Are equity funds just fair-weather friends?

There is one school of thought that believes that index funds are more efficient than the average actively-managed equity fund. It cites two popular investment theories ‘Efficient Market Hypothesis’ and ‘Random Walk Theory’ that suggest that it is impossible to ‘beat the market’ in the long term. The Efficient Market Hypothesis states that market efficiency causes stocks to trade at their fair value.

The Random Walk Theory concludes that stocks pick a random and unpredictable path; the past trend cannot be taken as a benchmark to predict the future movement of a stock. Thus, supporters of index funds say, it might be appropriate for an average investor to move with the market with the help of an index fund.

A diversified equity scheme attempts to beat the benchmark. The inherent inefficiencies in the market help these funds, with active investment strategies, to fare better than passive investment funds. According to the World Bank, Indian markets rank a poor 46 in terms of efficiency compared with Brazil (35), Japan (29) and USA (6). In the absence of inefficiencies, such as that of institutional investors emerging as market movers, the ability to outperform a broad market benchmark will become more difficult and rare.

Performance
To evaluate the performance of index funds and equity diversified funds, rolling returns have been applied — these returns not only show the performance of the fund but also the volatility the fund encounters to generate returns. Looking at the performance of equity diversified funds against index funds over one-year, three-years, five-years and ten-years, the average equity diversified fund has outperformed the index fund across the different phases.

Another interesting statistic shows that, in the longer run (over 3-10 years), 11-29% of equity diversified funds have underperformed the average index fund. Meanwhile, over the past year, the percentage of equity funds underperforming the average index fund is 17.68%.

This can be explained by the performance of diversified equity funds during market slumps, where the range of losses by these funds is much higher. That the average diversified equity fund is a fair weather friend is substantiated by data. During the 2008 meltdown, the range of losses clocked by these funds varied between 47% and 87%. In comparison, index funds managed to contain losses within a tight range of 57-62%.

Barring the debacle of 2008, the Indian market over the past decade has displayed one of the most spectacular bull phases in history, which in turn has presented ample opportunities for fund managers to deviate from their index allocations and generate higher returns than the index itself.

However, this equation changed when the market went down. During the recent equity market meltdown, the worse of its kind which stretched from 08 January 2008 to 09 March 2009, a whopping 63.80%of equity funds underperformed the average index fund. While in the recovery phase from 09 March 2009 to date (07 Jun 2010), only 23.68% funds underperformed the average index fund.

Post purchase dissonance
Based on the average rolling returns for different periods, it can be inferred that for an investor with an investment time horizon of one year, chances of being dissatisfied with the returns of an equity diversified scheme are higher. However, if the investor has a longer investment horizon, there is no evidence of any disappointment with the returns delivered.

Expense ratio
The argument of passive versus active is not complete without reference to Warren Buffett, arguably the greatest investor. He says investors are better off putting their money in low-cost index funds. He stresses on cost, as the cost incurred in actively managed schemes are sinister; these costs gradually eat into the earnings, unnoticed.

In the Indian scenario, as per Sebi mandate, the maximum expense ratio borne by an index fund can be 1.50% while it can go up to 2.5% for an actively managed equity fund. Given that the figure of the expense ratio looks nominal relative to a much higher return expectation, most investors brush it aside. However, the phenomenon of compounding should not be underestimated. A quick calculation, assuming a 10% return, reveals that a 2.5% expense ratio can wipe out as much as 13% of your gains over a period of five years.

This reduces to 7.65% if the expense ratio is 1.5%. But what is shocking is that over a very long-term horizon of 30 years, a high expense ratio of 2.50% could slowly gnaw at 53%of your gains!
However, if one invests in a fund with an expense ratio of 0.50% with the same expected CAGR (compounded annual growth rate) then one will loose only 2.48% of the gain over a five year period. The bottom line is expense ratios could be a critical factor for selecting fund. Since, there is a marginal difference in the performance of the index funds, the expense ratio plays very important role in choosing a fund.

Inference
In the Indian context there is enough evidence to show that equity diversified funds have delivered higher returns for investors who have the risk appetite and a long investment time horizon. However, the odds of selecting an equity diversified scheme that manages to beat an index fund and thereby justify the additional risk assumed are bleak.

There exist inefficiencies in the Indian market, which the regulator is trying to correct. Amongst the many regulations to correct the inherent inefficiencies was the reform in the IPO processing, subscription and listing. Hence, given a more efficient market in the future the ability to exploit the inefficiencies will reduce.
In such a scenario, stock prices will move in random fashion and the probability that one investment strategy will outperform will drastically reduce. It is at such a juncture that the true potential of a passive investment strategy will dawn upon the investor. The acceptance of the index fund as an investment strategy will depend on the pace of reforms and removal of inefficiencies in the Indian financial market.