Tue. Jul 5th, 2022

Buying and exiting active equity funds only based on their recent performance usually leads to a sub-par investment experience and poor returns over the long run.

Arun Kumar, Head of Research, FundsIndia, explains, “Active Equity Mutual funds by their very nature have portfolios which are different from the index (the degree of differentiation will depend on the fund strategy). As a consequence, for better or worse, the performance will be different from the index. ”

All investment strategies (even if they have a long successful track record) will inevitably have to go through temporary periods of underperformance versus the benchmark. “Sometimes the stretches of underperformance can be extremely long,” says Kumar.

He further points out, “The key is to differentiate between a good fund going through underperformance versus a weak fund going through underperformance.”

How should you choose?

Whenever a fund is underperforming the benchmark over 3Y, 5Y and 7Y periods, here are some of the things you should check for;

  1. Consistency, Kumar says, is in the underlying investment strategy and process. Does the fund continue to stick to the strategy?
  2. Is the underperformance trend seen in other funds following the same investment style?
  3. Does the fund have a long term track record (10+ years) of outperformance?
  4. Has the fund been a consistent performer in the past – What per cent of times has it outperformed the benchmark on a 5Y and 3Y Rolling Return basis over the last 10-15 years?
  5. Does it fall lower than the benchmark during market declines? (a rough proxy for understanding the risk in the fund)
  6. Is there a change in Fund Manager?
  7. Has the fund become too large and is facing size constraints?
  8. Does the fund communicate clearly and transparently the reason for its underperformance?

How long should an investor wait before moving out of an underperforming scheme?

Usually, in case of a good fund (satisfying all the above conditions) going through temporary underperformance, according to Kumar, you can give it a 3-5 year runway to check for improvement in performance. If the fund continues to underperform or if you find an alternate fund following the same investment style but with better performance consistency, you can exit the fund.

“Ideally a period covering an entire market cycle (usually around 5-8 years) – consisting of a bull phase, bear phase and a recovery phase is a good time frame to evaluate the long term performance of a fund,” adds Kumar.


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