Does your actively managed MF pass the benchmark test?

The investor expects that the actively-managed fund would be better than the benchmark’s performance. Photo: iStock
The investor expects that the actively-managed fund would be better than the benchmark’s performance. Photo: iStock

Summary

  • Overwhelming evidence suggests that actively managed mutual funds underperform the benchmarks as well as passively managed counterparts.

Total net assets under management of mutual fund houses in India stood at 35.6 trillion, as on 30 June 2022. At 12.86 trillion, equity-oriented schemes contribute 36% of the overall assets under management. This significant portion of assets under management are managed actively. The fund managers, presumably having superior skill sets, are expected to outperform the benchmark portfolio as well as index funds that replicate those benchmark portfolios.

Although investors seem to trust the ability of the fund managers, there has been overwhelming evidence that actively managed mutual funds underperform the benchmarks and their passively managed counterparts.

You might also like

A bumper September quarter for banks?

What drove the SBI stock above 5 trillion mark

Policybazaar to avoid Zomato-like situation as early investors plan exit

When an investor invests in a fund that is actively-managed, the expectation is that the fund performance would be better than the benchmark’s performance. To outperform the benchmark, the fund manager is required to deviate from the benchmark portfolio.

The fund manager is required to construct and manage a portfolio that is somewhat different from the benchmark portfolio in terms of securities and weightages, using his/her securities selection skills. The fund needs to be managed as per the regulatory requirements.

For example, as per Securities and Exchange Board of India’s (Sebi) October 2017 circular on categorization and rationalization of mutual fund schemes, large cap funds are required to have a minimum of 80% investment in equity & equity-related instruments of large cap companies.

Large cap companies are defined as top 100 companies in terms of full market capitalization. The fund manager needs to comply with these requirements.

Mint 
View Full Image
Mint 

Yale Professors, Cremers and Petajisto have developed Active Share as a way to quantify the degree of active management. Active Share measures how much the fund’s portfolio differs from the benchmark index.

The range of active share is from 0% to 100%. In case of 0% active share, the fund is identical to the benchmark. Theoretically, an index fund is designed to have an active share of 0%. If the active share is 100%, this means the portfolio is entirely different from the benchmark.

Conceptually, the higher the percentage of active share, the more “active" the manager is.

Generally, funds with more than 50-60% active share are considered reasonably actively managed. Lower the active share, closer the fund is to the benchmark portfolio. Such funds are similar to the index funds and can be termed as “closet index funds".

The table shows the active share of 20 large cap funds for their top 10 holdings vis-à-vis the Nifty 100, as on 30 August 2022.

All these funds have Nifty 100 as their benchmark. As can be observed from the table, the top 10 holdings of the funds constitute a significant portion of the funds’ investments.

In some cases, this is as high as 74%. In case of the Nifty 100, the top 10 holdings are approximately 50% of the portfolio. The active share based on the top 10 holding ranges from 9.46% to 58.20%. Funds that have low active share are closely following the benchmark for their top 10 holdings.

Though, high active share is no guarantee of outperformance as active share metric is merely an addition to the toolkit for evaluating actively managed portfolios, low active share surely helps in identifying closet index funds i.e. funds that claim to be active, but in reality, are very similar to the index.

Investors would be better off by investing through low-cost index funds mounted on the same benchmark index rather than these active funds that hover around the benchmark portfolio but come with higher expense ratios.

For long-term investors, these choices matter, as the saving on expenses is certain whereas outperformance is not!

Dr Rachana Baid is professor - School of Securities Education, National Institute of Securities Markets (NISM). The views expressed here are personal.
 

Elsewhere in Mint

In Opinion, Harsh V Pant says India should make the most of its geopolitical sweet spot. Jaspreet Bindra examines whether Sanskrit is the best language for AI. Sudipto Mundle argues why fiscal and monetary policies need to synchronise. Long Story tells how to fix a drowning Bengaluru.

 

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

MINT SPECIALS