Has Your ELSS Fund Underperformed the Benchmark? Here's What You Should Do...

Most ELSS funds follow a multi-cap approach with a large cap bias. The heightened volatility in the last couple of years has negatively impacted various stocks across sectors and market capitalisation and thus impacted the performance of mutual funds in different categories.

Over the last few years, mid and small cap stocks have witnessed significant consolidation. The prolonged slowdown in the economy impacted these stocks badly. To add to it liquidity crisis in the NBFC sector made it difficult for smaller-sized companies to raise capital. Moreover, SEBI's categorization norms for mutual funds led to offloading of many mid and small cap stocks.

On the other hand, though the large cap index soared to new highs the returns did not reflect on the performance of large cap-oriented funds. The surge in large cap index is being driven by a handful of stocks which have higher weightage in the index. But since large-cap oriented mutual funds invest in a diversified portfolio of stocks to avoid concentration risk the performance has differed significantly from that of the benchmark.

Mutual funds aim to outperform the benchmark through active management of the portfolio by way of right stock/sector selection and allocating its correct weightage in the portfolio. Therefore, the performance of mutual funds may differ significantly from its benchmark.

The pandemic-induced volatility worsened the situation for many stocks. As a result, a significant number of funds across categories have not been able to outperform the respective benchmark index in the last 1-year to 5-year period.

The heightened volatility is expected to continue in the near term due to the following factors:

• US Presidential election and economic stimulus package

• Fresh lockdown to curb virus outbreak in many countries

• Indo-China border tensions

• The rising risk of bank NPAs

• Growth in the unemployment rate and erosion in income

Despite volatile conditions, some ELSS funds successfully managed to outperform the benchmark and many category peers across most time periods by curbing the downside risk during depressing market conditions and participating well in recovery and bull phases.

As can be seen from the table above, there is a wide gap between the top performing fund and worst performing fund across time periods. ELSS as a category has showcased impressive record over the long term, generating alpha over the benchmark indices.

But if you decide on a not-so-worthy fund, you will have to bear the cost of underperformance for the entire 3-year lock-in period. This highlights the need to select worthy schemes for your portfolio that have the potential to generate high returns.

However, ensure that the fund does not take excessive risk to generate high returns. Invest in schemes that take timely stock, sector and market cap bets to performing consistently well during various market phases and cycles.

The scheme should focus on growth with an eye on valuation and quality to generated superior risk-adjusted returns rather than placing momentum bets. Even if such funds underperform in the short term they have the ability to reward investors with handsome gains over the long term.

Investors can ignore short-term underperformance due to market function, but if the scheme has been consistently underperforming the benchmark and its category peers over various time-periods, then you certainly need to track it closely and look for better alternative if required.

How to select worthy ELSS?

Before you select any fund for investment always define your financial goals; assess your risk profile; and then move on to pick suitable funds as per your needs.

To select the best mutual funds, you need to evaluate each one on both quantitative and qualitative parameters as follows:

1. Determine the consistency of a fund's performance by comparing it to the relative performance of the benchmark index and category peers across different market phases and cycles.

2. Assess if the fund has been able to reward investors well for the risks they undertake by comparing risk-reward parameters like Standard deviation, Sharpe Ratio, Sortino Ratio, etc.

3. Check the track record of the fund manager and the efficiency of the fund house in terms of risk management, investment processes and systems.

4. Consider portfolio characteristics such as stock/sector/market cap allocation, concentration of assets, and portfolio turnover ratio, so that you pick schemes that are in congruence to your risk profile.

Yes, we know that the above list is a lot for an average investor to look at. It involves a lot of number crunching and much of the data is not easily available in one place. But if you do need to narrow down on the top funds, these factors are of utmost importance.

So if you wish to select worthy equity mutual fund schemes, I recommend that you subscribe to PersonalFN's unbiased premium research service, FundSelect. As a bonus, you also get access to PersonalFN's popular debt mutual fund service, DebtSelect.

At PersonalFN, we arrive at top-rated funds using our SMART Score fund selection matrix to select mutual funds based on these five variables test, viz.

• Systems and Process

• Market cycle performance

• Asset management style

• Risk-reward ratios and

• Performance Track Record

Each fund recommended by PersonalFN goes through our stringent process involving both quantitative and qualitative parameters before providing you with Buy, Hold and Sell recommendations on equity and debt mutual fund schemes.

If you are serious about investing in rewarding mutual fund schemes, Subscribe now!

Warm Regards,
Divya Grover
Research Analyst

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