Year-end fund review: Is underperformance cyclical or fundamental?

Temporary underperformance could be due to the fund manager's investment style not being favoured by the market currently; wait out such phases

Once you have completed the annual review of your portfolio’s asset allocation and assessed whether rebalancing is required, the next step is to evaluate fund performance. Category average returns often conceal sharp variations in returns within a fund category. In the large-cap space, for instance, while the category average return over the past year is 3.8 per cent, the best-performing fund has delivered 9.6 per cent, while the worst has returned –6.4 per cent. Such divergence underscores the need to periodically identify and remove laggards from the portfolio.

 

Fund against benchmark 

Begin by assessing how a fund has performed against its benchmark. “Use the right benchmark and compare over a sufficiently long time frame,” says Aarati Krishnan, head of advisory, PrimeInvestor.in. Evaluating performance over longer periods helps establish whether a fund has consistently beaten its benchmark across market cycles — in both bull and bear phases.

 

Most Indian indices are market-cap weighted and automatically add outperformers while excluding laggards. Fundamental stock pickers find it difficult to beat them in the short run. “In the long run, wealth is generated by buying, at a fair price, strong businesses that compound earnings. Investors need to evaluate if their fund managers have these skills,” says Krishnan.

 

Comparing a fund’s one-, three-, five- and 10-year returns with its benchmark helps gauge consistency.

 

Capture ratios also offer useful insight. “An upside capture ratio of over 100 indicates that an investment has outperformed the benchmark during periods of positive returns for the benchmark. A downside capture ratio of less than 100 indicates that an investment has lost less than its benchmark when the benchmark has been in the red,” says Abhishek Tiwari, chief executive officer, PGIM India Asset Management.

 

Fund against peers or category average 

Benchmark comparisons should be supplemented with peer comparisons. “Category comparisons help investors understand how the fund has fared against peers with a similar mandate,” says Prashasta Seth, chief executive officer, Prudent Investment Managers LLP. The peers also face similar opportunities and constraints.

 

This comparison reveals whether a fund’s performance reflects genuine skill or broad market momentum.

 

Krishnan cautions that a fund must be compared with peers that have a similar investment style and risk profile. She cites two examples: A value-oriented flexicap fund may lag peers in a strong bull market but deliver steadier long-term returns, while a small-cap fund investing in illiquid stocks may outperform in rising markets but surrender gains quickly during downturns.

 

Look up rolling returns 

Rolling returns show how frequently a fund beats its benchmark across different periods. “For example, out of 60 rolling periods, if Fund A beats the benchmark in 45 periods (75 per cent), it is consistent, whereas if Fund B beats the benchmark in 18 periods (30 per cent), it is inconsistent,” says Tiwari.

 

Rolling returns provide a clearer picture of consistency. Luck or excessive risk-taking can drive short-term outperformance. “When you look up long-period rolling returns, the data smooths out the impact of luck and helps gauge a fund’s true ability to perform in all kinds of market conditions,” says Krishnan.

 

Sandeep Bagla, chief executive officer, TRUST Mutual Fund, emphasises that rolling returns remove timing bias — the bias that gets introduced when performance is evaluated over a fixed starting and ending date.

 

Rolling returns demonstrate the asset manager’s capacity to perform under various circumstances. “A fund that sustains positive rolling returns in 65–75 per cent of periods shows longevity and a solid investment approach,” says Seth.

 

Risk measures and risk-adjusted returns 

Assessing returns without understanding risk can be deceptive: a fund may have delivered higher returns but may have taken excessive risk to achieve them. “Higher volatility means the NAV might be exceptionally low at a time when the investor wants to exit,” says Bagla.

 

Risk matters for another crucial reason. “Recovering from loss of capital takes a lot of effort. To recover from a 50 per cent loss, a portfolio needs to gain 100 per cent,” says Krishnan.

 

Standard deviation measures volatility by gauging how far returns deviated from the average. Higher fluctuation, which results in a more uneven ride for investors, triggers greater uncertainty among them. “Investors find a fund that is able to generate similar returns with lower risk more desirable,” says Tiwari.

