MF investors beware: Study shows effects of '1-year return trap' in mutual fund investing

A 20-year deep-dive by HDFC Securities has debunked one of the most common myths in mutual fund investing — that past short-term outperformance guarantees future success. The analysis, spanning data from 2005 to 2025, reveals that investors often chase funds based on their 1-year or 3-year returns, only to find that these “hot” funds rarely sustain their momentum.

According to HDFC Securities, a mutual fund’s recent stellar run — especially over a 12-month period — can create an illusion of strength, temporarily boosting its overall record. However, such bursts of performance, termed a “purple patch,” usually stem from favorable market phases rather than consistent fund management. “A strong rally in the last year can inflate multi-year averages even if the earlier record was mediocre,” the study notes.

The 1-year test

To understand this behavior, HDFC Securities conducted a fascinating experiment involving 32 large-cap mutual funds. Each year since 2005, it ranked the funds based on their 1-year performance and invested in the top-ranked fund for the following year — redeeming it annually and repeating the process.

The result? No correlation between one year’s star performer and the next year’s winner. The supposedly “best” fund of one year failed to sustain its lead in the following period. Over two decades, this strategy yielded a CAGR of 14%. Surprisingly, if investors had chosen the 6th-ranked fund each year instead, the returns would have been 16% CAGR — a clear sign that chasing last year’s winners can backfire.

The 3-year check

In its second test, HDFC Securities examined how the short-term ranking impacted long-term results. Each year, Rs 100 was invested in the #1 ranked fund based on the prior year’s performance, and the investment was held for three years.

Here too, the findings were eye-opening. The top-ranked fund delivered an XIRR of 13%, while the #3 ranked fund returned a stronger 15% XIRR.

In mutual funds, XIRR (Extended Internal Rate of Return) is a metric that calculates the annualized return on investments involving multiple cash flows at irregular intervals. It takes into account the exact amount and timing of each contribution (such as SIPs) and redemption (like withdrawals) to give a personalized and precise annual rate of return. This makes XIRR a more accurate measure of investment performance than simple return calculations.

The takeaway? Funds with slightly lower short-term performance often exhibit greater consistency and better long-term outcomes.

The key lesson

The study’s conclusion is clear: recent outperformance folds into periodic averages, making a fund’s short-term record appear more impressive than it truly is. “Higher 1-year or 3-year returns do not imply consistent performance,” HDFC Securities warns. Instead, investors should evaluate funds on long-term track record, risk management, and consistency rather than getting swayed by short-term rallies.

In essence, the best-performing fund of today isn’t guaranteed to be the winner tomorrow — a reality every investor must remember before chasing last year’s star.