Timing Exit From Underperforming Fund

More often than not, when a fund in your investment portfolio begins to show signs of wilting or fading away from the limelight of growth, you may want to sell it. But what are the factors on which such a decision should be made? Could it be that it’s just a slow phase in the fund’s life with the possibility of a strong bounce-back? Or is the management to blame? The article lists the various reasons that you should consider before signing off from a poorly performing fund [EasyDNNnews:PaidContentStart]

All investments go through cycles but unfortunately, it’s impossible to reliably time these cycles and selling when an investment is in a downward cycle just means that you will miss the possibility of recovery. Consider a scenario when you had invested in Small-Cap-dedicated fund such as ABSL Small-Cap Growth Fund at the start of 2018. This is after the fund had generated return of more than 60 per cent in 2017. This was a very good year for the fund and it was tempting to think that the good times would continue. Now an investor’s ordeal starts as he sees the net asset value (NAV) of the fund starting to decline and continues to decline for the next 27 months. During this period an investor would have lost almost 44 per cent of his investment value. 

This is a common investment experience for investors. However, it is more prominent in small-cap funds. These categories of funds can be very volatile compared to Large-Capdedicated funds, and they can experience long periods of decline. This can be very frustrating for investors who may feel like they are making a mistake by staying put in the fund. The prolonged decline in the NAV of a fund, as experienced in the scenario of the ABSL Small-Cap Growth Fund, can test your patience and resolve. However, making a decision to sell a fund should not solely be based on short-term performance fluctuations.

It is important to remember that selling a poorly performing fund is not always the best option. If you sell the fund at a loss, you will lock in your losses. You will also miss out on the possibility of a recovery, which happened in the above case. Fast forward July 2023 and in the three years the NAV of the same fund is up by 223 per cent. It has moved up from ₹19.6 to its current value of ₹63.4, which is more than double. So, any impulsive decision based on short-term performance would have cost you such a huge profit.

Evaluating a fund’s underperformance requires a nuanced approach. Different dimensions reveal its shortcomings, demanding a discerning analysis for accurate assessment. One common gauge is the absolute returns, but a mere 5 per cent annual return from an equity fund over five years pales against even a bank deposit. Yet, such a conclusion may lack depth. Digging deeper, one finds that a fund’s relative performance surfaces as a pivotal consideration. How does it stack up against its peers? Does it trail or surpass the category average? A broader perspective is vital as hasty exits should align with prudent investment principles and not fleeting influences. So, when should you sell a poorly performing fund? Here are a few factors to consider:

Finding the Reason
There must be a reason for the poor performance. Is the fund underperforming because of the overall market conditions, or is there something specific about the fund that is causing the problems? If the poor performance is due to market conditions, then it may be better to wait for the market to recover before selling. In the above case you may find that between the start of 2018 and March 2020, even the fund’s benchmark small-cap index fell by 59 per cent. Therefore, the fall in the fund was more or less linked to the market situation. 

The graph below shows the performance of the fund against Nifty Small-Cap 250. We can clearly see that it is closely imitating the performance of the small-cap index. Therefore, purely based on returns it would not have been a right decision to exit. 

If the fund has consistently underperformed its benchmark or peers over a sustained period of time, it is a sign that the fund may be managed poorly or that the investment strategy is no longer working and you should exit the fund.

Fund’s Expense Ratio
A fund’s underperformance isn’t solely determined by its investment strategy – the expenses incurred in managing the fund also play a crucial role. These management costs encompass various elements, including annual operating expenses such as management fees, allocation charges and advertising costs. When evaluating funds within the same category, consistent research underscores the significance of fees, indicated by the fund’s ‘expense ratio’ in forecasting future long-term performance compared to similar funds. Funds with lower expense ratios have exhibited a propensity to outperform those with higher ratios. Additionally, a fund’s ‘turnover’ ratio, which reflects its trading frequency, offers insights into the impact of transaction costs that can erode potential returns.

Illustrated in the graph above is the distribution of expense ratios among small-cap-dedicated funds (Regular). On an average, 24 small-cap funds have an expense ratio of 1.935 per cent. Aditya Birla SL Small-Cap Fund (G) boasts an expense ratio of 1.94 per cent, aligning closely with the average and thus not categorically expensive. High costs and fees can eat into your returns over time. If you can find a similar fund with lower costs, then it may be a better option for you. Therefore, even when considering the expense ratio, the fund may not necessitate an immediate exit.

Change in Risk Tolerance
You can exit from the fund if your risk tolerance has undergone a shift. It’s worth reiterating that a mere stock market fluctuation isn’t sole justification for altering your portfolio. However, the dynamics of this concept become clearer with an example. Consider an investor named Smita Shah who has historically been comfortable with moderate risk and has invested a significant portion of her portfolio in growthoriented funds. However, recently, she finds herself becoming increasingly uneasy about the market’s volatility.

The sight of her investments fluctuating dramatically keeps her up at night, leading to stress and anxiety. This evolving emotional response indicates a change in her risk tolerance. In another scenario, let’s take the case of Manohar Patil whose financial goals have transformed over time. When he initially invested, his primary aim was capital growth for a long-term retirement plan. However, circumstances have evolved, and he now prioritises wealth preservation and income generation, particularly as he nears retirement age. This shift in objectives suggests that his current investment strategy might not be aligned with his new goals.

