Equity schemes have to now show performance against the total return index of their benchmark, which is harder to beat. Even before this change, funds were struggling to beat benchmark returns
Is the 1-year return of your large-cap equity fund looking inadequate, sitting at less than 10% since the start of April 2017? The benchmark returns are similar. The 1-year return for the large-cap benchmark Nifty 50 index was 10% till 23 March 2018 and 11.1% for S&P BSE Sensex. But of 52 large-cap equity funds as defined by Valueresearchonline.com, only 16 have outperformed their benchmark. Which means that the other 36 have delivered a return less than 10%.
Are large-cap fund managers losing their ability to generate alpha, the benchmark-plus return that they generate, which justifies their fees?
In the large-cap category, only 31% funds were able to beat their benchmark in 1-year returns (for the year ended 25 March 2018). Roughly 65% of the funds were able to do this in 2017 and 2016, and 85% in 2015.
In fact, actively managed funds in other categories too are struggling to deliver. Only 63-66% of the funds in the three other diversified equity categories—multi-cap, mid-cap and small-cap—outperformed their respective benchmarks for 1-year return.
Experts have often warned against just looking at 1-year performance, and rightly so. There are many factors that impact performance in the near term, and to get the most efficient equity returns, one has to remain invested for longer periods.
The outperformance statistics improved significantly in the 5-10-year period, with at least 75-85% funds outperforming their benchmarks. For the funds in the small-cap category, 100% funds outperformed the benchmark in 5-10-year returns; this holds true across different years as well.
But the caveat here is that we are still comparing returns against the funds’ stated benchmarks, which are mostly all price indices and not total return indices. A total return index (TRI), as opposed to a price index, considers returns from gain in price or capital gain and adds dividends to it. Using a total return index, as the capital markets regulator has also acknowledged, is the accurate way to measure performance. But since dividend gains are part of the benchmark’s stated returns, funds returns lag when seen against TRI as opposed to price index.
For example, five of the 13 funds in the large-cap data set which uses Nifty 50 price index as their benchmark, outperformed for 1-year returns (as on 25 March), and five out of eight funds outperformed the 10-year annualised returns taken on the same date. But the number of schemes outperforming in this set falls to four and three, respectively, if Nifty 50 price index returns are substituted with TRI.
Other analyses also show a similar trend. Over the 1-year period ending December 2017, as many as 59.38% of equity large-cap funds underperformed their benchmark, according to the SPIVA India Scorecard, published by Asia Index Pvt Ltd, which compares the performance of actively managed Indian mutual funds with their respective benchmark indices over 1-, 3-, 5-, and 10-year investment horizons. Over the 3-, 5-, and 10-year periods, 53%, 43.4%, and 53.54% of large-cap equity funds underperformed the S&P BSE 100, respectively (fund categories as per Morningstar and index returns are on total return basis).
In the short term, actively managed equity funds are likely to find it even harder to beat benchmark returns, thanks to increasing volatility and institutional investors. The long-term returns data does not show this trend yet. However, with the comparison metric now including TRI, as mandated by the Securities and Exchange Board of India (Sebi), and the regulator’s intended fund categorisation coming into place, lower alpha may be a reality even for longer holding periods.
Interpretation of historical performance for mutual funds will undergo a big change once all the schemes have readjusted their portfolios and merged according to Sebi’s categorisation guidelines. Moreover, as the stock selection universe gets tightly defined, it may become harder to consistently select outperformers from a smaller basket of stocks.
“Earlier, along with the performance number one had to refer to the portfolio to see how true to the category a fund was. Performance deviation could be higher if more stocks came from, say, the mid- and small- cap category in a large-cap fund. Next year’s returns will be easier to interpret as large-cap funds will have a defined 100 stocks to invest in," said Vikas Gupta, chief executive officer and chief investment strategist, OmniScience Capital. “Beating the benchmark should still be possible, but it will get harder. Larger funds are likely to have a higher proportion of a fund benchmarked to the index, rather than with active weights," he added.
However, not all are convinced that the end of alpha for large-cap funds is near. “Last year, many funds didn’t do well relative to the benchmark because they weren’t invested in the segments that rallied. There are still a lot of inefficiencies in the market and we don’t have any reason to doubt that selective large-cap funds will outperform consistently in the long run. Possibly, one has to be more selective in picking fund managers than in picking a scheme," said Nishant Agarwal, managing partner and head-family office, ASK Wealth Advisors.
At present, the market for actively managed funds far outweighs the demand for the lower-cost alternative of exchange traded funds which simply track the index. Data suggests that a majority of funds are still able to outperform the index in the long term. Nevertheless, if the trend of lower alpha continues, the 1-year underperformance will add up for the long term too.
With the new definition of large-, mid- and small-cap categories, one has to be even more careful in selecting schemes and discerning about the price paid for active management.
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