Investors who do a bit of research on their own are often stumped by how mutual funds with relatively similar portfolios have sharp variance in their performances. They expect such funds to post similar results by virtue of similar portfolios.
We believe this can be explained easily if investors factor in some points in their analysis.
At Personalfn, clients taking a keen interest in their investments are a common sight. They often evaluate their investments critically and do their homework, like comparing portfolios of various mutual funds looking for patterns, reasons for outperformance/underperformance and why similar portfolios have wide disparities in performance.
It's always a good sign for investors to take more than a casual interest in their investments. Although the financial planner is there to guide them, investors must never lose sight of the fact that it is after all their money.
While comparing portfolios of various mutual fund schemes, investors must keep the following points in mind:
1) If you wish to compare portfolios of two mutual funds, first ensure that they belong to the same category. For instance, comparing the portfolios of two diversified equity funds that invest across the market (large caps, mid caps) is rational but comparing a thematic fund's portfolio with that of a diversified equity fund isn't.
While comparing mutual funds across categories is flawed right from the start, there may be some instances when a diversified equity fund's portfolio might coincide with that of a thematic fund. But such a scenario is likely to be rare and short-lived. Short of these instances, such a comparison would give very misleading results.
2) Investors often evaluate portfolios to get into the fund manager's mind so to speak. At least that is the case with some popular names like Warren Buffett.
However, some investors go a step further and compare portfolios of two mutual funds to understand why there is a disparity in their performance despite the presence of similar stocks and sectors across the two portfolios.
For instance, they will compare the latest portfolios of two mutual funds and try to figure out why their returns over 3-year are so disparate? There is a fundamental flaw in this evaluation. The latest portfolios cannot unravel what happened 3 years ago.
To understand that, investors will have to go back 3 years and evaluate the portfolios of both the mutual funds over this time frame i.e. from then until now. The disparity in the two portfolios over this period (3 years in this case) should explain the disparities in their performance.
3) Another point that investors ignore while studying portfolios is that simply being invested in similar stocks and sectors is not reason enough for mutual funds to deliver the same performance.
Even when two portfolios have the same stocks and sectors, they could have invested in these stocks/sectors in varying allocations/proportions and over varying time frames, which could explain the disparities in their performance.
4) Let's assume there are two mutual fund portfolios with fairly similar stocks and sectors in roughly similar allocations, but yet have varying performance.
To unravel the disparity in their performances, it's necessary to examine the performance of each stock and sector in their respective portfolios in detail. When investors get down to doing that, they will find that there is at least one stock/sector that has appreciated very sharply which eventually proves to be the difference between the two funds.
That is what one smart investment decision can do to a mutual fund's performance. There have been many instances of just a couple of investment decisions changing the fortunes of a mutual fund dramatically. However, for investors to determine which particular investment decision made all the difference, they will have to evaluate each investment made by the mutual fund (in terms of stocks and sectors).
5) To continue the previous point, at times investors may not be able to trace a particular stock/sector that made a huge difference to the mutual fund's fortunes. In such a scenario, it could well be that it was not an investment in a particular stock/sector that did the trick; it could simply be a higher cash allocation in a particular month which coincided with a stock market crash.
We have seen this happen in the past, when a mutual fund's performance jumped not so much due to its stock/sector investments as much as its cash allocation during a market downturn. While evaluating mutual fund portfolios, investors must also keep this point in mind.
So while it is an encouraging sign to see investors take an avid interest in their investments, they must adopt the right approach so as to make an accurate evaluation. This way, they can have a fairly good idea about why certain mutual funds are doing well or have done well in the past.
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