Considering the current situation, where the market is down owing to COVID-19 pandemic, many of you must be thinking how to identify underperforming mutual funds. Although if you have invested for long term goals, short term volatility should not bother you. But still you should learn to identify underperforming funds and to take corrective action.
Mutual funds have been the most amazing tax saving investment instrument and simultaneously have outperformed conventional saving instruments in long term. However, even if you invest in mutual funds for long term, it is imperative to look at the performance of the funds periodically. But, the question arises, what if any of the funds underperform.
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How to take stock of the mutual fund portfolio?
Investing in the mutual funds is one of the best options to gain the maximum returns for the capital invested in the market. It is a better way to make money. But in order to gain the benefits, the mutual funds investments should be tracked regularly. The performance of the mutual funds has to be seen in the right way. Following are some of the measures :-
- Review the performance of all the mutual funds in your kitty periodically.
- Indicators to be checked for performance of the fund. Few of them are:-
1. AUM (Assets Under Management)
Reduction in size of AUM consistently may indicate underperformance.
2. CAGR (Compounded Annual Growth Rate)
If CAGR is less than benchmark as set by the mutual fund house, then it is not so lucrative to invest in the fund.
3. NAV (Net Asset Value)
NAV is debated to be considered as a performance measure. Since, stock markets fluctuate daily and mutual funds invest in stocks, mutual funds are subject to market momentum gains or losses. However, consistent lowest NAV in a similar fund category would be a red signal.
- You can identify the underperformer based on a combination of performance indicators. The mutual funds which lag in the category and with respect to the benchmark, in such measures, will be most probably the underperformer.
- If you are holding the funds for long like 2 or more than 2 years, and are still experiencing that the fund is not going to turn around the performance, then it’s the time to act.
- Deep analysis of the portfolio of the fund is essential. For e.g. if you are investing in blue chip funds, it is not necessary that your fund invests in large cap only. This fund may invest in large cap as well as mid cap, for a balanced exposure. Mid-cap and small cap stocks are known to be high risk- high reward, so if the market rallies, you will get superior returns, but in case of bear market, the same fund will underperform. In such a case, your investment is secure due to disciplined investment approach, but your fund may underperform a few times when the market goes down, which may not be a matter of concern.
Reasons behind underperformance of the mutual funds
- Fund investment strategy or change in existing investment strategy
If the fund is aggressive then it will fare better in bull market but will underperform in bear market. Similarly, a mutual fund with value investing approach will not be performing better in the bull market.
- Overweight on underperforming sectors or industry
Certain funds are sector specific or may follow and invest in stocks based on theme (like emerging equity or infrastructure industries). Every sector may not perform up to the standard every time.
- Higher expense ratio
The fund may have moderate to high return magnitude but may also result in reduced return due to higher expense ratio. This is because, returns are paid out only after deducting for management fees, administration fees, etc.
- Fund management approach
If there happens to be a change in fund management style or fund manager, which may result in total change in stock selection or even long-short strategy.
There may also be other reasons like merger of the fund with another fund. However, even if you could find out the reason why the fund is underperforming, you must know what to do next since you are already holding the units, so let’s see what you can do now.
What to do when the fund is underperforming?
If you are holding any flagship scheme or core scheme of the fund house, (which is generally promoted by the fund based on its performance), then you may continue holding it for a while. However, keep a look at its alpha (capability to generate returns over and above benchmark returns).
One more notable point is that if the fund manager’s approach is disciplined like value investing, then you may continue to hold the fund, even if it underperforms. Since all funds fluctuate in short and medium term owing to stock market fluctuations, it is not rare that even a sound and stable fund may underperform.
Some of the investors may even buy more units to achieve rupee cost averaging when the funds are underperforming. However, if the fund does not possess the capability to yield better returns in future and the investor buys the units just to reduce the loss, this step may even cause you to incur more loss in coming years.
- Switch or sell
If the fund is underperforming in its category as well as against benchmark, then it’s the time for some action. If the sectoral or thematic underperform due to cyclic changes in the sector, then you may redeem the units and may place the investment in another worthy investment, since thematic or sectoral funds are generally far too dangerous since they owe to seasonal fluctuations.
If the fund’s underperformance is due to some of the factors like merger of the fund or change in fund manager, then you may separate such funds from others in your portfolio and keep close watch for a year or so, to let the hidden potential to come up. However, quarterly reviews are must so that you may come to know whether these funds still underperform and that it is time to get out of those funds.