Should You Switch Your Equity MF Investments After One Year?

Mutual funds are meant for longterm investment. However, data shows that investors are exiting funds before two years more frequently than before. DSIJ studies the data to find if it makes sense to do so.  

The legendary US investor Waren Buffett, famous for his investments, is equally famous for his yearly letter to shareholders where he shares his wisdom on investing. In one of such letters in 1988, he shared his thought about years of holding of an investment. He wrote, ‘When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever’. Some of you might be tempted by his teachings, but forever may not exist when it comes to investments as investment horizon plays an important role in determining your overall returns. 

While entering a fund might not be an easy task, exiting a fund is; the reason being it forces you to deal with two of the strongest behavioural forces in investing. First is the fear of missing out on the profit on the upside, and the second is the fear of losing money on the downside. If you remain invested for long, large fall in the prices might wipe out years of gains. Large drawdowns are not rare in the investing world and we have witnessed how the fall in stock market in year 2008 inflicted losses that took years to recover. 

All this raises a pertinent question: When one should exit a fund or what is the optimum holding period for a fund so that returns generated are maximum? The data by Association of Mutual Funds in India (AMFI) shows that the period for which investors remain invested in mutual fund is getting lower with time. In 2010, the percentage of investors that remained invested in a fund for more than two years was as high as 57.13%, the figure for 2017 has come down drastically to 32.3%. Even in the last three years, the proportion of investors that remained invested in the funds for more than one year has declined. In year 2015, for every 100 investors, 59 investors remain invested for more than one year, however, for 2017, the number has declined to 50. On the other hand, number of investors investing for less than six months are on the rise. From 2015, it has steadily increased from 22.7% to 31.2% in 2017.

There are various reasons attributed to the decline in number of investors remaining invested for a longer period. The prominent among these reasons is that as the markets went up very fast in the year 2017, investors wanted to book profits as soon as possible. What is also prompting such early exit is recommendation from their financial advisors. Many times, distributors or financial advisors recommend investors to exit from old schemes and invest in new funds as it helps them to earn commission and other incentives.

The above reasons make sense. Nonetheless, to understand if there is any particular reason why the holding period in equity mutual funds is getting shorter, we thought of digging more into the data to comprehend if there are any financial reasons for such a shift. 

Data Speaks for itself 

The results are astonishing. Even if you had invested in top five funds every year since 2009 and had remained invested in those funds for three years, five years and seven years, the returns generated by these funds are inferior to the average returns generated by top quartile funds every year. Except for 2011, when the overall market gave negative return of almost 25 per cent, investment in best funds would have generated better returns for the next three-year and five-year terms. In both the cases you do not have to pay exit load 

For example, in the year 2009, the average returns generated by top quartile funds was 125 per cent, for 2010 it was 34 per cent and in 2011 it was negative six per cent. Hence, if you had invested Rs 100 at the start of 2009, it would have grown to Rs 225 by the end of the year. After that, Rs 225 invested in 2010 would become Rs 301. 5 at the end of 2010. Finally, Rs 301.5 is again invested at the start of 2011, which would become Rs 283.4 at the end of 2011 as market witnessed a fall of six per cent. 

Nevertheless, if you had remained invested in the top five funds of 2009, which had generated average returns of 150% in the year 2009, for the next three years, your Rs 100 worth of investment at the start of 2009 would have grown to Rs 234 by the end of three years. The difference in return in absolute terms is Rs 48, which translates into return of almost 14% annually, which is substantial.In another case if you had followed the same strategy wherein in year 2010 when you had invested Rs 100 at the start of 2010 and switched it every year and got average return of top quartile fund, you would have got Rs 162 at the end of three years. Nevertheless, the average annualised return for three year generated by top five funds of year 2010 is 18.95 per cent and your Rs 100 would have grown to Rs 168. In this case remaining invested in top fund would have created better returns, however, such cases are few and far between. 

(see : Comparison of returns generated on investments.) The Union budget 2018 reintroduced the long-term capital gain tax (LTCG), which further makes the strategy of switching funds every year more lucrative. According to the budget announcement, you have to pay tax at a rate of 10 per cent for all the returns generated from investments in equities and mutual funds. However, this is applicable only if you have made a capital gain of more than Rs one lakh in a year. 

