Active fund underperformance: Fund managers say focus on process, not short-term returns

As per the latest business developments, Active equity funds can go through periods of underperformance as market cycles favour different investment styles, but market participants should focus on whether a fund manager stays consistent with the stated investment process and whether the extent and circumstances of underperformance are in line with that process, fund managers stated speaking during a panel at Moneycontrol's Mutual Fund Summit.

Chandraprakash Padiyar, Senior Fund Manager at Tata Asset Management, stated active-fund performance needs to be viewed in the context of the earnings cycle and valuations.

He pointed to the 2020-2024 period, when earnings grew at more than 20% annually across micro, small, mid and large firms, while starting valuations were attractive. As businesses continued to surprise positively, broad-based market momentum benefited passive strategies.

Padiyar stated his active fund typically holds 35-40 stocks, compared with around 250 stocks in its benchmark. When a large number of benchmark constituents are performing well at the same time, the concentration of an active portfolio can make it harder to keep pace. “In that environment, passive tends to do extremely well,” Padiyar stated.

Rajat Chandak, Senior Fund Manager – MF Equity at ICICI Prudential AMC, stated market participants need to distinguish between a temporary challenge and a structural problem by understanding the investment style of the fund manager. “A lot of us in the fund management industry have a bend towards a particular style. And each style goes through its own cycles of performance or bad performance,” Chandak stated.

He stated market participants should understand the fund manager’s thought process before investing and assess whether they are comfortable with the approach being followed. “If you are okay with the fund manager's thought process, and if you have bought into his style, then you would rather stick to it,” he stated.

According to Chandak, styles such as value, quality and expansion can each go through periods of stronger and weaker performance. What matters is whether the fund manager stays true to the investment style through those cycles.

“Temporary underperformance is a given for any active fund manager, depending on the cycle,” Chandak stated.

Rishi Kohli, CIO at JioBlackRock Mutual Fund, further noted that market participants in systematic-active strategies can examine the behaviour of the model during periods of underperformance and compare it with how it performed during similar conditions in the past. Kohli stated JioBlackRock’s active strategies are designed to keep active risk, or tracking error, softer than that of other active funds while seeking consistency in the top quartile or upper end of the second quartile.

For systematic strategies, he stated the timing and nature of underperformance can provide useful information. If a model gives back some of its upside during a volatile period, market participants can assess whether the extent of underperformance was within the range anticipated from the model and whether it behaved similarly during comparable periods in the past.

“If you get yes answers to some of these things, then you know that everything is on track,” Kohli stated.

He further noted that the same test should apply to outperformance. If a strategy is delivering firm returns but the fund manager cannot explain why, that too can be a reason to examine the process more closely. “So on both the sides, being systematic active, I think, becomes a little easier for us to actually do the analysis and get the comfort ourselves first before going and telling market participants,” Kohli stated.