Have you not read the mutual fund past performance disclaimer? Then how can we select mutual funds using past performance alone? In this post, I discuss this question asked by Swati Joshi. It is no secret many in the financial services dislike me. So their favorite approach to criticism is to claim that my "fund selection strategy" is based on past performance and is flawed.
Again let me not beat around the bush. Yes, past performance is not an indicator of future performance. Neither is "careful selection" of a mutual by an "advisor".
Readers who have journeyed with me for a good part of the last 5 years will realize that my stress on the importance of fund selection (never high to begin with) has dramatically dropped to the extent that I wrote: How to use Inky Pinky Ponky for selecting Mutual Funds!
The reception to that post was expectedly lukewarm. Because most people still make too big a deal out of mutual fund selection. This is the problem with starting a SIP. To a newcomer, it resembles an insurance policy with monthly premium payment.
They think once the fund is selected and the SIP is set up, their goals will be automatically reached because "in the long term, equity builds wealth" - ha!
So they are so worried about selecting the right fund. Many advisors, including journalists who run advisory portals, exploit this fear and make a big deal about fund selection. See: Selecting the right equity mutual fund scheme is not possible!
The step in answering the title question is to recognize that unless we have a solid review strategy in place, which funds you select does not matter.
Now, suppose we ignore the past performance - this means returns and all risk metric like alpha beta, gamma, ....., upside-downside etc.
Some people seems to believe past performance only refers to returns. When once the NAV is declared on a business day, it is history. All data derived from NAV history is past performance.
So now that we have ignored NAV history and all its derivatives, please show me an alternative that will help me predict the fund's future performance.
Some people claim to look at the fund portfolio and investigating the fund managers picks, strategy, and potential future performance taking market outlook into account is a superior strategy. In fact, MorningStar calls this forward-looking analysis (Their qualitative rankings as opposed to the quantitative past performance based star ratings).
What amuses me about this, is the fact that the information used for such forward-looking analysis is historical information. So if there is no math involved, then it is merely a subjective opinion based on past data.
I am not interested in the debate of which is better? Who cares! However way you select a mutual fund, you will have to review its performance in real time again based on updated past data.
Personally, I have zero interest in tracking factsheets and worrying how much cash the fund currently holds. If I can make some sense out of such time spent, then I would be invested in direct equity. I used mutual funds because I have better things to do with my time and all I want is a black box with two labels - the current nav and the category the fund belongs to.
Those two labels are good enough to choose a fund, review its performance and choose another if necessary.
Swati's full question is: Can we select funds considering only past. Performance? No other criteria like a change in strategy, fund manager needs to be taken into consideration?
A change in strategy and or fund manager is also past information. If there is a significant change in the fund's strategy, we will be given a chance to exit without load (but not tax).
I have no idea who my fund's managers are. They some corporate employee waiting to jump ship when they can smell a better pay packet. Getting emotionally attached to them is a waste of my time and emotion.
Like I said, the black box with two labels should suffice. If there is a change in performance because the fund manager has changed or because he went loony, it will show in the NAV and I will take necessary course corrections. No biggie.
So Can We Select Mutual Funds Considering Only Past Performance?
I can spot nothing wrong with it. And I certainly cannot spot anything objectively superior to it.
If there were reliable ways in which future performance can be predicted, the "market" will no longer be one.
I feel like I have said it a zillion time already, a proper review process should be in place. This is possible only if there is a proper investment strategy in place.
1 Well defined goal (Financial Goal Planning: How to buy an Audi Car)
2 Suitable asset allocation (Deciding on asset allocation for a financial goal)
3 Choice of fund category Minimalist Portfolio Ideas for Young Earners
4 Selection of funds in each category (so many posts on this, here is the latest: Two Simple Ways To Screen For Mutual Funds)
5 Systematic investments with monitor and review (How to Review Your Mutual Fund SIPs
6 Portfolio management and systematic risk reduction (Simple Steps to De-risk Your Investment Portfolio and How to systematically reduce the risk associated with a SIP)
Once all this is in place, worrying about which fund to select would appear childish.
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