Investors encountering underperformance must be patient.
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.
Identifying and removing laggards from the portfolio is crucial.
Fund against benchmark
Assess 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.
Assessing a fund's ability to mitigate downside risk is crucial.
"A downside capture ratio of less than 100 indicates it lost less than its benchmark during a downturn," says Abhishek Tiwari, CEO, PGIM India Asset Management.
Fund versus peers
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, CEO, Prudent Investment Managers.
Krishnan cautions that a fund must be compared with peers that have a similar investment style and risk profile.
Rolling returns to gauge consistency
Rolling returns show how frequently a fund beat its benchmark across different timeframes.
"Out of 60 rolling periods, if Fund A beats the benchmark in 45 periods (75 per cent), it is more consistent than Fund B that beat the benchmark in 18 periods (30 per cent)," says Tiwari.
Sandeep Bagla, CEO, TRUST Mutual Fund, emphasises that rolling returns remove timing bias.
"Positive rolling returns in 6,575 per cent of periods show a solid investment approach," says Seth.
Risk and risk-adjusted returns
A fund may have delivered higher returns, but may have taken excessive risk to achieve them.
"Higher volatility means the net asset value (NAV) might be low at a time when the investor wants to exit," says Bagla.
Moreover, 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.
A fund that is able to generate similar returns with lower risk is more desirable.
The Sharpe ratio measures how efficiently a fund compensates investors for risk taken. It should be above one. Information ratio is another useful indicator.
Temporary versus structural underperformance
Even active fund managers have a particular style -- value, growth, quality, etc.
"Transient underperformance could be due to a fund's style being out of favour," says Tiwari.
According to Krishnan, if a fund has a seasoned manager with a strong track record across market cycles, and adheres to its stated mandate, investors can have greater confidence that the underperformance is temporary.
Avoid knee-jerk exits
Investors encountering underperformance must be patient. Tiwari points out that exiting too soon could result in quitting right before the fund recovers.
"If performance lags peers and benchmarks for three-four quarters without a clear explanation from the fund house, 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.
Keep an eye on cost
A higher expense ratio means the fund must generate stronger gross returns to deliver competitive net returns, so it is crucial to keep expenses low.
"Higher cost may be justified if the fund manages to deliver superior net returns," says Alekh Yadav, head of investment products, Sanctum Wealth.
Finally, Yadav says that when the tax outgo is significant, spreading redemptions over multiple years may be beneficial.
Evaluating passive fund performance
- Look up tracking error or tracking difference to gauge replication accuracy
- ETF liquidity matters: tighter spreads and higher volumes are better
- Very small AUM can affect liquidity
- Lower expense ratios improve tracking quality
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Feature Presentation: Ashish Narsale/Rediff
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