Before answering that, how does one identify an under-performing fund? As many times as you compare returns of 1/3/5/10 year performance of any category of equity funds, you will get as many different takers for the top spot or any other rank.
If a fund was a top performer in one year and not so in the next, is it an under-performer? Not really. You have to consider performance against a benchmark and how consistent a fund is when compared to its peers. Some aspects of fund selection are qualitative, you will not be able to see any immediate outcome in terms of returns.
However, along with the qualitative issues, you should filter performance against some standard to understand whether your fund is a consistent under-performer or if the downturn is temporary.
There is an opportunity cost of remaining invested. You could instead choose to invest in the index itself or a similar portfolio and get a better outcome. While on an annual basis it is not always possible to beat the benchmark, 2-3 years of under-performance versus the fund’s benchmark shows the fund manager is not able to use stock selection effectively; that’s a sign to exit.
Return relative to benchmark
Rather than jumping into return comparison within a category of fund, it helps to first understand performance versus its own chosen benchmark. One year of underperformance is not reason enough to sell. However, if there is sustained 2-3 years of underperformance relative to a benchmark, there is something wrong in the way the fund is managed. This is a serious red flag, especially if there are other similar funds who are able to outperform the same benchmark in the period under consideration.
There is an opportunity cost of remaining invested. You could instead choose to invest in the index itself or a similar portfolio and get a better outcome. While on an annual basis it is not always possible to beat the benchmark, 2-3 years of underperformance versus the fund’s benchmark shows the fund manager is not able to use stock selection effectively; that’s a sign to exit.
Let’s once again acknowledge that no single fund will be a top performer each time you check returns. Did you know, in the last ten calendar years (2008-2018), there have been nine different funds in the top position within multi-cap equity? The situation compounds with the launch of new funds over the years which come up top. So, now what?
One way to overcome this problem is consider funds which are say in the top 20% or 25% of their peer set in terms of returns. You can break up the return period as you like – so, compare for 3-year or 5-year return and only consider those schemes which consistently show up in the top quartile or top 25%.
Why? Because these are the funds where the fund manager is consistently able to pick a portfolio of stocks which delivers better returns than most others. While there is no way of knowing if the performance can continue, you have some historical evidence of ability and consistency. It also signals that good performance is not a one-off event and that the fund manager is able to recover from performance short falls, if any.
These quantitative measures are a guide or a filter that you can use on your underperforming schemes. There would be other factors involved as well. Don’t hang onto an under-performer thanks to past glory, a popular fund manager or a bias about the asset management company.