A reader asks, “I have been investing in MF through SIP for 15+ years. I have the habit of reviewing my mutual fund portfolio in January every year (15 years so far) and comparing my MFs to their peers. I check for 1 year returns. If my MF is in the top 3 for the year, I do nothing. If not, I stop the SIP and start a new SIP in the top performer.
I have accumulated too many MFs this way and I am pretty sure this is not right”.
“But is there a strategy that one can adopt? Is there a criterion (past 1/3/5/7 year relative performance) one can choose as a trigger to switch to a different MF?
Can we extend this further to the following?
1. Pause SIP (for 1 year) but do not sell
2. Restart SIP (after 1 year of pause)
3. Sell all units and move to new MF (after X years of pause and underperformance)”
We must learn to ignore what the mutual fund industry says in large font in their advertising brochures. We must take extremely seriously what they say in small font. When they say past performance is not representative of future performance, they mean every word!
It is quite easy to ensure that our portfolio always has the top past performers, but that is of little use to ensure they would stay that way. You can do any amount of analysis and use any duration but wanting the best performers at all times always means frustration and clutter.
This is why we recommend using index funds. This risk of outperformance and the constant headache of seeking “best funds” is eliminated.
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After you buy an active fund, how long are you willing to tolerate underperformance? Most people tend to say, “about 3-5 years”. This means they assume the fund would “stay on top” for at least three years after they started investing. Sadly, the underperformance kicks in a lot sooner!
Why? Because most mutual funds investors are lured by last year’s return (our reader seems to be a case in point). The higher the outperformance, the greater the AUM inflow into that fund. This a classic example of the hot hand fallacy. People expect the fund’s performance to sustain forever.
Sadly, the greater they soar, the harder they fall. No one can escape the law of averages. So the ringside admirers who entered become the first victims.
We have shown earlier that top performers in the past are the most likely to fall. Funds with a ‘reasonable’ history of past performance have a pretty decent shot at reproducing that in future. Or in other words, average performers have at least a 50% chance of remaining average performers in future. See: Mutual Fund Investing: Does Past Performance Matter?
Investors who crave to be invested in the ‘best’ funds will have to churn frequently to satisfy their craving. This will incur taxes and diworsify the portfolio to a point where it looks like an expensive index fund!
Don’t take out word for it. Use the portfolio visualization module in this tool to compare the performance of your active mutual fund portfolio with an index: Track your mutual fund and stock investments with this Google Sheet!
We might as well select an index fund (especially when the portfolio is young) and put our real wealth (time) to better use elsewhere.