Underperformance is a serious issue because it could jeopardize your chances of meeting your financial goals.
But it is never a good idea to sell a fund based on weak short-term performance alone. You must check to see whether the fund's downward shuffle is a recent development or part of a sustained pattern of performance weakness.
And finally, while it is important to remember that past performance is no guarantee of future returns, it can be a significant indicator of inherent problems with a fund.
Here are three pointers to keep in mind.
If a fund’s performance is lagging, your first move should be to investigate why.
It may be that the manager is simply sticking with an investment strategy that happens to be out of favour, as was the case with many value-leaning funds amid the tech boom of the late 1990s. Or avoiding momentum stocks in 2007. Such discipline is often vindicated over time.
Conduct a thorough investigation of why the fund is lagging. Spend some time digging into whether the fund is merely undergoing a rough patch for its style or whether there's a more serious problem going on. All too often, investors bail out of struggling funds only to see performance rebound shortly thereafter. So check to see if the fund's manager is still in place, and that he is still employing the same strategy that brought your fund success in the past. Most funds, especially those using truly active strategies, will trail their peers at times, often for very good reasons and for a few years or more.
However, weak performance could also be a sign that something more serious is afoot. For example, perhaps your mid-cap fund is lagging in a market led by small- and mid-cap stocks because it has grown too large and the manager cannot dabble in smaller fare as he did when the assets under management were much less. The once-nimble fund has lost its edge as investors have flocked to it due to its performance.
- Look at performance through a different lens.
Researching an investment's fundamentals can be time-consuming, which is why you don't want to get too caught up in investigating short-term bouts of underperformance. Instead, save your energies for checking up on funds when they've underperformed over longer periods
Also, look at periods when you would have expected the fund to perform well and it failed. If, for example, you prized a fund because of its low-risk tendencies but it lost far more than its peers in a market downturn, that's a legitimate reason to ask whether something about its strategy changed or its risk controls weren't what you thought they were. Even if the fund isn't bad, it may not be a good fit in your portfolio.
Check to see whether the performance shortfall is a recent development or part of a sustained pattern of performance weakness. For example, a below-average 3-year ranking might actually result from just one off-year combined with two decent ones. We reiterate: It's a mistake to pull the plug on a fund based on short-term performance.
In a related vein, investors can get worked up when a fund's relative returns are inconsistent on a year-to-year basis.
Sure, it can be comforting to see a fund land in its category's top half like clockwork but holding all of your holdings to that standard would cause you to kick out some fine offerings that, while not consistent performers on a calendar-year basis, are consistent where it counts: They employ their strategies with discipline and don't waver, even if the market isn't rewarding them in the near term.
It's also important to remember that a calendar year is a fairly short and arbitrary time period and the fund that has looked erratic January to December may appear perfectly consistent when measured over a different 12-month time frame -- say, from April through March.
- Conduct a legitimate performance check.
Although one year of underperformance may be nothing to worry about, it can get frustrating to watch your fund fall behind the competition for two or three years or more. But before cutting a fund loose, though, be sure that you’re comparing your underperformer to an appropriate benchmark and relevant peers. For instance, a mid-cap fund should not be compared to a flexi or large-cap fund. Alternatively, neither should it be compared to the performance of the Sensex, but rather to the more appropriate BSE Midcap index.
In conclusion…
Performance data are only helpful when used in conjunction with an understanding of a fund's strategy. And when viewed over various time periods. Just because the fund in question is not sitting on top of the performance chart in a year does not mean it has to be kicked out of your portfolio.
