4 Practical Steps to Review and Weed Out Underperforming Mutual Funds

Aarav feels anxious whenever he opens his investment app and looks at his underperforming funds. His own funds barely move when the market goes up, but they crash first whenever the market falls. He is unable to decide whether to sell those badly performing funds.

<i>"What if those funds do very well right after I sell them?"</i>

This blog will show the framework to use for removing your troubled emotions and building a high-performing fund portfolio by correctly recognizing and redeeming underperforming funds.

Step 1: The Rivals Test: Benchmark Against the Market and Peers

This step answers a simple question: "Are my funds doing well against the market and other similar funds?"

Benchmark Comparison:

The performance of your funds must always be compared with the Benchmark Index. If your funds grew 12% this year but your Benchmark index grew by 16%, then your funds actually did worse than an automated program tracking the market. Such a fund can be let go.

Similarly, when the stock market crashes and your funds lose 5% this year, but your Benchmark lost by 10%, then your fund manager was actually able to save your funds from the majority of the damage. Such a fund must be retained.

Compare values from the Fund Returns with the Benchmark Returns to make your decision. Use the official benchmark mentioned in the Scheme Information Document (SID).

Peer Group Comparison:

Similarly, your fund growth must be tallied with the growth of other funds of the same type. A Technology Fund must be compared with other Technology Funds instead of maybe a Banking Fund, simply because the two markets can be performing very differently at the same time.

This comparison is done using the Category Rank or Quartile Rank. This is a performance ranking calculated for all the funds in the specific sector market.

• 1st Quartile (Top 25%)
• 2nd Quartile (Next 25%)
• 3rd Quartile (Below Average)
• 4th Quartile (Bottom 25%)

Your funds in the top 2 performance quartiles are definitely keepers. The confusion usually comes for the funds in the bottom 2 performance quartiles. If your funds have been stuck in the 3rd or 4th Performance Quartile for more than a year, then those are to be removed.

Step 2: The Patience Window: When to Wait and When to Sell Your Fund

This step answers the question: "How long do I wait to know for certain that an underperforming fund should be sold?"

Timeline Check:

Comparing the fund to its Benchmark and its Peers, you notice it has been underperforming for only 3 or 6 months. But it can still start performing well soon, and should not be sold just yet. That is because short-term market ups and downs are part of the process, and the fund may need a better market to perform well.

Instead, if those funds are not performing well for over 12 consecutive months, then market fluctuations can be safely ruled out as the cause of their shrinking returns, and they should be sold.

Step 3: The Driver Check: Check Your Fund Manager and Strategy Style

This step answers the question: "Is the fund performance connected to a change in the fund manager or the style of fund management?"

Manager Shift:

Sometimes, your portfolio may see a change of hands, and the new fund manager will most likely have a different fund management style based on their experiences and risk appetite. In such cases, it is wise to go over the goals and strategies being used for your funds and see if they can be continued.

Style Shift:

A more common case is that of your Fund Manager suddenly changing his strategies. Many managers go through the experience of losing money on the funds and start buying highly inflated, risky stocks to make a quick profit. The wealth-building strategy or roadmap that was agreed upon by you and your fund/wealth manager was changed without notice. Now, the funds do not match their goals anymore. This situation also warrants correspondence between you and your fund/wealth manager to reevaluate the strategies used.

In both situations, if no common ground can be achieved on the goal of the funds, then those managed funds must be sold.

Step 4: The Hidden Toll-booth: The Invisible Cost of Hitting "Sell"

This step answers the question: "Should I sell this fund right now for a better fund?"

Exit Drag:

Every Equity fund has a lock-in period of usually one year. The Exit Load is a fee that the mutual fund charges an investor who redeems or sells their fund before that period. Additionally, Capital Gains Tax is also charged based on when the funds are redeemed.

Most equity funds in India have:

• Exit Load, calculated as a percentage of Fund Redemption Value, is 1% if sold before 1 year, and 0% if sold after 1 year.
• Capital Gains Tax, calculated on the gains made during redemption, is charged at 25% for funds sold before 1 year and 12.5% for those sold after 1 year.
• Other fund types may have no Exit Load, a Lock-in Period other than 1 year, or a Tiered Exit Load. Check your Scheme Information Document (SID) for the exact details.

Let's take an example,

You have invested ₹5,000 monthly in fund A through SIP. It is earning only 12% a year, and after only 10 months you decide to sell it and buy a better-performing fund, B, that earns 14% a year.

But after going through it, you notice that the possible gains have decreased, as you had to pay for selling Fund A.

Monthly SIP to Fund A (1% monthly return, ignoring Stamp duty & Transaction fees) = ₹5,000
Redemption Value of Fund A at 10 months = 5000 × [((1.01)10 − 1) / 0.01] = ₹52,311
Exit Load (1% on redemption value) = ₹523
Profit made = ₹2,311
Capital Gains Tax (25% on profit at redemption) = ₹578
Total amount paid for selling Fund A = ₹1,101

This amount could have been added to further grow the investment.

So, one can see that your funds should be held for at least a year, even if you felt like diverting them to better opportunities. It prevents leakage of that money towards unnecessary charges.

Conclusion

You don't have to wonder anymore if you should sell your funds right now. You now have the ultimate kit for spotting underperforming funds and shielding yourself against panic selling and lazy investing.

<i>Disclaimer: The information provided in this article is for educational purposes only and does not constitute investment advice or a recommendation to buy or sell any mutual fund. Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully before investing.</i>