Four surprising facets shaping mutual fund returns

Four surprising facets shaping MF returns
Four surprising facets shaping MF returns


  • As of February, over a 10-year period, less than two in five regular schemes outperformed the benchmark returns
  • Mutual funds regularly fail to beat their benchmark returns. In fact, this is not just an Indian phenomenon but happens all over the world. There are many reasons for this.

67% investors fail to beat benchmark index returns."

“62% SIPs in equity schemes failed to beat their benchmarks in 10-year horizon."

“86% mid cap funds fail to beat their benchmarks in 5 years."

“Most SIPs in mutual fund schemes fail to beat benchmarks."

Dear reader, these are some headlines that have been splashed in the media over the last few months. All these headlines tell us the same story: that when it comes to the performance of mutual funds, most schemes fail to beat their benchmarks.

Now, what is a benchmark and why is it important? When investors invest in a mutual fund scheme, they are seeking professional expertise in investment of their monies. Hence, this professional expertise should generate a return on investment which is higher than the return generated by the broader market. The benchmark of a scheme is an index which represents the broader market. If the benchmark of a scheme representing the broader market is the BSE Sensex, then the scheme should generate a rate of return higher than the BSE Sensex.

But as the above headlines suggest, that isn’t always the case. In fact, a consultation paper released in May by the Securities and Exchange Board of India, India’s mutual fund and stock market regulator, suggests the same.

As of February 2023, over a 10-year period, less than two in five regular schemes managed to beat or meet their benchmark returns. Over a five-year period, a little more than one in four regular schemes managed to meet or beat their benchmark returns. Over three years, one in three regular schemes managed to meet or beat their benchmark returns.

In this piece, we will try and understand why mutual funds regularly fail to beat their benchmark returns. In fact, this is not just an Indian phenomenon but it happens all over the world and has been happening for decades. In fact, the S&P Indices Versus Active Funds (SPIVA) US Scorecard 2022 points out that over a 20-year period, close to 95% of domestic equity large-cap mutual fund schemes in the US had underperformed their benchmark. When it comes to a 15-year period, more than 93% of schemes had underperformed their benchmark. Over the five-year and 10-year period, the proportions were more than 86% and 91%, respectively. Similar trends can be seen across other parts of the world as well.

Other than understanding the reasons behind this phenomenon, we will also try and see if there is something that investors can do to overcome this problem.

Problem in a flood

At the heart of most mutual funds not being able to beat their benchmarks is a rather simple point. As Jason Zweig writes in the commentary accompanying Benjamin Graham’s The Intelligent Investor: “The better a fund performs, the more obstacles its investors face." Why is that the case?

When a mutual fund scheme does well, it typically leads to investors pouring money into the scheme. This creates problems. This leaves the fund managers with a few choices and all of them are bad: “[The fund manager] can keep that money safe for a rainy day, but then the low returns on cash will crimp the fund’s results if stocks keep going up. He can put the new money into the stocks he already owns—which have probably gone up since he first bought them and will become dangerously overvalued if he pumps in millions of dollars more," Zweig writes.

The last option is to buy stocks which the fund manager did not like in the first place. All these points don’t work well for the investor. Now, this is not to say that all fund managers and all schemes face this problem when money comes flooding in. Nonetheless, at an aggregate level this is a problem.

‘Herd of overfed sheep’

Second, there is the question of the main incentive in this case. More the money that comes into a mutual fund scheme, the more the money that the asset management company running the scheme makes. As Pulak Prasad writes in What I Learned About Investing From Darwin: “The fund management company gets paid based on the size of the fund, not on its performance. But over the long term, many researchers have found that an increase in fund size can lead to declining performance."

Prasad offers the example of a study published in 2009 in the Journal of Financial and Quantitative Analysis. This was a study of actively managed funds in the US from 1993 to 2002 which showed that there was a significant inverse relationship between the size of a mutual fund scheme and its performance. Again, this is true at an aggregate level.

As Zweig puts it: “As a fund grows, its fees become more lucrative—making its managers reluctant to rock the boat. The very risks that the managers took to generate their initial high returns could now drive investors away—and jeopardize all that fat fee income. So, the biggest funds resemble a herd of identical and overfed sheep, all moving in sluggish lockstep, all saying “baaaa" at the same time."

Closet indexers

Third, fund managers, like many other professionals, make decisions that are the easiest to justify, and possibly not always in the best interest of the investor. Let’s try and understand this through an example. “Let’s assume there are 10 stocks in an index, each with a weight of 10%. If the fund invests $100 in the market, with $10 invested in each business, it has perfectly replicated the index. In such a case, their active share is said to be zero. If the fund invests in none of these stocks, its active share is 100%," Prasad writes.

