One of the most common disclaimers in the investment world is that "past performance is not indicative of future results."

 

However, when investing in mutual funds, many investors rely heavily on past performance as the primary yardstick for decision-making.

 

While historical returns are undoubtedly significant, they should not be the sole factor guiding your investment choices. Numerous studies have demonstrated that funds with impressive historical returns do not consistently maintain their performance in the future.

 

Insightful conclusions can be drawn by looking at how the top 30 funds did during the ensuing three years, from 2009 to 2022. Except for a few cases, the aforementioned high-performing funds have experienced a decline in their overall ranking due to their poorer performance.

 

In certain cases, the drop in ranking is rather dramatic. For example, the number one fund in 2015-2017 fell to 175 in 2018 – 20, when the fund universe comprised 177 funds. Likewise, the top-performing fund in 2017 – 19 is now at rank 165. The red cells serve to emphasize the volatility in the ranking of the funds, highlighting how the rankings of the funds have changed.

 

The above analysis clearly suggests that while past performance is a valuable starting point for evaluating mutual funds, it should not be the sole determinant of your investment choices.

 

This lack of focus on the underlying fundamentals of an asset can lead to misguided investment decisions. Price momentum alone cannot provide a complete picture of an asset's intrinsic value or long-term growth potential. Neglecting factors like earnings, cash flow, and competitive positioning can expose investors to unnecessary risks.

 

There are several reasons why it's not an ideal way to make money. When a particular asset or fund starts to perform well, it often garners significant attention and capital inflows. This influx of investors can create bubbles, driving prices to unsustainable levels.

 

When the bubble bursts, investors can suffer substantial losses. Rapid growth in fund assets can make it challenging for a fund manager to deploy capital, effectively diluting returns. As the fund's returns decline due to asset bloat, investors may experience diminishing returns, and the fund may no longer meet its performance expectations.

 

The performance of mutual funds can be influenced by market cycles. A fund that is currently excelling may see a decline in performance. Conversely, a fund exhibiting poor performance has the potential to transition into a high-performing fund during subsequent market phases, as indicated in the table provided.

 

The fund that achieved the highest ranking in 2020-22 had a significantly lower ranking of 113 during the period of 2017-19. Curiously, this phenomenon is not an isolated occurrence within the previous ten-year period; rather, numerous instances exist wherein a fund that exhibits subpar performance subsequently attains a position among the top ten rated funds.

 

Considering economic cycles, investors typically favor riskier assets during economic expansions and bull markets. This phase often sees growth stocks and sectors such as technology, consumer discretionary, and industrials outperforming. Growth-oriented investing benefit from increased consumer spending and tend to thrive.

 

As the economy approaches its peak and monetary policies start tightening, investors may shift towards more defensive sectors like utilities, healthcare, and consumer staples. At this stage, value stocks may also gain traction as investors seek undervalued opportunities.

 

During economic contractions and bear markets, defensive sectors like utilities, healthcare, and consumer staples perform better. Investors may rotate out of growth stocks and into value stocks, often perceived as less risky. In the early stages of an economic recovery and the beginning of a new bull market, cyclical sectors like financials, materials, and industrials may start to shine. Value stocks continue to perform well as investors regain confidence in the economy.

 

Likewise, analyzing interest rate cycles, defensive sectors like utilities and real estate may underperform when central banks increase interest rates. At the same time, financials can benefit from higher interest rates. Additionally, sectors that do well in a growing economy, like industrials and materials, might outperform.

 

Conversely, investors may favor dividend-paying stocks and bond proxies, such as utilities and consumer staples, when interest rates fall. Lower rates can also boost sectors like housing and real estate. Furthermore, investors may seek safety in value stocks during heightened uncertainty. In contrast, when sentiment is overly optimistic, growth stocks and riskier sectors may attract more attention.

 

As a potential investor, how do I proceed? is the following reasonable inquiry anyone might make.

 

Like so many other things in life, the distinction between the good and the bad can only be seen in retrospect. It is important to note that not all underperforming funds will rebound, and most will continue to struggle. Therefore, investing in a fund that has been a poor performer requires thorough research and careful consideration.

 

Thus, the first thing to do is combine funds based on past performance with their fundamentals and ensure high quality. By doing this, even if the stock price goes down for the short term, eventually, it will come back up, considering the strong fundamentals.

 

Because of how investing functions, Chris Geczy, a professor of finance at the Wharton School of the University of Pennsylvania, asserts that "investment style is incredibly important." "Risk and return are intertwined with fashion. Current modern portfolio theory states that you may balance risk and reward by blending various diversification strategies.

 

Investment styles in mutual funds refer to the overarching strategy or approach that fund managers use to select and manage investments within the fund's portfolio. Here are some common investment styles or factors that style-based investing focuses on:

Value: Value stocks are those that are considered undervalued by the market, trading at lower prices relative to their intrinsic value. Investors following this style believe that these stocks will eventually appreciate.

