The Art of Reviewing Mutual Funds Like a Pro!

Managing your mutual fund portfolio is like tending a garden—you need to regularly nurture and prune it to ensure it thrives. There is no correct way to do this but we’ll discuss a framework for our readers. Each individual shall develop their own style to review portfolio in tandem with their own personal goals for investing.

Disclaimer: This post is about review of existing mutual fund portfolios, “not investment portfolio”. We will discuss about investment portfolio in another blog. We will not discuss about how to create a mutual fund portfolio in this post. We are not financial advisors and content of this post should not be construed as financial advice. Readers are expected to use discretion and consult their advisors before making any financial decisions.

Now back to the blog...

Just like how regular health check-ups are essential for your well-being, reviewing your mutual fund portfolio is crucial to ensure it aligns with your financial goals and risk tolerance. Regular reviews help you identify underperforming funds, rebalance your portfolio, and ensure it remains in line with your financial goals.

Should you review your Mutual Fund Portfolio?

Yes, a mutual fund portfolio should be reviewed periodically. An active mutual fund should be monitored at least once a year, however, allow at least 5 years for it to 'perform'. (Why 5 years, and not 3 years? It is a personal choice; it can be 3 for you. What we want to convey is that active funds may go through a period of under performance and should be given time to perform.)

If a fund has not outperformed its benchmark, it's important to investigate the reasons before considering a change -

a) If a fund hasn't beaten its benchmark during a period when the benchmark rose, it may be time to consider replacing it.

b) Similarly, if a fund is underperforming while the benchmark is rising, it might be wise to replace it, even after just 1-2 years.

c) If a fund has not outperformed but has stayed close to its benchmark, compare its performance to similar funds to determine if a change is warranted.

I have just started investing in mutual fund, not completed 5 years. What should I do?

Investors, who are new to investing, should monitor their mutual fund portfolio and continue investing without making any drastic changes to the active portfolio. Give your portfolio time to perform and focus on developing the habit of investing. We do not want to chase top performers every year and clutter portfolio. Review portfolio with the benchmark and look for reasons for underperformance, if any.

Mutual Fund Review Process:

There are two main types of reviews you can conduct - performance review and asset allocation review (We will discuss asset allocation review in next post).

Why we review?

There are multiple reasons for reviewing such as - portfolio is cluttered with 20 different schemes, annual review, rebalancing, etc.

How we review?

Before we start with reviewing process, there are some assumptions to be considered –

a) We are reviewing equity mutual fund portfolio. Debt portfolio is not as volatile as equity and does not need frequent review.

b) Asset allocation (debt, equity, gold, etc.) is not considered for this review. We are only considering changes in mutual fund schemes.

c) As discussed earlier, changes are only made when portfolio is 5 years old. Before 5 years, we only monitor and focus on habit building.

To start the review process, we should first set clear expectation about returns from our equity portfolio. Return expectation could be different for every individual investor. It should be reasonable and linked to scheme category and volatility.

Now, next step is to calculate net portfolio return using XIRR. (XIRR is return calculated based on date of your investment till the date of review. It will be different for all, unless you invest on exactly same dates.)

Example -

This is how your individual scheme XIRR and net XIRR table look like –

This portfolio is large cap heavy. ELSS fund with 4% allocation has generated 10.91% XIRR. This scheme can be switched to Large and Mid Cap Scheme with 5% allocation. Another Large Cap Scheme with 1% allocation has generated 13.14% can also be switched to aforementioned Large and Mid Cap Scheme.

Trimming can be done for Contra Fund and Large and Mid Cap Fund with 2% allocation. If there is portfolio overlap with other schemes in the portfolio. These schemes have very low allocation to overall portfolio and adding to the clutter.

Further trimming is possible, but there is no need to make unnecessary changes. Most portfolios would be far from perfect. They can be gradually modified. The choice here will not so straightforward. If you want to trim down the portfolio further, a deeper study will be required. For instance, comparing the portfolios of individual schemes to check overlap. If there is a significant overlap, then the scheme can be removed.

Green bar in the middle is net portfolio return. Funds to the left of the bar are underperforming the average portfolio. This is normal in a diversified portfolio of mutual funds where some funds will underperform the net portfolio.

Everyone likes a large XIRR. So a second approach is to try (and hope) to keep the net XIRR well above the return expectation and make gradual changes to increase the distance between the two benchmarks (expectation and net XIRR) as much as possible.

That is, one could try and move the green bar to the right by increasing weights of the funds with highest returns. However, this has to be done without affecting diversification. One cannot accomplish this with knee-jerk changes. The idea is to do it with a method (considering tax effect, exit loads, etc.) and to do it gradually.

What to Do After Review?

After reviewing your mutual fund portfolio, take action:

Consolidate or Eliminate Underperforming Funds: If you find any funds consistently underperforming or not meeting your expectations, consider consolidating them into better-performing funds or eliminating them altogether.

Consider Tax Implications: Before making any changes to your portfolio, consider the tax implications of your actions, especially regarding capital gains taxes.

Conclusion:

It is best to not get emotionally attached to a fund, but be objective. Change can take a few months to happen. After all, exit loads and taxation are also important. Changes can hurt. The fund we exited can go on to do quite well and the new fund may fall to new depths.

What has been proposed above is only one of the possibilities. The idea of this post to highlight the importance of personal benchmarks (expected returns) and reviewing portfolio in context with this benchmark. There are many solutions to this problem. (Personally, I prefer benchmarking XIRR of each fund with the folios net XIRR. Feel free to critique and propose alternative strategies.)

If the portfolio was minimalist to begin with, nothing need be done as long as the net XIRR is close to or above our expectation from equity for a particular goal. Regularly reviewing your mutual fund portfolio is key to ensuring it remains aligned with your financial goals and risk tolerance. By following the steps outlined in this post, you can learn to review your portfolio and take control of your finances.