 

The Sharpe ratio measures how efficiently a fund compensates investors for risk taken. Bagla says that a higher Sharpe ratio suggests better compensation for volatility. Krishnan adds that the Sharpe ratio needs to be above one to conclude that the fund delivers adequate returns for risks taken.

 

Information ratio is another useful indicator. “It determines the fund manager’s ability to generate excess returns relative to a benchmark and also identifies consistency of performance by incorporating standard deviation,” says Tiwari.

 

Seth suggests that investors view these metrics against category averages.

 

Temporary versus structural underperformance 

Even active fund managers follow a particular style — value, growth, quality, and so on — which go in and out of favour. “Transient underperformance could be due to a fund’s style being out of favour,” says Tiwari.

 

Seth points out that a value-focused fund may lag during a momentum-driven rally but recover strongly once sentiment shifts. He adds that if a fund’s process, manager and portfolio quality remain intact, short-term underperformance is usually not a cause for concern.

 

According to Krishnan, there are no easy thumb rules to know if a fund’s underperformance is temporary or structural. “If a fund has a seasoned manager with a strong track record across market cycles, and adheres to the stated mandate of the fund, investors can have greater confidence that the underperformance is temporary,” she says.

 

The extent of underperformance also matters. “If a fund is trailing peers by 1–2 percentage points, you may be okay waiting it out, but a 5 percentage point lag may call for quicker action,” adds Krishnan.

 

Avoid knee-jerk exit 

Investors encountering underperformance must be patient. Tiwari points out that exiting too soon could result in the investor quitting the fund right before its recovery. Bagla warns that frequent churning of funds can also be tax inefficient.

 

Bagla suggests waiting at least a year before taking an exit call. Seth recommends tracking the fund for two to three quarters after underperformance appears to see whether rolling returns and peer rankings improve. “If the fund continues to lag its benchmark and category for 12–18 months despite stable markets, the issue is likely structural,” he says.

 

“If performance lags peers and benchmarks for three to four quarters without a clear AMC explanation, if risk metrics deteriorate or churn rises, if the fund no longer fits one’s goals, or if costs turn uncompetitive versus passive alternatives, investors should consider exiting,” says Jiral Mehta, senior manager, research, FundsIndia.

 

Tiwari adds that a mismatch between a fund’s philosophy and an investor’s goals is also a valid reason to exit.

 

Keep an eye on cost 

Expense ratio directly affects returns. “A higher expense ratio means the fund must generate stronger gross returns to deliver competitive net returns, which is why keeping expenses low is important,” says Alekh Yadav, head of investment products, Sanctum Wealth. He, however, adds that what ultimately matters is net return: Higher cost may be justified if the fund manages to deliver superior net returns.

 

Star fund manager exit, strategy drift 

A fund manager’s exit does not automatically warrant a sell decision. Process-driven fund houses with strong bench strength may be able to maintain performance. Yadav says that in the case of such a fund house, investors should wait and give the fund time to demonstrate stability. However, sustained deterioration in performance should prompt an exit.

 

Strategy drift should be taken seriously. It occurs when a fund deviates from its stated mandate, such as a value fund chasing growth stocks or a large-cap fund moving into mid- or small-caps. “This is a red flag because the manager may move into areas outside their expertise, the fund’s risk-return profile may change, and it can disrupt an investor’s overall asset allocation,” says Yadav.

 

Manage tax incidence 

Immediate exits may be necessary when a fund is no longer suitable for the investor’s goal, or if liquidity is required.

 

In other situations, such as when an investor is moving to a better alternative, a staggered exit can help manage the tax incidence better. “A staggered exit over three to six months via a systematic withdrawal plan reduces timing risk, manages taxes, and eases transition,” says Mehta.

 

Yadav adds that when the tax outgo is significant, spreading redemptions over multiple years may be beneficial.

 

The writer is a Mumbai-based independent journalist 

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