In a report released on May 15, Morgan Stanley dissected the returns of a universe of about 2,400 Indian stocks. Even as the Nifty hit a new set of successive highs over the past 12 months, MS pointed out that two out of every three stocks lost ground.
The Sensex basket gained about 11 per cent in the time period considered (early May 2006 to early May 2007). But the top five gainers contributed over 100 per cent of total returns. Reliance Industries, Bharti Airtel, Infosys, Reliance Communications and ICICI Bank contributed approximately 130 per cent of total Sensex returns over that period. The other 25 stocks delivered a negative return in toto. The median return for the MS universe was minus 17 per cent. The median return of the 67 per cent of losing stocks was minus 30 per cent.
Skip the following explanation if you remember high-school stats. The "mean return", which is positive for the Sensex, includes extreme gains and losses and is therefore, heavily influenced by outliers. The median removes extreme values (losses and gains) and calculates the mid-point of the data-series. Half the stocks got returns higher than minus 17 per cent and half, lower returns. Of the 67 per cent that delivered negative returns, the mid-point was minus 30 per cent.
May 2006 was a "swing month" when prices crashed sharply. So a point-to-point analysis of end-May 2006 to end-May 2007 offers very different results from early May2006-early May 2007. As of May 25, 2007, the Sensex has delivered 34.5 per cent in the past 12 months. The NSE Mid Caps returned 31 per cent and the BSE Small Caps returned 27 per cent. But over 60 per cent of stocks have been losers.
This narrow market movement made 2006-07 an interesting year. Returns depended on ownership of a few specific stocks. Investors overweight in winners made money and beat the index funds. If they were underweight, they lost money. Most active investors and active funds underperformed index funds last year. In calendar 2006, only 30 active funds beat benchmark indices while 116 underperformed.
It leads us to an interesting set of speculations. You can divide market moves into three types - sideways, up or down. Across all phases, in developed markets, index funds tend to outperform the majority of active funds. But the ratios are different in different market phases.
When markets move sideways, every sort of investor loses. When it's down or up, breadth is important. Although the fund universe has increased continuously in size, we can see a trend in terms of active fund performance linked to breadth. In a broad bull market, more active funds beat the indices. This happened in 2003 (when 67 active funds beat the Sensex and only five underperformed), and 2004 (the ratio was 77:5 in favour of outperformers). In a broad bear market like 2001, active funds were in difficulty with 26 funds outperforming while 34 underperformed.
In a narrow bull market when the average return is positive but the majority of stocks are down, the index funds are more likely winners. I cannot remember an extended "narrow bear market" where indices travelled down while the majority of stocks went up. In theory, the active investor, who is delinked from the major indices, may do well in such a phase.
What does all this mean for investors in 2007 and 08?
Active equity-diversified funds did not do so well in 2006. Consensus projections and Q4 earnings releases suggest that 2007-08 will not see broad growth. So a broad bull market is unlikely. If a narrow bull market prevails through 2007-8, active funds won't do very well. On the other hand, index funds will score positive returns. That is the case for index fund investments in 2007-08. If there is a big sell off, a few active funds will outperform while most deliver short-term negative returns. That is the case for active funds - provided you pick the right ones. Sooner than look for industry focus, I'd pick by size. Smaller stocks have already gone through correction and started recovery. Since December 2006, the NSE Midcaps has returned over 10 per cent; the BSE Small Caps has 9 per cent; the Nifty has returned about 6.5 per cent. Over 50 per cent of stocks have positive returns since December 2006. Since January 2007, 86 active funds have beaten the Sensex while 52 underperformed. The big gains have been in smaller stocks.
A very wide range of profit-making businesses suffered loss in market value in the past 12 months. That broadens the universe for stock-pickers - and also for active funds. If you are going stock-picking with a two-year or longer perspective, pick active funds with a smaller stock focus.
This article was originally published on July 25, 2007.
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