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What you need to know before choosing “Best/Top Mutual Funds:”

In this post, I discuss what investors need to know before reaching for Best/Top mutual funds with a past vs future performance study along the lines of the one made earlier: Mutual Fund Investing: Does Past Performance Matter? So this post is more of an update to that analysis.

Let us assume that you make a lump sum investment on Jan 1st 2010 by looking at the past 5 year returns. Then after 5 years on Dec 31st 2014, this is how the 2010-2014 returns (future when you make the investment) would fare against the 2005-2009 (past, the ones you based your investment decision on).

Set 1: Future (2010-2014) Returns vs Past (2005-2009)

A similar exercise with another set of years

Set 2: Future (2011-2015) Returns vs Past (2006-2010)

Set 3: Future (2012-2016) Returns vs Past (2007-2011)

 

Many funds that had great past returns did not do so well in future. Similarly, many funds that fared badly in the past, reversed their fortune in the future. Let us put this in better perspective.

Set 1: Future (2010-2014) Returns vs Past (2005-2009)

If you had chosen a fund from the "top 25 past returns"**  (pink returns below) and invested for 5Y without monitoring, then only  13 of those "top past" funds remained in the top 25 after 5 years (blue returns).

** that is a broad set, many choose from top 3 or top 5!!!

On the other hand, if you ignored the top 25 and bottom 25 and picked one from the middle 48 funds, then 25 of those funds remained in the middle band in the future.

Set 2: Future (2011-2015) Returns vs Past (2006-2010)

In this case only 5 of the past-top-25 feature in the future-top-25. One of the past-top-25 fell to the bottom-25 in the future (red return).

If you had ignored the top 25 and bottom 25 and looked at the middle 71, then 40 of those funds remained in the middle in future too.

Set 3: Future (2012-2016) Returns vs Past (2007-2011)

In this case, 12 out the past-top-25, feature in the future-top-25. The future list also includes two funds from past-bottom-25

In this case 59 out of the 85 "past-middle" funds remained there in the future.

My Lessons from this study

  1. If I chase after best/top funds, I better expect them to fall off the top at any time and actively track and manage my portfolio. Even then, getting "best returns" (whatever that means!) is not a guarantee. Past top performance is not a guarantee of future top performance.
  2. Similarly, past poor performance is not a guarantee of future poor performance (stats are similar to the above).
  3. If I do not want to monitor/manage my portfolio and simply buy-and-hold (in the hope that it will be alright in the end), then I better take my chances with the middle group (neither top 25 not bottom 25). This way I seem to have about 50% chance of success (3/3).

Points 1 and 2 is merely common sense and therefore decidedly uncommon. As for point 3, the message is NOT to choose from the middle group but to have reasonable expectations.

This way, even if I choose from the top 25 (human nature), I will not be disappointed if its performance dips when a peer comparison is made (often over periods different from the ones I invested in).

Perhaps the key lesson is: Higher the expectation, higher need to tinker the portfolio.  Considering that we are all taking a chance when we buy a stock/bond/gold/mutual fund, this can result in top/middle/bottom performance!

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1 thought on “What you need to know before choosing “Best/Top Mutual Funds:”

  1. The Big O

    How about comparing standard deviation, alpha, beta, upside and downside capture instead? You have explained it simply and very well in a separate article as well as in your first book...

    Reply

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