Understanding Risk and Returns from Mutual Funds

While looking at a mutual fund scheme's performance, one must not be led by the scheme's return in isolation. A scheme may have generated 10% annualised return in the last couple of years. But then, even the market indices would have gone up in similar way during the same period. Under-performance in a falling market, i.e. when the NAV of the scheme falls more than its benchmark (or the market), is the time when you must review your investment.
One must compare the scheme's return as against its benchmark return. It is better to be rid of investment in a scheme that consistently under-performs as compared to its benchmark over a period of time, from one's portfolio. It is important to identify under-performers over the longer time horizon (as also out-performers).
In addition, one may also consider evaluating the 'category average returns' as well. Even if a scheme has outperformed its benchmark by a decent margin, there could be better performers in the peer group. The category average returns will reveal how good (or bad) is one’s investment is against its peers which help in deciding whether it is time shift the investment to better performers.
One may be holding a too little or too much-diversified portfolio. Even the expense ratio of some of the schemes that one could be holding may be high compared to others within the same category.
Most importantly, the review helps an investor validate if the investments are aligned to his/her goals.
One should avoid the temptation to review the fund's performance each time the market falls or jumps up significantly. For an actively-managed equity scheme, one must have patience and allow reasonable time - between 18 and 24 months - for the fund to generate returns in the portfolio.
The review may become more pronounced in case of thematic or sectoral schemes as they are more prone to the changing economic environment.
It is advisable for common investors to make a separate watch list of funds that are found to be underperforming their benchmark or their comparable peers. From this list, one should look for improvement in performance over the subsequent 2-3 quarters. A consistent under-performance over 3-4 quarters may warrant shifting the investment to other better options. One needs to even check the reason for the under-performance, which may be expressed in the fund manager's commentary. The underlying stocks in the portfolio of an MF scheme keep changing and along with it change the associated risks. An important factor is the risk metrics. If the risk profile of the fund has skewed further towards "High" risk while the returns remain the same or do down, it may be advisable to exit the fund.
Therefore, a review of the fund's risk-adjusted return, i.e., a measure to find how much return an investment will generate given the level of risk associated with it, could be more helpful.
As an investor, high return at low risk is always preferable. Hence, MF schemes with high risk-adjusted returns are most sought-after. Risk-adjusted returns are well captured by several rating agencies.
The winners of today may not continue with the winning streak year after year. In other words, reviewing the performance as mentioned above may not always be fruitful. Moreover, tracking and reviewing of a scheme's portfolio is quite different from reviewing one's own portfolio. A mutual fund investor should not worry themselves about the portfolio of a fund. That's the fund manager's job.
Be mindful not to disrupt your overall portfolio allocation, while redeeming units from equity mutual fund schemes, as the redemption proceeds would have to be re-deployed in another equity scheme which will require undergoing the entire process of choosing the right scheme to invest in. Try to maintain the original levels of exposure to equities, unless your allocation needs a change.
Frequent review and tracking of mutual fund returns may tempt you into taking unwarranted impulsive decisions. Do not let an fall in NAVs tempt you to discontinue SIPs or redeeming units from a fund. When there are market falls steeply, try to invest lump-sum amount. An annual review comparing the fund with the benchmark as well as with the category peers will certainly help and advisable.