Most investors reach out to invest in best performing funds. But can that be a fatal attraction in many cases? Most investors leave no stone unturned in trying to unearth the currently outperforming mutual funds. While they eventually pick some of them, unfortunately, this fatal attraction typically hurts their financial progress in the long run since attractive short-term performance, typically made during 3-6 months, often slows down in the long term. Here are three reasons why investing in current outperformers typically turns out hazardous for investors.
Outperformance due to individual investments A surge in fund performance can often be due to individual stocks or those in certain sectors like banking, individual debt securities or categories of securities like commercial paper, besides investment themes like infrastructure sector. One of the reasons why many funds do well in the short run—typically 3 months to a year—is because these individual investments or investment themes do very well during this period. But the euphoria of this honeymoon dissipates over time as the performance of these individual and other investments start lagging in the long term.
Higher risk induced outperformance The impressive performance of a fund could be due to higher risk taken by the fund manager on investments. This could due to higher risk equity investments, such as small-cap stocks and higher risk debt securities that may have a lower rating but offer higher returns.
Many skilled fund managers make suitable adjustments to get the fund performance back on track. However, in most cases this may not eventually happen. In such cases, investors typically make premature exits. They are often painful and accompanied by losses, especially during market downturns.
Performance measurement quirks Sometimes outperformance can be due to the time periods when the returns have been captured. So, if the markets had hit the bottom six months ago and now stage a smart recovery, the spike in returns from certain equities would be an exception, rather than the norm for longer periods.
With investors typically making these three common mistakes, the question is what is the right away forward? Here are two suggestions.
Make the right performance assessment Look for funds that have performed well over different time periods of one, three, five years and since inception. It is also important to ensure that the fund’s own benchmarks are used to make an assessment of the performance. This insight can be supplemented with the insights from the performance comparison with peer funds.
Get accurate scheme information It is useful to find out the investment objective of the fund and have an idea of its major investments before investing. One can be informed about these aspects going through information sources such as Scheme Information Document (SID) and fund fact-sheet available on the websites of fund houses, besides in prominent financial websites. The same sources can be relied upon to track the performance of the mutual fund investments.
It is said that one swallow doesn’t make a summer. The same is true for mutual funds which need to exhibit consistent performance over different periods of time and adhere to certain investment basics. These aspects help you pick up the fund you that will truly help you invest with conviction. Don’t forget the famous saying: “All that glitters is not gold?”
Mutual funds are subject to market risks, read all scheme related documents carefully.