What factors drive your equity portfolio performance?

Worried about a poorly performing equity mutual fund in the portfolio?

Before you answer the above question, I have a basic question.

How do you decide that a fund has underperformed?

Do you judge based on returns you have earned in the fund (your returns experience)? OR

Do you measure based on 3-year, 5-year, 10-year returns or rolling returns?

Do you compare with other equity funds in the portfolio? OR

Do you compare performance against the respective benchmark?

Do you use just focus on returns or do you use a risk-adjusted measure? Do you focus on XIRR or absolute returns?

In this post, let’s start with multiple aspects that drive the performance of your portfolio. Subsequently, we shall see how to identify a poorly performing fund and what to do about it.

And what if I were to tell you that there is a category of funds that will never underperform the benchmark by a big margin?

What drives portfolio performance?

The portfolio performance (good or bad) is primarily a function of the following aspects.

1. Asset Allocation
2. Market Trajectory
3. Investment Trajectory
4. Market timing
5. Choice of funds/investment strategy

Let’s look at all these aspects in detail.

#1 Asset allocation

What percentage of your portfolio was in stocks when the markets did well or badly?

In my opinion, this is the biggest contributor to returns. Yet, it does not get the requisite attention. We are just keen to find the next best performing stock or mutual fund.

Then, what is the best or the most optimal asset allocation? Well, no fixed answers here. Depends on you, your risk profile, and financial goals.

Personally, I prefer to make this rule-based and not tinker too much based on the market outlook.

Why rule based?

Because we get affected by what’s happening around us.

Investors tend to prefer riskier allocation (higher equity allocation) when the times are good. In fact, during good times, they start to believe that equities are not risky at all. You just have to hold these for the long-term and everything will be fine. However, for most investors, a long-term investment is a series of short-term investments. When the times are bad, many investors turn conservative and want less risk in the portfolio.

With such an approach to investments, you are only setting yourself up for disappointment.

Nothing wrong in desiring high returns but you must appreciate high returns come with higher risk. It is a double-edged sword.

My own experience interacting with investors: During good times, they feel I am too conservative. During bad times, they feel I am too aggressive.

A rule-based approach helps keep emotions and biases under check.

Spending some time on market history will reveal that nothing lasts forever. Not good times. Not bad times. Hence, choosing an asset allocation that you can stick with is critical.

You control Asset Allocation.

#2 Market trajectory

When the equity markets do well, most funds do well. When markets struggle, most funds struggle.

1. You may have picked a good fund but at a wrong time or during (or just before) a bad market phase. Your returns experience in the fund may not be good, at least in the short term.
2. You may have picked a poor fund but at a good time or during (or just before) a good phase. The performance will appear good.
3. In your portfolio, Fund A may have done better than Fund B because Fund A has gone through a very good market phase, but Fund B has not. Hence, we need to look at these aspects too.
4. You cannot say that Fund A is better than Fund B simply because Fund A has given XIRR of 11% while Fund B has delivered XIRR of 7%. What if you invested in these funds on different dates or during different periods?
5. Your returns experience in a particular fund is also a function of when you started investing in that fund, when your investments went in (SIP), and when you are checking the performance.

You do not control market trajectory.

The following shows 1-year, 3-year, and 5-year rolling returns for Nifty 50 Price Index since January 1, 2013. I have considered monthly data. The investment vehicle is the same. Your returns experience depends on when you invest.

#3 Investment trajectory

How much were you investing when the markets were struggling?

How much were you investing when the markets were booming?

The market trajectory is the same for everyone but our reaction to different market conditions varies.

With the benefit of hindsight, if you look at the past data, we can say that bad stock market phases have been a great time to invest. While there is no guarantee that the past will repeat, it does tell us something about the nature of markets.

The question is: What do you do when the markets are struggling? Do you sell or stop SIPs? OR do you stick with discipline, continue SIPs, or even invest aggressively if your cashflows permit. Your response to different market conditions will affect your returns.

