Investors have a tendency to look at an investment’s past returns to arrive at investment decision. In most aspects of our life we look at the past performance of many things to gauge how they might perform in the future. For instance, we buy Hondas and Toyotas because of their reliable histories. Many colleges admit students based on their high school grades. However in contrast, when it comes to investment, past performance is just one of the many factors required to arrive at making prudent investment decisions.
That said, most of us look at past returns and various financial ratios, which are again backward looking and make investments decisions. More often than not, equity funds which have performed extremely well over the past one or three years end up getting a lot of inflows. For instance, mid and small cap funds are witnessing considerable flows as their performances in the last three years have been phenomenal. However, if one were to look at 2013 for the same, their past performances were not looking great and the interest was getting reflected in the meager flows. It is fair to say, past performance is the rear view mirror in the journey of investments. As goes the disclaimer “past performance is not an indication for future returns.”
So the obvious question would be—is there a better way to invest or foresee which funds will continue to do well? This question led us to explore the performances of various equity funds in the country over the last 18 years. One of the myths we wanted to bust was the bogey of past performance. We analysed the performance of all funds and ranked them in quartiles based on one and three year performance, post which we analysed how they performed in the subsequent one to three years.
Our study shows that there is a limited probability of getting investment decisions right which are solely based on historical data. If one were to translate the above numbers in terms of probability, your chance of selecting a top performing fund based on past performance is lesser than winning a coin toss!
We believe good performance is an outcome of a robust process. Hence, one needs to be cognizant of the latter at the time of evaluation. This thought process has given birth to our “4C framework of manager selection”— clarity of philosophy, consistency of performance, capabilities of manager and AMC, and class of the manager. For instance, by evaluating the pilot rather than just the plane, each “C” would enable us to unmask the different hues of investment process from the performance, which is the ultimate outcome.
The 4C framework implies a paradigm shift from the industry norm of ranking funds only on the basis of past performance. This framework has helped us identify a few managers who we believe are competent and pass the 4C test. The idea of this framework is to bring science and conviction to the process of manager selection. This should help in building a portfolio of select managers and staying invested through bad periods as well.
EVP & Head, Motilal Oswal Wealth Management