A review may reveal stocks and mutual funds that have been underperforming for years and no longer play a meaningful role in your investment strategy.
Holding on to such simply because they have been part of your portfolio for a long time could mean missing an opportunity to put that money to better use.
Such investments are often referred to as ‘zombie investments’. Here’s how investors can identify them and assess whether they still deserve a place in their portfolios.
What are zombie investments?
Arjun Guha Thakurta, Executive Director, Anand Rathi Wealth, explained that an investment is considered a “zombie investment” when it continues to sit in the portfolio even though the original reason for holding it may no longer be valid.
He said that in stocks, it is important to look at the sector the company operates in, along with its earnings, cash flows, and business outlook, to assess whether its performance has weakened over several years.
“A should not be called a zombie just because it has seen short-term underperformance. Investors should check whether the fund continues to underperform its benchmark and category average over 3-5 years,” he added.
How to identify zombie stocks in a portfolio?
Thakurta noted that “investors would need to do a complete assessment to understand if a stock still fits in their portfolio”.
He suggested the following framework:
- Start by assessing the company’s sector, including its current performance and future outlook.
- Compare the stock with its peers and assess key fundamentals such as earnings, revenue, cash flows, debt levels, and returns on invested capital.
- Look for red flags such as weak earnings, rising debt, or sustained pressure on cash flows before deciding whether to exit.
“A cyclical slowdown can be temporary, while a company losing its competitive position can be a much bigger problem. Investors should therefore assess multiple indicators together rather than reacting to a single weak quarter or year,” he noted.
How to identify zombie mutual funds?
Thakurta explained that there is no single metric to determine whether a fund is a “zombie” investment or whether it is time to exit. Short-term underperformance does not necessarily signal a problem, as markets, sectors, and investment styles can go through cycles of underperformance before recovering.
He suggested the following framework:
- Compare the fund’s performance with its benchmark and category peers to determine whether the underperformance is temporary or persistent.
- For example, if a large-cap fund underperforms its benchmark and peers for a year when the entire category is under pressure, that alone is not a reason to exit.
- If the fund consistently underperforms over three to five years, assess whether changes in its investment strategy, underlying stock portfolio, or fundamentals are driving the underperformance.
“Hence, decisions to exit a mutual fund should be based on changes in the fund, sustained long-term underperformance, or its role in your portfolio,” he said.
How frequently should investors analyze their portfolios?
“Investors should do a portfolio review and rebalancing once every 6 months. During the review, investors can go through their portfolio and understand how each fund fits and whether it is helping them get closer to their financial goals,” Thakurta explained.
He also mentioned that what qualifies as a zombie investment can vary from one investor to another, as each investor has a different time horizon, financial objective, and risk profile.