The motivated ignorance of staying invested with underperforming funds

We all are conditioned to believe that we need to be optimistic to make money in equities, what goes down, bounces back, is the mantra we all hear in every conversation. But there is a thin line between being optimistic and ignorant.

Driving a car on a busy road and believing in your excellent driving skills to avoid any accident is being optimistic. But trying to drive a car on a busy road without knowing how to drive is being ignorant. You may crash.

In this case you know whether you can drive or not. It isn’t tough, is it? But when it comes to investing in Mutual Funds, it is surely not as easy to identify whether you are being optimistic or ignorant.

Many investors remain optimistic about their underperforming funds and stay invested in them for years, hoping for a bounce back some day. Such act is called motivated ignorance.  Lot more money has been lost by staying with underperformers than actual loss due to market falls. Opportunity loss is something which is invisible and eats into your portfolio returns slowly over years.

last 5 years returns (cagr)

Best Multicap Fund: 18.1%

Average Multicap Funds: 11.56%

Worst Multicap Fund: 6.05%

Best Midcap Fund: 16.51%

Average Midcap Funds: 12.92%

Worst Midcap Fund: 7.90%

One should never ignore a bad performer. As they say, “one bad apple can spoil the entire bunch.” Similarly, one underperforming fund can decay your entire financial plan.

Firstly lets understand underperformance – It is when the fund delivers lower returns than its stated benchmark no. This is nothing to do with its star rating and performance against peers. One should not compare Fund’s performance with peers but benchmark. The moot question is how much underperformance is bad and when is that time when you are crossing the line from being optimist  to becoming ignorant?

I propose a simple “STAR” approach to find answer to this question. Rate the fund on these four parameters, see if it ticks any two or more of them, and it is time you say good buy!

STAR stands for –

Style of the Fund

Tenure of underperformance

Asset Manager change

Risk

Style of the fund:

Investment style is the core of any fund. Its outcome, good or bad, are directly linked to its investment style. When the underperformance in a fund is due to sudden change in its style then it is a red flag. Some common change and drift in styles are value to growth, benchmark hugging to contra, multicap to largecap, midcap to largecap, etc..

Such changes impact the performance of the fund rather permanently, as each style has its unique risk-return potential, and expecting past performance of a specific style being repeated is not achievable. In such cases it is prudent to reconsider your investment in such fund if it no longer suits your objective.

However, if the underperformance is due to style itself, for example, a value style underperforming in over heated market rally, then it is prudent to wait for one market cycle at least.

Tenure of underperformance:

This is the most critical aspect when it comes to deciding whether to stay invested or exit from the fund. Many investors panic after seeing their fund underperforming its benchmark and peers in last one year. Sometimes just one year’s underperformance effects 3 and 5 years trailing performance and investor feels that the fund is underperforming since last 5 years, which is not true. Hence, looking at calendar year performance is better indicator than looking at 1, 3 and 5 year trailing performance. 

Underperformance against the benchmark is a concern when it is for longer period, usually more than 3 years. Easy way to analyse this is looking at calendar year performance. If the fund has underperformed its benchmark consistently for 3 calendar years it is high time and you should exit the fund. Other measures like 3 and 5 year rolling return alpha over benchmark can be analysed to see how fund is stacking up against the benchmark. 

Asset Manager change:

The Fund Manager is the most important factor while analysing the funds future. When Fund Manager changes it is definitely a time you should review the fund closely. Each Fund Manager has a different approach, no two humans can think alike, and this is the very reason that the new fund manager may have very different style and approach.

Look for the credibility of the new Fund Manager by looking at performance of funds he has managed earlier. There are instances where Fund Manager change has effected scheme performance drastically, but there are also instances where the new Fund Manager has done a better job than the earlier man on the job. So be careful and give some time to judge the new Fund Manager and analyse what changes he is making in the portfolio and is he drifting away from the earlier style of the fund. The new Fund Manager has no track record and is churning the portfolio too much to fit his style, you are better off by exiting the fund. 

Risk:

Watch out if the fund is taking undue risk due to which the performance has been impacted. For example a big fund had taken huge bet on PSU Banks since last 4 years and it underperformed badly during that tenure. While the fund ultimately recovered, but those who wanted money during these 4 years had to exit with poor returns. Such undue risk is a red flag in a diversified fund.

Look out for any such sector skewed calls in the fund which is dragging the performance. Such contra calls may take time to recover or may not even recover. Another area could be concentration in top 10 stocks. Ideally it should not exceed 40% to 50% in a well diversified portfolio. Specially in small and midcap funds, diversification is important. If underperformance is prolonged and is due to such high concentrated bets it is a red flag. 

 

So next time you are confused stay away from motivated ignorance, use this simple STAR approach and you may be able to decide whether you should stay invested of exit the underperforming fund.

Happy Investing !