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How Funds Outperform Markets

Mutual funds outperform the major indices because they’re easy to beat if a fund manager is smart enough

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By and large, equity mutual funds, outperform the stock markets. Surprisingly, this is a controversial statement. That’s because some people firmly believe, based on imported studies that mutual funds don’t actually do so. However, in India, this has always been true. On the face of it, there can be two possible reasons for this. Either Indian fund managers are very good, or the Indian markets are very easy to beat. The truth, as always, is probably a mix of the two.

First, the numbers. Value Research has just done a study of the historical outperformance of Indian equity funds, compared to the stock markets. By ‘stock markets’, I mean the large cap indices like the Nifty and the Sensex. Of course, each fund has its own index and technically, the fund manager’s job is to beat that particular index. However, from a consumer perspective, it’s beating the big indices that matter. We ignored funds that were either limited to particular sectors or themes, and we also ignored funds that were focused on mid-cap or small-cap companies. Only funds that were dominantly large cap were included in the study.

Here are a couple of the interesting things that we discovered. One of the things we looked at was the five-year return of all such fund for all five year periods ending every year since 2002. On an average, for this entire period, 71 per cent of the funds outperformed the Sensex. Interestingly, for 2002-2007, the average was 81 per cent and for 2008-2011, it was 55 per cent. For just one five year period, 2004-2009, only a minority of funds (46 per cent) beat the Sensex.

However, when we dug in to see the story behind this decline, we found something very interesting. We looked at the annual numbers instead of the five year ones, there are nine years of huge outperformance and one of severe underperformance. In calendar year 2008, a mere 7 per cent of the funds outperformed the sensex. In the other nine years the average was 89 per cent and the minimum was 76 per cent.

That the story is so clear and the conclusions in data so sharply delineated is itself the real conclusion. The thing about funds’ outperformance of the markets in India is that you don’t have to dig very deep to find a rich lode. The issue is not the trend but what it means for investors. In a rapidly evolving economy (and stock market) like India’s there is a lot more churn of businesses than there is in the developed markets. Simultaneously, despite the sound and fury of a hyperactive market, there just don’t appear to be enough investors who will quickly latch on to trends and smother them with a large volume of buying and selling. There’s so much happening all the time in terms of businesses changing, evolving, growing and simply participating in the enormous pockets of growth, that there’s plenty of room to identify and exploit opportunities.

Basically, there’s a lot of money lying on the table. Well, may be not actually lying on the table but at least visible to a reasonably smart investment manager. And that’s something that’s been in reasonably good supply.

However, there’s another side to this story which some people believe in, that maybe the Indian indices are easy to beat. At the end of the day, neither the Sensex nor the Nifty are designed as investment portfolios. Both the indices are based on a number of parameters. The Sensex apparently bends towards being representative while the Nifty has a more numerically driven criteria that is focused on liquidity, measured by low impact cost of trading.

While the day may yet come when things change so much that index funds and ETFs become the logical choice, it probably won’t be any time soon.