Assuming the average returns generated by your investment in a year is 15 per cent, you can invest up to Rs 6,60,000 every year, which will generate profit of Rs 99,000 and hence you can avoid paying any LTCG. For a retail investor, investing Rs 55,000 per month (Rs 6,60,000/12) is a tall order, and hence, if he switches or books profit every year, for the first few years, he need not pay LTCG. However, as his corpus grows, he may have to start paying tax in later years. On the contrary, if you remain invested in the same fund and exit the fund after three years, your gain will be Rs 3,47,000 and you will have to pay LTCG of Rs24,700as Rs one lakh is exempt from LTCG and you will have to pay tax only on Rs 247000 at a rate of 10 per cent. Therefore, it is even tax-efficient with the usual caveat, ceteris paribus ('other things remaining the same'). We have seen the outperformance of the strategy of switching funds every year, rather than remaining invested in top funds for 3-7 years. 

Moreover, these are even tax-efficient. Hence, it makes financial sense to switch mutual fund investments every year as these have the potential to generate better returns. 

Despite all this, investors have been always preached to remain invested in the mutual fund for the long-term —an advice which most of the retail investors religiously follow. This is because, for a retail investor, looking for the right funds and switching involves large informational cost, which prevents him from following such an active strategy. Nonetheless, as the availability of information is becoming easier and cheaper, we may see retail investors too start following active strategy when it comes to investment in mutual funds. 

The Methodology: 

To know if it makes sense to shift your investment every year or remain invested in top performing funds of a year for the next three-year, five-year or seven-year periods, we did the following study. We divided the entire study in two parts; first, we assumed that you remained invested for a year in the funds that formed part of the top quartile in terms of returns of that year, and next year, you switched to funds that are again from the top quartile in terms of returns. In the second part, we assumed that you remained invested in the top 5 funds of any year for the next three-year, five-year and seven-year periods. 

To study this, we took monthly NAV of all the open-ended equity schemes since the start of 2009. After that, we calculated the yearly returns of each funds. These funds are than bucketed into four quartiles based on their yearly returns. Then, we averaged the returns of the funds in these quartiles and assumed that you have received the yearly returns that have been generated by the top quartile. Thereafter, we calculated the returns generated by switching funds every year. For example, the average returns of top quartile funds are 29 per cent, 17 per cent and 84 per cent over the three years, your investment worth Rs 100 would have become Rs 277 after three years. 

This was tested against the assumption that you remain invested in the top five funds of any year for the next three-year, five-year and seven-year periods. The returns that you will get is the average of the annualised returns generated by these funds for specified investment horizon. For example, if you had invested in a top performing fund that has generated annualised return of 30.4 per cent for three years, your Rs 100 investment would be Rs 173.66 at the end of the three years. Although every year the number of funds changed, on an average there were around 400 funds every year. We took only primary funds, that is, funds that are regular and growth oriented. 

Finding The Best Performer For The Next Year 

Our entire study was done after we had all the data. However, in real life, you do not have the performance data for the next year. Hence, to follow the strategy mentioned in this story, the uphill task is identifying the funds that are going to perform next year and the best funds to invest in. 

There are many rating agencies that give star ratings to MF schemes. However, a five-star rating may not mean better performance next year. These rating agencies consider various things, including historical returns and the risk taken to generate returns to arrive at certain rating. Moreover, these ratings are relative to the category under which these schemes are clubbed. So, a fund giving less negative return may get a higher star if all other funds in its category have generated higher losses. Moreover, with the rationalisation and categorisation of funds following the SEBI directive, the character of many funds would change,which means that the past ratings and returns will not reflect anything about the future performance. 

In this scenario, one of the thumb rules is that funds with lower expense ratio are expected to generate better returns. Global research has shown that lower expense ratio remains one of the strongest indicators of better performance going forward. Therefore, to start with, you can scan all the funds that satisfy your risk-reward profile and select those funds that have lower expense ratios. 

One of the advantages of our strategy is that you only need to identify those funds that remain in the top quartile in terms of performance. The probability of finding the top performing funds in a year is far more difficult than finding funds that will remain in the top quartile. For example, if there are 400 primary equity schemes in any given year, the chances of identifying and investing in top quartile funds is 25 per cent, while identifying top 5 performing funds is 1.25 per cent. Therefore, even if you are not able to identify top funds and invest in top quartile funds, you can generate superior returns over a longer period if you switch to the right fund next year. 

There is one place where you can find the best returns for the next one year.We at Dalal Street have developed a method to identify funds that are going to perform in the next one year. Based on the underlying portfolio, we predict the expected return of the funds for the next one year. Therefore, you can start with DSIJ ranking, which is available in our MF data bank. Nonetheless, our ranking is based on current holdings, which are subject to change. Besides any fundamental change in the stocks comprising the fund's portfolio may also change the return expectations. Hence, you should constantly keep a watch on our MF data bank to understand the return potential of various funds.