A sector that leads the market during one phase may underperform when market conditions change.
The experts highlighted how market leadership can shift between large-cap, mid-cap and small-cap stocks. Investors who concentrate their investments in the segment that has recently delivered the strongest returns may face difficulties if that segment subsequently corrects.
Bagla advised investors to maintain diversification rather than attempt to predict which investment style or sector will outperform next.
He said, “It is quite difficult to say which strategy will work in the future—value, momentum or growth—or which sector will perform.”
Bagla explained that a combination of diversified funds, along with suitable aggressive and conservative investments, can help prevent a portfolio from becoming excessively dependent on one sector or market-cap segment.
4) Higher returns may come with excessive risk
A fund’s strong returns do not automatically mean that it has delivered superior performance after accounting for risk. Some schemes may generate impressive returns by taking unusually high risks, which can hurt investors when market conditions turn unfavourable.
Mathpal recalled instances of fund managers who generated strong returns by investing in penny stocks but subsequently faced poor outcomes because of their stock-selection approach and investment philosophy.
He explained that investors should not judge a fund solely by its returns during a favourable market phase. The quality of its underlying investments and its ability to manage risk during a downturn are equally important.
“A fund manager may take excessive risks, and later both the fund manager and investors have to bear the consequences,” Mathpal said, explaining the potential downside of chasing returns without evaluating the risks involved.
Investors should therefore assess risk-adjusted returns to understand whether a fund has generated returns commensurate with the risk it has taken.
5) Weak portfolio quality or an unsuitable strategy can hurt performance
A fund’s long-term performance depends on more than its recent returns or the reputation of its fund manager. Its investment philosophy, stock selection, portfolio composition and the consistency of its strategy also matter.
Mathpal said investors should evaluate the fund manager’s approach and the quality of the portfolio before choosing a scheme. A fund may underperform temporarily because its investment style is out of favour, but that is different from a fund whose underlying investment strategy or stock selection is fundamentally weak.
He advised investors to have confidence in a fund house and its fund manager when the scheme’s underlying approach remains sound, instead of reacting to every short-term change in performance.
However, investors should distinguish between temporary underperformance and signs of deteriorating portfolio quality or a flawed investment strategy. Past performance alone cannot establish whether a scheme will recover.
Investors can also consult a mutual fund distributor to better understand a scheme’s investment philosophy, volatility, stock concentration and consistency of performance.
Bagla also recommended checking a fund’s active share, which indicates how much its portfolio differs from its benchmark index.
6) Looking only at point-to-point returns can hide inconsistency
A fund’s return over a specific period may not reveal how consistently it has performed across different market conditions. This is why investors should examine rolling returns alongside point-to-point returns.
Bagla explained that point-to-point returns show the change in a fund’s net asset value between two particular dates, whereas rolling returns help investors assess its consistency and volatility across multiple periods.
He said, “If you look at rolling returns, you will understand its consistency. You will understand its volatility.”
Bagla also recommended examining risk-adjusted performance measures, including the Sharpe ratio and Treynor ratio, as well as beta, to assess the relationship between the risks taken and the returns generated.
He suggested looking at three- to five-year returns, rolling returns, consistency and volatility rather than making an investment decision based on a single historical return figure.
What should investors check before selecting a mutual fund?
The experts also outlined a broader approach to mutual fund selection, emphasising that a suitable fund is more important than simply choosing the best-performing scheme.
Set your financial goal first: Determine what you are investing for, when you will need the money and how much risk you can afford to take. The goal and time horizon should guide your choice of fund category.
Choose the right category: Select a category that matches your investment objective and risk appetite before comparing individual schemes.
Check portfolio overlap: If you hold several equity mutual funds, compare their top holdings. Schemes with similar holdings may offer less diversification than their number suggests.
Understand the expense ratio: Mathpal highlighted that expenses deserve particular attention in debt funds and index funds. For index funds tracking the same benchmark, a higher expense ratio can reduce returns, all else being equal.
For actively managed funds, investors should also evaluate stock selection, portfolio quality and risk-adjusted performance.
Maintain asset allocation: Avoid shifting too much money into small-cap funds, silver funds or other investments simply because they have recently performed well. Diversification across asset classes and market-cap segments should reflect your goals and investment horizon.
Avoid unnecessary switching: Bagla said investors need not react to every market-related news development if they have selected a fund after adequate research and its investment-management team and underlying track record remain sound.
Active fund managers are expected to adjust portfolios in response to market conditions and relative valuations.
Mathpal also cautioned against holding too many similar schemes. He said a portfolio of around six or seven schemes may be sufficient, depending on the investor’s requirements, provided the investments are appropriately diversified.
Best-performing vs suitable mutual fund: What matters more?
The key takeaway from the experts’ insights is that investors should not assume a fund will continue to outperform simply because it has delivered strong returns recently. Market cycles change, sectors rotate and investment styles move in and out of favour.
Instead of chasing the latest winner, investors should identify their financial goals, select an appropriate fund category and evaluate the scheme’s strategy, portfolio quality, rolling returns, consistency and risk-adjusted performance.
As Mathpal emphasised, investors should prioritise a suitable mutual fund over a best-performing mutual fund. The objective is not to predict the next top performer but to build a portfolio that matches their financial goals, risk appetite and investment horizon.