What should you do when mutual funds underperform?

Manish KothariPaisaBazaar.comMost of us invest in mutual funds because it generates higher returns vis-à-vis other products such as fixed deposits and at the same time, is more secure when compared to directly investing in equities through stock markets. However, funds may often fail to achieve this basic objective and this makes us wonder whether we must continue to remain invested or pull out of it. So, what do we do when mutual funds underperform? How to assess the performance of a mutual fundWealth creation in mutual funds can be divided in two stages – investing regularly and monitoring investments regularly. We often misread long term investment as holding on to same fund for a long period of time and in process, ignore fund’s performance in regular intervals. Monitoring your fund’s performance and taking necessary action is as important as investing regularly. You can do so by breaking down the returns delivered by the fund over the last 8-12quarters and benchmark it against index performance. You can also compare it with other funds falling under the same category. If you find your fund underperforming the benchmark in a staggered manner (i.e. once in 4-6 quarters), you may choose to hold on to it. However, if your fund has been consistently underperforming for more than 3-4 quarters in a stretch, then your fund is a clear underperformer and you should consider pulling out of it. Find out the reason for such underperformance:Once the underperformance is detected, your next job is to find out the reasons for such underperformance. Some of the important reasons include:Change in fund manager: Each fund manager has his own way of managing portfolio and selecting stocks. Any change in fund manager may adversely affect the returns from the fund because of possible restructuring of the portfolio. Merger & Acquisition of the fund: Acquisition of a fund by another fund house or the merger of the fund with another fund can adversely affect the performance of a fund. While acquisition of a fund may lead to change in the fund management team, the merger of a fund with another fund may lead to both change in the fund management team and the investment objective of the scheme. This may influence many investors to either refrain themselves from investing further or pull out of the fund, thereby leading to fund underperformance. Fund management style: The underperformance can also be due to the fund management approach. While an aggressive fund management style may deliver in a bull market, defensive style works better during a bear market. Similarly, a fund with contrarian or value-based investing style may underperform a fund focusing on growth stocks during a market rally.Sectors out of favour: Sometimes sector-specific funds may underperform because of investing in sectors which are presently out of favour. However, these sectors may very well have strong fundamentals and have excellent possibility of delivering high returns in future. Expense ratio: Mutual funds incur various costs to manage investments, which are charged against the asset under management (AUM) of the funds. These expenses can range anywhere between 1.25%-3%. As every rupee of expenses brings down your return in equal amount, a small percentage point difference in expenses between two equally good funds can lead to sizeable difference in returns over the long term. What to do if it underperforms:“Buy and hold” approach does not always work in mutual funds. Sometimes, it is important to ditch a fund after a period of consistent poor performance. However, take the call only after convincing yourself that there is more to blame for the underperformance than just a temporary bad phase.Switch: Dump the fund if it has been a consistent underperformer over the last three years. Redeem the sectoral funds if the sectors they are invested in are cyclical in nature and are going through a rough patch. Often, the sectoral funds take too long to recover from the downturn.Hold: Hold the fund if its portfolio has a good probability of delivering in near future. Stick with it if the underperformance of the fund has to do more with the fund management style and overall market conditions. Remember that even highly successful fund managers can underperform over the short and medium term. However, if their fund management approach is sound, they will surely deliver in the long-run.