23% percent of Mutual Funds in SmallCap is underperforming the Index, what should you do? How to assess underperforming Mutual Funds?
Saturday, Jun 8, 2024
As investors, we have been caring only about the returns a scheme has made in the past couple of years. But should that be the only basis for investing?
It could be for reasons like even the index would have performed well and so would your mutual fund. But if it doesn't meet the benchmark, then it's not the ideal one to be invested in.
To back it up, the next thing to watch out for is whether it has been an outperformer amongst other peers. You need to keep an eye on category average returns too.
You have already invested and the returns are not favorable. What now?
It's good that you see something wrong here because it's underperforming. Your investments shouldn't be considered like you park money and leave it, to surprisingly see one random day. Does it work that way? Not really!
Your eyes must be periodically on it to assess the portfolio and make the required changes when needed. The markets will always not be at the same place where you left looking at them.
Let's see how you assess the performance of a mutual fund first. And then talk about your next move.
The ways to assess the performance of the mutual fund
Seeing it against the benchmark index
Has your mutual fund scheme outperformed the accepted benchmark index? Why should you see it against a benchmark index? Because it gives you an analogy of the market performance against your scheme allocation.
The returns in the long term
As appealing as a 1 year return could be, even a long-term return should be too. It speaks of consistency, not an unexpected spike. If you are looking for a long-term investment decision, you know this is very important and not otherwise. You must be looking at at least the performance of 5 to 10 years to make any decision.
The expense ratio
Besides the anticipated returns that you may receive, the expenses of handling a mutual fund are also charged to you. The brokerage charge, fund manager charge, and many others are associated here. The NAV - Net Asset Value, is what you'll receive as returns after deducting the deduction of TER - Total Expense Ratio from the total returns. For actively managed funds, TER is a bit high.
Risk-adjusted returns
You know every “investment is subjected to market risk,” a widely heard phrase in the investment sector. It's true, there is some level of risk associated with an investment. For an exchange of some degree of risk, you are invested to make returns, especially in the equity segment; otherwise, wouldn't a fixed deposit be a safe haven?
What is the level of risk you are exposed to in an investment, is a question, even if you are willing to take some. This measure is to check whether the investment compensated with the right returns for the degree of risk you took.
The ways to measure the performance of mutual funds
There are multiple indicators out there, you don't have to go through all but important ones.
The Alpha
This is the value that your portfolio manager brings to your portfolio. The value is either added or removed.
The alpha number is always expected to be higher and that's good for your portfolio!
If it's 1, you have nailed it by 1% compared to the benchmark index. If it's negative 1, vice versa.
You can find it using the formula:
(MF return - risk free return) - [(Benchmark return - risk free return) × beta] = Alpha
Alpha indicates the price risk.
The Beta
It's about the volatility associated with your portfolio compared to the benchmark index.
The lower the beta, the lower the volatility in your portfolio.
If 1, your portfolio is in line with the stock market movement. Greater than 1 means your portfolio surpasses even the volatility of the stock market. Lower than 1 is the vice versa.
Regression analysis helps you arrive at the beta value. Or you can calculate it as follows.
(MF return - risk-free return) - (Benchmark return - risk-free return) = Beta
Beta is the volatility risk.
The sharpe ratio
Is your portfolio yielding good returns because of the excessive risk you are taking or is it actually the wisest decision? That's what the sharpe ratio tells you.
It isn't worth the risk if the returns aren't generated.
You may find out that your friend's portfolio performed well but not yours. If it comes with excessive risk, it's not worth it. The greater the ratio, the more it is adjusted to the risk.
The risk-free rate is subtracted from the investment return rate, which is divided by the standard deviation of the return on investment.
Sharpe ratio = (Expected return of a portfolio - risk-free rate)/portfolio standard deviation
Sharpe ratio is about the worth of risk.
Standard deviation
It's the degree to which the returns of mutual funds vary from their average over time. Basically, from the expected returns, how much is the rate of return currently deviating?
Lower the SD for a consistently longer time, the better it is.
If the SD is higher, it means they are more volatile, and the level of risk is high.
You may calculate it by
𝝈=√ (∑(ri-ravg)^2/ n - 1)
ri = returns for the specific time period
ravg = the average returns usually observed over the time period
n = sample size
The standard deviation gives you a measure of the fund's volatility.
Reasons why they fail…
The performance, as mentioned, isn't a constant value but rather a fluctuating value over time. Let's understand the reasons why they underperform.
Market conditions aren't static but dynamic
How the market performs has an impact on how your portfolio may perform. Market conditions are unpredictable. For instance, when there is a recession, your mutual fund is mostly affected, despite the best mutual funds.
If the fund picked is exceptional, regardless of the downs, it must perform well; if it doesn't, then you should take a call.
An investment strategy is weak
The strategy matters to keep the portfolio going through the ups and downs. The underlying aspect is that it relies on how the assets in the portfolio perform and whether the right assets have been picked.
Even based on the economic conditions in the market, the fund manager can diversify and hedge appropriately to withstand the rainy weather in the portfolio.
Fund manager's performance
Each scheme is assigned to the fund management team, which is working towards growing the portfolio. Therefore, it becomes essential to know how your portfolio management team is working on it.
Their choices, skills, and experience play a great role in the performance of the portfolio. They must also be adept at assessing the mutual funds frequently and making changes appropriately if needed.
If they are skilled enough, think that your portfolio is in safe hands; otherwise, it is not.
The performance in the past
It's common to invest based on seeing the nearest returns that it has gained. Sometimes it's factual to look at past performance to arrive at a decision.
How strong it stood in the downtime and how well it performed in the obvious times can tell a story. If it hasn't performed well, the cycle will repeat.
What should you do?
Firstly, investments are subject to market risk but they can be sailed through when you look at the long term. But if that persists for a longer time, it's time you act on it.
If all the measures say your portfolio has been doing badly for quite a long time, consistently say 2 to 3 years, it's a bad investment to stay in.
Never make an exit looking at the performance for 1 year; short-term fluctuations always exist in any type of investment. The above assessment and measurement were briefed so that you could strongly identify any sign of it underperforming for legitimate reasons. If so, make an exit to enter a good portfolio again.
The Wrap
It all lies in how the stocks in the portfolio were picked and how the portfolio was managed. Do your fund managers have the sort of experience to consistently grow portfolios? If so, have they picked the right stocks for your portfolio? If that's a yes, have they protected your portfolio from excessive risk by managing it effectively?
All these matters for a good performing mutual fund, if you haven't found the right guidance, let us give it to you! Green Portfolio is a portfolio management service that has served 30k+ investors and whose portfolios have been consistently outperforming or you can also invest through rightly curated smallcases by Green Portfolio.
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