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Why do investment funds underperform?

While it is easy to leap to the conclusion that underperformance is simply down to an overpaid manager messing up, there are a number of factors that can contribute to poor relative performance.

Jason Hollands Jason Hollands
27 January 2014

The wrong macroeconomic decisions

A previously capable fund manager may, for example, get a big macroeconomic decision wrong and invest in a sector in the expectation of recovery that fails to emerge. Or it may be that their overall strategy is credible but a holding in a particular company turns horribly wrong for reasons that were difficult to predict as was seen when BP shares suffered following an oil leak in the Gulf of Mexico.

Investment styles go in and out of fashion

The ensuing sell-off has seen losses across most asset classes as investors have sought to exit those investments seemingly supported by current Fed policy. High yield equity, bonds and commodities have all been casualties, in some cases retracing all of the year's previous gains. In our view this reaction is both inevitable and healthy, helping to create a more stable and robust base upon which markets can build

Buying and selling holdings

Other factors that can lead to underperformance include liquidity issues and the drag impact of cash in a fund. For example, if a fund takes large positions in illiquid, small company stocks and the market enters a period of stress it may simply be difficult for a manager to buy and sell holdings and valuations of companies can be affected.

Likewise, significant cash coming into or out of a fund can have an impact on performance: if a fund receives large amounts of new cash in a rapidly rising market this may provide a negative drag on performance as it may take time to invest it whereas if a fund sees significant redemptions, then the manager may be required to liquidate key holdings, at the wrong price.

Don’t make snap judgements

For all these reasons, one has to be careful about snap judgements on ditching a fund that has underperformed in the past and delve behind the headline numbers to understand what has gone on.

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Spot the Dog is our landmark guide to the worst-performing funds across key investment sectors. Download the guide to find out if you hold any underperforming ‘dog’ funds, to find out more about what to do if you have a dog fund and to discover best of breed fund alternatives.


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