Reading between the past returns of mutual funds

‘Past returns are not indicative of future returns’ is a disclaimer you would have come across often. The reason why past returns cannot be taken as a yardstick is because the past returns that you typically see are point in time returns. That is had you invested on a certain date, what would be the return now. Looking at returns even a month later may have changed the picture! Even if the performance of the fund stays stable, a fund cannot be immune to external market conditions.For example, even in the best of funds, had you looked at it’s one-year return at the end of say 2008, you would have thought it was a poor fund. Even so, past returns give us important information about the fund’s performance. Let us see what they are and how to interpret them.

Why is it important and what does it tell us?  

To put it simply, past returns tell us the ability of the fund to generate returns.  Explaining with an analogy, let’s say that you are interviewing a candidate. You are trying to assess what he will bring to the company. The first thing you would do is look at how he has grown up the ladder in his previous company and what credentials he holds. Imagine if that is all you consider to assess if he is fit for the profile for which you require him. Wouldn’t that be insufficient? That is precisely what you will be doing if you consider just the past  return numbers while making an investment decision.

So how do we assess the candidate given all we have is his past accomplishments and a promise to deliver results in the future? What we try to do is, take a cue from how he has managed to deliver the results rather than just focusing on the fact that he has. For example, if he had managed to deliver results with lesser resources than maybe, another candidate, that would tell us about his efficiency. If he has managed to take up challenging roles, that tells us about his capacity to deal with stress. If he had initiated a new idea that worked wonders for the company, that would talk of his innovative skills. Essentially, we try to to assess his strengths under different scenarios and conditions that will give us more insight into his ability.

How should you be looking at returns?

Similarly, looking at returns as just absolute figures will not tell us the whole story. What we do is dissect the return numbers and understand how funds performed – in different markets, under different stress conditions, under different fund managers and of course how their strategies panned out. This will provide us with confidence on how the fund can perform under similar conditions at a future date. Let us try to break down returns in components that are necessary to assess a fund’s real performance:

1. Consistency –  The consistency with which the fund has been providing those returns is one of the important factors to be looking at. If you are just looking at the last 1,3 or 5 years return, you would only know how the fund has performed in that particular period. For example,  take an equity fund, HDFC Midcap Opportunities fund. It gave 1 year return of 7.9% on 26th Dec 2016 and 1 year return of 41.32% on 16th Feb 2017. If you had happened to check the returns on these two dates, you would have completely different views of the fund.

How to measure:  This is why we use rolling returns to understand the performance of the fund during different periods. Rolling returns is when you take returns of a particular period (say 1- year) and see it at different points in time. Say for example, you want to assess one-year return of a fund on a daily basis, you look at 1 year from today, 1 year from yesterday and so on. This eliminates the bias of any short term blip the fund would have had at certain points and also normalises periods of huge returns. You can take rolling returns of the fund and compare it to the benchmark and peers in the category to see how consistently the fund has performed.

What it tells us:  If a fund has been able to consistently hold its performance relative to its peers, it talks about its’ ability to steadily find good opportunities, manage downturns and up markets with alacrity and thus sustain performance in relation to peers. In other words, it talks of its ability to perform not once or twice but steadily across any day of the year.

2. Volatility – If a fund’s return sways too much, it becomes all the more difficult to base our  future expectations on it. In the financial world, the unpredictability attached to it is what makes the instrument risky. You consider bank deposits to be safe because of the certainty of cash flows from it. Extending the same logic, we measure volatility of the fund to gauge the extent of risk.

How to measure: Standard deviation is a statistical measure to know the deviation of returns from the mean. To explain with a simple example, a fund having 1 year return of 10% and 15% at different instances will have lower standard deviation than a fund having 1 year return of  5% and 20%. Higher deviation would mean, that there is a high chance that you end up with far higher returns (from average returns)  in the fund or equally, end up with far lower returns from the average. That adds a high element of uncertainty to a fund, which is already subject to market uncertainties.

What it tells us:  How volatile the fund has been in the past help us understand its risk characteristic. If a fund with a high standard deviation gives extremely attractive returns during an upturn, it is highly likely that it will move with the same momentum in the opposite direction during a downturn because of the risky calls it would have taken. The volatility of the fund could arise simply from the volatility of the underlying instruments or if the fund keeps changing its strategy or portfolio frequently.

3. Risk adjusted return – You may be pleased to choose a fund with high returns. But it is important to understand how much risk the fund has taken to generate those returns. To put it simply, would you go for a volatile equity fund if it delivered the same returns as a stable debt fund? The answer is an obvious no. You would not want to go for a riskier option when the returns earned are about the same. This is what you should be looking at while you are comparing different funds. If a fund takes enormous risk to deliver just above average returns, you would be better off going for a fund that takes lesser risk and gives average returns.

How to measure: Sharpe ratio is a measure used for this purpose. It computes the excess return (earned over the risk free rate of interest) for every unit of risk you take. A higher Sharpe ratio means the fund has delivered superior returns for the risk it took or has given better risk-adjusted return.

What it tells us: This will tell us how efficiently the fund has managed the risk-return tradeoff. We can infer whether the risk that the fund took paid off.

 4. Downside containment – This is the stress interview for your candidate. At any point in time of the period we are looking at, how has the fund been able to contain its losses? The ability to contain losses is one of the prime factors because, lesser the losses made, easier it is to bounce back.

How to measure: To assess this, a fund can be compared on proportion of times it has given negative returns and the maximum loss it has incurred in different periods. You can also look at the best and worst period returns for all the funds, online. The worst percentage returns a fund has given will provide an insight into how it manages downsides.

What it tells us:  This will tell us how different funds score on cutting back on losses without compromising on returns in the long run. This is important because, the steeper the fall for a fund, the more difficult it is to climb back. Many funds lose out in the long run because of their inability to contain downsides, despite rallying in bull markets.

The above are just a few parameters that we look at when breaking down the returns of funds. At FundsIndia Research, many of such metrics, together with the quality of a portfolio goes into deciding which funds are worthy of investment.