Typically, we are aware of the returns a fund generates which is based on the change in the net asset value (NAV).
Investors enter and exit a fund in varying proportions. Investor Return is typically a rupee average return, or an average return an investor holding that fund would earn. Globally, we have observed that investor return will be typically lower than fund’s return.
Suppose the average return of a fund is 12% per annum over the last five years. On the contrary, investors in this fund would have made around 9% average return per annum. Investors enter the fund at different points in time. The experience of one investor will be different from another unless both are holding the fund for the same time period. Very few investors earn returns on par with the fund return. This is where the behavioural gap comes in which investors need to address.
The proportion of the gap between fund return versus investor return can vary. If the fund itself is volatile, the gap tends to be higher. This is typically the case with sectoral or thematic funds.
Pharma Funds have received decent inflows in the past few years, typically post COVID as this sector performed well. We looked at the return of a Pharma Fund. Its three-year return as of April 2022 stood at 23% but the average return of investors was 6% lower. Investors look at the past performance of funds and chase those funds. They are often late to enter that theme and sell when they don’t earn returns. These behavioural biases hurt investors when they chase recent performers. This results in a significant gap between the fund return and investor return.
Why the Recency Bias is your enemy
Investor return can be calculated using excel using your inflows and outflows with dates using Extended Internal Rate of Return or XIRR. This will help you understand the return earned by you versus the fund. XIRR is used when there are multiple cash flows. In the case of lumpsum investment and redemption there are two transactions (investment and redemption). But in many cases, investors make fresh investments in the fund and redeem some amount in the interim. So XIRR is the right method to calculate your return.
Instead of timing your entry and exit, if you simply stay invested in the fund you can narrow the gap between the fund return and your return.
Funds will go through this cycle of outperformance and underperformance based on the style and the strategy of the fund. When we analysed returns of funds by quartiles, since 2009, funds featuring in the top quartile (best performing funds) received 85% of overall flows. This shows that investors are chasing funds that are recent performers.
We did another study to understand how many months of performance contributed to a fund’s overall outperformance over the benchmark over a ten-year period. We found that only 6 months contributed to a fund’s entire outperformance over the benchmark over this time period. If you as an investor missed being invested over those six months, which can come anytime, you would have underperformed the benchmark. So when investors chase trends and move in and out of funds, they can miss out on those critical months when the outperformance could strike.
Let me cite another example. The best-performing equity fund delivered 40% over the last three-year period as of April 2022. An average investor in this fund has made only 20% return, so the gap is half. Half of the returns were not earned by investors simply because they entered the fund late. Around 75% of inflows have come into this fund only in the last one year.
So our advice is to buy and hold funds rather than chasing outperformers as it will be counterproductive for investors.
Watch the full interview here.
