Continuing our articles on investment risks today we turn our attention to the promises made for high returns in mutual fund investments.
Much of the argument for investing in mutual funds rests on
- Getting high returns, and,
- Getting high returns year-after-year for many years
Let us take point (b) today.
The momentum effect
In the subject of finance, there is a term called Momentum Effect. In simple language the meaning of this term is that once a mutual fund earns high returns in any year, the momentum of earning high returns continues year after year. If a mutual fund earns, say, 15 % in any given year, it will continue to earn 15 % or thereabouts year after year for many years to come.
When you read articles in the media or watch TV shows or You Tube on investments the argument for investing in mutual funds goes something like this: Mutual Fund A earned 15 % return in the past year. If you invest Rs. 100,000 in Mutual Fund A, after 20 years you will get Rs. 1,636,654, compounded at annual return of 15 %. Too tempting to resist.
Apart from an unrealistic 15 % expected return on Mutual Fund A, the other major fallacy is expecting that return year after year for 15 years.
The assumption here is that the mutual fund returns have a momentum effect. Because 15 % return has been achieved in a particular year, you are told that the Fund A will have a momentum effect for many years in the future. This however is not supported by hard empirical evidence. Momentum effect has been an area of considerable research world-wide, including India. Nowhere has the momentum effect been noticed. The same fund rarely crops up as a top performer in subsequent years.
Evidence that the Momentum Effect does not exist
The S & P Dow Jones Indices published a research report in 2021, SPIVA Scorecard. They broke up fund performance into quartiles, in the year ending June 2019, 53.6 % of the funds were in the top quartile of performance. Of these funds, only 4.8 % remained in the top quartile in the year ending June 2021. Eugene Fama (who is a respected figure in investment theory and analysis) and Kenneth R. French (also a respected figure) showed through their research after studying over 10,000 simulations, that few funds can get you returns higher than the benchmark index. James Choi, a professor at Yale University, and many others also came to a similar conclusion through their research.
Next time a financial advisor gives you projections of high return consistently for many years in future, question the advisor. There is no momentum effect in mutual fund returns.
Read more about these issues in Ignis Fatuus: The Delusions Created in you and for you by the Investment Sector. Available on Amazon: https://lnkd.in/dR9yuJVQ