The Golden Thumb Rule| Don’t drive with the rearview mirror — Kaustubh Belapurkar on why past performance misleads investors

In this edition of The Golden Thumb Rule, Kaustubh Belapurkar, Director – Manager Research at Morningstar Investment Research, explains why relying solely on past performance can mislead investors.

While many chase last year’s top-performing funds, Belapurkar warns that only a fraction of them sustain their ranking over time.

He stresses the importance of consistency, strong investment processes, and disciplined teams over chasing flashy short-term returns — reminding investors that in mutual funds, it’s not the rearview mirror but the road ahead that matters. Edited Excerpts –

Kshitij Anand: Let us begin with the basics. What is the golden thumb rule for retail investors? What should they follow when checking if their mutual fund is performing well or not?
Kaustubh Belapurkar: If you just go back to basics, most investors, when you think about it, when they are looking to invest, obviously there are golden rules in terms of following an asset allocation approach and all of that.

And assuming all of that, that should be the driving force behind any investing decision to start with.

But when you have decided what the construct of your portfolio should look like and you have actually come down to picking the funds within, say, categories or asset classes, that is where you start thinking about which funds would best fit in your portfolio.

Now, traditionally, and this might sound a little counterintuitive, but of course looking at past performance is useful, but to our mind that should not be the endpoint of an investing decision.

More often than not, purely what we call rearview mirror driving — just picking funds that have done well over the recent past one, three, or five years — can actually be quite harmful to your investing decisions.

We will talk a little bit more about why that is and how you can avoid it. So that is something to keep in mind: look at performance, but do not make that the holy grail of investing. Saying, “I am going to just pick the best-performing fund over the last one or three years” is going to be counterproductive.

Kshitij Anand: Many investors look at past returns as the only measure. Should investors stop there, or is there a rule of thumb to go beyond returns while judging performance?
Kaustubh Belapurkar: Let me actually elaborate a little bit with some data. We ran some analysis over the last five years — and the data would hold even if we did it for the last 10–15 years.

What we observed was, if you looked at the monthly flows that have come into funds over the last five years and broke it down by quartile of fund performance across categories and asset classes, the one thing that stood out is this: a lot of investing that has traditionally been happening is simply picking the best fund over the last one year on a point-to-point performance basis.

That is because it is the most visible number, and it excites investors. If you see a fund that has done, hypothetically, 20% versus the category average of 10%, investors tend to think that perhaps this will continue forever — that the fund will always outperform. But we know that is not necessarily the case.

Looking at the data, what we saw was that quartile one and quartile two funds based on one-year track records over the last five years actually garnered about three-fourths of the flows.

But if I just do a simple exercise and look at what were the quartile one funds five years ago and what they are today, only 25% of those Q1 funds continued to be quartile one over that time period. So, the persistence of performance can be quite poor.

Investors need to get away from this short-termism and the point-to-point performance metric. Which brings me to your question: what should they do? There are a couple of things investors can do.

One is, obviously, the options for investors have been growing — there have been new fund launches, and there are a lot of existing funds, so the options are only growing. This makes it confusing, because even if you choose the category, how do you pick among, say, 40 funds?

The first thing investors can potentially do is, when we say long term, look at risk-adjusted rolling returns. You can also look at SIP returns, because many investors come through SIPs.

Look at three- to five-year SIP returns, which give you an element of consistency in how the fund has delivered month after month or over a longer period.

Then, very importantly, you need to look beyond returns. A very simple thing an average investor can do is think about the strength of the investment team and the consistency of the investment process.

Returns are a factor or the end result of a good team and a good investment process that can be repeatedly applied, which will give you consistent returns. It takes away the element of “maybe the fund was just at the right place at the right time.” Without a good team and a good process, it is unlikely that a fund can consistently deliver excellent returns. That is something to keep in mind.

Kshitij Anand: So, the management pedigree is also something investors should take note of.
Kaustubh Belapurkar: Yes.

Kshitij Anand: And, well, markets move in cycles, and so do returns. When we talk about consistency versus short-term performance or outperformance, how much weight should investors really give to consistency? Is there a thumb rule to balance the two?
Kaustubh Belapurkar: Absolutely. I would say focus purely on consistency rather than looking at short-term outperformance. Let me again elaborate with an example.

We did a study looking at the last 10 years of monthly return time series of funds versus their benchmarks. Essentially, we looked at funds that had outperformed their benchmarks.

We already know that it is becoming harder to beat benchmarks, so you are already looking at a smaller subset of funds that have actually beaten their benchmarks over, say, 10 years.

What we observed was that certain good months of performance can contribute to the entire outperformance of a fund versus its benchmark.

The data showed us that, on average, just five months out of the last 10 years — five out of 120 months, or only about 4–4.5% of the overall time period — accounted for the entire outperformance of the fund versus its benchmark.

That becomes very important: if you were not invested in that fund during those four or five good months, you would not have beaten the benchmark. The old adage “do not time the market; time in the market is more important than timing the market” is proven here.

This is why consistency becomes so important. Some of the best-managed funds will continue to deliver steady outperformance, rather than having great months at one time and poor months at another, which would give investors a very different experience compared to a more consistently managed fund.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)