Does It Make Sense To Invest In Winners?

The common tendency among those who invest in mutual funds is to simply look at some data and pick out the one that has been at the top, assuming that a fund which is performing well today will continue to do so in the future as well. There is something terribly wrong with such a strategy if you want your mutual fund to create wealth over the long term. The article explains the factors that must be taken into consideration prior to choosing the winner 

Investors would have noticed the fact that, of late, the equity markets have been displaying good momentum. This is primarily due to the state elections results and expectation of continuity of the present government at the centre along with the return of foreign institutional investors (FIIs) and the US Federal Reserve turning dovish with hopes of beginning a rate cut cycle from March 2024. Given that mutual funds are closely linked to the equity markets, the returns offered by them have witnessed a spike too. 

In the last one year, the lowest average return generated by any equity mutual fund category was 18.58 per cent. When it comes to individual funds, the lowest return generated by an equity mutual fund was negative 3.5 per cent, while on the higher end, equity mutual funds delivered return of 53.81 per cent in the last one year. 

Tracking the Equity Market
The reason for such superior returns by mutual funds can be attributed to better returns by the equity market, especially the broader equity market. 

After posting a low of 15,293.5 in mid-June 2022, Nifty 50 made an all-time high of more than 21,500 in mid-December 2023. Nifty 50 delivered absolute returns of 40 per cent and a compounded annual growth rate (CAGR) of 25 per cent in just 18 months. This was despite heavy FII selling. However, domestic institutional investors (DII) supported the market at that time, thanks to large SIP inflows. 

From June 2022 to mid-December 2023, FIIs were net sellers and DIIs were net buyers. FIIs sold shares worth `68,558 crore, while DIIs bought shares worth `2.51 lakh crore. However, from October 2023, FIIs began to increase their investments due to the factors mentioned above. This has shifted the overall market sentiment from bearish to bullish, alluring a lot of retail investors to park their funds in mutual funds. One of the most common ways in which retail investors select funds is to check out the funds that are outperforming or are the best performers in the category, and then invest. Therefore, every investor wants to bet on winners. 

Performance of Winners
To understand how the winners have performed over one, three and five-year periods, we carried out a comprehensive study, in the course of which we took three equity mutual fund categories, namely, Large-Cap, Mid-Cap and Small-Cap. There was no reason to take thematic or sectoral funds as they are very cyclical in nature and it would not have made sense to select funds based on their last year’s performance. The result was that we could find out winners based on calendar year returns. For more insights we have taken the top three and bottom three performers in a respective calendar year and their one, three and five-year returns after that year. 

Moreover, we have divided returns of each fund in four quartiles, Q1, Q2, Q3 and Q4. Q1 and Q2 have turned out to be the best performers as they outperformed their peers and have returns better than the average, while Q3 and Q4 have been the worst performers as they underperformed their peers. 

A point to note is that we have assumed regular plans instead of direct plans. The data is for the period ranging from January 1, 2013 to December 15, 2023. 

Large-Cap Funds
In this section, we would be analysing the returns of large-cap funds and understand how winners performed in subsequent years. So, in 2013, among the large-caps, Axis Bluechip Fund was the best performing equity mutual fund. In the next one year, the performance of the fund was better than its peers. Nonetheless, over the next three years, its performance slipped in Q4, which means that it underperformed its peers. Similarly, DSP Top 100 Equity Fund, which was the worst-performing large-cap fund in 2013, continued its underperformance in the subsequent period. 

If we take a closer look at the data represented in the tables above, there emerges a clear pattern which is visible in the one-year period. If you invest in the best performer of the calendar year, then there are high chances that it will continue to outperform its peers in the next year. The table below shows the aggregate of the above results in terms of probability. So, the top performing fund can either remain in Q1 (33 per cent probability) or Q2 (67 per cent probability) in the next one-year period. 

However, in the three-year period, there is no presence of any particular pattern. In a five-year period, once again there are higher chances of the best performer outpacing its peers. Therefore, when it comes to large-caps, our study shows that in a one-year period, there is a higher probability of the best fund outperforming its peers. Although, in the five-year period, 67 per cent of the times the best performer outperformed its peers while for the balance 33 per cent of the times it also proved to be among the worst performers. 

Mid-Cap Funds
In this section, we would be analysing the returns of mid-cap funds and understand how the best performer in a given calendar year performed over a one, three and five-year period. 

Analysing the above data, we can see that most of the times, the winner of a calendar year underperformed its peers in a one-year period. This means that for 67 per cent of the time, the best performer fund moved to Q3 in the following year and only 33 per cent of the time did it remain in Q1 or Q2. 

Things become unpredictable when it comes to a three-year period. In a following three-year period of a given calendar year, for 50 per cent of the times, the best performer became the worst performer. In fact, in the five-year period, 67 per cent of the funds turned out to be the worst performers and the remaining 33 per cent were not able to beat their peers. Therefore, in case of mid-cap funds, things don’t seem to pan out well in the near term as well as in the long term. 

Small-Cap Funds
In this section, we would be analysing the returns of small-cap funds and understand how the best performer in a given calendar year performed over a one, three and five-year period. 

As can be seen in the presented data, in the following one-year period of a given calendar year, the winner tends to underperform its peers 66 per cent of the times in Q3 and Q4. 

However, things change when you look at the medium-term and long-term periods. In a three-year period, for 84 per cent of the times, the best performer in a given calendar year outperformed its peers. Even in a five-year period, for 83 per cent of the times, the winner outperformed its peers. This shows that a small-cap fund is a long-term game. 

Conclusion
It is quite alluring to pick the best performing fund and invest in it, assuming that it will continue to give profitable returns in the future. However, that might not be the case. As per our study, though the large-cap and small-cap winners in a given calendar year have done well over a long term, you cannot rule out their underperformance. Moreover, when it comes to mid-cap funds, there is no clear pattern visible and this certainly means that investing in a mid-cap winner is a poor strategy. Therefore, before you pick up any mutual fund for investment, apart from returns, you also need to understand risks such as volatility, portfolio concentration and sector allocation. Even for systematic investment plan (SIP) investors, it is important to study the fund well before investing, and not just rely on past performance.