How to Handle Underperforming Funds in Your Portfolio

You diligently researched your investment options, set up your monthly Systematic Investment Plan (SIP), and committed to long-term wealth creation. But lately, when you check your portfolio, one specific fund is flashing red or severely lagging behind the rest of your investments.

Seeing a part of your portfolio drag down your overall returns is frustrating. It triggers an immediate urge to take action—to sell the laggard and move your money to yesterday's top performer. However, learning how to handle underperforming mutual funds requires removing emotion from the equation and replacing it with analytical discipline.

Every great mutual fund will inevitably go through periods of underperformance. The key to successful wealth creation is distinguishing between a temporary market cycle and a fundamentally broken investment strategy. In this comprehensive guide, we will walk you through exactly how to handle underperforming mutual funds, diagnose root causes like a style drift mutual fund or an AUM bloat mutual fund, and outline the precise framework for when to exit a mutual fund.

Step 1: Don't Panic-Sell

The absolute worst time to make a financial decision is when you are stressed. When a fund's Net Asset Value (NAV) drops, the human brain registers it as a physical threat, often triggering panic selling.

Before you hit the "redeem" button, you must pause. Selling a fund during a temporary downturn locks in your losses permanently and disrupts the mathematical magic of compounding. To understand the behavioral biases that trick us into making poor financial choices during drawdowns, read our deep dive on the psychology of investing and staying calm during market volatility.

Before analyzing the fund, ensure you understand the metrics you are looking at. If you are confused by terms like Assets Under Management (AUM), XIRR, or CAGR, take a quick look at our mutual fund jargon buster to equip yourself with the right analytical vocabulary.

Diagnosing the Root Cause: Mutual Fund Underperformance vs Benchmark

To figure out how to handle underperforming mutual funds, you must first diagnose why the fund is lagging. The true measure of a fund is not its absolute return, but its mutual fund underperformance vs benchmark.

Every mutual fund scheme mandated by the Securities and Exchange Board of India (SEBI) must track a specific benchmark index (like the Nifty 500 or BSE Midcap). If your fund is down 5%, but the benchmark is down 12%, your fund manager is actually doing an exceptional job of protecting your downside.

However, if the benchmark is up 10% and your fund is flat or negative, you need to investigate the following potential causes:

1. Broad Market Corrections

Sometimes, the issue isn't your fund; it's the macroeconomic environment. Rising interest rates, inflation, or geopolitical tensions can drag down entire asset classes. If the entire equity market is correcting, your fund will inevitably suffer. To understand how external factors shape domestic returns, review how global events impact Indian mutual funds.

2. Sectoral Headwinds

If your diversified equity fund is heavily overweight on a specific sector (like Information Technology or Pharmaceuticals) and that sector enters a cyclical downturn, the fund will underperform temporarily. This requires patience, as sector cycles eventually rotate. For a deeper understanding of how these concentrated pockets of the market operate, explore our guide on sector funds: high return potential or high risk?

3. Style Drift Mutual Fund

A style drift mutual fund occurs when a fund manager subtly changes the fund's core investment strategy over time, deviating from its original mandate. For example, a dedicated value fund might start aggressively buying overvalued growth stocks to chase short-term returns. This drift changes the risk profile of your portfolio without your consent. A sudden spike in how frequently the manager is buying and selling stocks can be a symptom of this. You can track this by understanding portfolio turnover ratio (PTR) and its impact on returns.

4. AUM Bloat Mutual Fund

Success can sometimes be a fund's worst enemy. An AUM bloat mutual fund happens when a scheme becomes so popular that thousands of crores pour into it rapidly. When the AUM becomes too massive—especially in the small-cap and mid-cap space—the fund manager loses agility. They can no longer easily enter or exit smaller companies without severely impacting the stock price, forcing them to hold excessive cash or invest in larger, slower-growing companies, which drags down overall returns.

When to Exit a Mutual Fund (And When to Stay)

Deciding when to exit a mutual fund should never be based on 3-month or 6-month returns. Equity mutual funds require a minimum holding period of 5 to 7 years to navigate full market cycles.

