Home >Money >Personal Finance >How market cycles affect an MF’s ability to outperform
Photo: Mint
Photo: Mint

How market cycles affect an MF’s ability to outperform

  • Conservatism of fund managers can affect performance during recoveries and bull phases, says study
  • If you are trying to choose between active and passive MFs, look at market cycles but don’t rely on it alone

Rising stock prices and positive sentiment characterize a bull market. The opposite is true of a bear market. A shift from bull to bear, technically, is said to occur when there is a fall of more than 20% from the recent peak. The opposite change moves a market from bear to bull.

As a mutual fund investor, these terms may mean little to you. This is because you are not trading in the market but investing for the long term. However, the conservatism of fund managers can act as a drag on fund performance during market recoveries and bull phases, according to a study by S&P Dow Jones Indices that was published in 2017. The study, which mapped the 10-year period between 2006 and 2016, also showed that the effect of fund managers’ strategies is the strongest when the market is in recovery mode. As a slow recovery gathers pace in the Indian market at present, the findings of the study gain significance.

We explain the phenomena the study explores and what they mean for you.

The study

In April 2020, S&P Dow Jones Indices released its SPIVA Report for year-end 2019 that compares how actively-managed funds perform against their benchmarks. The report shows that 82% of large-cap funds and 78% of equity-linked savings schemes (ELSS) underperformed their benchmark indices over the past five years.

However, the S&P Dow Jones’s study of 2017 was more detailed on what kind of market cycles actively-managed mutual funds capitalize on and which ones do they fail at (you can read the study at bit.ly/2YD1O6p).

The study looked at three market cycles—bull, bear and recovery—over a 10-year period ending 2016. For example, December 2006 to December 2007 was a bull market, December 2007 to February 2009 was a bear market and February 2009 to February 2010 was a recovery market, according to the study.

Graphic: Mint
View Full Image
Graphic: Mint

Bulls and bears: “We observed that large-cap and mid and small-cap fund returns had relatively low beta across different market cycles, which may have been driven by allocation to cash or defensive or low beta stocks in their portfolios. As a result, the active funds tended to outperform by a more significant margin in bear markets and by a relatively modest margin in bull markets," wrote Akash Jain, associate director, global research and design, S&P Dow Jones Indices. Beta is the sensitivity of a stock to the market as a whole.

Recoveries: “Active funds outperformed in trend-continuation markets and underperformed when the market regime changed," wrote Jain. “This implied that most fund managers may not have reduced their cash positions or tilted their portfolios to less defensive stocks when the market recovered from market downturns," he added.

This means, scared by a recession, fund managers do not gather enough confidence to capitalize on the bull market that follows.

“Intuitively, the findings of the study make sense. Funds will possibly hold more cash or low beta stocks in bear markets and, hence, outperform but still hold on to them in recoveries and, hence, underperform," said Nithin Sasikumar, co-founder, Investography, a financial planning firm.

What it means for you

“For retail investors, this market timing between active and passive is not very important. If you look at this comparison across cycles, we prefer low-cost index funds over actively-managed ones in the large-cap space. In the small-cap space, active does generate alpha and so we pick fund managers who are investing in quality names there," said Sasikumar.

This bears out in the data. Over the past 10 years, just 35% of large-cap funds beat their benchmarks and 53% of ELSS funds did so, according to the SPIVA report.

But what if these percentages are biased by small funds? Another way of looking at the same story is to asset-weight the funds since more investors will be present in larger funds than smaller funds. Such an asset weighted actively-managed index has done marginally better than the benchmark over the past 10 years for almost all categories. However, performance slipped in the last three to five years.

The underperformance story does not hold in the mid- and small-cap space. As much as 59% of such funds beat their benchmarks over the past five years and 55% did so over the past 10 years.

If you are a savvy investor trying to choose between active and passive funds, pay some attention to market cycles but don’t rely on it alone. Overall long-term outperformance against the benchmark across market cycles in an active fund matters far more. In an index fund, on the other hand, tracking error (ability to replicate index) and low costs matter a great deal.

If you are picking an active fund, try to ensure that the fund has seen various market cycles, to mitigate the bias created by a market cycle in the immediate past.

Subscribe to Mint Newsletters
* Enter a valid email
* Thank you for subscribing to our newsletter.

Click here to read the Mint ePaperMint is now on Telegram. Join Mint channel in your Telegram and stay updated with the latest business news.

My Reads Redeem a Gift Card Logout