Performance of active fund managers in India

Proponents of active mutual fund management claim Indian markets are different from global ones, and Indian fund managers will always be able to out-perform the benchmark, or generate alpha. The most common reason given is that Indian markets are inefficient, fund managers are privy to information, or their technical grasp is higher than that of the market. In developed markets, by contrast, nearly 80% of actively managed funds under-perform indices over the long term. So indexing is a core strategy for investors. Most fee-based financial planners in the US use index funds only for financial planning.

Many argue that active fund managers can consistently exploit market anomalies, and that, in considering performance, one should look at longer periods. Looking at three-year periods for rolling return analysis, to avoid aberrations and applied two filters to select schemes for analysis. One, they should have existed for the past five years. And two, they should have as their benchmark one of the broader indices (Nifty, BSE, CNX100 and BSE100). Comparing the funds with Nifty BeES, which captures dividend unlike pure Nifty Index, and which has management expenses like mutual funds.

Thus 47 schemes were analyzed and simple average of returns taken. For simplicity’s sake, only growth plans or dividend reinvestment plans assuming no payout were considered. The investment period commences on December 2002 and ends March 2005. The last observation date is March 31, 2008. Over 500 data points were analyzed.

The average out-performance of large-cap diversified active funds has steadily declined over the past few years, and is now in the underperformance zone, touching 5% per annum underperformance. This is three-year CAGR (compounded annual growth rate) percentage, so in absolute terms, underperformance is around 15%, excluding loads. If loads are included under performance is 17.25% over three years.

How does one explain this? An aberration or a paradigm shift? We believe this trend is here to stay. Our reasoning is based on the same factors that are responsible for indexing doing better elsewhere. Stock market investment is not a zero-sum game. When markets are up, every one wins; when they’re down everyone loses (except shorts). But out-performance is a zero-sum game. For some investors to outperform the average, others must under-perform. So all investors as a group earn the stock market’s return, and in the aggregate they’re “average” (fund managers included). This is before deducting costs. Each extra return that one of us earns (including an active manager) means that others must suffer a shortfall in the same proportion. Thus, beating the market (before costs) is a zero-sum equation. Net of costs, it’s a loser’s game. This mathematical law governing stock markets has been stated by William F Sharpe, Nobel laureate in economics: “Properly measured, the average actively managed dollar must under-perform the average passively managed dollar, net of costs.” This explains gradual under-performance by many active managers. The absolute skills of fund managers remain the same, but their skills relative to markets are diminishing. In an increasingly institutionalized market dominated by professional managers, all of them as a group are becoming a larger portion of the market. This is the emergence of an efficient market where price discovery is faster.

Mutual fund documents state that “past performance is no guarantee of future performance.” This is true for out-performance, too. Study shows that basing fund selection on past performance is an unreliable method.

An investor seeking long-term exposure in equity is likely to be disappointed by remaining under the illusion that alpha or out-performance is easy, and that every fund manager will deliver it consistently. Of course, at any given point in time, some funds will out-perform. But this is random. Sadly, a typical fund investor will not be able to identify the individual “alpha” in advance, except by luck. A deeper analysis of such funds may force us to conclude that such out-performance is largely due to luck rather than skill.

If this is the harsh reality, how does one select in advance a fund which will out-perform for next five years? Indeed, it is difficult to decide, and hence internationally, large investors like pension funds, insurance companies, and so on, eliminate this guesswork by making indexing one of their core long-term equity strategies.

One cannot time the market, nor can one predict future out-performance or under-performance. The only predictable factor in investment which can be controlled is the various annual costs, for example, index funds at 0.5% per annum or active funds at 2.5% per annum. This difference of 2% per annum can balloon into a huge difference over a number of years, because of compounding. In the moderate return environment, it becomes a significant portion of returns.