You find a mutual fund with a respectable 16% average annual return over the past decade (10-Year CAGR). This fund has outperformed recessions and earned a five-star rating. You happily invest your retirement savings, expecting similar growth of your wealth.
Then 3 years later, you find your portfolio growing at a miserable 2% per year (3-year CAGR) while all your investor friends and the rest of the market seem to be celebrating. After a little digging, you face the heartbreaking truth: the past success of the fund was built by a star fund manager who left before you bought the fund.
This is one of the dangers of buying mutual funds based solely on the past Return history. It gives an incomplete picture of why the fund had actually performed well.
Let’s walk through the key questions every investor should ask.
Is the picture of a Fund's Performance History Complete?
The Compounded Annual Growth Rate (CAGR) data shown on investing apps is not very reliable for understanding if the fund can perform well for your goals.
This metric is calculated on a point-by-point basis, which means it only cares about two specific points in time: the day you look up that metric and the date exactly 3 or 5 years before. It does not take into account the fund performance in between these two dates. And this makes it highly susceptible to endpoint bias. If the data you look up starts or ends near an unusually large bull or bear market, the growth rate calculated will be artificially high or low.
Rolling Returns
Instead, this shows your fund performance using the average return rate calculated in blocks of 3- or 5-year, shifting forward continuously across multiple time blocks. It reduces the effect of the endpoint bias and shows how your fund performed under various market conditions.
Key Takeaway:
Look for consistency in the rolling returns metric, especially if market conditions fluctuated a lot in the same time frame.
Where to find it:
Standard investing apps usually do not display this metric. But many other reputable sites do it for free. Visit the Prime Investor’s Free Rolling Returns Calculator, or the MF Online Rolling Returns Calculator for comparing funds.
Many Asset Management Companies (AMCs) are also publishing their own rolling return summaries in their Monthly PDF Factsheet for investors, as well as the Association of Mutual Funds in India (AMFI Monthly PDF Factsheets).
Has the Fund handled Market Volatility and Risks well?
Next, you may ask yourself:
<i>“Has this fund given good returns for the risks it took?”</i>
<i>“Does this fund value fluctuate too much?”</i>
<i>“Does this fund crash too hard when the market goes down?”</i>
These important questions require the combined use of 4 metrics to get the whole picture.
Sharpe Ratio
This value shows the extra return earned for choosing a higher-risk fund instead of a risk-free government bond. You accepted that extra risk because you expect a higher return, so that the risk is worth it.
If a mutual fund returns 15% and a safe government bond returns 7%, the fund’s extra return is 8%. This is divided by the fund’s Standard Deviation or its volatility to get the ratio.
Key Takeaway:
For choosing between two funds with the same return, choose the one with the higher Sharpe Ratio. Acceptable values will be between 0.5 and 1.0. Values above 1.0 are considered excellent.
Where to find it:
Basic investing apps do not usually show this metric. Instead, go to the Funds information page on the Value Research or the Morning Star India site, and then to the “Risk” or “Risk & Rating” tab.
Standard Deviation (SD)
This metric will show how wildly the daily or monthly returns of a fund fluctuate away from its own average returns.
Key Takeaway:
The lower the value, the better. Standard deviation is a relative measure. Always compare a fund's Standard Deviation against its own Category Average or benchmark, rather than against a fixed number, since volatility naturally differs by fund type.
Where to find it:
Go to the fund's information page on the Value Research or the Morning Star India site, and then to the “Risk” or “Risk & Rating” tab.
App users can also go to the "Peer Comparison" or "Scheme Documents" section of the fund of interest.
Maximum Drawdown (MDD)
MDD measures the absolute peak-to-trough drop in the fund’s value before a new peak starts, within the fund’s history. It shows how badly you can lose your returns during a market crash.
Key Takeaway:
Don't just look at one MDD number. Check whether the data is from a mild correction or a genuine crash period, and compare it to the fund's category average or benchmark index over the same window.
In a routine correction, a small-cap fund's MDD might run 20–25%; in a genuine bear market (like 2008 or 2020), small-cap indices have historically fallen 40–60%, per AMFI data.
Large-cap funds tend to see significantly shallower drawdowns in both scenarios, reflecting the relative stability of larger, more established companies.
Where to find it:
Basic investing apps do not usually show this metric. Instead, go to the Funds information page on the Morning Star India site. Go to the “Risk & Rating” tab, and then to the "Market Volatility Measures" section.
Downside Capture Ratio
This metric shows whether the chosen fund was able to reduce its return drop during a market crash, compared to that of the industry benchmark.
If the Nifty 50 index dropped 10% over a quarter but Fund A dropped only 8%, then your fund manager was able to shield your portfolio from the crash.
Key Takeaway:
According to risk evaluation benchmarks standardized by global fund research giant Morningstar, a Downside Capture Ratio above 100 is dangerous and should be avoided.
Where to find it:
Basic investing apps do not usually show this metric. Instead, go to the Funds information page on the Morning Star India site. Go to the “Risk & Rating” tab, and then to the "Market Volatility Measures" section.
Conclusion
Remember the fund with an impressive 16% CAGR from the start of this blog? A quick check of its rolling returns, Sharpe ratio, or downside capture would have revealed the truth before you invested: that its stellar track record was built by a manager who was about to leave, not by a repeatable process. Five minutes of research could have saved three years of disappointing 2% growth.
High returns look amazing on paper. But the best mutual funds are those that protect your money in the worst market conditions and let you sleep peacefully at night. Before your next fund purchase, run it through these checks. Your future self will thank you.
<i>Disclaimer: The information provided in this article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any mutual fund. Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully before investing.</i>
Responses
Join the conversation
Sign in to share your thoughts and interact with the author.
Sign In to Comment