Looking Beyond the Attractive Returns of MFs

Bumper demat account openings, greater financial awareness by influencers and recent market rally have boosted investor sentiment. Fund houses are taking advantage of this, launching new themes, even to cater to novices, putting investor interest on the back-burner. The emergence of similar thematic funds by almost every fund house is the biggest sign of the end of an up-cycle! China+1, EV, Green Strategies—Do These Names Ring a Bell?

Fund houses are also into aggressive marketing strategy. Some are citing misleading returns! Always keep in mind that the returns quoted by fund houses can only give you an idea about their past performance. In no way are they predictions or guarantees of future returns!

Now, imagine a scenario in which a fund has given a 5-year return of 20%. Does this mean that if one had invested five years back, he would have got a total return of 20% or something? With big words like CAGR, Absolute Return, XIRR, etc., fund returns can be quite intimidating and difficult to understand. Simply put, the CAGR calculation is the compound annual growth rate of your investments over a specific period of time using only the initial and final investment values. Because it only includes the two extreme data points, completely disregarding gap or mid-year, this window creates volatility in returns! This makes the returns from a fund beautiful. This can give investors a false idea that there has been, or will be, a steady linear increase in their investments. But this is not true. Not taken into account for CAGR calculation in the medium term, our investments can swing like a pendulum from one end to the other, that too rapidly every year! Maybe the underlying value of the investment was about to touch zero with negative returns and you still wouldn’t know it if you were focused only on the CAGR presented to you! So, don’t get captivated by the fancy marketing material of fund houses giving great returns.

Though, as stated earlier, past performance does not guarantee future returns, but gullible investors still fall for schemes that have given exceptional performance historically. And because of this tendency to report good returns, fund houses can also resort to fraud. The most common is that bull markets are recording annual growth, which shows only one year of great returns, which has been blessed with a bullish market rally. But when the bear market hits, the same fund house or distributor can easily turn to the CAGR of, ‘Hey, look the whole market is ruined, but just look at our historical CAGR!’. Let us explain it with the help of an example. Say, The number invested five years ago increases by 100 250. In the fifth year, market turns bearish, so fund houses will everywhere start quoting their historical CAGR to show attractive numbers. But what you’ll overlook is that in the fourth year, just before the tide turned, the same fund was happily boasting about its annual growth numbers in a bull rally! In this situation, the CAGR might have also shown good returns, but the rat race of publicly displaying excellent numbers led them to quote extra attractive annual growth numbers, which would certainly exceed the CAGR in a bull run! A simple yet effective advice when it comes to choosing a fund scheme is to proceed with caution and always go through everything carefully. One must look at both the CAGR and the Annual Growth Number to get an overall view of a fund.

Saloni Desai is Senior Equity Research Analyst at Mott Financial Services Pvt Ltd.