Past Performance and Future Expectations

All Mutual Funds carry a disclaimer saying

“Past performance of the sponsor / AMC / Mutual Fund does not indicate the future performance of the Scheme(s)”

Yet, in real life everyone including Mutual Funds want you to see the past performance and while they don’t claim anything, the message sent across is that there is correlation between past and the future and that given the great performance of the fund manager in the past, you can assume similar performance in the future as well.

When I recently tweeted about why I wasn’t comfortable with Nifty Quality 30 Index (despite me liking the idea in itself), one of the questions that I was asked was, you should not look at past performance to judge the future. Yes, past has no relation to the future and yet, every adviser and every rating agent looks at the past returns to come up with a list of Top funds to invest into.

If past performance really didn’t matter, we should have seen a more uniform spread of Assets under Management across various fund houses which is not true and hence showcases that we are really driven by the past performance even if we know that there is no way to know for sure whether the future will be as good as the past.

When the future performance is not in line with the past,we get disappointed and search for excuses as to why the fund manager could not replicate the performance of the past. Let me give a real life example.

HDFC Top 200 fund is one of the biggest single funds in the Mutual Fund industry. While investors continue to believe in the fund manager, there has been more than a murmur of voices as its performance. But is the peformance really so bad?

If you take a look at the fund performance over last 5 years, you shall see that it has performed inline with Nifty Total Return Index. So, why the angst and the disappointments that seem to have surrounded the fund?

The answer lies in how it performed over the 5 years previous to that. Rather than talk numbers, let me provide you with a chart where I have divided the data into two equal parts (10 year data) and re-based everything to zero to provide you with a clearer perspective

The first five year (2006 – 2011) was pretty good for the fund as it outperformed significantly against Nifty generating tremendous Alpha. The next 5 years, returns are all in line with its Beta and therein lies the difference.

When investors look at the past and invest, they are essentially hoping that the fund manager will provide  similar performance in future and any deviations on the lower side is not taken kindly.

Futher Reading: A paper on why you should not buy funds that have recently out-performed

To really generate Alpha using Mutual Funds (even as they decline in over all terms), you need to be the few who identify and invest with him early and exit when he starts to become a house hold name and that is really a tall ask to say the least.