Usefulness of past mutual fund performance?

“History repeats itself” – Many times in our lives we have heard others saying this and most likely might have said ourselves a couple of times too. While there might be instances that might have proved this statement right, do you think this is possible in case of your investments in mutual funds?

'Past performance is no indicator of future returns' – as an investor you must have seen this caveat several times in the bold disclaimers of mutual funds. Past performance might be very luring, but should you rely on it?

Past performance might be the most common selection criteria and plays a confirmatory role in the fund selection process but one needs to understand that it does not have any predictive powers to foresee the future of the fund. Past performance should really play a small, confirmatory role. For instance, what does the fund's track record tell you about its investment style? What does it reveal about how the fund manager has executed his approach? Can you reconcile the way the fund has performed to the manager's stated investing discipline? How has it done during certain, more-telling time periods (such as market downdrafts or sharp rallies)?

But if not past performance, lets look at the 4Ps you can consider before investing in a mutual fund:

Remember the 4Ps:

<strongPhilosophy:

Does the fund house follow a value philosophy, or do they follow a growth philosophy? All fund houses cannot be good in following all philosophies. Normally they would tend to be good in one or the other.

People:

How long have they managed money for? Do they have the experience of seeing the markets during good and bad cycles?

Process:

Does the fund have a good process to identify investments? Is the portfolio construction team biased? Or is it based on the whims and fancies of a star fund manager?

Performance:

If all the above mentioned criteria are satisfactorily addressed then a good fund performance will automatically follow. It will be predictable and it will reflect the philosophy being followed.

Other than this lets look at factors you should look at before selecting a good mutual fund:

Identifying investment goals and objectives

Before investing in any fund, an investor must first identify his or her goals for the money being invested. Are long-term capital gains desired or investment is done for a shorter period? Will the money be utilized for short term expenditures like a family vacation or to supplement a retirement that is decades away? It is very important that you always check whether the fund’s investment objective mentioned in the offer document is aligned with your investment objective or not.

Risk Tolerance

You must also consider the issue of risk tolerance. Are you able to afford and accept swings in portfolio value or are you more of a conservative investor? Identifying risk tolerance is as important as identifying a goal.

You can keep risks in line with your risk appetite by spreading your money across a range of different investments.

As all of us know, markets will rise and fall, how much of a fall we are willing to accept is what we need to identify as investors. We also have to live with the knowledge that no asset class will forever move upward, similarly no asset class will be in a downward spiral all the time.

Select Funds with Low Expense Ratio

You can choose a fund with a lower expense ratio. Expense ratio is the measure of what it costs to an investment company to operate a mutual fund. Remember, higher the expense ratio, a larger portion of your money is deducted as a fees by the AMCs, therefore this affects your amount of investment as less of your money is invested in the market.

Select Funds with Low Portfolio Turnover

Portfolio Turnover Ratio (PTRs) is the measure of how frequently assets within a fund are bought and sold by the managers. Mutual Funds churn their portfolio to weed out bad stocks from their portfolio or exit from the fund, which has reached its target. Portfolio Turnover Ratio numerically measures the trading activity in a fund’s portfolio. It is the percentage of the portfolio that is bought and sold in exchange for other stocks. If the portfolio is churned many times during a year, the fund will incur higher transaction costs, which means a further impact on the amount you have invested in the fund.

Larger Portfolio Turnover Ratio will increase the expenses while churning. When the fund’s expenses increase, it in turn reduces the returns or yields of the fund. Therefore it is advisable that investors consider Portfolio Turnover Ratios before deciding to invest in a mutual fund.

Therefore, the next time you decide to park your hard earned money to invest in a mutual fund, the above points would act as your check list and not mere past performance. Always remember, while mutual fund investing is not rocket science, these points can help you during your investment process. You are advised to take assistance of a financial advisor before investing.