Theory of behavior gap – investment return versus investor return – is widely popular amongst all us. In current times of market uncertainty, it is good to dwell upon this topic once again. What’s happening now is a clear reflection of investor mood swings from over-optimism to over-pessimism, those who were overbought in the equities in the recent past are sitting on notional losses. The challenge is faced by investors for their investment which has aged one or two years at best and are desperate to move out to funds which are reflecting better performances. This is especially happening in case investment have been made in the small and midcap segments or funds which are doing relatively better. A very common disclaimer in investment products you will find is as follows: “The past performance of a mutual fund scheme is not necessarily indicative of the future performance of the schemes”. Yet we see that investment flows chase funds which are among top 3 in returns on past 1-3 year time frame at the time of making investments, without understanding that those returns are behind and the same may may-not follow in subsequent years. Even if an investment is made in those funds than a reasonable time frame of 5 years and must be kept to live through the interim corrections in the returns at some point in time. Unfortunately, it is a reality that investors jump in and out of fund basis performances, typically they sell out of the underperforming fund and buy in the outperforming fund. Data will suggest that following such kind of strategy seldom works and such re-allocation of funds done frequently will come at a big cost.
Typically an active mutual fund manager tries to beat the market by having a strategy away from the market and it is difficult to beat the market if you mirror the market. Mutual fund returns are always mean reverting, funds which have outperformed for some time see their returns fall back, and the funds that have lagged reverse course as their performance improves. Actually, it is such mean-reverting moments when right investment decisions need to be made which means funds must actually be sorted with near term underperformance and then basis their underlying portfolio quality must be chosen for allocation, this will ensure buying quality at attractive valuations as the same is reflecting in their underperformance, the same holds true for exit strategy.
Obviously the intention is not to suggest that one must stick along with an under-performing fund forever in hope for it to mean revert, hence It is very important to do all sort of due diligence on product selection; for example seeking regular product updates on their performances, investment decisions, investment process, funds tracking error to its benchmark and many more. Once people have made a decision on investment it is extremely crucial for you to give the manager time to prove their worth with reasonable expectations that the fund will underperform over some periods. This is difficult to practice but important in order to make above-market returns.