Of the various types of numbers that financial advisors promote and mutual fund investors use, perhaps the most popular is a comparison of the one-year returns of mutual funds. However, when used without discrimination, this number can be as dangerous as any other shallow measure. This is especially important right now because the last few months and the coming few weeks are set to combine to give one year returns for equity funds a rollercoaster ride that will leave investors' gasping.
This is a good opportunity for investors to understand how to use data on past returns of mutual funds and how different pieces of data fit together. Equity funds' one year returns have looked particularly good in recent times. Even the recent drop in stocks hasn't had much of an effect on these numbers. Of course, more sophisticated investors understand that this is just a base effect but that doesn't prevent it from being the source of some bad decisions and exaggerated expectations.
Currently, the average one year return of diversified equity funds is 33 per cent. For the 230 such funds that have been around for more than a year, the top quartile has returns ranging from 42 to 78 per cent. The recent past has been even happier. In early April, the average of diversified equity funds' one year return was 88 per cent, with the top quartile ranging from 1000 per cent to 150 per cent. The reason for this sharp difference is obviously the change in the base. In April last year, the huge jump that the stock markets took in the days immediately after the general elections was still in the future. Therefore, one-year returns in April this year were done from a high point to a very low base.
Over the next few weeks, this base effect will disappear completely. The sharpest part of the boost that stock prices got after the elections had played out completely by mid-June. Not just that, the current weakening of stocks is having an opposite affect. By mid-June, if the situation remains the same, one-year returns for the average diversified equity fund will be down to a single digit percentages or even less. That means that in a matter of two months, the most quoted one-year return number would have declined from an average of 88 per cent to about 7 or 8 per cent.
In general, the financial turmoil of the last two years have led to some very misleading numbers being bandied about in all spheres of the economy. In India, the absence of seasonally-adjusted official numbers about the economy has made for some very optimistic headlines over the last year. However, for the individual investor, that's just the stuff of headlines. However, not considering the base effect can lead to mistaken and harmful investment decisions.
There are a number of different kinds of measures of historic mutual fund returns available on the web and in publications. Besides trailing returns for one year as well as shorter or longer periods, calendar period returns are also generally available. A yearly, quarterly or monthly history of returns is generally far more useful, specially in conjunction with returns that the funds' benchmark index generated during those periods. You can also find the best and worst returns in some sources. On ValueResearchOnline.com, for example, you can find the best and the worst month, quarter or year that a fund has ever had. Moving beyond just looking at returns, you can also get more sophisticated yet easy to use measures like Value Research star ratings that takes into account not just returns over a long period but also volatility and risk. If you are evaluating investments purely on the basis of returns that are of a rolling period ending on the current date, then you may well be using the least useful measure that there is.
This article was originally published on May 28, 2010.
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