Why You Shouldn’t Compare Mutual Funds Using Absolute Returns
Today, the returns for a one-year period show an exceptional rate. A good performing small-cap fund may show a rate of over 50% as its one-year performance. Similarly, a large-cap funds seems like an excellent option with returns during the past one-year exceeding 30%. However, these numbers change when you change the period to three or five years.
Why shouldn’t you compare mutual funds based on absolute returns?
Returns on different periods are known as point-to-point returns or absolute returns These returns simply show the earnings between two particular dates. Point-to-point returns show the earnings at a particular point in time and do not reflect the funds’ performances over a period.
Here are two limitations where point-to-point returns may not provide accurate information:
- Returns are in a particular point in time
- Events during the time is not factored
Particular point in time
As already mentioned, these are returns on a particular point in time. Therefore, the returns may be influenced by events that happened at the start or end date. Therefore, if the markets showed a downward trend on the end date, the mutual funds’ returns would be higher. Similarly, if market performed well, the returns would be lower.
For example, on December 1, 2016, the markets were still reacting to the demonetization drive implemented in November 2016. Therefore, returns on December 1, 2017, were better than September 1, 2017, because it is influenced by the events that occurred in the previous year on that date.
Similarly, gilt and debt mutual funds had double-digit growth in December 2016. However, one year later in December 2017, these schemes showed single-digit returns or even negative (in some instances). This is the result of yields reducing during the demonetization drive but has now recovered.
In addition to market forces, the returns may be affected by the fund manager’s performance. In case the fund manager or management changes, it may show higher returns as the fund’s performance improves. The opposite is also true where the returns may decline due to the deteriorating fund performance.
Does not consider events during the period
Another limitation of using point-to-point returns metric for comparing mutual funds is that it does not take into consideration events that may occur between the start and end dates. This is an important factor especially when investors compare long-term point-to-point returns. The markets may have gone through several phases during this period and the effects of these are not captured by this metric.
For example, the five-year mutual fund returns today do not capture the events that happened during this time. The markets during the last five years have been through three phases, which is not captured in the five-year point-to-point returns.
The daily changes in the returns, using only one, three, or five-year performance history is not the right way while comparing mutual funds. Using simply the point-to-point metric, one fund may show 15% returns while the other may deliver 17% returns on a particular date. However, on another date, the returns for both these funds may be 16% based only on the market and fund activities.
Furthermore, if a mutual fund shows improvement in performance, it may not be as good as it seems. Investors may determine their returns expectations on current performance and may make inaccurate investment decisions. They may avoid investing if the returns are lower or may invest because of higher returns.
One way to overcome the limitations of point-to-point returns is to evaluate the funds’ performances over a longer period. A longer period considers the different market cycles to provide a more accurate picture.
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