Dalal Street Investment Journal – July 20, 2019

DSIJ.in JULY 22 - AUG 4, 2019 I DALAL STREET INVESTMENT JOURNAL (^135)
MF page -07
Expert Speak

M

any investors tend to rely heavily on past

performance while selecting funds to invest

in. They believe that top-performing funds

cannot go wrong and, in all likelihood, would

replicate their past performance in future too.

Although past performance has to be an important

consideration in the selection process, it is critical to look for

funds that provide the right balance between one’s risk taking

capacity and the fund’s ability to provide commensurate

rewards.

In other words, the key is to build a portfolio consisting of

funds that allow you to have the right level of exposure to

different segments of the market such as large-cap, mid-cap and

small-cap stocks. In fact, your portfolio must always have a bias

towards large-cap stocks. However, if you rely on past

performance alone for selection of funds, the chances are that

you may either end up investing in very aggressive funds or

conservative funds depending on the performance of the stock

market.

Remember, basing your investment strategy on past

performance (especially recent performance) can backfire.

However, once the portfolio is built, it is important to measure

and analyze the performance of funds on an ongoing basis to

ensure that your investments remain on track to achieve your

varied investment goals. 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 your investments have

been doing over time. In other words, total return is a useful

tool for making comparison between the performances of

funds in the same category or a fund and its benchmark.

Securities and Exchange Board of India (SEBI) has mandated

that all mutual funds must benchmark the performance of their

schemes to total return indices instead of the simple price

return indices.

While assessing total return of your investments, 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 10 years cumulative

return of 100 per cent did not earn an average compound

return of 10 per cent; the annual compound return in this case

was 7.20 per cent.

Another aspect to understand is the difference between

compounded rate of return and simple rate of return. For

example, a fund with an annual return of 20 per cent, 25 per

cent and a negative return of 15 per cent on three consecutive

years will make `100 grow to `128. This works out to an average

annual compound rate of 8.30 per cent. On the other hand, if

the returns are added to arrive at the simple rate of return, the

value would be `130. In other words, the simple rate of return

would be 10 per cent.

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 average return on an investment that

provides a positive return of 100 per cent and negative return of

50 per cent in two consecutive years would be 25 per cent, the

average compounded rate would be zero. In this case the initial

investment of `100 would double to `200, only to decrease to

`100.

As is evident, it is important to measure the performance of

your mutual fund investments in a manner that it reflects a true

picture. Understanding how performance fits in with your

overall investment strategy can help you avoid making ad hoc

and abrupt decisions. DS

Hemant Rustagi

Chief Executive Officer, Wiseinvest Advisors

Relying On

Past Performance

Alone Can Backfire