If the idea is to take no or little risk, fund managers can just replicate an index and sit tight, with a very low active share. The trouble is that it is highly unlikely that they will generate a return higher than the return generated by the index. This works well for fund managers “unwilling to risk their careers, but happy to compromise returns for their investors".

If a scheme has to beat the benchmark, the fund manager needs to increase the active share of a scheme and invest in stocks that are not a part of the index or invest in stocks that are a part of the index but the fund manager’s investment in these stocks is in different proportions than the proportion of the stocks in the index. This automatically means taking on a risk which might not be easy to justify later when the performance of the fund manager is measured.

Let’s try and understand this through an example. Let’s say a fund manager has figured out that a particular stock has been beaten down badly and that its current price does not reflect its fundamental value. Now, the fund manager might want to buy the stock and hold tight with the understanding that as the broader market figures out what he or she has already figured out, the price of the stock will go up. The trouble here is that this might not happen immediately and take time. During the period, the returns generated by the scheme might be negatively impacted, making it difficult for the fund manager to justify the investment decision taken. The scheme’s lack of short-term performance may even lead to investors selling out and moving on to other schemes.

These reasons essentially encourage many fund managers to become closet indexers, where they largely try and stick to investing in stocks that make up for the broader indices. As Mervyn King and John Kay write in Radical Uncertainty: Decision-making for an unknowable future: “‘No one ever got fired for buying IBM’ was for long a mantra among mid-ranking executives, and a crucial factor in the success of that company’s technically unremarkable PC." Closet indexers work along similar lines.


Fourth, while fund managers keep emphasizing on the importance of people investing for the long-term, many of them seem to ignore the mantra totally. “The typical fund holds on to its stocks for only 11 months at a time, so trading costs eat away at returns like a corrosive acid," Zweig writes.

Further, a report titled Long-Term Conviction in a Short-Term World, published by Morgan Stanley, in 2018, points out: “The implied average holding period of mutual funds has fallen to less than one year from seven years in 1960.."

How do things look in the Indian case? We can figure this out by looking at the portfolio turnover ratio of the equity mutual fund schemes. A high ratio indicates a lot of buying and selling of stocks carried out by the fund manager, totally opposite of a buy-and-hold strategy. A low ratio would indicate the vice versa.

A look at the portfolio turnover ratio of more than 500 equity schemes suggests that many fund managers continuously keep buying and selling stocks, instead of following the buy-and-hold strategy. This mostly isn’t good for the overall performance of schemes because no fund manager can be right all the time about where stock prices are headed in the short-term.

The options

Now, what can the retail investor do about this? There are two ways of investing in a mutual fund scheme—the regular way and the direct way. In the regular way, the investors end up using a distributor/agent to invest. These can be banks, individual agents and brokerages. But one can invest directly in a mutual fund scheme and cut out the middleman. This ensures that no commission needs to be paid to the agents, leading to lower expenses in running the scheme and thus higher returns than in the case of investing through the regular route.

So, the chances of beating the benchmark return go up through the direct route. If we look at data, over a 10-year period, nearly two-thirds of schemes met or beat their benchmark returns when the investment was through the direct route. In case of the regular route, only two-fifth met or beat the benchmark return.

Over a five-year period, nearly 45% of the schemes met or beat their benchmark in case of the direct route, against 27% in case of the regular route. This is one way of going about it. Many apps now offer this option.

The other way is to invest in exchange traded funds (ETFs). These are index funds that can be bought and sold on the stock exchange. Index funds are essentially mutual funds which mimic an index. So, a Nifty 50 index fund is expected to buy and hold stocks that constitute the Nifty 50 index, in the same proportion as in the index.

So, what does investing in an ETF ensure? First, the risk of the investment decisions being made by the fund manager gets taken out of the equation. Of course, this works both ways. In an actively managed fund, if the risk taken by the fund manager works, it adds to overall returns. If it doesn’t, then the chances are the overall returns of the scheme might be lower than its benchmark.

Second, the expenses of running an ETF are low. The average total expense ratio of equity mutual funds operating in India is 2% and that of ETFs is 0.11%. Over the long-term, this makes a huge difference in the overall return and the total value of investment.

Further, the problem with ETFs in India is that beyond the large indices like the Nifty and the Sensex, there isn’t much investment that has been made in ETFs that replicate other indices. Given this, liquidity can be a problem—it is difficult to buy and sell units of these ETFs due to the lack of sellers and buyers. In this scenario, investors can invest in high-rated index funds.

Vivek Kaul is the author of Bad Money.

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