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B. Venkatesh

AS INVESTORS, we typically choose mutual funds that have performed well in the recent past. Studies, however, show that funds that perform well in the past often fare poorly in the future. Does this mean that our behaviour is irrational?

Suppose there are 10 mutual funds investing in the same universe of stocks. Assume that the investors are aware that four among them will do well the next year. Obviously, all the money will flow into these funds. Importantly, unit-holders may withdraw money from the other funds and invest in these four funds.

This creates problems for these four funds. Why? These fund managers will now have more money to manage. Investing in the same universe of stocks means that overall returns for these funds will decline. The reason?

The demand for these stocks will increase. When demand is higher than supply, the stock moves up. This means that capital appreciation and, hence, returns will be lower. The other six funds that face redemptions will, however, perform well because their holdings would have appreciated in value.

Assume that the 10 funds are benchmarked to the S&P CNX Nifty. Investors will buy units until returns on these four funds decline to match the returns on the Nifty index.

At this point, investors can buy an index fund and enjoy the same return for, perhaps, lower risk. They will, hence, stop buying these four funds.

Essentially then, unit purchases will lead to decline in returns for the four funds while the unit sales will lead to increase in return for the other six funds.

Of course, we do not know which funds are likely to perform well, as we assumed earlier. So, we buy units based on past performance. And that action, as explained above, drives down returns.

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