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Funds Falter on Returns

Recent trends show that stock market performances are far superior than those of the mutual fund industry

To the discerning investor, the ongoing happy hours on the stock markets have shown up mutual funds in a rather unflattering light. Sure, stocks are up and so are equity mutual funds (MFs). But relatively few funds are able to beat the equity market indices. Since the market turned upwards after hitting a bottom in early March, the average diversified equity fund is up about 70 per cent, with about 20 funds of the 268 funds rising more than a 100 per cent. During the same period the Sensex and the Nifty are up about 87 per cent and the broader indices are also up around 90 per cent.

This isn't what the deal is supposed to be with MFs. Their main job is supposed to be to beat the indices. That's what the investor pays for. Otherwise, the investor would be much better off investing in an index fund or an index-based exchange traded fund (ETF), which have far lower expenses than actively managed funds.

What makes this a curious case is that this isn't the way it has generally been in India. Historically, Indian equity MFs have managed to beat the indices quite handily. For example, from 2002 to 2007, the average equity diversified funds routinely beat the major indices. Rs 10 lakh invested in the average equity fund on January 1, 2002 would have become Rs 97 lakh by 31st December 2007. In the Sensex, it would have become Rs 62 lakh.

However, over the last year or so, this hasn't been true. During last year's market decline as well as the subsequent rise, relatively fewer funds have beaten the indices. Is this a fundamental shift? Have the markets changed or have funds changed? Or are these just unusual times and eventually one can expect normalcy to be restored?

A bit of everything, I suspect.

One major reason has been that over the last year and a half, stocks have been driven first one way and then the other by what could be called extraneous reasons. Historically, investment managers do well in picking out sectors and companies that will do better than others, but do poorly in catching trend changes that originate in the broader economy and polity. I know, that's not the impression they like to give when they speak in the media but it's true. The better fund managers are basically good stock pickers on a relative basis. If steel prices edge up, they'll know which auto companies will hurt more than others. But if you expected them to predict and time the swings and lurches of the global economic roller coaster, then that isn't going to happen. Some of them make the right guesses some of the time, but that's about it.

Moreover, the huge increase in the number of equity funds has inevitably led to a decline in fund management standards. There were 62 equity diversified funds in 2002; now there are about 270. On top of that, the product design choices made by fund companies have ensured that a huge number of the newer funds are constrained by some theme or the other which doesn't quite make it a sector fund, but doesn't allow the fund manager to exploit all kinds of markets well.

Does this mean that the age of index investing is finally dawning in India?

Perhaps it is. Going in for an index funds ensures that you will never underperform the index nor will you ever outperform it. I find that since equity investors are generally the kind of people who are both optimistic and overconfident, few of them like the idea of limiting their upside relative to the indices. Still, if present trends continue, the day may not be far when many more investors will start looking at index funds seriously.