MF Investments! Stay Away From 1-Year Wonders

The Principal Resurgent India equity fund delivered a mind-boggling return of 147.11 per cent for a one-year period ending November 15, 2003. It was at the top of charts among diversified equity schemes at that point of time. However, it could not sustain the performance for long, and for the next one year, it generated a return of 30.65 per cent and was ranked 39.

While selling mutual fund (MF) schemes, most distributors tend to highlight the recent performance. But the scheme that is hot at one point of time may not be so one year down the line — at least that is what a DNA Money analysis seems to suggest.

Only three of the top 10 schemes, as per their one-year returns on November 15, 2003, made it to the list one year later.

The story is no different in the subsequent years either.

Only five of the top 10 schemes, as on November 15, 2004, made it to the list a year later. Only one of the top 10 schemes, as on November 15, 2005, was in the top 10 list a year later.

And finally, only three of the top 10 schemes, as on November 15, 2006, remained in the top 10 list a year later.

This clearly suggests that the schemes that form the top 10 list by one-year returns usually disappear from the list the very next year. They are essentially one-year wonders which are not able to sustain their performance in the years to come. What this tells us is that investing in an MF, looking at its one-year returns, isn't really a strategy that works.

But what is it that makes a scheme that does really well in a given year become an average performer in the years to come?

When a scheme does well during a year, its performance gets highlighted everywhere and a lot of new money comes in.

As the amount of money invested in the scheme goes up, the impact a single stock has on its overall performance goes down. What this means is that the fund manager has to look for more multi-bagger stocks, which will help the scheme to continue to perform well. This may or may not happen.

Multi-baggers are usually stocks whose true potential has not yet been recognised or are currently out of favour with the market. Hence choosing a mutli-bagger involves some amount of calculated risks.

However, as the money coming into the scheme grows, the fee income (entry load, management fees, etc) that comes in with it also increases. Hence, the fund manager may or may not be willing to take calculated risks that made the scheme initially successful.

An excellent example is Sundaram Select Mid-cap fund, which was the top- performing scheme as per one year returns as on November 15, 2006. As on November 15, 2007, the scheme ranked 104 among all diversified equity schemes as far as one-year returns are concerned.

The good performance of the scheme in the previous years ensured that a lot of new money came into the scheme and it clearly was unable to handle that.

So, how does an investor figure out where to invest and not end up investing in what may essentially be a one-year wonder?

The way out is to look for the performance of a scheme over a period of 3-5 years. Schemes that make it to the top 10 list of 3-5 year returns, tend to stay there more often.

Seven out of 10 schemes, which were in the top 10 list, as of November 15, 2006, as per five-year returns were there a year later. The same is the case with three-year returns.

Nine out of 10 schemes in the top 10 list as per 5-year returns, as on November 15, 2003, were there a year later as well. What this clearly tells us is that certain schemes continue doing well over a longer period of time, irrespective of whether they make it to the top 10 list as per one-year returns or not. And it is in these schemes that an investor should be investing.