Investment Idea in Focus | September, 2024

Does Past Performance Affect Future Performance?

Introduction

In this edition of Investment Idea in Focus, we are going to discuss an extremely thought provoking idea. This is a product of various discussions that we had both with internal and external stakeholders. 

Within the team, we have had multiple debates around how choosing a fund/portfolio for investment shouldn’t be purely based on historical returns. In fact, in our April newsletter edition, we had put out a detailed 4-step framework on how one should choose the right portfolio. No points for guessing, our first step was not to base your decision on past returns. Hopefully, by the end of this piece, you will be convinced that past performance is not a crystal ball. 

We undertook an intriguing exercise to find out how persistent are fund returns? In the sense, if investors are really basing their fund choosing decision on past returns, how likely is it that they will be right? 

What did we do?

Before I jump on the findings of the exercise, let’s set some context. We took three broad categories under the equity schemes to run this exercise on. – Largecap (29), Midcap (26), and Smallcap (23). The number in the brackets indicate the number of funds under these respective categories. We have only considered the Direct-Growth option plan.  

Now, let’s move on to the exercise and the findings. Starting from Sept ‘22 to Sept ‘23 for all the funds, we calculated the past 1 year returns and next 1 year returns. 

For instance, for a largecap fund (say Fund A), we calculated the returns from Oct ‘21 to Oct’22  (past 1 year returns) and then Oct ‘22 to Oct ‘23 (next 1 year returns). Then from Nov ‘21 to Nov ‘22 (past 1 year returns) & Nov ‘22 to Nov ‘23 (next 1 year returns). Likewise, this will get carried forward till Sept ‘24, where the past 1 year returns will be from Sept ‘22 to Sept ‘23 & next 1 year returns will be from Sept ‘23 to Sept ‘24. Hence, for each fund, I would have 12 data points. A pictorial representation is attached below for better understanding.

What was the result?

And the results were rather conclusive. When we plotted the past and next 1 year returns for all the aforementioned funds, we saw that there is no real consistency when it comes to their returns. The two sets of returns were completely randomized indicating no strength. For instance, a particular largecap fund (say ABC) returned -7% between Apr ‘22 to Apr ‘23 and the same fund returned 32% in the subsequent period of Apr ‘23 to Apr ‘24. Check out the dot marked in red.

While this refers to a specific fund. If you want to take a look at all the funds under each category, the scatter plots are attached below.

By looking at the charts, it seems that there is no clear pattern of past and forward returns. To corroborate this further we found out the average rank correlation for all 12 months under each category. As mentioned in the respective plots, the rank correlation was pretty low in across all the three categories as we expected. A lower value clearly indicates that there is no strong relationship between the past 1 year returns and next 1 year returns.

What is the takeaway?

The takeaway from this exercise is pretty self explanatory. If you solely choose a fund to invest on the basis of its past performance, it’s a recipe for disaster. The reason being that there is no guarantee that if a fund has done extremely well in the past, it will continue to do so in the future and vice versa. If you take the example mentioned above, standing on Apr ‘23, if you were to take an investment decision purely on the basis of past performance, fund ABC would never be on the reckoning for you and it would go on deliver 32% returns in the coming year, perhaps one of the best performing funds in its said category. You see the problem?

And this faulty decision is not only wrong from a returns perspective. If you, as an investor, are basing your decision solely on past performance without running any risk suitability or fund strategy understanding or associated costs, then again you’re staring at a pitfall.

With our capital markets expanding, we definitely need more people to come into the markets and participate in the wealth creation. However, that being said, we want new entrants to stay put in the markets and not leave because of adverse events. Therefore, it’s important for investors to come in with the right expectation and in turn make informed decisions in order to play the long game.

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_{Windmill Capital Team: Windmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. CIN of the company is U74999KA2020PTC132398. For more information and disclosures, visit our disclosures page here.}