Should You Chase High Return Equity Mutual Funds of the Past

As of March 6, 2025, the BSE Sensex, BSE Mid Cap Index, and BSE Small Cap Index have corrected by 13.4%, 19.4%, and 21.6%, respectively, from their all-time highs.

[Read: Global Investing Amid Market Volatility: Should You Diversify Now?]

The mid-cap and small-cap segments, which have attracted considerable investor enthusiasm (owing to their higher return potential compared to large caps, which also makes them more susceptible to downside risk), have taken a particular beating.

Investors were perhaps drawn to the allure of high return mutual funds, either overlooking or being oblivious to the fact that past returns are in no way indicative of future returns.

Given the current market volatility and various global and domestic headwinds at play (e.g., U.S. President Donald Trump's tariff threats, geopolitical tensions around many parts of the world, a weakening rupee against the greenback, and Foreign Portfolio Investors (FPI) dumping Indian equities) it would be unrealistic to expect similar decent returns in the near future.

You, the investor, might think that mutual funds with stellar 4 or 5-star ratings would perform well and help you achieve your financial objectives.

Excessively relying on high-star ratings, however, can prove to be a significant blunder.

You see, the way these ratings are assigned by certain agencies or institutions is inherently flawed.

Most ratings are given based on quantitative parameters, mainly historical returns, which are not a reliable indicator of future performance. They may not consider other important factors such as the portfolio holdings, the fund's management team, the investment philosophy, and so on.

Additionally, each rating agency uses its own methodology and criteria. This means that a high-rated mutual fund by one agency might not be cast in as favourable a light by another. Besides, there is a possibility that the top-rated mutual funds by an agency are actually sponsored advertisements from certain fund houses or brokers to promote a specific scheme.

Always keep in mind that mutual fund star ratings say nothing about the future potential of the fund.

There's always a chance that a 4 or 5-star rated fund that you added to your portfolio today may lose some of its stars or gloss if its performance lags in the future. This is one of the reasons why many investors find their mutual fund portfolio underperforming over time despite investing in highly rated schemes.

Why Can't You Rely Solely on the Past Performance Data of Mutual Funds?

For the past few decades, the Securities and Exchange Board of India (SEBI) and mutual fund houses have been emphasising the message, "Past performance is not an indicator of future results."

As you may know, market conditions change constantly. A fund that excelled in a particular environment may underperform in another.

Let's consider the bull and bear market comparison of 2 funds, Fund A and Fund B...

It is clear that Fund A excels at generating high returns and typically outperforms Fund B in bull markets. However, a closer examination reveals that it tends to lose more value in bear markets.

If you only consider the most recent performance, you are likely to favour Fund A due to its recent high returns compared to Fund B.

The graph above shows that Fund A is not as dependable in maintaining consistent performance.

The high returns in bullish phases likely stem from taking higher risks compared to Fund B, which makes it more susceptible to significant losses during bearish periods. This tendency could negatively impact the fund's overall long-term performance.

On the other hand, Fund B demonstrates better stability and potential for long-term success, offering increased value appreciation with relatively lower risk.

Therefore, when picking mutual funds, it's essential to look beyond past performance as there are other factors at play including a fund's strategy, adaptability to economic conditions, interest rates, and global events.

In the current environment, investors should be looking for 'predictable returns' rather than chasing past or historical returns. This means that while a fund's NAV (Net Asset Value) would naturally move up and down, the movement should not be too erratic. A large part of this depends on the inherent portfolio characteristics of the fund.

How to Approach Mutual Funds?

When it comes to selecting mutual funds, it is wise to adopt a comprehensive approach that considers both quantitative and qualitative factors.

[Read: How to Invest in Equity Mutual Funds During a Stock Market Crash]

While quantitative factors focus on how the fund performed in the past, qualitative factors dig into the reasons behind that performance. This well-rounded approach allows a deeper evaluation of the factors behind a fund's success or failure, providing better guidance on its future potential.

Unfortunately, most star ratings tend to focus solely on the quantitative aspects, overlooking the qualitative side. In addition to past performance, there are a host of other qualitative parameters that serve as a guiding principle to understand the fundamentals and evaluate the quality of the fund.

To Conclude...

Mutual fund star ratings, which mainly consider historical returns, are only a starting point. You, as an investor, should remember that past performance, while useful, doesn't guarantee future returns.

A sensible and prudent approach is required to choose winning mutual fund schemes from a plethora of options.

Rather than simply adding high return mutual funds to your portfolio, focus on adding suitable schemes that align with your risk tolerance, broader investment objective, financial goals, and the time in hand to achieve those goals.

Be thoughtful in your approach.

Happy investing!

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MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.
 

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.