What to do when Mutual Funds underperform?
People generally hold their positions in mutual funds even if they underperform. This is not a wrong strategy if the poor returns are for a short-term, let’s say for 3-4 quarters or if the returns are above the benchmark. But what if the mutual funds continuously underperform the benchmark for let's say last 2-3 years? Then should you hold it further or sell it off?
Before answering that, here are a few things that every investor should know while investing in mutual funds-
1. Mutual fund investments are subject to market risks. If the market is weak, it is very unlikely that your equity mutual fund investments will do well.
2. Different funds follow different strategies, have different benchmarks and vary on the basis of different risk-return characteristics. Investing in money market mutual funds or Debt mutual funds is comparatively safer than equity funds but on the other side, they are expected to generate fewer returns compared to equity mutual funds.
3. You should first consider your financial goals, legal constraints, applicable taxes and time horizon for the investment. Also, you should first realize your ability and willingness to take the risk and then only invest in those mutual funds which fulfil your requirements.
4. You should be mindful of exit loads applicable to your investment before you switch to other funds. The exit load will be a drag on the investment returns.
Now, if you have considered the above points and still think your investments are not performing according to your goals, then you definitely need to reconsider your investment funds and if possible, book your losses and move on. To make it simpler, you can simply compare the fund's performance to a suitable benchmark or to similar funds. Repeatedly poor comparative performance should be a signal to sell the fund.
Different types of Mutual Funds
Money Market Mutual Fund
Money market mutual funds (MMMF) are used to manage the short-run cash needs. It is an open-ended scheme which deals only in cash equivalents. These securities have an average maturity of one-year; that is why these are termed as money market instruments.
The fund manager invests in high quality liquid instruments like Treasury Bills (T-Bills), Repurchase Agreements (Repos), Commercial Papers and Certificate of Deposits. This fund aims to earn interest for the unit holders. The main aim is to keep fluctuations in the fund’s Net Asset Value (NAV) to a minimum.
Money market fund can be compared with savings account which comprises of cheque facility, the facility to redeem without lock-in period and electronic money transfer.
Types of Money Market Instruments
Following are the few types of money market instruments that every investor should know
Certificate of Deposit (CD)
These are almost similar to fixed deposits that are offered by scheduled commercial banks. The only difference between FD and CD is that you cannot withdraw CD before the expiry of the term which is usually not very long.
Commercial Paper (CPs)
These are issued by companies and other financial institutions which have a high credit rating. Also known as promissory notes, commercial papers are unsecured instruments which are issued at the discounted rate and redeemed at face value. The difference is the return earned by the investor.
Treasury Bills (T-bills)
T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. These are among the safest investment instruments available as these are backed by the Government of India. The rate of return, also known as risk-free rate, is low on T-bills as compared to all other instruments.
Repurchase Agreements (Repos)
It is an agreement under which RBI lends money to commercial banks on collateral of T-Bills. It involves the sale and purchase of agreement at the same time and is one of the main tools of RBI to keep inflation under control.
Who should invest in Money Market Mutual Funds?
Money market fund seeks to provide the highest degree of short-term income via maintaining a well-diversified portfolio of money market instruments. Investors having a short-term investment horizon of up to 1 year can invest in these funds.
Those investors with surplus cash in savings bank account and low-risk appetite can invest in money market funds. These funds will give you higher returns than the savings bank account. The investors could be corporate as well as retail investors.
However, if you have a medium to long-term investment horizon, then money market fund won’t be an ideal option. Instead, you may go for dynamic bond funds or balanced funds which may give you relatively higher returns. Similarly, don’t think of money market funds unless you have short-term surplus cash which you don’t need urgently.
What to do if Money Market Mutual Funds underperform ?
Money Market funds are generally short term, usually for less than a year. Hence, it is less risky than any other mutual fund. The underperformance by the money market funds is very rare. But there can be some events which can put pressure on a money market fund. For example, there can be sudden shifts in interest rates, major credit quality downgrades for multiple firms and/or increased redemptions that weren't anticipated. These events can reduce your returns but only for a short while. During that period, switching to other funds might turn out to be more expensive than having a low returns for short term.
Debt Mutual Funds
Debt Mutual funds are funds that invest money in fixed interest earning instruments like treasury bills and corporate bonds. The main objective to invest in a debt fund is to accumulate wealth by means of regular interest income and steady appreciation of the fund value. The underlying securities generate interest at a fixed rate throughout the tenure of the instrument you have invested in.
The fund manager invests in different securities on the basis of their credit ratings and the type of fund he is running. A higher credit rating indicates a more secured debt security with a chance of getting regular interests along with repayment of the principal amount upon expiry of tenure. Apart from that, the fund manager aligns his investment strategy according to his expectations for the interest rate movements.
Who should invest in Debt Mutual Funds?
