Is 'rolling return' the best way to measure performance of mutual funds?

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Which is the first and the most common criteria to choose equity mutual funds? Most of us would say- past returns, which is true. Most retail investors look at the historical returns generated by the scheme in the different periods, say, one-, three- and five-years while choosing an equity scheme. The plain reason is that these are easily available and also that the ultimate motive of anyone investing in an equity fund is to earn good returns.

However, mutual fund experts argue that using trailing returns does not actually give us the correct picture. Investors should in fact look at the rolling returns if they want to base their choice on past performance.
“Rolling returns is a bullet proof method to understand market volatility as against trailing returns. This method helps you make the decision by looking at the probability of the past by looking at the probability of the future,” said Sunil Subramaniam, Managing Director, Sundaram Mutual Fund, while talking at ET Wealth Investment Workshop in Hyderabad last month.

What’s the problem with trailing returns? In an improved or uptrend of a market cycle, trailing returns of all the periods for a scheme would improve as they are calculated point to point. Similarly, in a bad market, trailing return of all the periods for a scheme will fall.

Rolling return is the solution. But why? And how is it calculated?

A rolling return is the average of a series of returns over a long period of time. It is like a daily SIP for a certain interval and then taking an average of the series of returns.

An example will make it clear. Let’s assume an investor wants to invest in Sensex for a time period of five years. We have taken Sensex just for an illustration purpose here. And five years because it is the minimum horizon an equity fund investor should have. Assuming she wants to test the five year returns over 15 long years, on an excel sheet she can start with daily price of Sensex. Next, she needs to calculate returns if she invests in Sensex on April 01, 2003 for five years, which means her SIP will end on March 31, 2008. Again calculate returns if she starts SIP next day that is on April 02, 2003 for five years, which means her SIP will end on April 01, 2008. Again calculate five years SIP returns if she starts on April 03, 2003. Continue this exercise over a span of 15 years. This will give her almost over 3,800 sample five year returns of Sensex over the period of 15 years. The average of these returns is the rolling 5-year returns, rolled daily over 15 years.
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Returns can be rolled on weekly and monthly basis as well.

The benefits of this exercise do not end here. While doing this exercise, you can also find out for how many periods (3,800 in our example above), did a scheme gave positive returns and for how many it gave negative periods. Also, you can find out for how many periods did a scheme beat the inflation. You can also know the maximum and minimum return a scheme has given for a five year period over a long span of 15 years. This will give you an idea about the probability of happenings in future.

Though future is unpredictable and there is no guarantee of repetition of the past performance, we can rely on this method if we evaluate the performance over a long span (like 15 years in example above) and big sample periods (3,800 in example above).

“ When we use rolling returns method, it erases the impact of timing the market and you can actually reach at expected performance of a scheme in future.

Next big question, where to find this data. Computing this for a scheme or two can be done but it does not solve the purpose till you find rolling returns for all the schemes in a category and choose the best scheme to suit your risk profile.
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You can find this data on various online portals available. Otherwise, you can ask your financial advisor for the data as s/he will have access to paid databases as well.
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