A number of people analyze the past performance data of funds to determine which funds to buy. If you are one of them, and if your analysis has been working well for you, don’t bother to read any further. If not, here are three guideposts that you might want to use. These are not absolute truths but merely a personal opinion of some of the things to bear in mind.
1. Performance analysis is best done in the context of fund strategy.
Not knowing a fund’s strategy carries the risk of misjudging the fund’s performance. For instance, given their strategy, certain equity funds are expected to do better than market indices in periods when share prices are falling while others are expected to do better than market indices in periods when share prices are rising. Lack of awareness of the strategy may result in giving more credit to a fund manager than is necessary, or less credit than he/she deserves.
2. Be careful of performance snapshots
Most of us use performance snapshots in one form or another. Tables showing the trailing returns (e.g. returns for the last 3 years/ 5 years etc.) are a common example of such a snapshot. Charts showing the NAV movement over a period of time are another common example of such a snapshot. While, these are easily available and appear easy to understand, these have limitations that can also lead to misjudgment of a fund’s performance. Here’s an example. Table 1 below gives the trailing returns of two funds as on 31 Dec, 2010.
Table 1: Trailing Returns (Annualized) as on 31 Dec, 2010
|
| Fund A | Fund B |
| Last 1 year | 17.9% | 14.6% |
| Last 2 years | 54.0% | 59.3% |
| Last 3 years | 13.2% | 15.3% |
| Last 4 years | 23.5% | 24.4% |
| Last 5 years | 24.2% | 24.7% |
A number of people are inclined to conclude that except for the immediate previous year, Fund B had mostly given better returns than Fund A. The truth is somewhat different. Table 2 below gives the quarterly returns of these two funds from 2006 to 2010. You may notice that other than in the second quarter of 2009, Fund B had never beaten Fund A in any of the remaining quarters.
Table 2: Quarterly Returns 2006-2010
| 2006 | Fund A | Fund B |
| Q1 | 14.7% | 14.7% |
| Q2 | -11.2% | -11.8% |
| Q3 | 15.8% | 15.2% |
| Q4 | 7.7% | 7.7% |
| 2007 | Fund A | Fund B |
| Q1 | -3.4% | -3.5% |
| Q2 | 20.5% | 19.6% |
| Q3 | 15.0% | 14.6% |
| Q4 | 19.6% | 18.3% |
| 2008 | Fund A | Fund B |
| Q1 | -15.9% | -16.2% |
| Q2 | -12.9% | -13.4% |
| Q3 | 2.6% | 2.5% |
| Q4 | -18.7% | -18.8% |
| 2009 | Fund A | Fund B |
| Q1 | 2.7% | 2.5% |
| Q2 | 52.1% | 68.5% |
| Q3 | 20.1% | 20.0% |
| Q4 | 7.3% | 6.8% |
| 2010 | Fund A | Fund B |
| Q1 | 4.8% | 2.4% |
| Q2 | 0.1% | 0.1% |
| Q3 | 11.9% | 11.5% |
| Q4 | 0.4% | 0.3% |
In effect, one recent month or quarter of good returns or bad returns can have a cascading effect on the trailing returns.
3. Performance is more than just returns
Actual returns represent one aspect of performance. While to some, this may be enough, the fact is that these returns were never assured and that there was always a degree of uncertainty attached to these returns (technically referred to, as ‘risk’). Most experts agree that the actual returns need to be seen in light of these risks. Technically speaking, they refer to this, as examining ‘risk-adjusted returns.’ In my opinion, too, analyzing risk-adjusted returns represents a better way of assessing the competence of a fund manager.
It may appear, from the above, that analyzing fund performance data isn’t as simple as one may have thought. If so, I suggest using the services of a good financial advisor. However, if you would like to understand more on this subject, Morningstar has put together an excellent article that offers multiple perspectives from their in-house experts on how to use fund performance data to evaluate funds. Here is the link.
