Why you should not exit funds based on a year's underperformance

Large-cap funds have underperformed their benchmarks by a wide margin over the past year. Even funds in the large- and mid-cap category and the multi-cap category (most funds in these categories currently have high exposure to large-cap stocks) are also underperforming their benchmarks by wide margins (see table). Experts say that investors should avoid reacting hastily to what is essentially a short-term spell of underperformance, and should be guided by the long-term performance of their funds.   

A key reason for the current bout of underperformance is the nature of the rally. "The current rally in the Nifty 50 has been driven by barely five or six stocks. The rest of the stocks in the index have either not performed or have detracted from returns. Such a narrow rally makes it challenging for funds to outperform," says Radhika Gupta, chief executive officer, Edelweiss Mutual Fund. She adds that funds that held these five-six stocks have outperformed while those that didn't have lagged behind.

Some experts attribute the current underperformance to style drift. "Midcap stocks had delivered outstanding returns in 2017 and drove the outperformance of the mid-cap category over others. Large-cap and multi-cap funds had added significantly to their mid-cap exposure over the past year in a bid to catch up with the returns delivered by mid-cap funds. As mid-cap stocks have performed poorly in 2018, this strategy has backfired on most large-cap managers," says Kunal Bajaj, founder and CEO, Clearfunds.com, a Sebi-registered online investment advisor.

Experts say that even in future the large-cap category may find it difficult to outperform.  After recategorisation, 80 per cent of a large-cap fund's portfolio has to be invested in the top 100 stocks, a stipulation that limits the potential for alpha generation. Even structurally, alpha within the large-cap category has been coming down. "A few years earlier, the average alpha generation by the large-cap category used to be in the range of 7-8 percentage points and now it has come down to 2-3 percentage points. Now if the current alpha is around 3 percentage points and funds charge an expense ratio of 2 per cent, then net of cost there is not much alpha left," says Gupta.

Investors should not react to a fund's one-year outperformance. "When evaluating an equity fund's performance, you should consider at least a five-year plus kind of horizon," says Ankur Kapur, founder, Ankur Kapur Financial Advisory Services. He adds that fund managers who look to outperform over the a shorter horizon tend to have a trading kind of mentality and their probability of outperforming over the long term is lower. 

Investors should also check whether their fund has been reclassified. "If a fund has been reclassified, then to compare its past performance with its peers in a new category is meaningless," says Kapur. He also warns against the temptation of switching to funds that have outperformed in the current rally. "The risk in switching to such funds is that they may be outperforming currently by taking higher risk," adds Kapur.

Gupta suggests that investors who want the safety of large-cap funds should opt for one whose expense ratio is moderate. Beginners, she says, who want a category that combines the safety of large caps with the alpha generation potential of mid-caps, should consider the large- and mid-cap category, where the fund manager enjoys greater flexibility. Financial planners suggest that within the large-cap category, investors may also consider low-cost index or exchange traded funds (ETFs).