How long is long term for equity and how to ride it

These are trying times for investors. As of 16 August, the three-year compounded annual growth rate (CAGR) on large-cap equity funds is just 8.56%. For small-cap funds, it is even lower at 3.55%. However, the five-year returns are higher at 8.32% and 10.43%, respectively, according to data provided by CRISIL Fund Research. Within debt, gilt funds gave 9.59% over the last five years and short-term debt funds delivered 7.31% in the same time period. Patience is wearing thin, especially when it comes to investing in equity funds, and the oft repeated mantra—stay invested for the long term—feels harder and harder to follow.

Mint decided to look at some numbers to give answers to some questions related to long-term investing. How much does investing for five or 10 years actually give you? What if you go down the systematic investment plan (SIP) route?

What we did

First, we pulled out the returns of open-ended equity mutual funds for three-, five-and 10-year holding periods over the past 15 years. Remember that the mutual fund industry is over 20 years old, but most of the action happened in the last 10-15 years, which means we have covered a good part of its existence. Of the 311 equity schemes as of July 2019, only 66, or one fifth made the 15-year life-span cut.

Second, we took rolling returns shifted forward on a monthly basis, for these schemes. To put it simply, we wanted to ask the question—what would have happened if you picked any random point in the past 15 years and held your equity fund for three-, five- and 10-year periods? Using rolling returns answers this precise question. Rolling returns look at returns between, say, 1 January 2018 and 1 January 2019. It then looks at returns between 1 February 2018 and 1 February 2019 and so on. In this way, it accounts for investors entering and exiting the market at different points of time and takes snapshot after snapshot of returns at different points of time.

In the third step, we calculated the average and minimum returns for the schemes in question. Before you read the result, take note of an important disclaimer. Bad funds are often merged with other schemes by mutual fund houses. This creates what is called a “survival bias” in a study of such schemes and over-states the result because such “bad eggs” no longer feature in the calculation. According to the rules by capital markets regulator Securities and Exchange Board of India (Sebi), when scheme A is merged into Scheme B and the features of Scheme B are retained, only past returns of Scheme B should be displayed. However, in the second section of this article, we will give returns you would have got for investing in the index itself, which can be easily done through an index fund or exchange-traded fund. This second component eliminates survival bias.

Click here to see the enlarged version of the graphic

A three-year holding period gives you an average return of 13.88% in an equity fund (see graph). Surprisingly, this number does not change if you increase the holding period to five and even 10 years. The corresponding figures are 13.57% and 13.41%. Before you rush to conclude that there are no benefits to staying invested for the longer term, take a look at another, more important statistic. The minimum return for any three-year holding period in an equity fund is -25.86%, -18.53% for any five-year period and -1.64% for any 10-year period. In other words, although your average return does not change much if you hold for the long term, the effect of picking a bad point of time gets ironed out when you hold for the longer term.

When it comes to mutual fund investing, you can get poor returns either because of bad timing or a bad scheme. Our data shows that investing for the long term will iron out both problems, with one disclaimer—the survival bias, as explained earlier, can affect the results of our study.

Investing in the index

What if you just invested in an index, say the Nifty 100? Note that in this section, we are not using index funds as a proxy, we are assuming that you invested in the index itself. Index funds deliver a slightly lower return due to tracking error and their expense ratio. Tracking error is the inability of an index fund to precisely mirror the returns of an index. Expense ratio is the charge levied by the fund house (up to 1% as allowed by Sebi).

So what were the results? The average return in the Nifty 100 if you invested for any random three-, five- or 10-year period is not very different. You get 13.55%, 13.03% and 12.94%, respectively. However, the minimum return is far better. This changes to -3.77%, 0.49% and 7.51% over the three time periods, respectively.

Does that mean we are advocating a switch to passive investing? Not necessarily. The maximum return in an actively managed fund over three-, five- and 10-year periods is 87.46%, 47.14% and 27.47%, respectively, which is more than the 50.87%, 25.41% and 18.97% you get by simply investing in the Nifty 100 for the same time periods. In other words, an actively managed fund has the potential to give you far higher returns than the index over the long term, but at the same time it can also give you a lot less. Do you want to take this risk? The answer will depend on your individual risk appetite.

Investing in SIPs

In the final iteration, we looked at the effect of investing through an SIP. In this case, we considered a SIP in the index for the sake of simplicity. You can do this in practice by setting up an SIP in an index fund. Here, your average return is quite similar to the average return of an actively managed fund or an index when you invest in a lump sum. It is 13.89%, 12.88% and 12.81% over a three-, five- and ten-year holding period. However your minimum return is much better than the minimum return in an actively managed fund or in the index. It goes from -23.75% to 1.82% to 9.06% over a three-, five- and 10-year period, respectively. Take a moment to think about that. An SIP in Nifty 100 over any 10-year period over the last 15 years would have given you at least 9.06%. In other words, investing in an SIP is not necessarily better in terms of returns, but it is a lot safer. Does changing the index make a big difference? Not really. The minimum return for an SIP over any three years in the last 15 years, in the Nifty 50 is -22.09%. It goes to 1.79% over five years and 8.21% over 10 years. The average return over the three periods is 8.20%, 12.08% and 12%, respectively.

The much-repeated financial planning tenet—stay put for the long term and invest in SIPs—is not about giving you better returns but reducing risk or cutting down the chances of losing money in equities. Don’t take our word for it, the data proves that.