Why pick stocks when you can pick an index? In the classic active versus passive debates in India, proponents of stock-pickers (active fund managers) have always claimed that Indian markets are different and Indian fund managers will always be able to outperform the benchmark or generate alpha. The most common argument is that the Indian markets are inefficient and the fund managers are privy to better information or their level of intellect is higher than the market. To test this, we did some calculations. The theory falls flat.
We looked at three-year periods for rolling return analysis to avoid any aberrations. The schemes were selected by applying two filters. First, the scheme should have had been in existence for the past five calendar years. Second, the scheme should have had as its benchmark one of the broader indices (Nifty, BSE, etc). We have compared these funds with Nifty BeES because it includes dividends unlike the Nifty and also includes management expenses like other mutual funds.
After applying these filters, we were left with 47 schemes. We took a simple average of returns. The period of investment is between December 2002 and March 2005 (daily). The last observation date is 31 March 2008. Thus, over 500 data points have been considered for the analysis.
We discovered that the average performance of large-cap diversified active funds has been consistently declining over the past few years. The underperformance is close to 5% per annum. This is a three-year CAGR, and hence, in absolute terms, it means the funds underperformed by 15%. If we include the loads, the figure increases to 17.25% over three years.
This trend is here to stay. In an increasingly institutionalised market dominated by professional managers, they are, as a group, becoming a large portion of the market. The direct consequence is the emergence of an efficient market, where price discoveries are faster. The moral for investors: Keep it boring. Keep it simple. Keep it cheap. Invest in index funds. The most common parameter for choosing a fund is its past performance. The results from our study show that this method is highly unreliable.
An investor seeking a long-term exposure in equity is likely to be disappointed by remaining under the illusion that outperformance is easy and that every fund manager will deliver it consistently. Of course, at any given point, some funds will outperform. But this is random. A typical fund investor will not be able to identify the individual alpha in advance—except by luck.
If this is the harsh reality, how does one select a fund that will outperform for the next five years? Internationally, large investors like pension funds and insurance companies eliminate such guesswork by indexing—one of their core long-term equity strategies. No one can time the market or predict over- or underperformance. The only predictable factor which can be controlled in investments is the various annual costs. Here, too, index funds with lower expense ratios (0.5% p.a.) score over active funds (2.5% p.a.). This annual difference of 2% can balloon into a huge sum over a period of time.
These reasons should encourage investors and the financial industry to invest in them.
— Sanjeev Shah, Executive Director, Benchmark Mutual Funds