Case 087Products and fund selectionCore

A large-cap fund has beaten its index by 2 points a year for 7 years, but its manager has just left. Hold, switch to an index fund, or watch? Use the numbers and what the record now shows.

The situation

A client holds Rs 50 lakh in the Pranjal Bluechip Fund, a large-cap fund, with Rs 20 lakh of long-term gain. Over seven years under one manager the fund beat its index, after costs, by 3.1, -0.8, 4.2, 2.5, 1.0, 3.6 and 0.4 points, an average of 2.0 points a year. Last week the manager resigned; the fund house has named a successor from its mid-cap team.

The fund's direct plan costs 1.0% a year and a large-cap index fund costs 0.2%. Use an illustrative 12.5% tax on long-term equity gains and tell the client to confirm current rates.

Your task

What does the seven-year record tell you now, what would switching cost, and what do you do?

Quick check

Does a strong seven-year record carry over to the new manager?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Watch, with written triggers, and send new money to the index fund meanwhile. The record was strong, an average of 2.0 points with a t-statistic near 2.9, but it belongs to the manager who left. Switching now costs about Rs 2.5 lakh of illustrative tax; if the successor has no edge, staying costs 0.8 points, Rs 0.4 lakh a year, a payback of about 6 years. A review in twelve months, or sooner if a trigger fires, settles it.

Step 1What did the seven years actually show?

Something real, for the manager. A cricket team's win record under one captain says little about the next captain. Seven years averaging 2.0 points above the index, with a spread of about 1.8 points a year, gives a t-statisticThe average result divided by its standard error; around 2 or more suggests the average is unlikely to be luck alone. of about 2.9, which is unusually strong evidence of skill for so short a record. That evidence described one person's decisions. The fund's name, its benchmark and its portfolio on the day he left are what remain.

The Pranjal Bluechip Fund beat its index in six of seven years under its old manager, averaging 2.0 points a year with a t-statistic near 2.9, but the years after the manager's exit start with no record at all.

Step 2What does switching cost against what staying risks?

Price both sides. Switching Rs 50 lakh realises Rs 20 lakh of gain, about Rs 2.5 lakh of tax at an illustrative 12.5%. Staying costs nothing if the successor is as good; if he has no edge, the client pays 0.8 points more than the index fund, Rs 0.4 lakh a year, so switching would take about 6 years to pay back. A switch today is paying a certain cost to avoid a risk that has not yet shown itself.

Choice	Cost today	Cost each year if the successor has no edge	When it is right
Hold and forget	None	Rs 0.4 lakh	Never, without a review
Switch to the index fund now	Rs 2.5 lakh tax	None	If the process clearly broke
Watch with triggers, new money to index	None	Up to Rs 0.4 lakh for a year	The default here

Switching costs about Rs 2.5 lakh of tax today; staying costs up to Rs 0.4 lakh a year if the successor adds nothing, so a year of watching is cheap relative to the tax.

Step 3What exactly do you watch, and what would trigger the switch?

Write the triggers down now, so the decision later is not made on mood. Watch whether the portfolio keeps its holdings and style, whether turnover jumps as the successor rebuilds it, and whether the analysts who worked with the old manager stay. A successor from the mid-cap team raises the risk of style drift, so check the fund's share in smaller companies each month. If turnover doubles, the large-cap share falls, or the old team leaves, switch in tranches that use the annual exemption. Meanwhile every new SIP goes to the index fund, which costs nothing and caps the exposure.

Where candidates lose it

The common error is treating the fund's record as the fund's property and holding on the strength of seven good years. The record describes decisions by someone who no longer makes them.

The opposite error is switching the whole holding the day the news breaks, paying Rs 2.5 lakh of tax to avoid a cost of at most Rs 40,000 a year that may never appear. The interviewer wants the middle path, priced.

What the interviewer asks next

The fund house says the fund is team-managed and the process continues. What evidence would convince you?
After a year the successor is 1.5 points behind the index. Is that enough to switch?
Would your answer change for a small-cap fund, where manager skill tends to matter more?

Company names and figures are illustrative.