On the very same lines, the definition of underperformance of a fund is usually linked to the level of returns generated by the fund. The returns may be higher or lower compared to its benchmark or compared to other funds in the same category. If it is higher, then, we say the performance is good and vice versa. In any of these instances, the accent is on the fact that the performance as indicated by returns is falling short of expectations.
While the above is a widely accepted definition or approach, it should be borne in mind that performance does not just return alone. If you go by just returns alone, you may be probably overlooking some other important aspects of performance, the evaluation of which is equally important. Therefore, it is imperative that we may look at performance from a much broader perspective.
The major return-based parameters are point-to-point returns for performance and rolling returns for consistency in performance. The more prominent risk-based factors are risk-adjusted returns, outperformance, portfolio quality, tracking error, net selectivity, information ratio etc. There needs to be a balance of these factors while deciding to invest or while evaluating.
In short, performance is to be understood not just from the return’s perspective but also from the risk perspective as well. It is likely that a fund has given higher returns by taking extraordinarily high risks. So, there are several other factors which go into determining what is a good portfolio. The portfolio needs to be looked at for the consistency in returns to find out whether the returns it has generated is just the result of one big uptick in the market, or is it because of the consistent performance of the fund manager over a period of time. It is also possible that the fund manager has selected the stocks carefully based on the distinctive skills that he has been able to deliver the excess returns over the benchmark. This measure is called net selectivity.
In debt portfolios, it is important that one looks at the composition of the portfolio in terms of its credit quality and the duration, apart from the returns. This is because duration defines the price risk while the credit profile of the instruments in the portfolio defines the portfolio ‘s vulnerability to credit risk. It is possible to show higher returns by enhancing the duration of the portfolio by picking up longer-dated instruments for the portfolio. It is also possible to show high yield on the portfolio by picking up instruments which are of lower credit quality and they naturally will have higher yields. But they will have a higher default risk or potential for downgrades.
It may well be impossible for an individual investor to look at all these myriad parameters and decide about investments or understand performance or underperformance of the schemes. But there is a way out. There are some professional advisors and advisory firms which use sophisticated models in advisory and mutual fund scheme selection. One of the most popular models is the Enhance Efficiency Model (EnEf Model) which uses both risk-based and return base parameters in selecting potential performers. These models scan the funds for basic hygiene factors like minimum acceptable track record in the number of years, a minimum acceptable level of assets under management at the firm level as well as that the scheme level. In such models, the various parameters, which are either risk-based or return-based, are given appropriate weightage, and the schemes are ranked in a comprehensive fashion. It is this type of comprehensive ranking that helps one to identify performers and underperformers.
The long and short of it is that underperformance is not just lower returns but also several other factors which may be risk-based. There may be some good performers who have generated reasonably good returns on a relative basis but ranking lower in terms of other parameters. This is where the relevance of professional advice comes in.