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"XYZ fund has delivered a return of 30% for the past three years; I will switch my holding in other funds into this fund to get more gains."

This is a very common statement we hear from clients when they look at the past return chart of mutual funds. However, as investors, we must recognize that past performance alone cannot be the sole basis for making investment decisions. It is extremely difficult to predict which fund will be the top performer in the coming years.

Apart from this, we find many online tools that highlight the underperformance of your portfolio relative to the highest performer, indirectly suggesting that you switch to the top-performing fund. However, what many investors fail to understand is that these tools do not guarantee that the suggested fund will deliver the highest returns in the future. Investors need to grasp this distinction before making any investment decisions.

Performance Trends in Mutual Funds

To illustrate this, let us examine the flexi-cap category. We analysed the top 10 performers of this category for each calendar year, based on data from NGEN research:

• Top 10 performers of 2020 for flexi-cap funds

• Top 10 performers of 2021 for flexi-cap funds

• Top 10 performers of 2022 for flexi-cap funds

• Top 10 performers of 2023 for flexi-cap funds

• Top 10 performers of 2024 for flexi-cap funds

From this data, it is evident that the best-performing fund in a given year is not necessarily the same every year. Therefore, investing in a fund solely based on high returns over the past 1, 3, or 5 years may not always yield the expected results.

The Pitfalls of Frequent Switching

Our objective is neither to promote nor discourage investment in any specific fund. However, it is important to highlight that frequently switching from one fund to another can lead to unnecessary tax implications, whether in the form of short-term or long-term capital gains tax. Additionally, investors may not achieve the expected returns due to market fluctuations and timing risks.

There may be periods when a fund does not perform as expected. However, making impulsive decisions and shifting investments hastily can be counterproductive. Instead, during such times, investors should analyse the reasons for the fund’s performance, exercise patience, and seek guidance from their financial advisor or distributor before making any investment changes.

Understanding Online Portfolio Optimization Apps

Many investors rely on online portfolio optimization apps that analyse mutual fund performance and provide suggestions for improving returns. These apps often display charts comparing an investor's portfolio performance with that of the best-performing funds. While these tools can provide useful insights, they can also be misleading if used incorrectly.

For instance, let’s say an investor uses an app that shows their portfolio underperformed the top fund by 8% last year. The app might suggest reallocating funds to match the top-performing fund. However, what it does not guarantee is whether this fund will continue to outperform in the coming years. The app provides retrospective data, not predictive insights.

Instead of blindly following such recommendations, investors should use these tools as a reference while considering broader financial goals, market conditions, and risk tolerance. Consulting with a financial advisor before making portfolio adjustments can help avoid impulsive decisions driven by short-term market trends.

Key Factors to Consider Before Investing

Instead of focusing solely on past performance, investors should evaluate funds based on the following key parameters:

1. Investment Objective & Style: Does the fund’s investment strategy align with my financial goals?
2. Risk Appetite: Is the fund suitable for my risk tolerance?
3. Investment Horizon: Does the fund align with my investment time frame?
4. Consistency of Performance: Has the fund demonstrated stable returns over different market cycles?
5. Volatility & Stability: What has been the variation in the fund’s past performance?
6. Fund Management: What is the track record and expertise of the fund manager(s)?
7. Expense Ratio & Fund Size: Are the fund’s expenses justified in comparison to its performance?

Conclusion

Investing in mutual funds requires a well-researched and disciplined approach. While past returns can provide some insights, they should not be the only factor influencing investment decisions. By considering the above factors and consulting a financial advisor, investors can make more informed and strategic decisions that align with their financial goals.

Disclaimer

Mutual fund investments are subject to market risks. Past performance is not indicative of future results. Investors should conduct their own research or consult with a qualified financial advisor before making any investment decisions. This article is for informational purposes only and does not constitute financial advice. Additionally, the insights shared here have been refined using ChatGPT, an AI-driven language model, and should not replace professional judgment.