January is that time of the year when analysts publish their rankings of best and worst performing mutual funds. This can be a source of FOMO (fear of missing out) for investors. Once you discover that the category-topping equity fund gained 200 per cent from its March 2020 lows, it becomes tough to hang on to your faithful fund which managed only 45 per cent.   

The perils of churn

In theory, regularly weeding out underperformers from your portfolio and replacing them with better performers may seem a good way to bump up portfolio returns. But in practice, doing this often (even once a year or once in two years) can cost you dear. Each time you sell an equity fund, you give up part of your returns to the taxman by way of capital gains tax (at 15 per cent for holdings less than a year and 10 per cent otherwise). Worse, the fund you added can start performing poorly, while the one you sold suddenly tops the charts.

Investors who’ve busily churned their portfolios in the last three years have learnt this the hard way. For instance, those who switched out of their underperforming large-cap funds into Axis Bluechip Fund at the end of 2020, dazzled by its record, found the fund turn a middling performer with a 21 per cent gain in 2021 and 6 per cent loss in 2022. Those who gave up on ICICI Pru Value Discovery in 2019 saw it pull up its socks to outdo the Nifty50 and deliver a 22 per cent gain in 2020, 37 per cent in 2021 and 15 per cent in 2022.

Investors who threw in the towel on HDFC Flexicap after its long spell of underperformance in 2021 saw it turn a top flexicap fund in 2022 with a 17 per cent gain. Pharma and NASDAQ funds, the chart-toppers of 2020, came a cropper in 2022. PSU and Infrastructure funds, laggards until 2020, turned big winners.

But while too much churn can harm returns, total neglect of fund performance can hurt too. In the last 10 years, the best performing diversified equity fund delivered a 21 per cent CAGR while the worst one eked out just 11 per cent. So, how do you strike a balance between giving a good fund a second chance and hanging on to a basket case?  

Benchmark, not category returns

When deciding whether to hold an underperforming fund or sell it, assess its returns against its benchmark and not its category. There are valid reasons why a reasonably good fund can trail others in its category. One, the fund manager may be taking on less risk than his peers. A fund that loads up on micro-caps or momentum stocks in the breakout phase of a bull market will beat its peers, but it will be an equally big loser when a correction hits. If your fund has a higher allocation to large-caps, lower portfolio concentration or a focus on out-of-favour stocks, these risk containment strategies can hold back returns in bull phases. But you’ll get a smoother return experience in the long run.   

Two, your fund may be following a different style of investing from peers. Until 2021, contrarian and value funds struggled to deliver against their quality and growth peers, as record-low interest rates supported high stock valuations. But as rates have shot up, value and contrarian funds have begun to outperform. Rather than switching between styles, it is best to choose a style that suits your temperament and stick with it through cycles. The decision to sell should also be based on who’s managing your fund. A seasoned manager at the helm, who has seen multiple market cycles, may be better able to recoup lost ground, than one who’s barely been in the business for five years. 

Funds that shoot out the lights in one year often crash and burn in the next. To get good long-term results, it is enough if your funds remain in the top two quartiles of their category while at least matching benchmarks.  

Meeting your goals

Bull markets can make you lose sight of the returns you expected when you invest in an equity fund. If you invested in a flexicap fund with a CAGR expectation of 15 per cent, you shouldn’t get unduly worried about Quant Flexicap Fund delivering a 38 per cent CAGR in the last three years while your fund earned 20 per cent. The 20 per cent return is still better than the BSE500 and will get you to your financial goals at the pace you expected. If funds you own are delivering a decent absolute return, relative underperformance shouldn’t be the reason to sell them.  

Also, note that the point-to-point returns that you see on fund rankings will be different from your personal return experience. Before switching, check the actual returns on your own fund portfolio. If an underperforming fund has managed to give you a reasonable return, doing nothing may be the best course. Most folks invest in mutual funds to reach specific financial goals. In evaluating a fund’s returns, your ability to meet your goals matters far more than whether the fund is a top ranker.   

Exceptions

Of course, there are situations in which you must get rid of an underperforming fund weighing down your portfolio. If a fund is consistently lagging its benchmark or failing to deliver to your initial return expectations, don’t hesitate to replace it. You have scores of low-cost index funds today that track the Nifty50, Nifty Next 50, Nifty 100. So, there’s no reason to hang on to underperformers that don’t even deliver index returns.

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