The category average is just a hypothetical number; it is much better to look at the range of returns to truly understand how funds of a type have performed
In colloquial language, the word ‘average’ is a single number taken as representative of a list of numbers. But is it really so when it comes mutual fund returns? When investors read about the category average of returns what is the conclusion that they should take? This problem haunts investors reading about mutual fund category averages. Different websites have different ways of expressing the category average. Some give 1 year, 3 year, 5 year, and even 10 year category average of a collection of funds. When people read about averages they are inclined to think that if a fund category has a better average, then it has done better. Often, the truth is stranger than averages.
Mutual fund investors must note that there is nothing more misleading than the category average. With just four funds, a fund category average can have an average number that is better than another category with 30 funds. Does that mean the category with four funds has done better than the category with 30 funds?
A category average is merely a hypothetical number. If the category average is 12.5%, it does not mean that a large number of funds have given that return. In fact, if you do your research, you may find that none of the funds has given that return. If you want to truly know how a fund category has done, a much better starting point is to look at the full range of returns and understand how the funds of the same type have performed. Read on to know more.
Mutual funds are all about financial returns. Investors, as well as fund managers, do not know what the future returns will be. So, everybody wants investors to have an understanding of the returns that were experienced previously. Thus, the average started gaining prominence.
The average is the arithmetic mean. It simply involves taking the sum of a group of numbers and then dividing that sum by the count of the numbers used in the series. For example, if fund A has given 34%, fund B has given 44%, fund C has given 56% and fund D has given 78%. The sum is 212. The arithmetic mean or fund category average is 212 divided by four, or 53%.
As you can understand now, this number — 53% is misleading. None of the funds has given 53%, but yet the category average at 53% means something. What is it exactly, nobody knows!
The misuse of the category average is rampant. While we admit that average rates of return can be a relevant statistic in some cases, they are not useful with investments. Why? This is because of a statistic like category average masks the reality of performance loss and negative years in the market.
Take the example of ELSS (tax-saving funds). Over Rs 93,000 crore of investor money is locked up in ELSS category. The 5-year category average of ELSS is somewhere around 8.4% CAGR. CAGR is Compounded Annual Growth Rate (while investments usually do not grow at a constant rate, the compound annual return smoothes out returns by assuming constant growth). The 8.4% CAGR number can give you the impression that your money grows by 8.4% a year at least in some funds. Fund houses, advisors and media often will use the 8.4% number and compare it with other competing tax-saving avenues like PPF or tax-saving bank FDs to drive home the point that ELSS is one of the best return generators. The 8.4% number is misleading because it fails to tell you that in 2018 about a dozen ELSS funds lost 10-20% value.
When we compare two fund categories with two different average returns at one point in time, we make a few glaring mistakes. One of them is that a fund category with a higher average rate of return can underperform another category with a lower average rate of return. So, a historical average essentially has no use in the present or the future.
In categories of funds where the number of funds is very low, category average completely can mislead people. We will explain with a live example.
There is a thematic category of funds – MNC funds. It has just three funds with at least one year track record of returns. SBI Magnum Global Fund has given 10% in last one year. Aditya Birla Sun Life MNC Fund has given 7.6% in the same one year. And, UTI MNC Fund has given 1.9% return in the same 12 months. Now if you do a category average of MNC funds, the one year return is about 6.5%.
Notice how the category average conveniently hides the extremely poor performance of one fund (33% of the whole set). That’s one of the big problems with a fund category average! If you thought funds in this category got around 6.5% in one year period when you looked at the average number, you would be very very wrong.
The arithmetic mean or average always creates problems especially when a single outlier can skew the mean by a large amount. In the above example, the average was produced from a collection of three numbers belonging to three different funds. What if there were just two funds in the category? Then, the category average would be 8.8%. So, as you can see the addition of 1.9% return number of the 3rd fund significantly impacts the final category average.
There are many fund categories that have a small number of operating funds in them. So, investors must be careful when they look at such category averages.
Stock markets often move in strange ways. At times, a few stocks pull up or pull down the market. Such times are technically called ‘concentrated’ performances. During these periods, funds will show wide dispersion in returns. Take a look at the midcap category of equity mutual funds. There are over two dozen midcap funds in existence.
The top-performing fund today is Axis Midcap Fund from a three year perspective. It has generated 18% CAGR. In the same three year period, the five poorest funds have given 2.45%, 4.29%, 4.74%, 5.62%, and 5.64%. If you do a three year category average of all the midcap funds, the number will be 8.8%.
How do you interpret this 8.8% number? Experts will tell us that the category average is a median (or the middle-most number) in a series of data. The idea is to show how a scheme has performed against others. Okay. So, what is the percentage of schemes that have beaten the category average? Just 50% of the schemes have done better than 8.8% number in the last 3 year period. This also means 50% of schemes have not done as well as the category average.
The category average of 8.8% also belittles the stellar performance by one fund that has generated 18% and three other funds that have given 11% odd CAGR. This is the reason that we strongly feel that it is much better to look at the range of returns to truly understand how funds of a type have performed. Instead of saying the midcap fund category average for three years is 8.8%, say that midcap funds in the last three years have given between 2.45% and 18%.
A category average is not a real number, per se. More often that not when an average is used, the purpose behind it is to distract you from potentially ugly information. Mutual funds do not always move like a herd. There will be times when some funds do exceedingly well, while there will be times when the same funds will perform badly. So, a certain degree of variance in returns will always exist. There is always a chance that your investment in a fund may not perform well; a category average will hide such poor funds just it will also hide the great funds.
A fund category average rate of return doesn’t equal the actual rate of return. In fact, a fund category average is meaningless from an investor’s point of without knowing how many funds and what is the range of returns.
Disclaimer: Views expressed here in this article are for general information and reading purposes only. They do not constitute any guidelines or recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide/investment advice / intended to be an offer or solicitation for the purchase or sale of any mutual fund.
Subscribe & keep learning!