You should consider staying invested if:

• The underperformance is short-term (less than 18 to 24 months).
• The fund's core investment philosophy remains intact.
• The fund still aligns perfectly with your original financial goals and risk profile.

Compare Against the Benchmark and Peers

You should strongly consider exiting if the fund has consistently underperformed its benchmark and its category peers for three consecutive years.

To evaluate this accurately, you must look at risk-adjusted metrics. Is the fund taking on massive risks just to generate average returns? Understanding these deeper metrics is crucial; you can learn how to evaluate them by understanding Sharpe ratio, Alpha, and Beta. If the fund's alpha—the excess return generated by the fund manager's stock-picking skills—turns consistently negative, it is a glaring red flag.

Should I Switch My Mutual Fund? The Decision Matrix

If you have definitively concluded that the fund is fundamentally flawed, you will inevitably ask: should I switch my mutual fund?

A switch is essentially a simultaneous redemption from the underperforming scheme and a fresh purchase into a better-performing scheme within the same Asset Management Company (AMC), or moving capital to an entirely different AMC.

You should initiate a switch if:

1. Fund Manager Exit: The star fund manager who built the stellar track record abruptly leaves the AMC, and the new manager drastically alters the strategy.
2. Merger or Acquisition: The AMC is bought out, resulting in a fundamental change to the scheme's mandate that no longer suits your asset allocation.
3. Chronic Underperformance: As discussed, 3+ years of trailing the benchmark and peers.

Evaluating Exit Load and Capital Gains Tax on Switching Funds

One of the biggest mistakes investors make when figuring out how to handle underperforming mutual funds is ignoring the friction costs of moving their money. A "switch" is legally treated exactly the same as a "sale."

Before you move your capital, you must meticulously calculate the exit load and capital gains tax on switching funds.

• Exit Load: AMCs levy an exit load (typically 1%) if you redeem or switch your units before a specified period, usually 12 months from the date of purchase. If you switch too early, this penalty directly eats into your capital.
• Taxation: According to the Income Tax Act of India, any profit made on the sale or switch of a mutual fund is subject to capital gains tax. If you hold an equity fund for less than a year, it attracts Short-Term Capital Gains (STCG) tax. If held for more than a year, it attracts Long-Term Capital Gains (LTCG) tax.

To ensure you don't accidentally trigger a massive, avoidable tax bill just to escape a slightly underperforming fund, it is highly recommended to consult a mutual fund capital gains tax calendar before executing any major portfolio restructuring.

The Value of Regular Plans: Why Distributor Guidance Matters

When facing portfolio underperformance, the narrative often shifts to the debate between regular and direct plans. It is tempting to think that saving a fraction of a percent on expense ratios will magically solve the problem of a bad fund.

This is where the true value of an AMFI-registered distributor (ARN-306591) like midfin360 becomes apparent. We exclusively offer regular plans because DIY investing frequently fails during periods of underperformance. When you invest through a direct app, there is no one to tell you if the underperformance is a temporary blip or a structural failure. There is no one to stop you from panic-selling at the bottom.

An expert distributor acts as an emotional and analytical anchor. They conduct regular portfolio reviews, identify a style drift mutual fund long before it destroys your XIRR, and execute tax-efficient rebalancing. This ongoing service, goal alignment, and behavioral coaching are exactly what you pay for with regular plans, and it is the single most effective way to protect your long-term wealth creation.

Conclusion

Knowing how to handle underperforming mutual funds is a defining characteristic of a mature, successful investor. It requires shifting your focus away from short-term noise and toward long-term data.

By taking the time to properly diagnose mutual fund underperformance vs benchmark, keeping an eye out for AUM bloat and style drift, and carefully calculating the tax implications of a switch, you can manage your portfolio with confidence. Remember, you do not have to make these critical decisions in isolation. Partnering with a professional distributor ensures your wealth creation journey remains disciplined, tax-efficient, and perfectly aligned with your life goals.

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Explore the midfin360 app and see how our team can support your portfolio.