The reason is quite simple. Because most of us invest through Systematic Investment Plans (SIP). Not many of us invest in equity mutual funds in lump sum. This is not to say lump sum investing in mutual funds is a bad idea. But it is quite risky for sure. Only very smart investors can pull it off consistently.
When you visit various mutual funds aggregator and analysis websites such as ValueResearch or MorningStar, trailing returns (1-year, 3-year, 5-years and so on) are prominently highlighted. A 3-year trailing return gives the CAGR (Compounded Annual Growth Rate) of fund NAV growth over the last three years. So, if you check the 3-year trailing return on October 1, 2015, it gives you the annual growth w.r.t. to NAV on October 1, 2012.
If NAV on October 1, 2012 was 100 and is 140 on October 1, 2015, the 3-year trailing return is 11.87% p.a. If NAV had dropped to 95 on November 1, 2012 and NAV goes to 147 on November 1, 2015, 3-year trailing return is 15.66% on November 1, 2015. 5% rise or fall in a month is not uncommon in equity markets. And this is where the problem lies. Two investors who invested a month apart are experiencing very different 3-year returns in the same fund. For someone who is short listing funds for investment, which return should she trust, trailing return on October 1, 2015 or November 1, 2015?
Moreover, as a mutual fund investor taking the SIP route, you want consistently good returns. Trailing returns do not give you any idea about fund performance during market up and down cycles in between.
Even while highlighting the virtues of mutual fund investing, most of the commentators on television talk about point-to-point returns. For instance, if you had invested Rs 10,000 in XYZ fund, it would have become 200,000 in 20 years. How do such results matter to you? Since you are investing through SIPs, you need to know if you had invested a particular amount on particular date of every month for 10 years, how much would have your corpus grown to?
How to calculate SIP returns?
You can find out the SIP returns of your fund in Microsoft excel easily using XIRR function. You will need the SIP amount, SIP date and NAV of the fund on respective SIP dates. Sounds cumbersome? I think so too.
Since your installments get invested at different values of NAV, the CAGR that each installment experiences is different i.e. first installment may grow at 12%, second at 10%, third at 13.5% and so on. This depends on the NAV on the date of installment and on date of calculating returns. SIP return is like average CAGR i.e. all the installments compounded at SIP return (XIRR) would yield your total current value of investment in the fund.
There are a few sites that offer SIP returns for the funds. You can even compare SIP returns of multiple mutual funds and even the benchmark index. You can visit the following link at MorningStar to calculate SIP returns.
Not sure what benchmark means?
Every mutual fund selects a benchmark index to measure its performance against. For instance, large cap funds may have S&P BSE Sensex or CNX Nifty as their benchmark index. Midcap funds will have CNX Midcap or other such index as their benchmark. Benchmark index also gives an idea about the kind of companies a particular fund will invest in. If a fund consistently outperforms its benchmark over the long term (3-year, 5-year and 10-year) term, it speaks well of fund manager’s security selection abilities.
How is SIP return a better indicator of performance?
It tells how consistent the performance has been. Equity markets (and fund NAVs) do not move in straight line. Markets go through up and down cycles. Your return depends on the levels of NAV you invested at. Though individual installments in SIP can experience different levels of returns, SIP return averages out the returns and reflects the performance of your investment better.
Additionally, if you are investing through SIP, SIP return is the return you are experiencing on your investments.
Here is a snapshot of fund performance comparison between UTI Equity Fund Growth and DSPBR Top 100 Equity Fund. Both have S&P BSE 100 at their benchmark.
You can see DSPBR gives better point-to-point returns (trailing 10 year returns) than UTI fund. Rs 5,000 per month over a period of 10 years is equal to total investment of Rs 6 lacs over 10 years. Had you invested Rs 6 lacs lump sum in the two funds, you would have ended up with Rs 26.1 lacs in DSPBR fund and Rs 24.9 lacs in UTI fund.
However, if we look at SIP returns (XIRR), UTI fund is far ahead. At Rs 5,000 per month, you would have Rs 13.8 lacs today in UTI fund and Rs 11.7 lacs in DSPBR fund. UTI fund has XIRR of 15.79% while DSPBR fund has XIRR of only 12.7%.
