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Trending Funds - Whether to hop on or not
By Vivek Banka
2024-04-07
5 MIN READ

Trending funds are often displayed prominently on app home pages, search results pages, and promotional materials put out by many fintech apps. These apps utilize eye-catching pictures, banners, or carousel placements to gain attention. However, their emphasis on past performance may give significance to short-term gains while underplaying risks. Key components such as expense ratios, risk variables, and investment strategies are sometimes provided in a simplified or condensed form, which could lead investors to take rash decisions without sufficient research. Even though investing in such advertised or trending funds doesn’t necessarily align with their financial goals, users may be persuaded to do so because of the incentives or other rewards.

“Past returns are not an indicator of future returns" is a disclaimer that we often see in every mutual fund or investment advertisement, however the irony being that investments are bought and sold globally on the basis of past returns. Despite all the disclaimers and information, it continues to be difficult to overcome human psychology of greed, fear and herd mentality.

Herd mentality that drives investors to hop onto the best performing asset class is being exploited by platforms seeking business that is not necessarily in the best interests of the user.

Reversion to mean, which implies that asset classes that outperform or underperform drastically eventually revert to their means, is an often-used strategy by value investors globally aiming to capitalize on this with a far lesser degree of risk than by playing the latest fad in town.

Unfortunately, most transactional platforms that have expanding the user base with the least amount of money focus on luring investors with high past returns and hence sell funds or themes that have the best past performance which, in most cases, turns out to be a wrong decision for the investor.

Data from the Association of Mutual Funds in India shows that small-cap funds that have done exceedingly well in the past 12 months have grown from around 10 million folios in December 2022 to around 17 million folios in December 2023, while mid- cap fund folios have grown from 10 million to around 12.8 million. Small-caps alone have had a whopping 70% rise in folios, while flexi-cap funds have in the same period grown only by 1 million folios.

This is a worrying trend as, going by past data, the winners of yesterday seldom perform well in the next up move while the losers often become the new winners.

The BSE Small Cap index generated 70% return in 2017 only to see a massive decline of 50% from its peaks and a 4-year period to regain the earlier highs. Most large transactional platforms even dedicate front pages of newspapers throwing up data of “best performing funds/ popular funds of the year or so", luring investors to transact in those schemes as no one, despite knowing the above trends, wishes to invest in an asset class that is underperforming.

This is where new-age registered investment advisers (RIAs) try to provide value by ensuring investors do not fall prey to latest trends and while making an investment decision, thoroughly check their risk tolerance, risk capacity and financial goals.

A prudent financial planning practise is to ensure that risk tolerance (which defines the emotional tolerance to risk, often taken in the form of a questionnaire) and risk capacity (ensuring that funds for short-term financial goals of less than three years are not invested in equities) are considered while planning any investment.

Proper financial planning also takes into consideration stability and optimization of returns over maximization with high risks.

Nobel laureate Daniel Kahneman, in his book Thinking Fast and Slow, refers to the two systems in our brains. While system 1 is fast, instinctive and emotional; system 2 is slower, more deliberative, and more logical. Decisions taken in a hurry often lead to bad decisions, however it is more common due to the fact that humans do not wish to tax their minds often and hence do not use system 2. This instant thinking is what is capitalized by platforms and distributors in their pursuit of getting more users.

Today, there are around 150000 mutual fund distributors and only 1,300 RIAs, clearly demonstrating the massive shortage of well-informed advisers. As new rage RIAs get deeper with easier regulations and better data reforms like the Account Aggregator ecosystem, it is hopeful that the next few years will see platforms and systems that will ensure users have better access to a well-thought-out advice that does the more logical thinking for them.

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