Why Do Certain Mutual Fund Schemes Underperform?
May 16, 2019

Author: PersonalFN Content & Research Team

(Image source: Image by mohamed Hassan from Pixabay)

Responsible investment advisers always recommend mutual funds with a proven track record to investors/clients. And they hope that their suggested schemes will continue to outperform not only the benchmark indices but even the peers in the fund category.

Investors too expect to maximise their returns in their journey of wealth creation when they invest in top-rated schemes.

Despite the diligence of investment advisers and investors, many mutual fund schemes underperform.

What leads to the underperformance of mutual fund schemes?

Let's find out...

But before that please remember: no mutual fund scheme can remain a top-performer every year through all market phases.

In fact, underperformance shouldn't be always seen with pessimism, particularly if the mutual scheme follows a well-thought investment strategy and comes from a fund house that follows robust investment processes and systems.

For instance, when a handful of stocks drive the market--like some have over the past 12-15 months---a well-diversified fund will underperform.

Contrary to what you might think, isn't it sensible to stay put if the fund's portfolio is well-constructed and diversified that can potentially make up for the underperformance in the long run? And as you may know, holding an ultra-concentrated portfolio of certain heavyweights that drive the benchmark index is far riskier (exposes you to extreme volatility) than holding a well-diversified portfolio.

[Read: Is Your Mutual Fund Portfolio Overcrowded?]

Shifting from an underperforming mutual scheme to a performing one is a crucial choice; hence, you should make it carefully.

Take another example, if all schemes of the same mutual fund house have underperformed, it could be well because of some strategy or investment process and systems going wrong at the fund house level.

For instance, had the fund house or a scheme been an underweight on the NBFC sector in 2017, it would have resulted in considerable underperformance. But this strategy has proved to be effective in 2018 and 2019, so far.

You see, it is the repeated underperformance that calls for attention to the quality of fund management. You need to deal with it carefully.

What's common among habitual underperformers?

Lack of process-driven approach - Mutual fund houses that rely excessively on their fund managers, usually end-up underperforming, when their star fund managers leave the fund house.

Lack of robust risk management systems - When a fund manager takes excessive risk, chases momentum, ignores the fundamentals and portfolio diversification; mutual fund schemes under his/her watch underperform.

Experience of the fund management team - During the bull market phases, even inexperienced fund managers and their teams survive. But the real test is when the market hits a turbulent patch for a fairly long time period (months to years) and/or enters a bear phase. That separates the wheat from the chaff and give an indication of their skillset, conviction, grit, and temperament.

If the fund manager and his/her team are inexperienced, he/she could fail to recognise the change in market cycles or the undercurrents, although no single portfolio strategy can work under all market conditions.

For instance, staying invested in infrastructure stocks post-financial crisis could have cost a pretty penny. Even though the infrastructure theme had created massive wealth between 2001 and early 2008, since then, the capital appreciation in this theme has been limited.

Similarly, if you go back to the dot com era, mutual fund managers were bullish on technology stocks, but many of these today are much lower than their all-time highs.

Take one more example, the pharmaceutical sector did exceedingly well post the financial crisis; however, if a mutual fund had remained overweight on that even after 2013, it may have shown on the underperformance of a mutual fund scheme.

Fund managers who could foresee the infrastructure boom stayed away from them. Their patience bore fruits for next 6-8 years.

The change could come in any form, structural or cyclical. Opening of the Indian economy in 1991 was a structural change. Implementation of GST is a structural change. Demonetisation was a structural change, to an extent. Such changes can throw up opportunities and threats; new winners and losers.

Therefore, the experience of the fund management team holds the key.

Appetite to outperform - Fund managers are always keen to show outperformance in schemes under their watch. Sometimes, this tendency makes them myopic. They tend to focus too much on the short term (chase momentum) and miss the bigger picture (the fundamentals).

What should IFAs do when their recommended schemes underperform?

IFAs should avoid churning portfolios (recommend switches to another scheme) of investors looking at merely the short-term underperformance - the returns.

Instead, digging deep to recognising the portfolio characteristics of the mutual scheme, the securities bought and sold by the fund manager, the macroeconomic undercurrents, and if the investment strategy was truly followed as per the scheme's mandate can help take a prudent call and know the reasons for underperformance. Beyond this, as mentioned earlier, paying attention to the investment process and systems of the fund house is necessary.

Once the above is done, if the scheme has been consistently underperforming should raise a red flag. If a scheme underperforms despite taking all due care at the time of selection, IFA shall search for suitable substitutes.

IFAs need to keep track and recommend substitutes (mutual fund schemes) that are in line with the investment objectives, risk profile, financial goals, and the investment time horizons of the investor.

A word of advice for investors...

Instead of switching from an underperforming fund to a star-rated fund, investors must try to identify reasons behind the underperformance by doing their own research and then, of course, reach out to their investment adviser for more meaningful advice, so that investors can be handheld in the path to wealth creation.

[Read: Why You Should Stop Looking At Mutual Fund Star Ratings Now]

The other occasions when investors shall redeem their mutual funds are:

  • When there is a change in the fundamental attributes or investment objective of the scheme

  • On meeting financial goals

  • To rebalance the portfolio On finding better alternatives

Do you want to stay away from underperforming schemes? Avoid these 5 mistakes while selecting mutual fund schemes:

  1. Disregarding your financial situation, risk profile, investment objective, financial goals, the investment time horizon, etc.

  2. Relying solely on past performance (because it is no way indicative of future returns)

  3. Ignoring qualitative parameters to select winning mutual funds

  4. Relying on top star-rated funds

  5. Taking advice from friends and relatives who may not be competent

In a nutshell:

The underperformance of mutual fund schemes isn't uncommon, but the frequency and its quantum along with factors that led to the underperformance matter the most and need to be viewed carefully and deeply.

That said, basing investment decision based on short-term underperformance, mainly the returns, is not recommended.

However, if a mutual fund scheme has been a consistent underperformer in a respective category for long, replace it with another worthy mutual fund scheme/s from a fund house that follows robust investment processes and systems.

[Read: Why Some Mutual Funds Do Not Generate Consistent Returns]

PersonalFN believes scheme selection is the most important factor to avoid underperformers.

This article first appeared on Certified Financial Guardian.  


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