Don't quit underperformer if fund manager remains true to mandate

Your portfolio shouldn't contain stocks picked at exorbitant valuations or those that have corporate governance issues

Parag Parikh Flexi-Cap, a fund with assets under management of Rs 27,712.07 crore, has given its investors a compounded annual return of 18.01 per cent since inception. But it has been underperforming its benchmark, the Nifty 500, over the past year. Should investors stay put in this fund or exit it?

As you review your portfolio at the year end, you may come across several funds that have underperformed.

Check duration of underperformance

Don’t get worried if the trailing returns show underperformance over a one-year or two-year span. “If the fund has been underperforming over a three-year or five-year period, that’s when you should start monitoring it,” says Arun Kumar, head of research, Fundsindia.com.

Look at rolling return

A fund’s rolling returns indicates what the performance would have been if you had entered it at different points of time. Check its five-year returns rolled daily or monthly over a 10-year period. “If the fund has outperformed 90 per cent and underperformed 10 per cent of the times, that tells you it is a quality fund,” says Kumar.

Over the past 10 or 15 years, look at performance in those calendar years when the market fell. If the fund fell less than its benchmark, it means the fund manager is good at containing downside risk.

How is the style faring?

Fund managers follow a certain style — growth, blend, or value. They underperform when the market doesn’t favour their style. “Growth funds performed well in 2019 and 2020. When the cycle turned, it was to be expected that these funds would underperform,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser.

Any underperformance, he says, which is in line with changes in the market cycle is understandable.

Take the example of Parag Parikh Flexi-cap. The scheme invests a part of its portfolio in Indian and a part in overseas stocks. “In periods when India does well, compared to the global markets, it is to be expected that the fund will lag behind its benchmark, the Nifty 500, and vice versa,” says Rajeev Thakkar, chief investment officer, PPFAS Mutual Fund. The Indian market has been resilient over the past year while the US market has underperformed (Nasdaq 100 is down 28.3 per cent).

Consistency is the key

The fund manager should continue to stick to his style despite underperformance. A fund manager who follows a value style shouldn’t pivot to the growth style, or vice versa, just because the market is favouring that style.  

Keep an eye on portfolio churn (measured by turnover ratio). “A spike in churn indicates the fund manager has panicked and is making wholesale changes to his portfolio,” says Kumar.

Evaluate the communication from the fund manager. To cite the example of Parag Parikh Flexicap Fund, the fund is underperforming because it takes exposure to US tech stocks which have seen a downturn.

“The companies we have invested in are profit-making with real cash flows. They are mature businesses with proven business models. Even before the correction over the past one year, their valuations were not exorbitant,” says Thakkar. He adds that most of these companies are monopolies or oligopolies with high profit margins and return on equity. All of them are debt free. Since they continue to look sound on fundamentals, he says he plans to stick to them.

Don’t quit prematurely

If the fund manager continues to adhere to his original style of management or mandate, he didn’t pick stocks at exorbitant valuations, and he didn’t invest in those that have corporate governance issues, stick to the fund. “If, say, you move from a growth style fund to a value style fund because the latter’s performance is looking good, you will miss out on the former’s performance when growth comes back into favour,” says Belapurkar. Instead, he suggests building a portfolio containing funds that follow different styles.