July 20, 2014

The Illusion of Underperformance

A few days ago, a friend came to me with a question.  He had invested in a couple of funds in August, last year.  According to his calculations, one of these had so far delivered absolute returns of around 88%  whereas the other had delivered absolute returns of around 42%.  As is often the case with people who observe or experience such a difference, he had praise for the manager of the first fund and had doubts about the competence of the manager of the second fund.  His question: should he exit the underperforming fund?

During phases of rising stock prices (or ‘bull runs’), it is often seen that some equity funds deliver astronomical short-term returns.  We also get to see huge differences between the returns of funds.  What is not so well understood is that what appears to be underperformance may not actually be so.  Secondly, a number of investors miss seeing the bigger picture of fund performance (or underperformance).  In this post, I propose to expand on these thoughts.

Is it really underperformance?

I have previously shared my thoughts on this, although in fragments, across multiple posts.  In this post, I’ll gather these together.

Most experts agree that actual returns represent one aspect of performance, and that the risk attached to these returns also needs to be considered.  Thus, analyzing risk-adjusted returns is considered a better way of assessing the competence of a fund manager.  Even so, there is likely an element of luck that is far more difficult to understand and assess.

If we are still seized with an urge to compare, the least we could do is to be sure we are comparing funds which are comparable (i.e. they have similar investment objectives).  Consider, for instance, a fund that has the objective of investing in some stocks or sectors where prices have happened to rise much more sharply than others.  Comparing its performance with a fund which, say, cannot invest in the same stocks or sectors, is a pointless exercise.

One way to check if there is a case for a meaningful comparison, is to see how online research agencies such as Value Research or Morningstar categorize these funds.  Any fund is best compared with other funds in the same category, rather than with funds in other categories.

If it is underperformance…

In the stock market, we can be certain that every bull run will inevitably be followed by a phase of falling prices (or ‘bear run’) and vice versa.  What we cannot be certain about is as to when one phase will end and the other begin.  Thus, unless we choose to exit an underperforming investment in a bull run (for the purpose of a financial obligation, or lack of faith in a fund manager), we will get to see a bear run.  If so, then the odds favour a fund with a below-average performance in a bull run to have an above-average performance in a bear run. 

Recently, I did a study on the relative performance of diversified domestic equity funds from 2007 till date.  I divided this period into five smaller periods that represented either a phase of rising prices or a phase of falling prices.  These were:

  • 5 March, 2007 to 8 January, 2008 (Rising)
  • 8 January, 2008 to 9 March, 2009 (Falling)
  • 9 March, 2009 to 5 November, 2010 (Rising)
  • 5 November, 2010 to 20 December, 2011(Falling)
  • 20 December, 2011 to date (30 June, 2014) (Rising)

I looked at open-end equity funds that were a part of the following categories of Value Research:

  • Equity – Large-Cap
  • Equity – Large and Mid-Cap
  • Equity – Small and Mid-Cap
  • Equity – Multi-Cap
  • Equity – Tax Planning

There were, in all, 157 funds across these categories, which had been around since 5 March, 2007. Based on their returns in each phase, these were grouped into quartiles.  Here are some observations that can be linked to this post:

In the 2008-09 phase of falling prices, only 5 of the 39 funds in the top quartile were those that had been in the top quartile in the preceding bull run of 2007-08.  25 of the 39 funds had been ranked in the bottom half of that bull run.

In the 2010-11 bear phase, 9 of the 39 funds in the top quartile were those that had been in the top quartile in the preceding bull run of 2009-10.  20 of the 39 funds had been ranked in the bottom half of that bull run.

There was evidence supporting the reverse as well i.e. the lists of funds in the top quartile in the periods 2009-10 and 2011-date were overwhelmingly dominated by funds that been ranked in the bottom half in the bear runs that preceded each of these periods.

In case you’d like to analyze this data on your own, email me and I’ll send you an Excel file.

To keep the record straight, while there were no funds that remained in the top quartile across all five phases, there were 3 funds that remained in the top half all throughout.  With due respect to the skills of  the fund managers, I believe luck had a role to play in that.  Given the contentious nature of luck and the difficulty to quantify it, it is up to each one of us to draw our own inferences. 

I want to close this post with one last bit of food for thought.

In phases of falling stock prices, fund returns never appear to be earth-shattering, so to speak.  Additionally, the differences between returns of funds do not appear to be much.  This is essentially an illusion.  For illustration, let me share the absolute returns on two funds during the 2007-08 and 2008-09 phases.




Fund A



Fund B



It might be easy to believe that over the complete cycle, an investor in Fund A was better off than an investor in Fund B.  Fact is, an investor in Fund A would have ended up losing around 15% of his wealth whereas an investor in Fund B would have lost about 10% of his wealth.

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