1. Investors are more comfortable investing aggressively when the markets are booming. Not so much when the markets are struggling. Ideally, it should be the reverse.
2. And this also presents an interesting problem. Let’s say the markets are struggling and the funds are not performing well. An obvious reaction is to stop/reduce investments. However, by doing that, we are letting go of an opportunity to accumulate ownership at lower levels. This can be counter-productive over the long term.
3. If you continue to invest through a bad market phase and the markets recover subsequently, you will see good returns since you bought units at lower NAVs and averaged your purchase price down. Contrast this with a scenario where you stop investments during a bad market phase. Your purchase price will remain high.
4. I understand there is luck involved. You don’t know upfront how long this testing market phase will last. But this is about investment discipline too.

You control investment trajectory, at least to some extent. Sometimes, investment trajectory is just a function of your investible surplus.

#4 Market timing/ tactical calls

We can work around (2) and (3) with market timing. But not many can make this work. For most investors, a rule-based approach will work better over the long term compared to a gut-based approach.

#5 Choice of funds/investment strategy

1. There is where most of us spend the most amount of time. However, in my opinion, this is also the least rewarding step.
2. For most investors, this usually does not translate to better returns.
3. Everyone wants to pick funds that will beat the market/benchmark by a wide margin. How many of us can do that? More importantly, how many of us can do that CONSISTENTLY? Don’t know about you but I can’t.
4. When you try to beat the market, there is a chance that you may underperform the market. You get some calls right while you get others wrong.
5. Plus, even right or wrong is not an objective assessment. What looks bad today may look very good after a few months or years.
6. Fund schemes, fund managers, and investments strategies keep coming in and going out of favour.
7. This is where cap-based index funds score over active funds or even factor-based products. You don’t have to worry about the choice of funds. There is no confusion and that translates to better investment discipline. You focus more on asset allocation and the investment trajectory.

Fund Performance and Your returns experience

Returns experience implies what the fund has done for you. And the timing of your investments can affect the returns experience for you.

Fund performance is the performance of an MF scheme that you see on ValueResearch and Morningstar.

The fund scheme may have compounded at 20% p.a. over the past 5 years. But in your portfolio, it is showing negative returns. Good fund performance but poor returns experience.

Your returns experience can be unsatisfactory even in a well-performing fund.

And your returns experience can be great in a poor performing fund.

Therefore, you must not exit a mutual fund simply because your returns experience has been bad.

As we have seen above, your good/bad returns experience could also be a function of the market trajectory/investment trajectory/market timing. And if that’s the case, the blame/credit of bad/good performance does not rest with the fund/fund manager or even the choice of fund. It is just luck.

You exit a fund when the fund performance is not satisfactory.

We still have two questions to answer.

1. How do you decide if the fund performance is satisfactory or not?
2. What do you do with a fund whose performance is not satisfactory? When do you exit an underperformer?

How do you decide if the fund performance is not satisfactory?

You can’t term a fund scheme bad simply because you have not earned good returns. The poor performance could be due to market or investment trajectory or due to the timing of your investment. You can’t blame the fund in such cases.

Similarly, you can’t term a fund scheme good simply because you have earned good returns.

How do we then assess the performance of a fund?

Simple. Compare with the benchmark.

For actively managed funds, we compare the performance of the fund with the right benchmark.

For instance, a large cap fund with Nifty 50 or Nifty 100.

A midcap fund with Nifty Midcap 150 index.

And do not compare very short-term performance. Focus on at least past 3-to-5-year performance.

If the fund has outperformed (or has given returns closer to benchmark), we don’t have to do anything. If the underperformance seems stark, that’s where we need to dig deeper and take a call.

And we don’t just look at Point-to-Point returns. This can be misleading.

You must either consider rolling returns. Or compare the performance of the fund against the investment in the benchmark index on the same dates.

