Why your good fund feels bad
Think of an investor who puts a large sum of money into a good equity fund a few months before a market peak. It's a well-managed fund, and in the fall that follows, it loses 18% while the index drops 24%. On any sensible basis, the fund has done well: the market has fallen sharply, but the fund manager has lost much less.
When the market turns, this head start will matter. The fund needs to rise about 22% to get back to where it started; the index needs about 32%. But our investor sees none of the good news. On his screen, there’s a big red number next to the fund. The fact that it beat the index feels like a meaningless statistic.
Two different yardsticks
The difficulty is obvious: two different things are being compared. Judged against its benchmark, especially during a fall, any analyst would say that this fund did well. The investor’s yardstick, though, is not benchmark-relative returns but his own absolute returns. Those depend on when he invested, whether he made a lump-sum investment or used an SIP, and simply where he entered the market cycle. In my experience, his own loss drives the decision to sell, but he blames the fund to justify it. This allows the investor to ignore the responsibility he should take and shifts it to the fund manager.
When the market turns, this head start will matter. The fund needs to rise about 22% to get back to where it started; the index needs about 32%. But our investor sees none of the good news. On his screen, there’s a big red number next to the fund. The fact that it beat the index feels like a meaningless statistic.
Two different yardsticks
The difficulty is obvious: two different things are being compared. Judged against its benchmark, especially during a fall, any analyst would say that this fund did well. The investor’s yardstick, though, is not benchmark-relative returns but his own absolute returns. Those depend on when he invested, whether he made a lump-sum investment or used an SIP, and simply where he entered the market cycle. In my experience, his own loss drives the decision to sell, but he blames the fund to justify it. This allows the investor to ignore the responsibility he should take and shifts it to the fund manager.
Something similar happens when a fund that was a leader a couple of years ago becomes ordinary. Suppose a fund delivered 8% last year, but its five-year annualised returns are 18%. This kind of variation is routine in equity funds, whose track records are built on uneven years: some great, some good, some bad, and a few ugly.
An investor who has stayed invested for a few years sees one dull year among many good ones. The one who arrives after the boom feels tricked into buying a fund that used to be good but has now suddenly turned bad. It's the same fund, but the two investors' experiences are the exact opposite.
The reason all this matters, and why I’m explaining it in somewhat tedious detail, is that the psychology here can wreck the arithmetic. A red number on your portfolio tracker is just a paper loss until you talk yourself into selling, at which point it becomes real. Except for the occasional brief bonanza, the rewards of equity investing come from years of your own patience and consistency, along with the quality of the fund you choose. This is even more true of SIPs, where stop-start investing can seriously damage your returns.
When to worry
But of course, there are funds that genuinely decline. What I have said above shouldn't be taken to mean every fund should be held indefinitely, regardless of performance. The test for when to start worrying is, I admit, not that easy.
The first thing to watch is how a fund performs against peers in the same category. Look over a period of a year or more, because shorter periods are subject to all kinds of random variation. Funds that perform exceptionally well for a time can slip to the middle of the performance tables. This is natural and common. But when a fund sinks towards the bottom and stays there for more than a year, it is a different situation and warrants a closer look. Another useful test is its five- and seven-year returns, which put recent problems in a longer-term context and show whether the fund still deserves patience.
The same tests also protect you in the opposite situation: you could be invested in a fund that is going bad, but because of the timing of your investments, the number on the screen could still be green. A good investor should therefore apply these tests even to funds that are showing a profit.
Of course, this is too much hard work to do manually and could easily become a distraction. But today, you can use tools to automate the process and let it run in the background. The colour of the number on your screen tells you about your timing, not about your fund.
Dhirendra Kumar is founder and chief executive officer of Value Research, an independent investment advisory firm.