Now that seems like an erroneous statement, doesn't it? A typo perhaps? You might be tempted to say, how can the 'best' ever be the 'worst'? But in the domain of mutual funds, it's possible.
The best (read the best performer on the NAV appreciation front) could well be the worst (read a bad investment that is grossly unsuitable for you).
There's something about a top-performing fund.
The glowing reviews, self-congratulatory advertisements by the fund house and a host of stars (read ratings) and awards. It's a pretty heady mix. The fund makes a case for itself in the strongest possible manner. But scratch the surface and a different picture could emerge.
Don't get us wrong. We aren't suggesting that there is necessarily something wrong with every top-performing fund. However, the possibility of everything not being in order cannot be ruled out either.
Sadly, the NAV performance in isolation presents a one-dimensional picture i.e. it may conceal more than it reveals. In this article, we make a case for looking beyond just the NAV performance by listing instances, when top-performing funds could potentially be bad investments.
1. Funds taking on higher risk in a rising market
In a rising market, the more risk a fund takes on, the better performance it is likely to deliver. Dabbling in the season's flavour is one strategy that almost never fails. The fund could do so by taking sectoral bets i.e. holding a disproportionately high portion of its portfolio in a single sector or theme; similarly, stock bets i.e. making a higher than warranted allocation to individual stocks is another method.
In a rising market, it is not uncommon to see diversified equity funds sacrifice their 'diversified' nature at the altar of performance.
However, the strategy of taking on high risk to deliver an impressive showing works best during an upturn. When the tide turns, such funds can find themselves in a rather unenviable situation. They are likely to be the worst hit in terms of volatility.
The learning: Dig deeper into a top-performing fund's investment style and portfolio; find out how it delivered the impressive performance. If the fund was just banking on a high risk strategy on the back of rising markets, there might be a case for giving it a miss, especially if the fund doesn't match your risk profile.
2. Bull-run wonders
Continuing with the first point, there are some funds whose existence coincides with a bull-run. For instance, in the domestic context, there are several equity funds launched in early 2005, which until recently enjoyed a virtually secular bull-run.
These funds have an impressive track record to show for on the returns front, but are untested as far as performing over a prolonged bear phase is concerned. And the latter is an integral test in determining if the fund makes the grade as a worthy investment avenue. Such funds run the risk of ending up as 'bull-run wonders'.
The learning: Invest only in funds that have comprehensively proven themselves over longer time frames and across market phases. As regards funds that have only experienced a bull-run, avoid getting invested until they prove themselves to be 'all-season' performers.
3. Funds that don't adhere to their investment mandate
Funds are known to have professed investment styles and mandates. For example, a fund positioned as a large cap one is expected to invest in large cap stocks. However, at times, these mandates can prove to be restrictive; for example, if the mid cap segment hits a purple patch, a large cap fund would find itself missing out on attractive investment opportunities.
Some funds are known to circumvent such a situation by simply contravening their stated investment style. For example, a professed large cap fund ends up holding a portfolio dominated by mid cap stocks to make the most of market conditions. In effect, while the fund has delivered on the returns front, it has done so by being unethical and disregarding its stated mandate.
More importantly, in this particular instance, it has enhanced its risk profile considerably by transforming into a predominantly mid cap fund in clear contravention of its mandate to remain invested in large caps.
The learning: Find out if the fund has rigidly adhered to its investment mandate at all times. A fund that fails to do so does not merit inclusion in your investment portfolio, irrespective of its showing on the returns front. Do not underestimate the risk of investing in a fund that blatantly breaches its investment mandate in the quest for NAV appreciation.
4. A sector/thematic fund's performance
Sector/thematic funds are known to deliver an impressive growth in time periods when the underlying sector/theme hits a purple patch. More importantly, such funds typically deliver a blistering performance over shorter time frames. However, over longer periods (say 5 years), diversified equity funds are known to outperform sector/thematic funds.
Given that a sector/thematic fund's performance is linked solely to that of the underlying sector/theme, investing in them based only on the NAV performance is fraught with risks. You run the risk of investing at a time when the sector/theme has run its course i.e. it has become a spent force.
The learning: Appreciate the unique investment proposition offered by sector/thematic funds and the higher risk associated with them. They are at best suited for informed investors who have a view on the underlying sector/theme and can time their entry into and exit from the fund.
Retail investors should steer clear of sector/thematic funds. Instead they should invest in diversified equity funds with proven track records; such funds can also participate in the sector/theme targeted by sector/thematic funds, without the associated restrictive investment style.
5. When a star fund manager is at the helm
The 'star' tag can only be enjoyed by a fund manager who has a track record of delivering. In effect, the star fund manager has achieved a certain degree of success and created a standing for himself, which is distinct from the fund house he represents.
A star fund manager's presence means that his views take priority over what the fund house's investment processes may suggest. Simply put, the star fund manager calls the shots in key investment decisions. When a star fund manager is at the helm of a fund, the latter virtually owes its existence to him.
The trouble is that when a star fund manager quits the fund house, he takes the performance with him. And the fund house without the star fund manager is no longer equipped to repeat its glorious performance. You could be in for a rude shock, if the top-performing fund that you invested in, is no longer managed by its star fund manager.
The learning: Steer clear of funds managed by star fund managers, irrespective of their impressive performance. Instead, opt for funds from fund houses wherein fund management teams and a process-driven investment style rule the roost; such funds tend to deliver a sustainable performance.
Admittedly, for you as an investor, understanding a fund house's investment style is easier said than done. This is where your investment advisor needs to step in.
In conclusion, you would do well not to rely on the NAV performance in isolation, while selecting a fund. Clearly, there can be instances when the best-performing fund can prove to be a bad investment and completely unsuitable for you.
Make the most of Sebi's "zero entry load" guideline. Read on.
