Should you invest in a Top 10 fund?

MUMBAI: Sundaram BNP Paribas Select Midcap (growth option) has been the top-performing mutual fund scheme of the last one year ( as on November 6, 2006) having given a return of 80.63%. During the same period, the scheme’s assets under management (AUM) have gone up by 308% to Rs 1,408.36 crore. The AUM has grown by almost Rs 663 crore from April 30, 2006. This clearly shows that more money has come into the scheme after the market realised its good performance. Tata Infrastructure Fund (Growth) comes in second in the yearly rankings by generating a return of 74.81%. The fund house has gone on an overdrive to advertise this, in order to seek more investment.
 
The key question is: Can toppers sustain their top-notch performance? Or are they only one0year wonders?

Evidence coming out of an analysis carried out by DNA Money seems to suggest that schemes that form the top 10 list by returns during a particular year disappear from the list the next year. Only two of the top 10 schemes as on November 6, 2005, made it to top 10 list a year later.

The evidence from the earlier years is similar. Only three of the top 10 schemes as on November 6, 2003, made it to the top 10 list a year later. Given this, investing on the basis of one year’s top performance may not be such a great idea.

A scheme that does well during a particular year sees its AUM increase. As the assets go up, the impact a single stock multibagger has on the returns goes down. Hence the fund manager needs to discover more multibaggers. This may or may not happen.

Multibaggers are usually stocks whose true potential has not yet been recognised or are currently out of favour with the market. Hence choosing a mutlibagger involves some amount of calculated risk. But as the asset size grows in a fund, the fee income (entry load, management fees, etc) that comes in with it also increases. Hence the fund manager may or may not be willing to take calculated risks that made the scheme initially successful.

Further, an increase in assets may leave a fund manager with fewer options to invest money in. If he decides to retain the money as cash and not invest, the returns of the fund go down.

If he decides to invest in a stock which he already owns and which would have probably gone up by then, his returns are again less. The last option is to buy stocks which the fund manager would not have bought in the first place.

The easiest thing to do in such a situation is to invest in stocks that form a part of the index the scheme is benchmarked against.

This ensures that the scheme at least does not generate returns lesser than the benchmark index.

So how does an investor figure out where to invest and not end up investing in what may be essentially a one year wonder?

One way is to look at the performance of schemes for a greater time period - three to five years. Six of the top 10 schemes (as per three-year returns) as on November 6, 2005 made it to the top 10 list as on November 6, 2006. The evidence from earlier periods is also similar. Seven of the top 10 schemes (as per three-year returns) as on November 6, 2003, made it to the top 10 list as on November 6, 2004. The evidence gets even more pronounced if we taken returns over a five-year period. Six of the top 10 schemes (as per five-year returns) as on November 6, 2005, made it to the top 10 list as on November 6, 2006. All of the top 10 schemes (as per five-year returns) as on November 6, 2003, made it to the top 10 list as on November 6, 2004.

What this clearly tells us is that certain schemes continue doing well over a longer period of time, irrespective of whether they make it to the top 10 list or not in any one particular year.

Another way is looking at the performance of the scheme for a one-year period for the last few years. Sundaram Select Midcap has been in the top 10 list for the last three years, clearing suggesting that the scheme is a little more than a one-year wonder.