Form is temporary, class is permanent
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In cricket, we see many big players being criticized when they are out of form in a few games. Then there are some players who play well in a T-20 format but are unable to perform in the 50-overs or the test-match format. But history has proven that it is just a matter of a few games before quality players regain their form. There is a famous phrase often used for such players: Form is temporary but class is permanent. On the other hand are players who have stellar performances but cannot find a place in the team for the long term because they cannot perform on a sustained basis. As fans, we tend to idolize such cricketers in the short term, but the names we remember are those that show class and quality over the long term.
This short sighted approach is common in case of mutual funds also. For instance, in case of equity mutual funds, some investors tend to choose funds on the basis of their near-term performance, and in the bargain, ignore funds with a strong long term track record. This is called ‘momentum’ investing and usually happens when markets are in a prolonged bull phase, where one prefers to flow with the tide and follow a herd mindset. But the truth is that markets operate in cycles, and the tide will turn. When we buy any product that we expect to own for a long time, like a TV, car or washing machine, we check its durability and resilience over time besides its performance. But we tend to overlook these factors when we buy equity funds. In fact, a product that works well in shorter time frames need not necessarily work well over longer periods.
In the case of equity funds, it is important to check the fund’s performance track record across up and down market cycles, and over a sufficiently long period before investing. If we intend to invest in a fund for 3, 5 or even 10 years, then should we not evaluate the fund’s past performance over such sufficiently long periods? Do remember, however, that past performance is no guarantee of future results and looking at past performance is only one way to analyse a fund. The fund house’s track record, brand, reputation and process are all important factors to look at. While higher returns in a bull phase are great, knowing that markets operate in cycles, it’s equally important to see how a fund behaves when the market cycle changes. Hence, what one should seek is optimum returns and not maximum returns. Optimum returns mean strong returns on the upside but also a relatively lower downside in a bear phase. In other words, choosing a fund that gives higher returns for a commensurately lower risk (volatility) as measured by risk adjusted returns.
Let me explain with some numbers. We analysed the performance of the benchmark index Nifty 50 over a 20-year time frame (October 1997 to October 2017) across all available 1, 3, 5, 7 and 10-year periods (daily rolling basis). While 1- and 3-year periods are classified as short term, the 5-, 7- and 10-year periods fall in the long-term range. Just to get a sense of the scale of the analysis, we saw over 4,000 observations (data points) in each of the short-term periods across the 20-year range and over 3,000 observations each for the 5- and 7-year periods, besides over 2,000 observations for the 10-year periods.
We then looked at the highest and lowest returns in each of the periods across these observations. The idea was to gauge the fluctuation between the highest and lowest returns. Higher the fluctuation, higher is the volatility or risk of investment. Here are the results:
In case of short-term periods (1 and 3 years), the highest and lowest returns were 103% and minus 56% (1-year time frame) and 59% (annualized) and negative 16% (3-year periods).
However, the maximum and minimum returns across all 5-year time frames were 44% (annualized) and minus 5% while they were 28% and 4% for all 7-year periods and 21% and 6% for all 10-year periods, respectively.
This analysis clearly shows that returns are more volatile over the short term.
Hence, higher short-term returns cannot be the sole criteria for choosing funds. The choice also needs to factor the volatility or the risk taken to generate the returns (risk adjusted returns).
Another factor to watch is portfolio valuation. Higher short-term performance could be the result of a run-up in valuations of a few stocks in the underlying portfolio of the fund. This may not necessarily sustain going forward and could impact future returns of the fund.
Creating wealth by investing in funds on the basis of short-term performance is only possible if you are able to perfectly time your entry and exit such that you can encash the high short-term returns before the market cycle changes. The reality, however, is that timing the market is very difficult and there is a high probability of an error, which can significantly impact your portfolio returns and your ability to meet your financial goals. As has been famously said, ‘time in’ the market is more important than ‘timing’ the market.
A goal-oriented investing approach, based on a sound evaluation of a fund over a sufficiently long period, and that too not purely on the basis of past performance, but after also taking into account qualitative filters like people, philosophy and processes (3Ps) followed by the fund house will help deliver the best outcomes.
Investors must avoid choosing funds looking only at their current ‘form’ (performance) as form could be temporary. Go a step further and look for funds with ‘class’ (strong long-term risk-adjusted returns), which is more permanent. Class is a combination of 5Ps—people, philosophy, processes, besides performance and portfolio. Remember, the last two Ps are merely outcomes if the first three Ps are right.
Sanjay Sapre is president, Franklin Templeton Investments–India