One of the most important money decisions to take is to weed out underperforming funds. It involves admitting to yourself that your original selection may have been poor. If you have a financial adviser, it might be equally difficult for him/her to make this admission. Alternatively, what was earlier a high performer may have gone off track subsequently. Another question to ask is, how long should a fund underperform in order to be placed in the exit list? Todays column answers questions with regards to any such underperforming fund.
Identifying an underperforming find
On a lighter note, this exercise is somewhat akin to reprimanding one of your (spoilt) child who has not been living up to your expectations for a while now. For anyone who simply has chosen a fund based on the ‘flavour of the season’ and ‘highest one-year return’ concept, discarding the chosen fund may be the simplest (but surely not the wisest) decision as most of the times the trend reverses and the outperformers turn into underperformers. The said fund then goes out of the portfolio and with it goes the chance of long-term wealth creation. Identifying an underperforming fund can broadly be attributed to three factors and more importantly a time frame of around two years should be given for judging its efficiency. The first factor would be to evaluate the fund performance in context of the overall economy and market conditions. Second should be its relative risk-adjusted performance with its peers in the specified category and finally, check if the fund manager has stuck to his core fundamentals of managing the fund. These should be some of the crucial facts to consider.
Watch the performance closely for 4 to 6 quarters
Underperformance shouldn’t be always seen with pessimism, particularly if the scheme follows a well-thought-out investment strategy and comes from a robust fund house. It’s important to look at the rolling return for at least a cycle. If the track record of a particular fund has been strong (rolling returns) but is currently going through a patch of underperformance, then investors should have more patience. Investors should understand if the underperformance is coming from style drift. For example, if a value manager generates returns by investing in expensive growth stocks, the fund may catch greater downside as markets correct. Conversely, a manager is following a time-tested strategy that may not be in sync with the current trends but could prove to be vindicated over time.
However, it is also true that good fund managers go through lean patches of performance at times. We watch the performance more closely and have tolerance of four to six quarters before we deliberate further action. Remember the golden words, ‘past performance is no guarantee for future returns’.
A Diversified fund will bounce back sooner or later
If you are invested in a fund and it is down 20%, should you keep it or let it go? It depends. A fund that is down 20% can easily gain 20% or lose another 20% going forward. This makes timing fund rebounds extremely hard. So, once you start an SIP in a well-diversified fund, keep it running through its ups and downs. Research on fund returns does give us some insights.
First, if it is a well-diversified fund, then keep averaging through the SIP. Sooner or later, they will bounce back. Second, if it is a style fund, say a value fund, then you must give the style time to come back. The risk here is that investment styles can be out of favour for long period of times. If you cannot wait for the style to come back as your goals are nearing, shift to well-diversified index funds. Lastly, research by Werner De Bondt and Richard Thaler, who won the Nobel prize in economics in 2017, suggests that worst performing funds in the past three-five years may outperform in the future. So if your fund already features in the worst performing fund, then carry investing in it as a turnaround might be around the corner.
AMC size and the longevity of the scheme matters
Risk matters. It is important to note the risk, which is measured in terms of standard deviation. If the standard deviation of large-cap, mid-cap or small-cap fund is higher than the standard deviation of their respective index, then one must consider exiting from the fund. Say, the standard deviation of a mid-cap fund is 20 and the standard deviation of mid-cap index is 18, then one must consider exiting the fund.
AMC size and the longevity of scheme matters. If the AMC is large in size and more than 10 years in existence, there is no reason to worry as you would expect deeper analyst teams of the top five fund houses to work in revival of the funds.
So to summarise its important for investors to keep a close eye on its returns but its equally important not to panic when the fund doesn’t keep up with your expected returns. So if you have funds that are underperforming in your portfolio remember patience is a key element of success.
