If the Employees’ Provident Fund Organization (EPFO), which began investing in equities for the first time this year, had allocated money to actively managed funds, it may have got better returns. The annualized median returns for these funds were 2-7 percentage points higher than their benchmarks.
EPFO allocated capital to passively managed exchange-traded funds (ETFs) which track benchmark indices. It recently expressed disappointment with limited returns so far over a three-month period, which in any case is too short a period to be looking at equity returns.
But even over a longer time period, actively managed funds have done better in India. For example, if EPFO had allocated ₹ 5,000 crore 10 years ago to a passive equity fund with the same constituents as an index, it would have grown to ₹ 14,823.12 crore now, assuming an annual 11.48% return. In actively managed funds, the corpus would have grown to ₹ 19,013.07 crore (assuming median return of 14.29% per annum).
To be sure, EPFO’s move to allocate capital to passive funds is backed by a significant body of global research which points to passive investment as an efficient way to invest in equities. For instance, Nobel prize winner Eugene F. Fama and Kenneth R. French in their study, entitled ‘Luck versus Skill in the Cross-Section of Mutual Fund Returns’, noted that few (actively managed) funds were able to generate returns which made money for investors after accounting for costs.
The majority of American actively managed mutual funds have underperformed their passive counterparts. According to mutual fund tracker Morningstar’s data from a June report, only 32.7% of large blend funds in the US yielded higher over a one-year period than an equivalent passive fund. The term blend refers to funds in which neither growth nor value investing styles dominate. A value-based approach focuses on undervalued companies, while a fund managed in the growth style is willing to pay a premium for companies showing high growth rates. The data broadly showed actively managed funds had lower ability over longer time frames to beat equivalent passive funds in the US.
The experience in India is different. An analysis of Indian equity mutual funds across multiple return periods shows that the vast majority of actively managed funds have actually outperformed their benchmark indices, as the chart shows.
Actively managed funds generated a median return of 2.74-6.13 percentage points above their respective benchmarks on an annualized basis. This applies over longer time frames as well. Over a 10-year period, 96.26% of assets under management by active funds beat their benchmarks.
How are they able to do this?
One reason could be the low efficiency of markets in India. Research is only available for a small portion of the listed universe. Most brokerage firms only cover the top 200 stocks. Nearly 3,000 companies are traded on Indian exchanges.
“We are a very under-researched and wide market," said Dhirendra Kumar, chief executive of Value Research, a mutual fund tracker.
A second reason could be size. Mutual funds here own a small fraction of the overall market which allows them to move in and out of stocks with ease. The American mutual fund industry’s assets totalled one-quarter of the country’s $24.03 trillion market capitalization. Indian mutual funds owned 4.28% of the country’s ₹ 98.45 trillion market cap. EPFO has a corpus of around ₹ 6 trillion, so an increasing flow of funds to Indian stocks could change that.
India’s outperformance is not unique among emerging markets.
A study of the performance of pension plans’ active and passive equity positions noted active funds’ outperformed by 250 basis points per year in emerging markets, 50 basis points in EAFE (Europe, Australasia and Far East) markets and there was little difference in American markets. One percentage point is 100 basis points.
EPFO may have adopted a conservative approach because of the difficulties in managing an equity allocation in the first place, according to Ranjeet S. Mudholkar, vice-chairman and chief executive officer, Financial Planning Standards Board India, a body for financial planners in India.
“There has historically been a strong resistance" to investing in equities, he said. More options could come in as financial literacy increases, but till then subscribers will have to be happy with 8.5% returns.