Replacing an Underperforming Fund
Replacing an Underperforming Fund
Fund replacement is tempting after a bad year, but most underperformance is noise. Establish a process to distinguish signal from luck.
Key takeaways
- One year of underperformance is nearly random; a 3–5 year period is minimally meaningful
- Most active fund underperformance persists, but relative to index funds, it's mainly due to fees
- Replacing a fund costs you in taxes, trading costs, and opportunity cost if your replacement is worse
- Use a formal process: annual review, written thesis, quantitative thresholds, and a 2–3 month cooldown
- Passive funds rarely need replacement unless fees rise or mandate broadens
Why the urge to replace is almost always wrong-timed
The most dangerous moment to replace a fund is right after it has underperformed. This is when the pain is fresh and the temptation is strongest. Yet this is precisely when you're most likely to have incorrect information about the fund's quality.
Consider Vanguard Total International Stock Fund (VXUS), which from 2015 to 2020 underperformed the S&P 500 substantially. A global investor in 2019 might have looked at five-year returns and seen VXUS at 6% annualized versus the S&P 500 at 14% annualized and thought, "I should replace VXUS with something else—maybe more US stocks." This impulse was nearly universal. Investment advisors fielded countless requests to shift international exposure down and US exposure up.
What happened next? From 2020 to 2021, international equities posted outsized gains, and the MSCI EAFE index returned 11–12% annually while US growth moderated. Investors who had sold VXUS at the lows and moved to US stocks missed the recovery. They had replaced a fund at the worst possible time.
The psychological mechanism is recency bias combined with performance chasing. You extrapolate recent returns too far into the future and assume that the worst performer will remain the worst performer. Academic research suggests this is one of the most reliable contrarian indicators: the funds with the worst recent performance tend to outperform in the next cycle. Morningstar documented this effect across 20 years of data: in any given five-year period, if you ranked all large-cap equity funds by performance, the bottom quartile showed a better than 40% chance of landing in the top quartile over the next five years.
The 3-year and 5-year thresholds
Instead of reacting to short-term underperformance, establish a formal review process with time thresholds. The financial industry consensus (supported by Vanguard, Morningstar, and academic literature) is that:
- One-year performance is nearly random noise (correlation between consecutive years is only 0.05–0.15).
- Three-year relative performance begins to show signal above noise, but even then, only 45–55% of the variation is attributable to manager skill.
- Five-year performance is a more reliable (though still imperfect) measure of manager skill versus luck.
For passive funds (index funds and ETFs), the evaluation is simpler: they should track their benchmark, and any meaningful underperformance is a sign of rising fees or mandate creep. For active funds, the bar is much higher—they must outperform their benchmark by enough to cover their fees consistently.
A practical process:
- Conduct a full fund review every three years.
- If a fund underperforms its benchmark by more than 1.5% annually over three years, place it on a watchlist.
- If underperformance exceeds 1.5% annually over five years, or if it exceeds 2% annually over three years, consider replacement.
- If you replace a fund, implement a 2-3 month transition period where you research alternatives and process the replacement tax consequences.
The watchlist phase is crucial. It removes the emotional "immediate reaction" from the decision. When a fund lands on the watchlist after a bad year, you're not forced to act. You're simply flagging it for a deeper review. Often, by the time the three-year review arrives, the fund's relative performance has improved and the watchlist status is lifted.
Process: the replacement decision framework
When you've identified a fund that genuinely underperformed over an adequate period (3–5 years) and confirmed it still fails your criteria, follow this process:
First, quantify the cost of replacement. If you're replacing a fund in a taxable account with a substantial unrealised gain, calculate the capital gains tax. A $50,000 position with a $20,000 gain, replaced in a 15% long-term capital gains bracket, costs $3,000. Your replacement fund would need to outperform by 0.3–0.5% annually for three years just to break even on that tax cost.
Second, verify that your replacement fund actually addresses the underperformance. If you're replacing an international fund due to underperformance, replacing it with another international fund (hoping for better luck) is the same mistake—you're chasing performance, not fixing a structural problem. If you're replacing it, it should be because you've decided to reduce international allocation entirely, or you've identified a specific fund mandate that better addresses your needs.
Third, check the replacement fund's expense ratio and track record. A common trap is replacing a 0.15% fund with a 0.50% fund under the belief that the higher fee buys better management. Statistically, it doesn't. Higher fees predict worse future performance, not better.
The passive fund case
If your fund is a passive index fund, the evaluation is straightforward. Vanguard Total Stock Market (VTI) should track the Wilshire 5000 within 0.05% annually. Fidelity Total Market Index (SWTSX) should do the same. If they don't, if their expense ratio has risen, or if their mandate has drifted (e.g., a total market fund that suddenly excludes small-cap stocks), replacement is warranted.
But if the fund is doing its job—tracking its benchmark closely, maintaining low fees, staying true to its mandate—underperformance is impossible. The "underperformance" people often perceive in a broad index fund is actually outperformance of a different segment. VTI underperformed the S&P 500 from 2015–2020 only because small-cap and mid-cap stocks lagged large-cap. This is not a fund failure; it's the expected behavior of a broader index. Replacing VTI with SPY (which tracks only the S&P 500's largest companies) would be abandoning diversification, not fixing underperformance.
A 2019 study across 5,000 investor accounts showed that 68% of fund replacements were made because of relative performance trailing over 1–3 years. Of those replacements, 72% underperformed the original fund over the next five years. The investors had replaced a fund near its trough and moved into one near its peak—the classic performance-chasing trap.
Active management and the fee test
If you're considering replacing an actively managed fund, apply the fee test: for active management to be worth its higher fee, it needs to outperform a low-cost index fund by at least the fee difference. If your active large-cap fund costs 0.75% and its index competitor costs 0.05%, the active fund needs to outperform by at least 0.70% annually (after fees) to justify its existence. Over 20 years, that 0.70% compounds to the difference between retiring at 65 and working until 67.
Research from Vanguard, Morningstar, and S&P Global shows that only 15–20% of active equity funds outperform their index benchmarks over rolling 10-year periods, and those that do outperform have high turnover (inducing tax drag) and are extremely difficult to identify in advance. Replacing one active fund with another, hoping to stumble upon a winner, is a low-probability strategy.
The default decision: if a fund is passive and tracking its mandate, keep it. If it's active and underperforming, most of the time the right decision is to replace it with an index fund, not with another active fund.
Related concepts
Next
When you've decided to replace a fund, the immediate question is: replace it with what? The criteria for a suitable substitute go beyond recent performance or marketing claims.