In a two-part series, I would like to discuss how to spot (I) and how to handle (II) mutual fund underperformers. I write this after suggestions on twitter and by Kunal Lal.
The first step is to define underperformance. This is possible only if the right category of mutual funds is first selected for investment. Most investors do not do that. AMCs offers incorrect suggestions regarding investment durations and I have little confidence is the levels of understanding about investment risk among the 'advisor' community.
If I choose an equity fund and expect 15% return every year or 25% return after 3 years, the fault lies with me. I have discussed investment risk in multiple posts before and do not wish to do so again. Interested readers may consult: Equity investing: How to define ‘long-term’ and ‘short-term’.
Low expectation, not just reasonable, is the key to investment success. Especially for those who do not wish to understand how market fluctuations can be measured.
The second step is to ask, what is the role of a fund manager?
The fund manager of an actively managed portfolio has only one goal, beat the benchmark index. If the fund management starts to worry about star ratings, it is a sign that they have no process in place.
If possible, the benchmark for comparison should be the total returns index and not the price index. Here is an example: Sensex Total Returns Index as a Mutual Fund Benchmark.
Many fund managers manage to beat the benchmark by allocating stocks from outside the index (style impurity). This is an unhealthy sign of outperformance. Not easy to spot, more on this later.
The third step is to ask, 'how long am I willing to give the fund manager time to beat the benchmark?'.
If your answer is one year, I suggest you stick to index funds! I would recommend at least 3 years and a maximum of 4/5 years. My goals are decades away. So I have no problem with 5 years.
The outperformance should be consistent.
Before investing: the fund should have bet the index for most of the every possible 3/5 year period, say for the last 10Y. This can be evaluated using
Mutual Fund SIP and Lump Sum Rolling Returns Calculators
After investing: Give it at least 3 years to beat the index (total returns).
Beating the index cannot always mean spectacular outperformance. Sometimes, it can be less than 1%. It depends on too many factors: age of the fund, investment style, market movements etc.
If this has not happened, the reasons must be investigated. What kind of market are we in now?
Have funds with the same benchmark managed to beat the index? If I look at the rolling returns graphs, do I see a dip in performance?
How has the fund figured in your portfolio? What is the XIRR of the fund vis-à-vis the portfolio XIRR?. Read more:
Then the key question, 'do you think the fund will recover?'. This is a difficult question to answer and one needs to look at the stock portfolio.If you have faith, continue, else chuck it. I will discuss how to handle underperformers in the next post.
If I have enough expertise to do that, why would I choose mutual funds? There is also no way of knowing if an 'advisor' has such expertise.
If you are someone like me, incapable or uninclined of answering the above question, sticking to it if you have faith, else chuck it.
What matters is the ability to gauge the present health of our investment portfolio, not the future health of a mutual fund portfolio.
Part II: how to handle underperformers
- Ignore opinions about the fund manager: 'why did he pick this', 'why is holding on to this' etc.
- Do not seek random opinions about what to do! Eg. from star ratings, Asan Ideas for Wealth etc.
- Having low expectations. This guarantees minimum disappointment and minimum portfolio management.
- Do not ditch your funds in favour of a fund that 'everyone is talking about'
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