Past performance is arguably the most influential filter when ranking a list of funds. And as one of the only ways to quantify a fund’s worthiness, it is difficult to ignore. But some investors make the mistake of looking at past performance as the sole parameter when making investing decisions.
While the predictive power of past performance is limited, it can be remarkably informative when used in the right context. The real value in using past returns is to supplement, not dominate, a holistic assessment of a strategy because a good strategy can experience years of bad returns, and a bad one can experience years of good returns. Past performance rarely provides sufficient information to strongly affirm or disconfirm a strategy's merits.
For instance, if the manager of a particular scheme follows a value approach to stock picking, when momentum stocks are on a roll, this particular fund would naturally be punished from a performance perspective. On the flip side, a fund grabbing attention simply because it has momentum stocks that the market is currently favouring is not necessarily a great investment.
Past performance, however, can be indicative if investors are more nuanced in how they probe the data. Start by looking at trailing returns, preferably over 5-, 10-, and 15-year periods. See how the fund fares on these long-term periods after all equity investing is all about staying in for the long haul.
Even if the returns are sterling, look at its annual performance. The trailing returns could cloak a trajectory that is not quite as smooth. How did the fund fare during the market rally of 2009? How did it perform during market slump of 2011? Also look at the polar opposite years, such as 2007 and 2008. All this can help you understand the fund’s character and set expectations about its future behaviour. Is it a perennial bull run winner only to languish at the bottom of the ladder in a bear market? Or does it climb moderately in a bull run but manages to hold its own in a downturn? Or does it follow a sawtooth pattern — fall, rise, fall in spaced intervals.
The upside capture ratio and downside capture ratio can also be valuable tools in assessing how a fund performs under various market conditions. Putting together funds with different characteristics--one with very strong upside performance, another with a history of better downside activity--can also help you assemble an all-weather portfolio.
The idea behind upside/downside capture is to quantify the degree to which a fund has outperformed or underperformed its benchmark when the market has gained in value (upside capture) as well as when it has lost value (downside capture).
A fund with an upside capture ratio of 110 would have outgained its benchmark by 10% on average each month that the benchmark gained in value (a ratio of 100 would be a perfect match in performance). For downside capture, only months that the benchmark lost value are considered. Therefore, a fund with a downside capture ratio of 90 would have lost 10% less on average than the benchmark in all the months when the benchmark lost value.
Thus, for upside capture higher numbers are better while for downside capture lower numbers are better. You can locate this data on our website under the ‘Ratings & Risk’ tab on any specific fund page
A final word of caution. When looking at past performance, see how the fund has performed versus its benchmark and peer group. Don’t make the mistake of comparing a mid cap with a large cap, or a sector fund with a diversified equity one. Comparing funds from different peer groups will result in your analysis getting completely skewed.
Most importantly, the fund should be a fit in your portfolio. A fund may have scored on all the above parameters but may be a thematic fund or a small-cap fund. Do you really want such a fund in your portfolio? Take a look at the fund manager’s strategy. Does he take aggressive stock positions? Is the fund heavy on small caps? Is he only focussed on growth stocks? Ask yourself how comfortable you are with such a strategy. And even if you are, is the fund manager consistent with the strategy or does he waver depending on market sentiment and the flavour of the moment?
Past performance in cohesion with all these factors will give you a clear picture of a fund’s position in your portfolio.
