Fund managers find the Street too smart

MUMBAI: “Equity investments are just 3-4% of India’s household savings,” is a favourite refrain from mutual fund (MF) managers, especially when questioned about the prospects of new equity schemes.

They do have a point there. But if this proportion is to grow, then fund managers need to certainly pull up their socks.

A DNA Money analysis of the one-year returns of 152 diversified equity funds shows that 74 of them, or almost 50% of them, have failed to beat their benchmarks.

And 57 of them have failed to beat the Sensex. The situation was worse a year back, in 2005-06, when nearly 90% of the equity funds failed to beat the Sensex.

The regulations governing the MF industry require each scheme to have a benchmark index.

This is meant to help the investor figure out whether the MF is giving good returns because of the investment abilities of the fund managers or good market conditions.

An MF scheme is deemed to have done well, if it beats the returns of its benchmark index and vice-versa.

Agreed, the Indian markets have been running wild over the last four years, and this makes the fund manager’s job that much more difficult. Between this July and last, the Sensex has returned 54%.

That throws up the question: why should anyone invest in an actively managed equity fund when they can get better returns from an index fund?

Index fund is an MF which collects money from investors and invests them in stocks that make up a stock market index, in the same proportion as their proportion in the index.

Sandesh Kirkire, chief executive officer, Kotak MF, has an explanation. “Over a long period of time, the Indian market is a stock pickers’ market.

In fact, this applies to all developing economies as newer sectors and opportunities keep opening up. Only the actively managed funds can tap such opportunities. Index funds would cover only a narrow part of the market,” he says.

Kirkire’s views can be justified to a certain extent when seen against the number of new listings and the emergence of newer sectors.

But even he advises caution when picking one’s funds. “In a maturing market, investors need to carefully consider the past performance of the funds before making investments,” he said.

Another problem with following indexing as a strategy is that among the broad indices, index funds are currently available only on the Sensex and the Nifty.

One reason for the underperformance of so many schemes could be that assets under management (AUM) of equity funds have witnessed a phenomenal growth in the recent past.

What was Rs 31,834 crore in January 2005 has now grown four-fold to Rs 1.26 lakh crore.

When AUM swells, it leaves the fund manager between the devil and the deep sea. If he decides to retain the funds collected and not to invest, the returns would go down. 

If he decides to invest in a stock which he already owns and which would have probably gained handsomely, his returns are again reduced to that extent.

The last option — to buy stocks which the fund manager would not have bought if the AUM were smaller — will again slacken returns.

These reasons, to a large extent, clearly explain why most schemes easily beat their benchmarks from mid-2002 to mid-2005.

Jason Zweig, in his commentary to Benjamin Graham’s investment classic, The Intelligent Investor, cites another reason. “As a fund grows, its fees become more lucrative - making its managers reluctant to rock the boat.

The very risk that managers took to generate their initial high returns could now drive the investors away - and jeopardise all that fee income.

So, the biggest funds resemble a herd of identical and overfed sheep, all moving in a sluggish lockstep, all saying ‘baaaa’ at the same time.”

Yet another opinion offered for the underperformance is the way Indian markets have behaved in the last two years. While funds are usually an assortment of small-, mid- and large-cap stocks, they are mostly benchmarked to large-cap indices.

Hence, by getting a few calls right on stocks outside the large-caps, earlier, they could beat the benchmark returns. But with the market rally in the last two years proving to be narrow, and led by large-caps, many schemes have underperformed.

Says Dhirendra Kumar, chief executive officer, valueresearchonline.com: “Fund managers are getting beaten by the same trick they used earlier to beat the benchmarks.”

But Kumar says that it’s impressive that about 50% have still managed to beat the benchmarks.

“Overseas, 95% of the schemes trail their benchmarks. One, there are too many funds there and MFs themselves form a significant portion of the market. Here, they are still a fraction of the market and hence it’s much easier for them to beat benchmarks.”

In the all-time classic, A Random Walk Down Wall Street, Burton G Balkiel explains that over the entire 30-year period from 1973 to 2003 “two-third of the funds (in the US) proved inferior to the market as a whole”. The last thing we want is an Indian encore.