Investors should evaluate funds on rolling returns over the long term

Investors must remember that past performance may not get repeated in the future. And any investment is worthwhile only if it suits an investor's risk profile

My spouse and I went to a concert held in Worli in mid-town Mumbai. We started in separate cars from Bandra. My spouse took the Bandra-Worli Sea Link, while I was forced to take the old route as I needed to pick up a friend from Shivaji Park. Both of us assumed that my spouse would reach faster. However, she got stuck in a traffic jam at the Sea Link exit. Consequently, she arrived much later than I did despite taking the “faster” route. However, we both agreed that she would have reached faster via the Sea Link under normal circumstances. 

I shared this experience with my client Rohan, whose bank manager had pitched a passive fund replicating the Nifty 200 Momentum 30 Index (MI). MI consists of 30 high-performing stocks from the prior year, chosen according to a specified formula. The momentum style is based on the premise that stocks with strong past returns are likely to perform well in the future. The sales brochure highlighted MI’s 64 per cent annual return for the year ended October 1, 2024, outperforming the Nifty50 Total Return Index (TRI), which returned 34 per cent. Thus, MI outperformed the Nifty50 by an “extra” 30 percentage points over that one-year period. 

Over five years ended October 1, 2024, MI provided a 30 per cent annual return, delivering an “extra” 11 percentage points in annual returns compared to the Nifty 50, which returned 19 per cent annually over the same period. Rohan found the MI index fund appealing and sought my opinion. 

We examined the data points related to such indices. I cautioned Rohan against relying solely on point-to-point data to evaluate MI’s “extra returns”. 

A more comprehensive analysis of one-year rolling returns from April 1, 2005, to October 1, 2024, showed that MI outperformed the Nifty 50 71 per cent of the time (the Nifty 50 performed better during the remaining 29 per cent) with an average margin of 7 percentage points —far less than the 30 percentage points claimed in the brochure. 

Similarly, over five-year periods, MI outperformed 95 per cent of the time with an average margin of 6 per cent. Only over 10-year periods did MI outperform the Nifty 50 100 per cent of the time.

 

I explained to Rohan the key risks: One, past performance may not repeat in the future. Two, the first MI-based fund was launched on August 25, 2020. MI’s pre-launch performance (April 1, 2005 to August 24, 2020) is back-calculated. This is akin to calculating time savings for simulated journeys before the Sea Link existed. 

Three, even if MI outperforms the Nifty 50, this does not guarantee high outperformance. Both routes could encounter traffic jams. Although the Sea Link is generally better than normal roads, a specific trip might take longer than average. 

Four, an investment makes sense only if the investor has the necessary risk appetite. The Sea Link, for instance, saves time only for travellers going from Bandra to Worli, not those heading to Borivali. 

Momentum funds, a type of factor fund, are becoming popular among investors chasing quick gains, who are drawn to them due to their high returns over the past year. 

Truth be told, there is no magic bullet that guarantees high returns. The closest to a “magic bullet” is a sound plan combined with patience. Patience stems from making informed decisions after understanding the risk-reward trade-offs. Few investors can achieve this without the guidance of a competent advisor who can develop such a plan. A well-crafted plan should consider investments based on risk, goals, and resources. Even this can only enhance the likelihood of success, not guarantee it. Investors must reconcile themselves to this inherent uncertainty. 

This is not advice to invest or avoid investing in any specific fund. Please consult your investment advisor before making decisions. 

The writer heads Fee-Only Investment Advisors LLP, a Sebi-registered investment advisor; X @harshroongta