More than 90% active mutual funds beat the indices. There is still time for ETFs.

While we are reaping the benefits of Indianization of Uber and Amazon (thought the VCs might be bearing the brunt of the same), all facts and theories that apply to west, might not be the best. Pink papers in the US are frequently abuzz with articles discussing the benefits of ETFs how the active fund managers are unable to beat the indices. Reports have outlined how less than 10% fund managers have been able to beat the indices and hence it's better to invest in Index Funds/ETFs rather than paying for the expenses of active fund managers. The connected digital world has made the news ubiquitous. I was recently speaking to one of my friends who quoted a leading US pink daily and mentioned that that active funds do not beat the indices. He was surprised when I told him that it's not the case in India and active fund managers do generate consistent alpha in India. The case for ETFs exists in western countries, because the markets are efficient and mature, and consistent stock picking becomes difficult over periods. Besides, any alpha generated by stock picking is eaten up by the fund management fees. However, India is different and something that applies to West need not be necessarily true for India. While we may have our thoughts and beliefs of what would work and what may not, Edwards Deming made a famous statement "In God we trust; all others bring data." Let's get an understanding from the data to bring out the facts.

For an apple-to-apple comparison, we have compared active funds with ETFs (exchange traded funds) and index funds, rather than the indices themselves, for the following reasons: "

Do Active Funds beat the indices and generate alpha?
The following graph shows the comparison of average returns of large cap mutual funds vs. index funds/ ETFs, over multiple return periods.

The returns are annualized (with data of 30-Nov-16). The active funds have outperformed the ETFs by wide margin, ranging from 2.3% to 5.2% annualized for different return periods. Considering compounding over time this is serious alpha. (Since direct funds have been in existence for less than 5 years; the 5 year return for direct plans is imputed from regular plans) It's important to note that the above performance of large cap funds is after the fund management fee which means that this is the return to an investor. Proponents of ETFs in developed countries have cited that the fund management fees often eats up the alpha generated by fund managers, but this is clearly not the case in India. On the contrary, investors are able to get value via active funds. However, in case of ETFs, the return for an investor might have been lesser as per the brokerage charges that an investor might have been paying. The key question is clearly answered. Active fund managers in India are generating substantial alpha over the ETFs. The image below showsthe percentage of funds that have outperformed these ETFs/Index Funds.

Risk Adjusted Performance
Risk is an important aspect of investing and it's important to look at the comparison from that standpoint for a comprehensive analysis. While the active funds take marginally lesser risk as compared to the ETFs/Index Funds, they clearly perform better on the Risk Adjusted Performance too. This clearly shows that active funds deliver higher return at similar/lesser risk.

In nut shell, the analysis makes a few things clear to us:

• "Active funds do generate alpha in India and are a better choice as compared to ETFs/Index Funds "   
• Active mutual funds have also been performing better on the risk adjusted basis as compared to ETFs/Indices "   
• Fund management fee, being charged by active mutual funds (though coming down over time), is worth paying as the extra returns are achieved net-of-fee

It seems Indian markets still have some time to mature and get enough efficient that would make it difficult for fund managers to generate alpha. This is not only the function of market participants and liquidity, but also, a function of economic development of the country. As and when that starts happening, ETFs would start finding more flavor with the investors. Till then, active mutual funds are better than the west.

By, Sharad Singh, CEO, Invezta.com