Mutual funds and the elusive search for alpha

The core rationale for mutual fund (MF) investing is an assumption of outperformance (also known as Alpha). The raison d'etre of active fund management is the ability of the fund manager to outperform the benchmark. Traditionally, MFs in India have been known to be solid Alpha-generators. But evidence has been mounting in recent times about declining levels of Alpha.

This impacts investors directly, as strategies need to change in case active MF managers cease delivering expected results. To examine the issue empirically, we undertook a study of more than 500 schemes from the ACE-MF database to assess their performance over the last decade, i.e., between 2008-2018. While the results were less flattering there were a few positive takeaways too. 

The annual average outperformance vis-a-vis their respective benchmarks for the equity oriented schemes, weighted by their respective schemes, for the entire mutual funds industry stood at 2.2% during 2008-2018. However, their outperformance has continued to fall since the spike of 2014 and have turned negative for the last three years with 2018 recording an under performance of -2.8%. 

While the overall outperformance has come down, a consequential question to ask is that what is the probability of 'success' of picking a scheme that would be winner. It turns out there are wide variations in the performance of the mutual funds industry with only around half the schemes generating positive returns on an average during the period 2008-2018. Here too the percentage of outperforming schemes reached a peak of 78% during 2014 but the ratio has dropped to mere 23% during 2018. Thus it's a matter of coin toss that a selected scheme would outperform in a particular year.

As equity is primarily a long-term investment and for an investor with longer-time horizon the reasonable question to ask how many years (out of 10 years) a selected scheme is expected to outperform. It so happens that only 45% of the schemes have managed to outperform the benchmark for six or more number of years in the last decade. Thus, one has less than half the chance that a selected scheme would outperform at least half the time.

Judged against a stricter criteria of continued outperformance, we find that the slippages are far higher in terms of contagious rather than discreet outperformance. After 50% probability of outperformance during the first year, the probability of continued outperformance drops barely to 20% within the third consecutive year.

One of the often repeated market adages is that as size of a scheme grows in size (AUM) its performance starts declining. We do not get any evidence of this whatsoever in multiple data exercises that we undertook to check the veracity of this claim. Indeed, AUM-weighted returns are higher than unweited average of all schemes. Performance of upper two quartlie as per size class is also better. Even among mid-small cap where this trade-off is expectedly higher, the upper quartiles perform better. Finally, on the continious scale of size too we do not get any correlation between size and outperformance across all the schmes all the years. In all cases, if anything, there is a mild evidence that bigger schemes have performed better explaining their growing endurance. 

Market-cap wise, large caps are most susceptible to lack of consistency in outperformance. While it may be somewhat counter-intuitive at first glance, the number of years of success is agnostic to the size of the funds. Also a larger proportion of mid-cap schemes outperform their benchmark than that of the proportion of large cap schemes.

As the extent and occurances of outperformance whether for a year, across the years and on a continued basis drops and location of outperformance becomes more random, one might be tempted to look for performance hugging strategies based on past record to select winners on a continued basis. We examined one such strategy of selecting the 10 top schemes every year based on their return in the previous year while investing in equal proportions among these top 10. The result however, was a further degradation in performance even from the average of all schemes for these years.

Make no mistake. Market tend to reward the outperformers and punish the ones with continued underperfornance. AUMs do tend to chase the outlier outperformers. For the top two quartile of schemes, the AUM growth of these schemes far outweigh that of the underperfomers. Long period performance (10 years) too tend to be higher for the top quartile funds, hence, highlighting the necessity of both fund selection and advice from skilled advisors. 

Fund selection has become an even more involved, tricky, and an important activity than ever before. Yet, it is possible to identify winners, as there would be styles and trends that reward active fund manager calls, given the pockets of relative underperformance. 

The writer is the managing partner and head - Products, Investment Strategy & Advisory and International Business and Associate Director – Research at ASK Wealth Advisors.

Mukherjee is managing partner and Mitra is associate director-Research at ASK Wealth Advisor