What to Do When a Holding Is Underperforming

Kavita is looking at the wrong column

Kavita has one holding that has lagged the others for two years running. Every time she opens the app it is at the bottom of the list, and the sense that she should do something about it has been building.

What she is reading is a ranking over a short period. What she needs to know is whether anything about the holding has changed. Those two questions feel like one question and they have different answers, and the ranking is not evidence about the second.

Why a short run of underperformance says so little

Start with what "underperforming" is being measured against. Almost always it is other things in the same list over the same recent period — which means the comparison is against whatever has recently done well, and it will keep identifying whatever has recently done well for as long as you run it.

Second, most differences between holdings over a year or two come from what kind of thing each one holds, not from how well it is run. A fund concentrated in a part of the market that is out of favour will lag while that part is out of favour, with the same people making the same decisions throughout. Then it will lead when the wind changes, and if you replaced it in the meantime you will have paid for the lagging half and missed the leading half.

Third, and most importantly, a short comparison cannot separate a bad holding from bad luck. That is not a counsel of despair — it is a statement about how much evidence is in a year of relative performance, and the answer is very little. Distinguishing skill from luck needs far more observations than a couple of years supplies, and it needs the funds that closed to still be in the sample; the whole difficulty is set out in why past performance is not enough to choose a fund.

The trap in switching

Suppose Kavita sells the laggard and buys whatever is at the top of the list. Notice what selection rule she has just used: buy what has recently risen most.

That is the same rule that put her in this position, applied again. And there is an arithmetic problem underneath it — whatever has risen most is now more expensive relative to what it earns than it was, and the holding she is selling is less so. Selling low and buying high is what this procedure does mechanically, whatever the intention.

There is also a cost to switching that never appears in the comparison she is looking at: transaction costs, potentially a tax bill on gains realised in order to make the change, and, if the new holding is more expensive to own, a charge she will now pay for as long as she holds it. Those are certain. The improvement is not. The scale of that annual charge over a long period is not small — how investment fees reduce wealth.

The test that is actually worth running

Stop asking whether it underperformed and ask whether it is doing what you bought it to do. Four questions, none of which is about the return.

Has the mandate changed? Does it still hold the kind of thing you chose it for? A fund that has drifted into holding something else is a different holding from the one you bought, whatever its recent numbers.

Has the cost changed? This is checkable, it is certain, and it applies whatever happens next.

Has it lagged its own kind, or the market? These are completely different findings. A fund lagging a benchmark that matches what it holds is a problem with the fund. A fund lagging because its whole category is out of favour is not — that is the market, and you already knew it could happen when you chose the category. This single distinction resolves most cases.

Does it still fit the plan? Your allocation and your goals may have moved. A holding can be performing perfectly well and no longer belong, which is a legitimate reason to sell and has nothing to do with underperformance.

If all four come back clean, the honest conclusion is that a period of lagging is what owning that thing looks like sometimes, and there is nothing to do.

When action is warranted

A holding that has drifted from its stated mandate. A charge that has risen without a reason. A holding that no longer fits an allocation you have deliberately changed. And a position that has grown so large through success that it now dominates the portfolio — which is a risk problem, not a performance one, and is handled by rebalancing rather than by switching.

Notice that none of those triggers is a return figure. That is the point.

What to take away

The urge to act arrives from a ranking, and a ranking over a year or two carries very little information about anything you actually care about. Replacing the laggard with the leader is a rule that buys what has already risen, and it charges you costs and possibly tax for the privilege.

Run the four checks instead. If the holding still does what it was bought to do, at the cost it was bought at, within a plan that has not changed, then the correct response to two disappointing years is to note them and leave it alone — and to book the review for a fixed date rather than the next time the app makes you feel behind, which is what the annual review exists for.