Every investor dreams of a portfolio that only goes up, generating high returns year after year. However, the reality of the financial markets is quite different. Volatility is a natural feature of investing, and at some point during your wealth creation journey, you will inevitably face underperforming mutual funds in your portfolio.

Seeing your hard-earned money dip in value or lag behind your expectations can be emotionally taxing. It often triggers the impulse to sell immediately and move to the next shiny, top-performing scheme. But reacting purely on emotion is one of the biggest mistakes an investor can make.

Understanding how to handle underperforming funds separates successful, long-term wealth creators from those who constantly buy high and sell low. In this detailed guide, we will explore what true underperformance means, why it happens, and the systematic steps you should take before deciding to exit or switch a mutual fund.

What Does "Underperforming" Actually Mean?

Before taking any action, you need to define what "underperformance" means in the context of your mutual fund. A temporary drop in the Net Asset Value (NAV) does not automatically mean the fund is a dud.

When evaluating performance, you must look beyond absolute returns and focus on relative returns. Here is how to properly assess the situation:

• Compare Against the Benchmark: Every mutual fund has a designated benchmark index (like the Nifty 50 or BSE Sensex for large-cap equity funds). If your fund is giving 8% returns while the benchmark is giving 12%, the fund is underperforming. However, if your fund is down by 5% during a market crash, but the benchmark is down by 10%, your fund manager is actually outperforming the market by protecting your downside.
• Compare Against Category Peers: Look at how other mutual funds in the exact same category are performing. If you hold a mid-cap fund, compare it only to other mid-cap funds, not to large-cap or liquid funds.
• Time Horizon is Crucial: A few weeks or even a couple of quarters of low returns do not constitute chronic underperformance. Equity mutual funds should be evaluated over a rolling period of at least 3 to 5 years.

5 Reasons Your Mutual Fund Might Be Underperforming

To fix a problem, you must first diagnose the cause. Here are the most common reasons a mutual fund might lag behind its peers or benchmark:

1. Broad Market Corrections

Sometimes, the fund is not the problem; the market is. Geopolitical tensions, changes in interest rates by the RBI, or global economic slowdowns can cause the entire stock market to correct. If the broader market is down, almost all equity funds will show negative returns. This is systematic risk, and the best action is usually to do nothing and continue your Systematic Investment Plan (SIP).

2. Style Drift

Every mutual fund has a stated investment mandate. For instance, a value fund manager is supposed to look for undervalued stocks. However, if the manager starts chasing high-growth momentum stocks to boost short-term returns, this is called "style drift." This uncalculated risk can lead to severe underperformance when market cycles change.

3. Changes in Fund Management

The performance of an actively managed mutual fund is heavily tied to the expertise of the fund manager. If a star fund manager resigns or is replaced by someone with a drastically different investment philosophy, it can temporarily or permanently impact the fund's returns.

4. Sectoral Headwinds

If you have invested in sectoral or thematic funds (like IT, Pharma, or Infrastructure), your returns are entirely dependent on that specific industry. If that sector faces regulatory hurdles, global headwinds, or a cyclical downturn, your fund will underperform significantly, regardless of the broader market's health.

5. Ballooning Asset Under Management (AUM)

While a high AUM indicates investor trust, it can sometimes become a handicap, particularly for small-cap and mid-cap funds. When a fund becomes too massive, the fund manager may struggle to deploy cash efficiently into smaller companies without disrupting the stock price, forcing them to hold more cash or invest in suboptimal ideas, thereby dragging down overall returns.

Step-by-Step Guide: What to Do When a Fund Underperforms

When you spot a laggard in your portfolio, follow this structured, emotion-free approach.

Step 1: Don't Panic-Sell and Don't Stop Your SIP

The worst time to sell a mutual fund is during a temporary market panic. If the underperformance is due to a broad market correction, stopping your SIP is counterproductive. Continuing your SIP during market lows allows you to buy more units at a cheaper NAV, taking full advantage of rupee cost averaging. This significantly boosts your wealth when the market eventually recovers.

Step 2: Analyse the Timeframe

Is this a short-term blip or a long-term trend? Check the fund's performance over the last 1-year, 3-year, and 5-year rolling returns. If the fund has underperformed its benchmark consistently for 3 to 4 consecutive quarters, it warrants a deeper review. If it is just a bad month, ignore the noise.

Step 3: Review Your Financial Goals

Why did you invest in this fund in the first place? If you invested in an equity fund for a retirement goal that is 20 years away, a one-year period of underperformance is just a blip on the radar. However, if you are nearing your goal (e.g., you need the money for your child's college fee next year), you should be shifting to safer debt funds anyway, regardless of the equity fund's current performance.

Step 4: Consult Your Mutual Fund Distributor

This is where the structure of your investment truly matters. DIY (Do-It-Yourself) investing can be lonely and stressful during market downturns. Reaching out to your dedicated relationship manager can provide the objective analysis you need to make a rational choice.

Why Regular Mutual Funds Have the Edge During Underperformance

One of the greatest misconceptions in the investing world is that direct mutual funds are universally superior to regular funds merely because of a slightly lower expense ratio. However, handling an underperforming portfolio is exactly where regular mutual funds—and the distributors behind them—prove their immense value.

When you invest through a SEBI-registered distributor like midfin360 via regular plans, you are not left to navigate market volatility alone.

