Can you identify underperforming funds?

Underperformance can be a fairly nuanced debate and we need to consider a number of factors before identifying underperformance.

Dec 18, 2019 09:12 IST India Infoline News Service

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Mutual fund performance is always relative, never absolute. A 12% return on an equity fund may appear reasonable in isolation, but not if the Nifty has given 19% returns during the year. Similarly, if an equity fund generates 14% returns with 12% standard deviation that is a good show. But, if a similar fund has generated 16% returns with 40% standard deviation, then the second fund has clearly underperformed on a risk-adjusted basis.

In short, underperformance can be a fairly nuanced debate and we need to consider a number of factors before identifying underperformance.

Absolute returns vs. CAGR returns
Back in the late 1990s, mutual funds gave front page advertisements in newspapers announcing 120% returns in one year. If you are already scratching your head, the logic was quite simple. The AMC would take a fund that generated 10% in the last one month (not really unimaginable in a volatile market). These monthly returns would be annualized and presented as 120%. Of course, SEBI intervened and banned such ads to avoid misleading investors, but that brings us to a bigger point. What are the returns that you should actually consider? Saying that the fund generated 15% returns last year is hardly illustrative. You need to see how much returns the fund generated over a period of 5-10 years on a compounded annual basis. This CAGR returns will give a much better picture of outperformance and underperformance of a fund as it includes the compounding effect.

Fund performance vs. the benchmark
Any fund is an underperformer or outperformer based on the benchmark. Such benchmarks can be of two types. Firstly, it can be the index that is most relevant to the portfolio mix. For example, a diversified fund can be benchmarked to the Nifty or Sensex but a mid cap fund must be benchmarked on the Mid-Cap Index. When you benchmark to the index, it is essential to consider total returns index (TRI) rather than point-to-point returns as it ignores the impact of dividends and overstates fund performance. By this definition, quite often outperformers end up being underperformers when TRI is considered.

Another way to benchmark performance is with the peer group or the peer average by excluding the outliers. Here you consider funds consistently below the peer average as underperforming funds.

Underperformance on a risk-adjusted basis
It is quite common for equity and debt fund managers to take on additional risk to earn higher returns. Normally, equity funds tend to take more of concentration risk or mid cap risk to enhance returns. Debt fund managers take on higher risk by opting for longer duration or by going down the rating curve in the case of credit funds. In these cases, the underperformance must not be seen on pure returns basis but on the basis of risk-adjusted returns. Sharpe and Treynor ratios are commonly used in such cases.

Fund performance based on base effect
Normally, you use a more long term metrics like 5-year return or 10-year returns to gauge the performance of a fund. But what if the fund is less than 3 years old? In such cases, your yearly fund performance can be very vulnerable to the base effect. What does that mean? For example, if the fund in question had performed badly in the previous year, then the performance may look overstated in the current year. This needs to be adjusted for when you judge the underperformance or outperformance of a fund.
Fund performance based on consistency of returns

While CAGR returns of a fund are the best way to gauge the performance of a fund, it has some serious limitations. It does not consider the consistency of the fund performance.
Fund A Returns (%) NAV (Rs.) Fund B Returns (%) NAV (Rs.)
Opening NAV Rs100.00 Opening NAV Rs100.00
Year 1 14% Rs114.00 Year 1 6% Rs106.00
Year 2 13% Rs128.80 Year 2 -4% Rs101.80
Year 3 14% Rs146.90 Year 3 -2% Rs99.70
Year 4 15% Rs168.90 Year 4 33% Rs133.60
Year 5 14% Rs192.50 Year 5 44% Rs192.50
CAGR Returns = 14% CAGR Returns = 14%

In the above table, both the funds have the same CAGR returns over a five year period, but in terms of consistency, the (Fund B) is clearly an underperformer compared to (Fund A).

Underperformance based on asset quality
This is, in a way, related to the idea of risk adjusted returns but it is a lot more subjective and judgement based. Underperformance in this case is looked at in case of potential underperformance which includes concentrated portfolio, low grade bonds, high duration portfolio when rates are rising, sectoral or thematic predominance, etc. While this can be slightly subjective, it is an important way to close the loop on fund performance.

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