Which is a better fund?
UTI Equity Fund is better since it has performed better during up and down cycles. This is demonstrated through better SIP returns (higher XIRR).
Points to note:
- Do compare SIP returns with SIP returns on the benchmark index. SIP returns on the benchmark index means the returns you would have got if you had invested the same amount in the benchmark index. This will give you the idea of how the fund has performed vis-à-vis its benchmark.
- Comparison with benchmark index is important because in absence of benchmark performance, it is difficult to tell if your fund has been performing well. If your fund has returned 12% when the benchmark has given 8% p.a., you have invested in a very good fund. However, if your fund has given returns of 12% per annum when the benchmark has given 15% p.a., you may have to revisit the choice of your fund. A total return index (which accounts for the dividends paid) would have been the right benchmark. I have used S&P BSE 100 Total Return Index for comparison.
- Select the right benchmark to compare SIP returns. Comparing SIP returns of a large cap fund with CNX Midcap makes little sense. You can find the benchmark of an index from its scheme information document. Alternatively, you can find the benchmark easily from ValueResearch or MorningStar.
- Do not expect outperformance from index funds. Index funds try to replicate the performance of benchmark index. The intention is not to outperform the index but only to replicate its performance.
- Focus on long term returns i.e. SIP return for 3-year, 5-year or 10-year term is better indicator of performance than 1 year SIP return. Learn to live with short term volatility. A few quarters of underperformance is no reason to exit the fund.
- Choose growth option for comparison. Growth option is preferred over dividend option because different funds may have different dividend payouts. Hence, NAVs are not comparable.
- Choose regular plans for comparison. This is because direct plans have been around since 2013 only. You will not have sufficient performance history for direct plans. In any case, direct plans and regular plans have same portfolio. The difference is only in intermediary costs.
- Risk adjusted performance matters. A fund manager can generate higher returns by taking higher risk. However, he deserves the credit only if he generates higher returns taking low (or equal) risk. Alpha is a measure of risk-adjusted performance. Higher the alpha, the better it is for an investor. Alpha can be different for different periods. Do consider the correct period.
Shouldn’t we use rolling returns?
Another alternative to point–to-point returns is rolling return. For instance, under 5-year rolling return, you will calculate point-to-point return from October 1, 2005 to October 1, 2010, October 2, 2005 to October 2, 2010 and so on till October 1, 2010 to October 1, 2015. Assuming there 250 business days in a year, you will have 1500 values of 5-year returns. You can take an average of these values to arrive at average 5-year rolling return over the 10 year period. This is an even accurate assessment of fund performance than SIP performance because this has taken all the data points into account.
Under SIP returns, we are taking into account just one value of NAV each month. For example, SIP return for installment on 1st on each month can be different from SIP scheduled on 15th of each month.
You can find out 1-year, 3-year, 5-year, 10-year (or any other period) rolling returns provided the fund has sufficient history. Unfortunately, there is no website that offers rolling return calculator for mutual funds (or at least I could not find one). There are a few excel based rolling returns calculators available on the internet. You can use those if you want.
I personally feel long term SIP return is a good enough estimate for you. You can do without looking into rolling returns to measure fund performance. However, please focus only on long term SIP returns. I prefer 10 years. Moreover, if you are an investor, SIP return (XIRR) gives you the return that you are actually experiencing. You do not really experience average rolling return.
Point-to-point trailing return, especially the long term returns, tells you a lot about mutual fund performance. I still use long term trailing performance to prepare my initial shortlist of mutual funds for selection. However, as mentioned, there is information about the return in the interim period.
SIP return is a more accurate assessment since the returns get smoothened out as there are multiple data points involved. SIP return (XIRR) is easily available too on many websites.
SIP return (XIRR) is especially useful while reviewing your portfolio as you get to know the exact performance of your investment (if you are investing through SIP). Do compare the performance against the benchmark to see if your fund is under-performing or out-performing. Focus on long term returns.
Image Credit: Simon Cunningham/LendingMemo[dot]com, 2013. Original Image and information about usage rights can be downloaded from Flickr.
Deepesh is a SEBI registered Investment Adviser and Founder, PersonalFinancePlan.in