Even as equity-fund investors in the US make a beeline for index funds, Indian investors have every reason not to do so. One look at the long-term records of actively managed equity funds in India is enough to convince anyone to avoid index funds.
The margins by which some Indian funds have been beating their benchmarks is mind-boggling.
Far behind
For instance, in the large-cap category, top-ranking funds earned a CAGR of 15 per cent in the last five years against the 10 per cent return of the Nifty and the Sensex.
Top mid-cap equity funds delivered 20-21 per cent CAGR, while the CNX Midcap Index has managed only 9.9 per cent. Small-cap equity funds have done an even more splendid job of beating the index, managing 21-22 per cent CAGR over five years, while the BSE Smallcap Index delivered a measly 6.6 per cent.
Now, one conclusion from this could be that Indian fund managers are far more talented stock pickers than their US counterparts. This could well be true.
But the margin of outperformance by which active managers are able to beat their benchmarks raises another question too. How good are the benchmark indices that funds use if they are so easy to beat?
A fund manager beating his benchmark by 2-3 percentage points through stock selection is fine. But when a whole bunch of schemes in a category manages twice or thrice the returns of the index, it may be time to raise questions about the quality of the index itself.
Why indices lag
On analysis, there seem to be three reasons why active funds in India seem to leave their benchmarks so far behind.
One, Indian funds use bellwether indices such as the Nifty, Sensex, CNX Midcap/BSE Midcap and CNX Smallcap/BSE Smallcap as their benchmarks. These indices are designed to capture the market mood of the moment and do not select stocks using any fundamental or quality criteria.
When the index committee of the BSE or NSE sits down to select stocks for the Sensex, Nifty or their mid- and small-cap indices, their mandate is not to play Warren Buffet and look for the best wealth creators in the listed universe. Instead, their objective is to put in stocks that will best capture the market mood and behaviour on a particular day, month or year.
The selection criteria for these indices makes this clear. They are based entirely on liquidity and tradability in a stock. The key criteria for a stock to figure in bellwether indices are its free float, market capitalisation and impact costs, not the company's return on equity, cash flows or earnings growth.
Yet, the Indian investment universe is cluttered up with hundreds of poor-quality companies; many don't even disclose their quarterly results. Therefore, by picking stocks for their fundamentals rather than tradability, active funds manage to do far better than the indices.
Two, the indices that Indian funds use as benchmarks are pretty narrow. As compared to the listed universe of nearly a 6,000 stocks, the Nifty is a 50-stock index and the Sensex a 30-stock barometer. Even the CNX Midcap Index is a 100-stock index. Now, the stocks in these indices may be the most traded ones, but that doesn't make them in any way representative of all the other 5,900-odd stocks that make up the listed space. Effectively, active managers have so many non-index stocks to choose from that they can easily beat these indices.
In developed markets like the US, many funds are benchmarked to broad market indices such as the Russell 3000 or even total market indices such as the Wilshire 5000 and these have proved far harder to beat than the Dow Jones Industrial Average.
Three, the free-float market-cap methodology used by the Indian indices also favours momentum. What this method of index construction essentially does is it assigns higher and higher weights to the most active and fancied sectors in the market. For instance, if a lot of FII money is flowing into banking, the market caps of bank stocks rise and they get higher weights in the index too. This is in fact how the Nifty or Sensex have ended up having 30-31 per cent weights in the financial sector. Now, any active manager who is bearish on PSU banks may outperform the index.
New benchmarks
There is nothing wrong if active managers select fundamentally good stocks and manage to beat the indices. But by using only liquidity-driven indices to benchmark their performance, it appears that active funds in India are setting too low a bar.
Having comprehensively beaten their old benchmarks, maybe it is time Indian fund managers raised the bar by changing their yardsticks. Today both the NSE and the BSE have a range of new strategic and thematic indices that use non-liquidity criteria to select stocks. Fund houses can consider these for their benchmarks.
The NSE, for instance, now has a NSE Quality 30 (companies with most sustainable business models), CNX Alpha Index (50 stocks with the highest alpha), NV20 (20 companies that meet value criteria), which may be good benchmarks for active funds.
If fund houses feel these are too narrow, they can consider broader market benchmarks like the BSE 500, BSE AllCap Index (comprising over 700 stocks across market caps) or CNX 500 as benchmarks.
Active funds in India have come out in flying colours against the conventional benchmarks. But now that private fund houses are over two decades old, it is time they raised the bar for themselves.
After all, if your weighing machine isn't working well, will you get fitter?
This article was originally published on September 24, 2015.
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