And yes, it is unfair on my part to just focus on the returns. You may value lower volatility, lower drawdowns, and better risk adjusted returns. Adjust your analysis accordingly.

XIRR or absolute returns

Clearly XIRR.

However, XIRR/IRR calculations can throw up crazy numbers if the investments are not old.

Therefore, for investments where the holding period is short, do NOT get blown away by the XIRR.

Once the holding period touches 3-5 years, XIRR becomes a more reliable indicator of performance.

And while XIRR is a good measure of your portfolio return performance, you can’t eat XIRR. Eventually, you need absolute returns. And when it comes to absolute returns, the size of your investment matters too.

You see meaningful returns in the portfolio only once your investments have been through a good market phase. Therefore, to make your risk of equity worthwhile, your portfolio must go through a good market phase with a decent amount of money invested.

Consider giving a longer rope

No active fund or investment strategy will beat its benchmark all the time.

So, even good funds/investment strategies can underperform for a period.

Similarly, even bad funds/investment strategies can outperform for a period.

Hence, while dealing with an underperforming fund, you need to give the fund a longer rope. You can’t keep churning portfolio every few months.

However, we can’t offer an infinitely long rope either.

How long? That’s difficult to answer, especially with active funds.

If an actively managed fund is underperforming, how do we know whether the underperformance is transitory or is likely to persist for a much longer period? There is no objective answer to this question.

Coming back, how long?

No fixed answer. I tend to wait for 12-24 months before doing anything.

Once we establish underperformance, we need to take a call.

1. STOP incremental investments and EXIT existing exposure OR
2. STOP incremental investments but RETAIN existing exposure. OR
3. CONTINUE incremental investments and RETAIN existing exposure (we can do this if the underperformance is only over a short term. And we have conviction in the fund/strategy).

Again, no right or wrong answers here. Use your judgement.

As an investor, I would struggle to route more money to a fund/strategy that I am uncomfortable with. Here, the reason for discomfort is underperformance. Usually, I stop incremental investments in an underperforming fund and observe the performance for a bit longer. If the performance does not improve, I might exit completely. A problem with this approach is that it can increase the number of funds in the portfolio, at least temporarily. Here is how to reduce the number of funds in your portfolio.

Note: If it is an index fund (cap based such as Nifty 50, Nifty next 50, or Nifty Midcap 150), there is no question of underperformance or outperformance. The good or bad performance is because of the market trajectory or investment trajectory or market timing.

Ditto with factor-based indices (momentum, quality, value, low volatility etc.) The only difference (compared to cap-based indices) is whether you retain conviction in the strategy. As long as you have the conviction, you continue or else you exit.

It is not a race

Let’s say you have been investing in equity funds for the past 15 years.

The large cap fund in your portfolio has delivered you an XIRR of 13% p.a.

Nifty 50 has delivered an XIRR of say, 15% p.a. (Assuming investment on same date for Apples-to-apples comparison).

Bank FD returns have averaged say 7% p.a. during this period.

While your fund has clearly underperformed its benchmark, it has still delivered better returns than a bank FD.

Would you be happy or sad?

Sad, isn’t it? After all, this post is all about finding underperformers and eliminating them from your portfolio.

But should you approach your portfolio this way?

If your fund (average performer) has delivered enough to achieve your financial goals, you should be fine. How does it matter if it underperformed its benchmark or if your colleague or neighbour did better? There is a positive side to this approach too. You don’t stress over the choice of funds. Less stress leads to better investment discipline. Again, that’s where cap-based index funds can make your life simpler. With index funds, you don’t have to worry about underperformance.

Then, why am I writing this post? Well, everybody is wired differently. I tend to complicate things. And you can’t ignore that I advise investors for a living.

You have no such compulsion. You don’t have to be the best to be happy and content.

How do you deal with underperformers in your portfolio? Let me know in the comments section.

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This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.