We get many queries on our website seeking guidance on what to do with mutual fund schemes which are not performing well. Should you redeem and sit on cash? Should you switch to better performing funds and if yes, which mutual fund scheme should you switch to? Should you continue to hold and wait? How long should you wait? These are not easy questions to answer because underperformance may be due to several factors. In this blog post, we will discuss how you should evaluate fund performance, possible causes of underperformance and options you can consider.
Before you evaluate the performance of mutual fund schemes in your investment portfolio, you should be clear about three points with regards to every investment.
- What is your investment objective or your financial goal?
- What is your investment horizon?
- What is your risk appetite?
If you are clear about these points then you will be able to evaluate performance more objectively. For example, if your investment horizon is 10 – 15 years, then 1 – 2 year underperformance should not cause major worries. If you have moderate risk appetite and have substantial investments in midcap and small cap funds, then you are not investing in the right asset class; you may need to revisit your asset allocation. You should always invest according to your financial goals and risk appetite.
Performance versus expectations
Different investors have different expectations from their investments. If the returns of your funds are lower than your expectations, then you are likely to feel dissatisfied. However, if your expectations are themselves not realistic, then your evaluation of fund performance will not be objective. It is therefore, important to form realistic expectations about investment returns.
For example, stock market returns are correlated with nominal GDP growth in most industrialized countries. In India, agriculture contributes 18% to the GDP but has low correlation with the stock market, where the listed companies are from industrial and service sectors. Long term industry and service sector real growth rates are 7 – 8%. If you add 4% inflation (which is RBI’s medium term target) to real growth rates, then long term equity returns should be around 11 – 12%.
For long term fixed income investments, you should base your expectations of the relevant interest rates. By interest rates, we do not mean bank FD rates. You should use the relevant Government Bond yields. For example, the 10 year G-Sec yield is currently around 6.5%, while the 3 year G-sec yield is around 6%. If your debt fund invests primarily in high quality papers, you can add another 100 – 120 bps (1- 1.2%) of AAA credit spread versus G-Sec. So your expectation of long term (at least 3 years) returns should be in the range of 7 – 7.8%.
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Hybrid fund long term returns should be somewhere between equity and fixed income returns. It is important to form realistic expectations so that you do not get disappointed and make wrong decisions.
Objective evaluation of fund performance
Mutual funds are market linked investments and their performance will be subject to prevailing market conditions. While it is important to monitor fund performance on a regular basis, you should have objective criteria for performance evaluation. Performance of a fund should be evaluated versus the relevant fund benchmark e.g. Nifty 50 TRI, Nifty 500 TRI, S&P BSE 100 TRI etc. You can find scheme benchmarks in Scheme Information Documents (SID), Monthly Fund Factsheets etc. available on the AMC websites or on our website in our MF Research section.
You should always evaluate fund performance over sufficiently long periods. For equity and hybrid funds, you should see scheme returns versus benchmark over minimum 3 year performance periods. Over sufficiently long performance periods, you should expect your scheme to outperform the benchmark.
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Possible causes of underperformance
It is important for investors to understand the possible causes of underperformance, so that they can make informed investment decisions. There can be several causes of underperformance:-
- The timing of your investment may cause temporary underperformance. For example, if you invested in midcap or small cap funds in 2017, when small and midcap valuations were at their peak, you may be staring at poor returns even 2 – 3 years later.
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- A fund may outperform or underperform the benchmark in the short term depending on the investment strategy of the fund manager vis-a-vis prevailing market conditions. For example, if a diversified equity fund has high allocations to small and midcap stocks, it is likely to underperform in bear market, but will outperform in bull market. Similarly a hybrid fund with high equity asset allocation will underperform in bear market and outperform in bull market.
- Some funds which have contra investment strategies may underperform in bull markets. You need to have sufficiently long investment horizons (minimum 5 years) for these funds.
- The fundamental attributes of the scheme may have changed, e.g. a multi-cap fund may have become a large cap fund, a midcap fund may have become a large cap fund etc. Scheme mergers can also change fundamental attributes. You should understand what has changed and then make informed decisions.
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- Change in fund manager can sometimes lead to relative underperformance. The new fund manager may have different strategy and you should give the new manager sufficient time to see if he or she is able to deliver the same or better performance than the previous fund manager.
- The fund manager did not do a good enough job.
Possible courses of actions
- Most often, doing nothing is the best course of action. If the fund was performing well and then started underperforming due to a change in investment cycle, you should simply wait for the current market phase to pass.
- If there have been changes in the fundamental attributes of funds in your portfolio, you should understand what has changed and if the new attributes are consistent with your investment needs and risk appetite. If they are not, then you can consider switching to a different scheme which is better suited to your investment needs.
- If there is a change in fund manager, lookup to the long term track record of the other schemes managed by the new fund manager. You can find the performance of other schemes managed by the fund manager in the fund factsheet. If the new fund manager has good long term track record, then there is no need to take any action.
- If your fund has been unable to beat its benchmark over sufficiently long performance periods (at least 3 years for equity and hybrid funds), then you can consider switching to a better performing fund.
- When evaluating fund performance in your portfolio, it is also useful to review your asset allocation and make necessary changes if your asset allocation is not consistent with your risk appetite. For example, if your equity asset allocation is higher than your target asset allocation, you can switch from equity funds to hybrid mutual funds.
- Always consider the tax consequences of your portfolio actions, e.g. will redemption or switch lead to short term capital gains tax and make decisions accordingly.
In this blog post, we have discussed how you should look at mutual fund performance. It is important to set realistic expectations in order to meet your investment objectives.
Over long term, you can have absolute returns expectations but in the short to medium term performance should be measured on a relative basis with respect to scheme benchmark. If your scheme is underperforming you should try to understand the possible reasons for underperformance and make informed decisions. As mentioned in this post, you should always tie investment decisions with your financial goals and risk appetite. You should also consult with your financial advisor before making investment decisions.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.