MF Investments - Avoid past glory

Many investors tend to believe that the best way to invest in equity funds is to go for top performing funds. The general belief is that these funds cannot go wrong and in all likelihood would replicate their past performance in the future too. The moot question, however, is whether one should rely on the past performance alone or is there a need to look at other factors before deciding to invest in a fund. Although past performance can be an important consideration, it is critical to look for a fund that provides the right balance between one’s risk-taking capacity and the fund’s ability to provide commensurate rewards.

Simply put, one must avoid funds that show very high past returns because of a very big but isolated period of a great performance. Clearly, it is important not to depend entirely on the past performance. The key is to invest in the right mix of equity funds especially if one is looking to invest for the long term. For example, if one were to go by only the past performance, the chances are that one may end up investing in a particular class of equity funds, say, mid-cap or thematic funds. After having selected appropriate funds, it is equally important to know how to measure their performance. Invariably investors consider either dividend or change in the NAV for measuring performance. This method obviously does not give them a true picture.

Total return is the best way to measure the performance of funds in the portfolio. Total return is the sum of two components — dividend and capital appreciation. When combined, these elements provide the “big picture” of what one’s investment has been doing over time. While the concept of total return is the best way to analyse the performance, it is often ignored by advisors as well as investors. It is important to remember that total return is a useful tool for making a comparison between the performances of funds in the same category or a fund and its benchmark.

While assessing total return, there are some important issues that need to be taken into account. Total return can be presented either on a cumulative basis or as an average annual compounded rate. However, it is not advisable to rely solely on cumulative return as it does not reflect the true picture. For example a fund with a cumulative return of 100% over ten years did not earn an average compound return of 10%. The annual compound return in this case was 7.20%.

Another aspect that a mutual fund investor needs to take into account is the difference between the compounded rate of return and the simple rate of return. For example, a fund with an annual return of 20%, 25% and a negative return of 15% in three consecutive years will make Rs 100 grow to Rs 128. This works out to an average annual compound rate of 8.30%. On the other hand, if the returns are added to arrive at the simple rate of return, the value would be Rs 130. In other words, the simple rate of return would be 10%.

Let us now understand as to why the average compounded return should be taken into account to get a clear picture. For example, while the aver-age return on an investment that provides a positive return of 100% and a negative return of 50% in two consecutive years would be 25%, the average com-pounded rate would be zero. In this case the initial investment of Rs 100 would double to Rs 200, only to decrease to Rs 100. As is obvious, it make sense to take the geometric rate of return - annualised on a compounded basis - that should form the basis of calculating total return, rather than the simple arithmetic rate of return.