At the end of the day a mutual fund investment will be judged by the returns it generates. A great idea needs to generate above market returns, otherwise you will be better off staying invested in an index fund or perhaps in debt instruments. But the concept of returns itself is quite vast and all-encompassing. There can be different measures of returns for mutual funds. Let us look at the most basic form of returns that mutual funds use..
A basic approach to mutual fund returns..
Let us assume that the NAV of an equity fund launched on 1st October 2007 has progressed as under over different time frames..
DateNAVTotal ReturnsCAGR Returns01st October 2007Rs.10.00NANA01st October 2010Rs.13.0030%9.14%01st October 2012Rs.20.00100%14.88%01st October 2017Rs.39.00290%14.58%
As the table above indicates, the fund has been an average performer over the last 10 years but has managed to do quite well over the 5 year period. This period has been marked by intense gyrations in the Nifty and the Sensex and the fund has definitely outperformed the indices during this period. However, there is a practical problem in this measure. These returns are only relevant for a unit holder who would have entered on October 01st. Had the investors entered on any other date, these returns may not be reliable and, in fact, they may also be misleading. The above measure is called trailing returns and the shortcoming of this measure is that it does not capture the consistency of returns. After all, returns will be more reliable if they are consistent as it will assure the investor that even if she were to choose a slightly different time period, the returns would still be comparable. So how do we measure consistency of returns? The answer could like in rolling returns..
So, what do we understand by rolling returns?
In rolling returns you basically break up the trailing return data into a number of sub-series and then calculate the rolling returns. Over longer periods of times, you use time frames like weeks, fortnights or months to give a better and simpler idea of the rolling returns. Let us understand the concept of rolling returns with a small example..
The above chart has used a very basic example for calculating the trailing returns and the rolling returns for 20 days with the help of a NAV of an equity fund. The data has been considered from 1st of the month but since we have considered 3 day trailing returns, we have displayed data only from the 4th of the month. As the above table depicts, the trailing returns point to point works out to 1.30%, which is quite reasonable for a 1-month period. But that does not tell us anything about the consistency of the fund. That is where we turn to the 3-day rolling returns of the fund.
As the table above can intuitively tell you, there is a huge inconsistency in the returns of the fund on a rolling basis. The picture will become a little clearer when you look at the mean and the median of the rolling returns. The average 3-day rolling return works out to 0.03%, which is much lower than the 0.13% that the fund returned over a 3-day period (1/10th of monthly returns). The situation gets worse when you consider the median returns because it has come in at a negative (-0.20%). That means it is more likely that a person entering the fund on a random date would have made a loss over the last month. The point-to-point returns of the fund are fairly impressive, but when you look at consistency, the fund scores quite low. Of course, this is a very short time frame considered for the sake of understanding but it explains the concept nevertheless.
How to apply the rolling returns concept while investing..
The concept of rolling returns may not be too important over longer periods of time, especially in case of equity funds. The point to point returns give a fairly good illustration. Hence from a long term financial plan perspective, this concept of rolling returns may not be too important. This concept may have some importance when it comes to those who are looking at equity funds from a shorter time frame of 1-2 years. However, this concept of rolling returns is a lot more relevant for short term funds and liquid funds.
When it comes to shorter term funds, the consistency of returns is more important since most of the investors are corporate treasuries who are looking to maximize the yield on their cash balances. Hence, such corporates will prefer to invest in short term funds where the rolling returns chart consistently outperforms the trailing return charts. Because, when it comes to the short to medium term, the consistency of the returns becomes a lot more important. That is where rolling returns have a key role to play!