How to handle mutual fund underperformers?

A reader asks, “How to decide whether to persist with or exit an underperforming equity fund? By switching too frequently, one may catch the bad periods of the funds and end up doing worse than all the funds tried. Persisting too long will, of course, hurt if the fund keeps underperforming”.

“It is understood that one can’t expect to stay invested in top-performing funds all the time. At the same, there must be something better one could do than investing in a fund and leaving the rest to fate. Can you suggest any reasonable strategy to follow? Assume an ordinary investor who can’t, for example, analyze stocks in the fund’s portfolio, assess the prospects and so on”.

Unfortunately, this is a dilemma all mutual fund investors face, even those who invest passively. Yes, active mutual funds suffer a lot more. When we start investing in a fund, our results depend on a future outcome (which some may refer to as fate).

This “fate” factor is significantly higher with an actively managed fund due to active management risk. We can talk about thumb rules like, “give a fund at least 3=5 years to perform”, and so on, but there are essentially arbitrary. So what can be done?

• If you wish to choose actively managed funds, choose funds with a reasonable performance consistency over several years. Reasonable here means neither stellar nor abject performance.
• Never choose funds by looking at their recent performance, last 1Y, 2Y etc. See: What is the biggest mutual fund investing mistake?
• If a fund is performing poorly, find out how the other funds in the same categories are doing. If all of them are in a similar state, then there is not much to do except wait (unless you wish to become an index investor).
• If your fund is among the few in the category to do poorly, you will have to evaluate how long it has been underperforming. How long is too long is arbitrary. So it would be best if you created your own rule here.

However, switching from one active fund to another, even if you give the fund manager a long enough rope, could result in clutter if you do not switch out completely. Most investors leave existing units as is and make fresh investments in a new fund. And so the pattern continues.

One could wait for the capital gains to turn negative and switch without tax incidence, but this may not happen with old holdings. So chasing performance is a messy situation. I know many investors (and I am one of them) who prefer to do nothing and sit through periods of poor performance as long the returns are “reasonable”. Naturally, this comes at a huge cost – the total expense ratio.

This is a rather bleak portrayal of the plight of active mutual fund investors, but sadly it is the bitter truth. No one or nothing is immune to the law of averages. We have only two choices. Either stay away from active funds or readjust our expectations from them with the understanding that any outperformance is sheer dumb luck.