Do five star mutual funds always perform?

We live in a world ruled by stars and ratings. Right from Bollywood to Cricket, people tend to favour megastars. You may wonder, what this has got to do with the world of investments?

A lot because when it comes to investments most of us tend to give a lot of weight to the winners of last year. We want the highest rated fund or best-performing stock. The financial services industry along with its aggressive marketing entices people to chase performance by touting 5-star mutual funds. Magazines and television channels are not far behind in getting experts to tell you how you should identify these gems. And for some people, it's easy to just pick last year's best-performing funds or stocks.

In reality, the phenomenon of the best performing fund to falter, after a year or two of success, is not unheard of. Thus, the question you should be asking is why does this happen? Let's try to examine a few reasons:

The star performing scheme suddenly attracts a lot of money and is sitting on cash for some time trying to figure out what to do with it.

Lack of opportunities in the mid-cap space for funds collected either makes fund managers look out for large-caps or buy more of the same stock.

When a core product does well, mutual fund houses often tout these returns and launch several other schemes, which tend to dilute the focus of the fund manager from the core product to several other offerings.

I am not trying to say that one should not look at a 5-star rated fund. Instead, from a broader perspective, I would like to highlight that there are other important things that one should look out for when choosing funds for his/her portfolio. Besides your financial goals, current situation, returns required and asset allocation, here are a couple of other filters you need to check out:

Look at the risks

It feels great to look at exotic numbers on the upside but when the same happens on the downside, you are either out of the stock market forever or you take a short term equity holiday only to enter again when your friend is making money.

Consistency of performance

How has the fund performed in rising and falling markets? The best funds are the ones that have the potential to rise fast and fall less. It is hard to identify such funds and there might be very few such funds. Look at the performance over the last 1, 3, 5 and 7 years to see how the funds have done and especially look closely at the fund's performance in falling markets.

Mutual fund houses, themselves, know that selecting funds on the basis of past returns alone is a lousy concept and hence by law, they are required to give this caveat saying "Past performance is not an indicator of future performance" and yet all the funds tout returns like it's the only thing people respond to. Well, it's partly true and sad that returns supersede discussions about risk and the decision is generally skewed in favour of returns.

The point that I am trying to make is that there is no way to know in advance who the first or the best will be. So, it's a futile exercise to identify the number one and anyone who has this "Midas touch" is fooling both you and themselves.

Your objective as an investor should be to ensure that you make investment decisions keeping your financial goals in mind. This will help you determine what returns you reasonably need to achieve your financial goals. Additionally, you must review the performance of your portfolio in line with your goals. Knowing your benchmark can help you avoid taking more risks than necessary. The idea should be to strike the right balance between your investments and your goals, risk appetite, and goal time frame.

The writer is the founder of Happyness Factory