Understanding the Discrepancy Between 3-Year and 1-Year Return of Mutual Funds

The discrepancy between the 3-year return and the 1-year return of mutual funds is a common source of confusion for investors. To understand this phenomenon, it is essential to examine several key factors such as market volatility, compounding effects, investment strategy, manager changes, and time horizon. In this article, we will delve into these factors to provide a comprehensive understanding of why 3-year returns often appear lower than 1-year returns.

Market Volatility

Market volatility plays a significant role in the difference between one-year and three-year returns. Over a shorter period, a single strong year can significantly boost the 1-year return, whereas the 3-year return averages out the performance over multiple years, including any downturns. For instance, if a mutual fund experiences a highly volatile market, its 1-year return might be exceptionally high due to a one-off positive event. However, over a 3-year period, the performance is erratic, reflecting the true nature of the fund's consistency.

Compounding Effects

Compounding effects are another factor that contributes to the difference in returns. When returns compound, each subsequent year's performance builds upon the previous year's gains. This can lead to situations where a fund with a particularly poor year within the three-year period drags down the overall average return, reducing its 3-year return compared to a single strong year. For example, if a fund experiences a 20% return in the first year, a 10% return in the second year, and a -5% return in the third year, the 3-year average return would be less than the 1-year return if it had a 20% return.

Investment Strategy

The investment strategy of a mutual fund can also lead to discrepancies in returns. Some funds might focus on short-term gains, which can lead to exceptional performance in specific market conditions, resulting in a high 1-year return. However, if these conditions are not sustained, the 3-year return may reflect a more moderate performance. For example, a fund that heavily invests in technology stocks might see a surge in returns when technology stocks perform well, but these gains might diminish in a down cycle.

Manager Changes or Strategy Shifts

Manager changes or strategy shifts can significantly impact a fund's performance. If a fund's management or investment strategies changed during the three-year period, the earlier returns might not be indicative of the current performance. For example, if a fund shifted from a growth strategy to a value strategy, the returns in the early years could be misleading, and the 3-year return would provide a more accurate reflection of the fund's current performance.

Time Horizon

Time horizon is a crucial factor that affects how investors evaluate mutual fund returns. While some investors may focus on 1-year returns for a snapshot of recent performance, long-term investing requires patience, and the 3-year return provides a better perspective on how the fund has weathered different market conditions. For instance, if a fund has a short-term focus, its 1-year returns might be impressive, but the 3-year returns might be more indicative of the fund's true performance over time.

A Special Case: Market Cycles

It is important to note that a year earlier, in April 2020, the markets were in an extremely pessimistic mood. But subsequent to that, a remarkable surge upwards occurred, leading to equity funds with returns of 40% to over 100%. This situation is an extraordinary case and reflects the cyclical nature of the markets. Because markets are cyclical, it is likely that three to five years from now, markets may start falling again, thereby balancing out the positive returns with years of negative performance.

In conclusion, while a high 1-year return can be attractive, the 3-year return offers a more comprehensive picture of a fund's performance over time, taking into account both gains and losses. Understanding these factors will help investors make more informed decisions and avoid overestimating a fund's performance based on short-term fluctuations.