In the past year, the Nifty has rallied from 5700 to over 8000, for a 12-month index return of 40 per cent. In the past three years, (since Sept 2011), the Nifty has run up from 5000 levels and returned over 60 per cent. That is roughly 17.3 per cent CAGR. In the past five years, the Nifty has returned over 11 per cent CAGR.
A passive index investor would benchmark portfolio returns to these levels at minimum. Using systematic methods (assuming buying on the first day of a month), an index investor would have received about 23 per cent CAGR over the last three years. In itself, that IRR-6 per cent in excess of flat compounded return-is a great advertisement for a SIP. The data also shows how high the barrier is, for an active investor, who should ideally, beat the SIP return by a clear margin.
Note that the Indian economy was in slowdown through most of the last three years with the two latest financial years registering less than 5 per cent GDP growth. The corporate economy also saw a slowdown. Corporate financials deteriorated across the board.
But the stock market defied poor fundamentals and yielded excellent returns, mostly upon the back of strong investment flows from overseas. There was a combination of large returns and the mismatches between the fundamentals and market movements.
Picking stocks during such phases is difficult. Most fundamental analysts would have been uncomfortable at selecting stock portfolios during this period. Many balance-sheets were fragile and valuations would often have been too rich for the value-oriented investor.
However, the overwhelming majority of Indian diversified active equity (DE) funds did beat the market. Some 213 DE funds have been in operation for at least a year. Out of these, as many as 179 (84%) beat their respective benchmarks last year. As many as 199 funds were in operation for the past three years. Out of these, as many as 162 (81.4%) beat their benchmarks over three years. And, out of the total of 174 funds, which have been in operation for five years, as many as 140 (80.5%) beat their respective benchmarks over five years.
That sort of success ratio is amazing when it is compared with the performance of active funds in developed markets. There is quite a lot of literature on active and passive fund investing over much longer time periods and most of it suggests that few people beat the market consistently.
In the US, 63% of large-cap funds, 80% of mid-cap funds and 67% of small-cap funds failed to outperform their index benchmark on a one-year basis. Over three years, 86% of large-cap funds, 80% of mid-cap funds and 67% of small cap funds underperformed. The five year numbers are 75%, 90% and 83% of under-performance, respectively for large, mid and small-cap active funds.
Most developed country fund performances are similar to the US experience-very few funds hit, or exceed their benchmarks. One of the key elements is cost difference. Active funds have much higher cost ratios than index funds.
There are key differences in other respects between the US and Indian markets, which must affect stock market returns and mutual fund performance. India is a much less perfect market than the US. Information is more unevenly distributed. The information asymmetry should make it possible for more skilful and above all, better-informed investors to score higher returns with more consistency.
Several of the US studies feature performance over many decades. It is debatable if Indian markets in the 21st century are less evolved than US in the 1970s or the 1980s. So, trends which have been visible in the US over many years should be similar in India.
The studies are worth discussing anyway because they give a baseline of what Indian fund performance “should” be. Kenneth French and Eugene Fama did a series of studies that suggested that overall, active funds underperformed the US market between 1984-2006 by at least the margin of their expense ratios. They also said it is difficult to find managers with above-average skills. In effect, those studies indicated that the passive US investor would beat the active US investor under most circumstances.
Other studies suggest that a very small number of superior investors exist. A few people consistently outperform. Some of these out-performances could be attributed to random luck. But some studies suggest that an extremely small number of funds show consistently positive outperformances, even after controlling for luck. Again these studies are US-oriented.
Another set of interesting mutual fund studies look at individual manager performances in the US. Here, a study by Ajay Khorana in 1994, found that in some cases, manager replacement is inversely correlated with manager performance. The reason is obvious: A manager with a poor record is more likely to be replaced.
A subsequent study by Khorana also suggested fund manager replacement can lead to a drop in risky portfolio construction. This could be due to the fact that managers tend to be replaced only when they underperform. An underperforming manager could be prone to take higher risks to try and generate excess returns since he fears that he is on the verge of being replaced.
In 2012, two American researchers, Gary Porter and Jack Trifts concluded that, while a very small number of managers can outperform over a long period, fund-performance tends to revert towards the mean over a long period. In 2014, Porter-Trifts have done another study, which reinforces the first study's conclusions.
This implies that the best performing managers scored high in initial periods of management. It also meant that funds which had high returns for say, the initial five years (in relative terms, compared to other funds) had lower returns in the next five as performances pulled back towards the mean.
Another set of studies suggests that manager tend to “herd” into popular stocks and sectors because being part of the herd makes it less likely for a given manager to deliver relative underperformance. The rewards for relative out-performance are not high enough to compensate for the risk of relative underperformance. In Indian stocks, the herd instinct definitely seems to be there because most Indian mutuals hold very similar portfolios.
Nobody has done these sort of exhaustive comparative studies for India. The differences in terms of outperformance are so startling, the entire area must be worth further close investigation. There isn't data going back decades because the mutual fund industry was decontrolled only in the 1990s.
Apart from the relative imperfection of Indian markets pointed out above, there are other factors to be considered. Manager compensation in India is not structured the same way as in the US and this may change the incentives somewhat. But while it may explain investing style, it doesn't explain the skill factor-how do the majority of Indian fund managers effortlessly beat their benchmarks?
A third factor which may be unusual is the presence of LIC of India and the legacy of UTI. For many years, UTI was a monopoly player-it's large even now. LIC often seems to act as a government agent in that it picks up stakes in PSU disinvestment, etc. Their actions are predictably.
Does this skew the market and maker it easier for a fund manager to “herd” profitably?
A fourth factor is that many investors focussed on ULIP schemes floated by sundry insurance companies. ULIP compensation or cost structures are very different from classic funds and ETFs of course. If those schemes are considered “mutual funds” and, if the majority of ULIPs have underperformed their benchmarks, the India fund performance statistics would then start looking more “normal”.
Whatever the underlying reasons, it seems Indian investors have a good case for looking at the active diversified equity fund as an investment vehicle. Some of the studies cited above seem to suggest that a track record of outperformance is not very sustainable.
But the Indian market appears to be exceptional and it may be worth checking out the funds, which do have an excellent track record.
The writer is an independent financial analyst.
This article was originally published on November 14, 2014.
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