For both Smita and Manohar, the realisation that their risk tolerance and goals have evolved prompts them to reconsider their investment approach. In such cases, a prudent step might be to explore alternative funds that match updated risk profiles and objectives. This adjustment doesn’t stem from a reactionary response to market fluctuations but rather from a proactive effort to ensure their investment strategy remains in harmony with their financial wellbeing. In essence, while a poor show of your fund shouldn’t drive hasty changes, the cumulative impact of evolving emotions and objectives can signal a legitimate need to realign your investment choices. Transitioning to funds that mirror your current risk tolerance and goals can offer a more comfortable and secure investment journey.

Change in Management of the Fund
There could be a case when the fund has experienced changes in management or strategy that have negatively impacted performance. This could be a sign that the fund is no longer a good fit for your investment goals. A change in the management of a fund can significantly impact its performance, often warranting a reassessment of your investment. Let’s delve into this concept through an illustrative example. Imagine you have invested in a fund known for its consistent and impressive track record under the leadership of its former fund manager. Over the years, the fund has delivered remarkable returns and aligned well with fund’s style and investment goals. 

However, news emerges that the current fund manager has decided to move on to a different opportunity, and a new fund manager will be taking over. At first, you may approach this transition optimistically, hoping that the fund’s success will continue under the new management. But over the next few quarters, you start noticing a significant shift in the fund’s performance. The once-consistent growth begins to falter and the fund starts underperforming its benchmark and peer funds in the same category.

There are several factors that contribute to this phenomenon. One of the foremost factors to consider is the fund’s investment philosophy and strategy as fund managers often possess distinct approaches that underpin their decision-making. Should a change in management occur, this shift in leadership can trigger a re-evaluation of the fund’s strategic direction, potentially resulting in adjustments to its investment approach that may impact its performance. Another critical facet influenced by a management change is the composition of the fund’s portfolio. New managers might opt to revise the portfolio’s structure, leading to modifications in asset allocation, sector preferences and individual stock selections.

These alterations can consequently reshape the fund’s risk and return profile, effectively steering its overall performance in a different direction than before. Furthermore, the varying degrees of market expertise among fund managers come into play. A newly appointed manager may bring a distinct understanding of market dynamics and macroeconomic trends, influencing the investment decisions made on behalf of the fund. This disparity in market knowledge could lead to adjustments in the fund’s holdings and strategies, subsequently impacting its performance. Equally crucial is the element of investor confidence.

When management changes occur, existing investors and market participants might respond by adjusting their positions, resulting in fluctuations in the fund’s asset inflows and outflows. These shifts in investor sentiment can have a bearing on the fund’s stability and overall performance.

Recognising this interplay, you decide to exit the fund and reallocate your investments to a fund managed by a professional with a proven track record aligned with your goals. This decision to exit stems from a logical assessment of the changed circumstances and a desire to safeguard your investment returns. In essence, a change in fund management can bring about a shift in investment dynamics that significantly impacts performance. 

Monitoring the performance of your investments and being attentive to management changes empowers you to make informed decisions that align with your financial objectives. We have seen this in reality when a star fund manager and CIO of one of India’s largest fund houses left. Following this there were some hiccups in the performance of the fund he was managing and there was anecdotal evidence that investors pulled out of the fund initially. However, it has stabilised now. Even in the case of Aditya Birla SL Small-Cap Fund, there has been a change in the fund manager. However, there were no visible changes in the portfolio composition or change in style of investment and hence the fund continued with its historical performance.

Focus on Investment Goals
If you are investing for the long term, then you may want to be patient and ride out the storm. However, if you need the money in the short term, then you may need to sell the fund, even if it is at a loss. Your investment goals could also be linked to portfolio diversification and asset allocation strategies. If a poorly performing fund represents a small portion of your diversified portfolio, you might be more willing to maintain your position and give it time to rebound, especially if other investments are performing well. However, if the fund’s underperformance threatens to disrupt your desired asset allocation, you might decide to reallocate your investments to restore balance within your portfolio.

In essence, the impact of investment goals on decision-making in the face of poor fund performance underscores the significance of aligning your actions with your broader financial objectives. Your timeframe, financial needs, risk tolerance and portfolio structure play a role in determining whether to remain patient, make adjustments, or exit a poorly performing fund. The key is to ensure that your decisions serve the purpose of advancing your overarching financial aspirations. Continuing with the above case, if you are holding fund for a long term you can continue to hold it if it is not representing more than 10-15 per cent of your portfolio. 

Conclusion
Ultimately, the decision of whether or not to sell a poorly performing fund is a personal one. There is no right or wrong answer, and the best decision for you will depend on your individual circumstances. In conclusion, every investment decision should be driven by a clear understanding of financial goals, risk tolerance and time horizon. While selling a poorly performing fund might be a viable option in some cases, it should be a carefully considered and rational decision based on a comprehensive evaluation of various factors. Ultimately, the key to successful investing lies in staying focused on long-term objectives and maintaining discipline during market ups and downs. 

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