• Emotional Circuit Breakers: When a fund drops by 15%, the DIY investor's instinct is to panic-sell, effectively turning a paper loss into a permanent capital loss. A distributor acts as an emotional circuit breaker, helping you see the bigger picture and preventing wealth-destroying decisions.
• Professional Portfolio Reviews: With regular funds, you benefit from ongoing portfolio tracking. Your distributor actively monitors the benchmark, category peers, and fund manager changes on your behalf.
• Tailored Action Plans: If a fund truly needs to be removed from your portfolio, your distributor will guide you on the most tax-efficient way to switch, recommending a superior alternative that perfectly aligns with your risk profile and life goals.

The nominal distributor commission baked into the regular plan expense ratio is a small price to pay for the continuous guidance, peace of mind, and financial discipline that ultimately leads to long-term wealth creation.

When is the Right Time to Exit an Underperforming Fund?

Holding onto a bad investment out of stubbornness (hoping it will bounce back) is just as dangerous as panic selling. You should strongly consider exiting or switching a mutual fund under these conditions:

• Consistent Underperformance: The fund has consistently lagged behind its benchmark and category average for 12 to 18 months, across different market cycles.
• Fundamental Change in the AMC: The fund house is facing severe regulatory issues, or there has been a dramatic, unexplained shift in the fund's core investment strategy.
• Rebalancing Requirements: The fund might be performing fine, but your asset allocation has skewed too far. For example, if a bull run has made your portfolio 90% equity when your target is 70%, you should trim (exit) some equity funds to buy debt, thereby rebalancing your risk.

Tax Implications and Exit Loads

Before hitting the sell button on an underperforming fund, you must calculate the costs of exiting.

• Exit Loads: AMCs charge an exit load (usually around 1%) if you redeem your units before a specified period (typically 12 months for equity funds). Ensure you check this to avoid unnecessary penalties.
• Capital Gains Tax: In India, exiting a mutual fund triggers a tax event. For equity funds, if you sell before 12 months, you are liable to pay Short-Term Capital Gains (STCG) tax. If you sell after 12 months, Long-Term Capital Gains (LTCG) tax applies on profits exceeding the annual exemption limit. Even if you are switching from one scheme to another within the same AMC, it is considered a redemption and is taxable.

Disclaimer: Tax laws are subject to change based on government regulations. Always consult with a tax professional or your distributor before making large redemption decisions.

Effortless Portfolio Tracking with midfin360

Identifying and acting on underperforming funds doesn't have to mean staring at complex spreadsheets all day.

At midfin360, our platform provides a deeply consolidated, transparent view of your entire financial portfolio. With tools designed to automatically calculate your XIRR and track your investments against your specific life goals, you always know exactly where your money stands.

More importantly, because midfin360 exclusively offers regular mutual funds, our investors benefit from dedicated relationship manager (RM) support. If you are worried about a specific fund's performance, our team is just a tap away via in-app chat or WhatsApp, ready to provide objective, expert analysis. We help you block out the market noise so you can focus on what truly matters: achieving financial freedom.

Frequently Asked Questions (FAQs)

1. Should I stop my SIP if my mutual fund is giving negative returns? No. Stopping your SIP during market downturns is a common mistake. A falling NAV means your fixed SIP amount buys more units of the fund. When the market eventually recovers, this accumulation of cheaper units will significantly boost your overall returns. This is the core benefit of rupee cost averaging.

2. How long should I wait before deciding to sell a bad fund? For equity mutual funds, do not judge performance on a month-to-month basis. You should monitor the fund against its benchmark and category peers. If it consistently underperforms for 3 to 4 consecutive quarters (12 to 18 months), it is time to review the fund with your distributor and consider an exit.

3. Does a drop in NAV mean the fund is underperforming? Not necessarily. If the entire stock market crashes, the NAV of almost all equity funds will drop. True underperformance is relative. If the market drops by 10% but your fund drops by 15%, that is underperformance. If your fund only drops by 5%, it is actually outperforming the market.

4. Is there a tax penalty for switching from an underperforming fund to a better one? Yes. In the eyes of the Income Tax Department, a "switch" is treated as a sale of the old fund and a purchase of the new one. Depending on your holding period and the type of fund (equity or debt), you will be liable to pay STCG or LTCG tax on the profits made from the underperforming fund.

5. How can midfin360 help me handle underperforming funds? midfin360 offers a consolidated portfolio view with clear performance metrics like XIRR. Furthermore, because we operate entirely on regular mutual fund plans, you have access to dedicated RMs. Our experts can help you analyse if a fund's poor performance is a temporary market phase or a structural issue, guiding you on whether to hold, switch, or redeem.

6. I invested a lumpsum amount and the fund is down 20%. What should I do? If the fund's fundamentals are still strong and the drop is due to market-wide volatility, the best course of action is usually to hold. If you have surplus cash, you might even consider investing more to average out your purchase cost. Always consult your distributor before making a decision based on short-term market movements.

Secure Your Financial Future Today

Dealing with underperforming mutual funds requires patience, objective analysis, and strict financial discipline. While market volatility is guaranteed, reacting emotionally to it is optional.

The smartest way to navigate the ups and downs of wealth creation is by having a trusted partner by your side. With regular portfolio reviews, expert guidance, and a commitment to your long-term goals, the midfin360 ecosystem ensures you are never investing in the dark.

Ready to build a resilient, goal-oriented portfolio? Download the midfin360 app today, complete your quick eKYC, and let our experts guide your wealth creation journey every step of the way. Let’s build your wealth, together.