If you are a type of investor who goes through the fact sheet or offer document, in order to study a particular scheme before investing in it, you would have come across a disclaimer (below the scheme's historical returns) stating, "past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments."

According to the Sebi (Securities and Exchange Board of India) guidelines, fund houses must state this disclaimer explicitly whenever they mention the past performance of a scheme. As usual, this guideline came into force because fund houses were mis-selling their schemes based solely on the past performance.

However, disclaimers apart, as a practice investors continue to make investments based on a scheme's past performance.

To make matters worse, fund houses are only too pleased to toe the line by actively advertising the past performance of their schemes leading investors to conclude that it is the single-most important parameter (if not the most important one) to be considered while investing in a mutual fund scheme.

The marketing tactic of playing the 'past performance card' at frequent intervals inevitably raises the question - is past performance the only parameter to be considered while investing in mutual fund scheme?

In our view -- No. Let's see why at Personalfn we are so adamant about this point.

Relevance of past performance

Past performance of a particular scheme simply informs you, the investor, how much return the mutual fund scheme has generated over a time frame. However, there are certain critical points that the past performance numbers in isolation do not tell. We discuss these points below:

a) The risk the investor has been exposed to in the mutual fund's quest for growth. In a rising market, it is not altogether difficult to clock higher growth if the fund manager is willing to take on higher risk (we have seen this on several occasions like the tech rally in 1999-early 2000, the mid cap rally in 2003-05). In that case, the past performance numbers in isolation will be inaccurate because they do not give investors any inkling of the higher risk they have been exposed to.

At Personalfn, we believe that before investing in any investment, it must be evaluated based on the risk-return criterion; evaluating it across any one of them (risk or return) will not serve the purpose as the investor will ultimately end up investing in avenue that is not completely suited to him.

b) Even while showcasing past performance, funds are careful to show the compounded annualised growth rate (CAGR) numbers over longer time frames (3-5 years). Over this extended time frame, a CAGR figure is not entirely representative of the ups and downs (which could be considerable given the extended time frame) witnessed by the mutual fund over that period.

This is because the CAGR number tends to even out the fund's performance over the long-term and the bad times (based on wrong investment calls) are not that easily discernible.

A statistic that underlines, how much a mutual fund has fallen during a particular market slump (as compared to the benchmark index and peers) or how it has performed during a particular calendar year, is far more illustrative in our view as opposed to just a CAGR figure; after a market rally, a CAGR figure looks much better than it did before.

c) Another reason why past performance is not entirely representative of a mutual fund's 'good showing' is because; it does not take into consideration the performance of its peers. It is possible that a fund has performed reasonably well (across relevant parameters) by itself, but hasn't quite made the mark when compared to its peers.

In other words, some of its peers that have outperformed it deserve to be considered by investors before the mutual fund under question. At Personalfn, we compare an investment (be it a mutual fund, fixed deposit, unit-linked insurance plan � ULIP, among others) with its comparable peer group before giving a view on whether or not you should invest in it.

d) Past performance fails to highlight the investment processes and approach pursued by the fund house. It does not give the investor an idea whether the past performance is the result of 1) good fortune/luck 2) a star fund manager 3) a team-based investment approach that takes decisions based on well-defined processes that are not over-dependent on a particular individual (like a star fund manager).

At Personalfn, our preference is for Point 3); unfortunately the marketing campaign doesn't help us with that information, this we learn after constant interaction with fund houses and their investment teams.

e) Past performance often ignores the change in guard or mandate. Fund houses first talk of a star fund manager who was instrumental in sprucing up their performance. They get a lot of money based on this star fund manager.

The performance numbers that are advertised are attributed to the 'brilliance' of the star fund manager. When the star fund manager quits (which in many cases is often a matter of time), the fund house continues to use the performance attributable to the ex-fund manager to draw fresh monies under the new (star) fund manager!

Investors however, are clueless as to whether the performance being advertised is the result of the existing team or an older team.

On the same lines, a mutual fund that revises its mandate/investment objective continues to use the performance figures under the older mandate/investment objective. Again, investors have absolutely no idea whether the performance numbers correspond to the revised mandate or an older mandate.

In an article we wrote earlier, we had addressed this particular issue in detail and had recommended that fund houses either stop using older, irrelevant performance numbers or mention that the performance came under the previous fund management team or an older investment mandate.

When funds alter their positioning. . .

f) Of course, last but not the least, past performance is no guarantee of future performance. While this is adequately mentioned in the advertisements, we wonder why it needs to be advertised in the first place. It's a bit like advertising tobacco products freely with a small disclaimer at the bottom!!

Nonetheless this disclaimer is important; we have mentioned it right at the end because we believe that the 5 points discussed earlier are a lot more important.

What should investors do?

Our advice to investors is that they should adhere to the basics of mutual fund investing. They should evaluate mutual funds across parameters, including of course past performance, before considering any investments.

In our view, the Sebi, as a regulator of Indian stock markets, should take note of such campaigns and discourage fund houses from misguiding investors through such misrepresentative and inaccurate advertisements.

Till then we can only hope that, unlike on previous occasions when such one-off cases started trends in the mutual fund industry, this particular problem is nipped in the bud by the regulator at the earliest.

By Personalfn.com
Attention NRIs! Here's how you can better the performance of your India portfolio. Read on...