Are Your Equity Mutual Funds Failing You?

September 29, 2022 Mutual Fund

An overwhelming number of equity mutual fund schemes have underperformed their respective benchmark indices despite the fact that the equity market has more than doubled since the March 2020 lows. Mutual Fund schemes across categories such as Large Cap Fund, Flexi Cap Fund, Mid Cap Fund, etc., are lagging at a time when the mutual fund industry has witnessed substantial growth in AUM and number of folios.

These equity mutual funds trailed the benchmark index even over the long-term time frames of 5-year and 7-years. Out of the 164 equity mutual fund schemes considered for analysis over 5-years period, 63% of the schemes have underperformed their respective benchmarks. Over the 7-year period, 71% of the equity mutual fund schemes have underperformed their respective benchmarks out of the 156 considered for analysis.

Category-wise performance of equity mutual funds over 5-year period

Data as of September 23, 2022
Regular plan – Growth option considered. Past performance is not an indicator for future returns
(Source: ACE MF, PersonalFN Research) 

Category-wise, Large Cap Funds fared the worst, with 24 out of 26 (92%) schemes underperforming over the 5-year period. Around 71% of Large & Mid Cap Funds, 67% of ELSS, 62% of Flexi Cap Funds, and 57% of Mid Cap Funds also failed to beat their benchmarks.

Meanwhile, Small Cap Funds were among the best performers as 13 out of 15 schemes managed to beat their benchmarks.

Category-wise performance of equity mutual funds over 7-year period

Data as of September 23, 2022
Regular plan – Growth option considered. Past performance is not an indicator for future returns
(Source: ACE MF, PersonalFN Research) 

Over the longer time period of 7-year too, most Large Cap Funds, Large & Mid Cap Fund, Mid Cap Fund, Flexi Cap Fund, and ELSS underperformed the benchmark. Small Cap Funds had the most number of schemes outperforming the benchmark, while Value/Contra Funds also fared better.

Why are equity mutual funds underperforming?

While the equity market witnessed a stupendous rally between 2020 and 2021, the momentum slowed down towards the end of 2021 as foreign investors turned their backs on Indian markets. Since then, the equity market has witnessed sharp volatility and several bouts of intense sell-off. Though the market recovered later, it was not without pullbacks. Subsequently, mutual fund returns have suffered.

The Indian equity market has witnessed intensified volatility

Data as of September 23, 2022
(Source: ACE MF) 

In the last one year, many equity mutual funds have suffered losses in NAV in the range of 1% to 15%, which in turn has impacted their longer tenures as well.

[Read: Best Mutual Funds to Invest in Right Now]

While the large-cap index once again reached near its previous peak in recent months, only a few top names in each market capitalisation witnessed significant growth. However, since actively managed funds restrict the maximum allocation in any individual stock to avoid concentration risk, the fund’s returns were lower than the index returns.

On the other hand, while the mid-cap and small-cap index continues to outperform, some schemes in the Mid cap Fund and Small Cap Fund categories could not overpower the underperformance seen between 2018-2020.

In addition, stocks in certain sectors like Infotech and Pharma, where equity mutual funds currently hold significant exposure, have been declining sharply. Popular Infotech stocks such as Infosys, TCS, and Wipro are currently trading near their 52-week low amid fears of global recession which has led to expectations of lower growth forecast, higher attrition rate, and higher operating costs.

Pharma stocks have been declining, as well as the COVID-19 pandemic ebbed gradually. Thus, the recent sharp volatility, as well as the sell-off triggered by foreign investors, have hurt the returns of equity mutual funds across time frames.

Should you worry if your equity mutual fund is underperforming?

While the equity market has more than doubled from its March 2020 lows, mutual funds could not keep pace. Amid this, many investors have tried their hand in investing directly in equities. However, selecting stocks for direct investment is not everyone’s cup of tea as it involves timing the market. Accordingly, investing in equities through well-managed equity mutual funds is the most convenient option for most investors.

[Read: How Long-Term Investments in Best Equity Mutual Funds Help in Goal Planning]

It is important to note that numerous mutual fund schemes have efficiently limited the downside risk during bearish market phases, such as the one we witnessed in early 2020. Moreover, a market correction provides fund managers with the opportunity to pick high potential stocks available at attractive valuations, which rewards them during the recovery phases. However, mutual funds may not do well during saturated market phases or if the market rally is driven by a handful of stocks.

Equity mutual funds have managed to limit the downside risk during bearish phases

Bear phase of January 2020 to March 2020 considered for analysis
Regular plan – Growth option considered. Past performance is not an indicator for future returns
(Source: ACE MF, PersonalFN Research) 

Equity as an asset class outpaces other asset classes such as debt, gold, real estate, etc. over a longer time period. But remember that no mutual fund scheme/category/investment style can remain a top performer every year through all market phases. Thus, investors should focus on creating a well-diversified portfolio of equity mutual funds with a long-term view.

Opt for the SIP route of investing to mitigate the impact of volatility and benefit from the compounding of wealth over the long run. Furthermore, you can opt for the Direct plans of equity mutual fundsto earn about a percentage point higher return than the Regular plans of the scheme.

SIP investments can generate higher returns than lump sum over the long term

Data as of September 23, 2022
Returns based on the average of diversified equity mutual funds
Regular plan – Growth option considered. Past performance is not an indicator for future returns
(Source: ACE MF, PersonalFN Research) 

Final thoughts….

Underperformance shouldn’t be always seen with pessimism, particularly if the mutual scheme follows a well-thought investment strategy and comes from a fund house that follows robust investment processes and systems.

Do note that when a handful of stocks drive the market, a well-diversified fund will likely underperform, but the strategy will reward you reasonably well over complete market cycles.

It is a sensible strategy to stay put if the fund’s portfolio is well-constructed and diversified and can potentially make up for the underperformance in the long run. Avoid investing in a concentrated portfolio in a bid to earn higher returns, as it can expose your investment to high risk. Consider switching to another scheme only if your investment has consistently underperformed its peers and benchmark on various parameters such as historical returns, performance across market phases, and risk ratios such as Sharpe, Sortino, etc.

Watch this video to find out the SMART method to pick the best mutual funds for your portfolio.

This article first appeared on PersonalFN here