Filters to apply before exiting an underperforming mutual fund

Filters to apply before exiting an underperforming mutual fund

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Investments in actively managed mutual funds meant for the long term may sometimes warrant a second look and even a change. So when do you exit a mutual fund scheme and replace it with another? If the suitability of the scheme in terms of risk given the investor’s need for growth, stability and liquidity is not an issue then the performance of the scheme is typically the primary reason to consider an exit.

But to evaluate a scheme’s underperformance is not simple. Mutual fund schemes are relative return products. Schemes that may appear to be doing poorly may not actually be underperforming. You need to run various filters before labelling a scheme as an underperformer and exiting it. We tell you what to look at before deciding to exit a scheme you hold.

Benchmark matters

Returns from mutual funds track the markets in which the schemes invest. An actively-managed fund is expected to make higher returns than the market, as represented by an appropriate benchmark index, when the markets are appreciating. At the same time, it is supposed to protect the downside, or fall less than the index, when markets decline. If the fund is underperforming its benchmark, then it is a cause for concern and you need to run some checks.

First, check if other schemes that are benchmarked to the same index and have similar investing mandates are also underperforming. For example, most large-cap-oriented equity funds tracking the Sensex or the Nifty have underperformed the benchmark in the last one year since the run-up seen in the index was driven by a few stocks while these funds held diversified portfolios. Such a situation may not warrant an exit. It may, however, lead to a rethink on the investing strategy by the investor. “Our inclination for large-cap investing has started shifting from active to passive strategies such as index funds and ETFs since their post-expense performance has not been encouraging,” said Saurabh Bansal, founder, Finatwork Investment Advisor, a Sebi-registered investment advisory firm. A second check would be to see if the fund’s benchmark is relevant to its portfolio. For example, the performance of a mid-cap fund that also takes exposure to small- and large-cap stocks within the permissible limits may not be completely in line with, say, S&P BSE Midcap Index.

Compare with peers

At the next stage evaluate a fund’s performance relative to other similar schemes or its peer set.

Variations in performance can, typically, be explained by the strategy and style adopted by a fund. For example, in the last one year, multi-cap funds that took greater exposure to mid- and small-cap sectors underperformed in line with the fall in the segments. Multi-cap funds that took greater exposure to large-caps outperformed in this period. Similarly, a value strategy underperforms when markets are in a momentum phase.

Different strategies can have quite different outcomes on return and risk and work well at different points of time. Look for a satisfactory explanation for the fund’s performance in its portfolio and the information that fund managements, typically, provide when there is underperformance.

Period of trouble

If you have the right benchmark to compare and you have taken the impact of style and strategy into consideration, then at the next stage, look at how long the fund has been in trouble and the extent of underperformance. Seeking to invest in the top-performing fund may not always be viable. It’s better to ensure that the fund is a top quartile performer or is in the top-third of a category.

“We look at the preceding five one-year discrete period performance to classify schemes into green, yellow and red categories. 70% weight is given to return numbers and 30% to standard deviation, portfolio concentration, asset size and other relevant portfolio features,” said Shyam Sunder, managing director and co-founder of PeakAlpha Investment Services Pvt. Ltd, talking about the process his firm follows when filtering schemes for investors. “Green category schemes are those in the top 25% of the peer set and are recommended to investors. Yellow category schemes are the next 25% schemes into which fresh investments are not recommended but existing investments can b held and the red category has the bottom 50% of the schemes from which investors are advised to exit,” said Sunder.

If a fund slips from a top quartile or top third slot, then give the fund some time to make course corrections. You can tolerate under-performance of 3 to 4 quarters to give time for an investment call or course correction to be visible in the performance. If it still does not show signs of regaining its position, then it is advisable to switch. “We don’t dislodge a scheme immediately just because it falls off the top quartile list. It comes to the watch list if the fund’s performance does not pick up in two-three quarters. We reach out to the fund managers for a better understanding of the performance,” said Bansal. “As a first step, we stop further investments into the scheme, including SIPs. Investors are routed to alternate schemes in the same category,” said Bansal. “The decision to remove a scheme from the recommended list is taken only after as much as four to eight quarters of underperformance,” he added.

Other factors

There are costs and taxes associated with the switching decision you must consider. “We would like the exit to be as efficient as possible, which means there must be minimum impact of taxes and loads,” said Bansal.

While chasing last year’s best performer may not be the best way to manage your portfolio, ignoring poor performance for long periods can hit your returns. Have a sequence of action in place that should begin with having a review process, noting underperformance, examining and investigating the reasons, keeping a close watch for signs of a turnaround and then taking a call to stay or exit.

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