Debt funds are chosen if you prefer conservative investments and want some safe returns or if you want to diversify your investment from equities and commodities. Simply, if your goal is to grow your wealth but in a less volatile manner or if you need a regular income, then debt mutual funds are best suited for you. Investors usually invest in debt funds for a short to medium-term horizon. So, you need to choose an appropriate debt fund according to your investment horizon.
Liquid funds may be suitable for a short-term investor who usually keeps their surplus funds in a saving bank account. Liquid funds might provide higher returns in the range of 6%-8% in addition to the flexibility of withdrawals at any time just like a saving bank account. On the other side, if you want to earn a little higher return and are ready to take comparatively higher risk, then dynamic bond funds may be an ideal option. These funds follow different yield strategies to generate capital returns and are suitable for a medium-term investment horizon.
What to do if Debt Mutual Funds underperform?
With credit risks increasing post the IL&FS and DHFL episodes, and low returns in the past year, should you just abandon the Debt Mutual funds and stick to bank FDs? The short answer is NO.
It is engraved in people’s minds that because debt funds have a diversified portfolio, fixed interest income and a fixed maturity period - investors won’t lose capital in debt funds. But the truth is that even the bank FD is not 100% risk free. So, the trick is to understand how much risk you are comfortable with before investing in a debt fund and hold on to that risk appetite without panicking, because one single default in debt scrip doesn’t make debt funds bad.
Equity Mutual Funds
Equity funds are riskier than Debt or Money Market funds, but in comparison are expected to generate higher returns, by investing in the shares of listed companies with different market capitalization. The company’s performance in which the fund invests, decides how much an investor can make based on his shareholdings.
An equity fund generally invests at least 65% of its assets in equity shares of companies in varying proportions. This should be in line with the investment mandate. The funds might be categorised on the basis of their market capitalization, for example- large-cap, mid-cap, multi-cap fund or can be based on particular sectors. Moreover, the investing style may be value-oriented or growth-oriented.
Who should invest in Equity Funds?
Generally, if you have a long-term goal (More than 5 years), with somewhat medium to high risk tolerance then it is better to invest in equity funds. It will give the fund ample time to ride out the market fluctuations and generate a higher return compared to any other type of mutual fund.
● For beginner investors: In case of beginners, they may want to take exposure in equities as they would generally have a longer time frame. In this case, the investor can consider large-cap equity mutual funds or any index mutual funds which invests in equity shares of the top companies in the Indian stock market with well-established setup and have been historically delivering stable returns over the long-term.
● For market-savvy investors: If you are well-versed with the equity market but want to take calculated risks, you may think of investing in multi-cap funds or diversified equity funds. These invest in shares of companies across market capitalization and give the optimum combination of high return and lower risk as compared to equity funds that only invest in small-cap or mid-caps.
What to do if Equity Mutual Funds underperform?
Well, at least 40 per cent actively-managed equity mutual fund schemes failed to beat their benchmarks in the five-year period. Even in the three-year period, 67 per cent equity mutual fund schemes failed to beat their benchmarks. The worst performer is the large cap category; 57 per cent of the actively-managed large cap schemes failed to beat their respective benchmarks. Further in the multi-cap category and ELSS funds category, 48% and 47% of actively-managed mutual funds underperformed respectively.
Hence, if your equity fund is continuously underperforming from 2-3 years, then it is suggested to either shift to passively managed equity mutual funds like Index Funds or to other mutual funds which have better performance . One of the advantages of moving to an Index fund is it has lower expenses as it is passively managed and can closely mimic the index return.
Other Reasons to Dump your Mutual Funds
Mutual Fund Changes or Mismanagement
Mutual funds might change in a number of ways that can be at odds with your original reasons for buying. For example, a star portfolio manager might leave and be replaced by someone lacking the same capabilities or experience. Or there may be style drift, which arises when a manager alters his or her investing approach.
Other signals to move on includes an increase in management expense ratios (MERs), or a fund that has grown large relative to the market because of which managers would face difficulty in generating excess return (alpha) over market and its risk-return will be similar to the market overall.
Life Cycle Changes
Although investments in equities have historically been the best investment to own over the long run, their volatility makes them an unreliable vehicle in the short run. When retirement, children's education or some other funding deadlines approach, it is a good idea to shift out of stock-market funds into assets that have more certain returns, such as bonds or term deposits, whose maturities coincide with the time that the funds will be needed.
Sometimes, an investor’s due diligence may be incomplete or incorrect. This causes them to own funds they otherwise would not have purchased. For example, the investor might discover that the fund is too volatile/ risky for their tastes.
Portfolio errors might also have been committed by the investor. A common mistake is over diversifying by investing in too many funds, which can be difficult to keep tabs on and will most probably have higher positive correlation i.e. have similar performance, which will in-fact lower the diversification and can tend to average out to market. It is common to confuse owning a large number of funds with diversification. What is needed is a collection of funds of which some can be expected to be up when others are down.