Many mutual fund investors look at a fund’s 1-year returns as the primary performance indicator, without taking into account other parameters like longer-term returns, the fund house’s pedigree, consistency, risk-adjusted returns and the investment allocation.

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What is wrong with 1-year returns?
Investors believe that the fund manager with the highest returns in the last 1 year must currently be the smartest guy around but in reality, such short term performance in equity markets is driven more by co-incidence than skill.

For eg take the case of small-cap funds in 2017 and 2018. In 2017, SBI Small Cap Fund gave block-buster returns of 80.4% followed by L&T Emerging Businesses Fund with 67.8% returns. What happened in 2018? Both funds gave negative returns - SBI Small Cap with -18.5% and L&T Emerging Businesses with -12.9%.

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What happened? The markets went in a risk-off mode and decided to favour large-cap stocks over mid & small caps. Did fund managers know this was going to happen? No. Such short term trends are part and parcel of stock markets and no one can predict when one trend is going to stop and the other start. Mutual Funds whose portfolios coincide with the current trend give good returns till the current trend changes and then such funds perform poorly.

Hence you want to look for funds that have given good and consistent returns over longer time frames because that means they were able to identify and tap into longer term trends. These funds may not have given the best returns in any particular year but have a better average overall. 

What to do instead?

The first step is to understand how the stock markets work. You can buy the best camera in the world but if you are going to use it like you use your point and shoot camera in your phone, you are not going to get the desired results. 

Forget 15% returns, no fund will give you even positive returns every year, irrespective of how much research you (or the fund manager) do. The biggest determinant of a Mutual Fund’s returns are the overall stock market returns - so if the stock market is in the red, it is very unlikely your Mutual Fund will be giving you positive returns.

Further understand that all Equity Mutual Funds are not the same. They are classified primarily based on what kind of stocks they invest in (large cap, mid cap, small cap) or which sector they invest in (eg pharma, IT, etc). Sectoral funds and mid & small cap funds are more volatile (i.e. will have higher ups and downs) than large cap funds or multicap funds which are more diversified. So choose a category as per your investment thesis. For most retail investors sticking to large cap and multicap funds would be the correct choice.

Now within these categories, look for funds with good 1-year, 3-year, 5-year and 10-year track records. No single fund would have the best returns across all the time periods so as such there is no ‘best’ fund. One simple way is to rank funds across each time period and then take the sum of all ranks to get a combined rank. Short list the top 10 funds based on the combined ranking and then look for how these funds have done during crisis years like 2008. Select funds that held up relatively well instead of which just fell apart. These funds have shown a good balance of returns and risk amongst their peers over a long time period and hence can be invested in with a good degree of confidence.
 
Will such funds give the highest returns next year? Most probably not. No selection criteria can ensure such kind of clairvoyance. And like how there is no single best Mutual Fund that will beat all other Mutual Funds every year, there is no single selection criteria that is better than every other selection criteria. But if you have a good selection strategy, your funds would most probably do above average and if you keep doing above average over the long term, then you will end up close to the top.

(Authored by Ankur Choudhary, Co-Founder & CIO, Goalwise.com)