Growth: Growth stocks are companies with above-average earnings growth rates. Investors who favor this style expect these companies to continue growing faster than the overall market.

Size: This style refers to investing in stocks based on market capitalization. For example, small-cap stocks represent smaller companies, while large-cap stocks represent larger, more established companies.

Momentum: Momentum investing involves selecting assets that have shown strong price performance recently, expecting this trend to continue.

Dividend Yield: This style involves investing in stocks that offer high dividend yields, which can provide income to investors.

Quality: Quality investing focuses on companies with strong financials, stable earnings, and low debt levels. These companies are often seen as more resilient in challenging economic conditions.

Volatility: Some investors may target low-volatility assets, seeking stability and reduced portfolio risk.

 

When choosing their assets, mutual fund managers use many investment strategies and factors. As a result, you should carefully consider the manager's investment approach before selecting a mutual fund to ensure it matches your risk-reward profile.

The performance of mutual funds can be significantly influenced by prevailing market conditions and investor sentiment towards different investment styles. Funds following that style may underperform when a particular investment style falls out of favor. Conversely, when the same style experiences a resurgence in popularity, these funds may see improved performance.

 

A clear evidence is visible in the calendar year style returns pattern, wherein the performance of a particular style fluctuates over time. For example, the investment strategy known as value investing exhibited the lowest returns from the start of 2018 until 2020. Afterward, it showed superior performance compared to other investment methods throughout the succeeding three-year period commencing in 2021 and continuing to the present.

 

Similarly, based on size, the portfolio demonstrated a negative return of 13% in 2018. However, it experienced a modest return of 15% in 2019, followed by a substantial increase to 26% in 2020 and a remarkable surge to 48% in 2021. In 2020, quality-based funds saw the highest level of performance, primarily attributed to a flight to quality amidst the pandemic. However, as market conditions gradually improved and substantial liquidity flooded the market, quality-based funds experienced a negative return of 4%.

 

Financial markets are influenced by many factors, making style rotation strategies complex to execute. The primary challenge with style rotation strategies is timing. Overconfidence in one's ability to time style rotations can lead to excessive trading, increased transaction costs, and potential losses.

 

Short-term underperformance doesn't necessarily mean a fund is fundamentally flawed. Some investment strategies take time to bear fruit, and patient investors may eventually see positive results. Conducting thorough research to understand why the fund has been underperforming is vital.

 

The fund's underperformance might result from taking on less risk than its peers. Such funds can provide stability and downside protection during market downturns, serving a valuable role in your diversified portfolio. Look at its holdings, investment strategy, and track record. Adopting a long-term perspective helps to understand that it may take time for the fund's strategy to play out and its performance to improve.

 

One should focus on diversifying portfolios across asset classes, investment styles, and sectors to spread risk. One can follow the GARP (Growth At a Reasonable Price) or BARP (Buy At a Reasonable Price) strategy based on the goals and objectives.

 

GARP, which stands for "Growth At a Reasonable Price," is an investment strategy that seeks to identify and invest in companies that balance growth potential and valuation. The rationale behind the GARP strategy is to find companies that are expected to grow their earnings and revenues at an above-average rate but are not excessively overvalued relative to their growth prospects. This approach combines growth and value investing elements to capture the best of both worlds.

 

The GARP strategy can help investors manage risk by avoiding excessively overvalued stocks, reducing the potential for sharp corrections. GARP investors often prioritize the quality of a company's financials, management, competitive positioning, and business model, in addition to its growth prospects and valuation.

 

The "BARP" strategy, which stands for "Buy At a Reasonable Price," is an investment approach similar to the GARP (Growth At a Reasonable Price) strategy but with a stronger emphasis on the valuation aspect. BARP investors seek to purchase assets, typically stocks, at prices they consider to be reasonable or undervalued based on fundamental analysis without necessarily requiring high growth prospects.

 

This strategy aligns more closely with traditional value investing principles. BARP investors can capitalize on sector-specific opportunities by identifying undervalued assets within sectors poised for growth.

 

These strategies are primarily designed to capture returns across various market regimes. Investors can benefit from both up and down market movements by including factors like value and quality, making them well-suited for retirement and wealth preservation. It's important to note that the "reasonable price" definition can vary among investors based on individual preferences and risk tolerance.

 

My dear readers, remember that investing is not about chasing historical returns but constructing a well-balanced, cost-effective, and strategically diversified portfolio that aligns with your objectives and risk tolerance. As a retail investor, a better approach is to create a portfolio with a mix of all strategies so that, in the end, you benefit from it. Adopt a long-term perspective. Avoid frequently churning your portfolio based on short-term results.

 

Every strategy works until it stops working.

 

Best Regards
 
Dr. Tarunika Jain Agrawal Ph.D. 

Alpha Research