Can you beat the index ?

Can you beat the index 3 Can you beat the index ?

In the last 2 years, a vast majority of the Indian mutual funds have underperformed the equity indices like the Nifty and the Sensex. In fact, if you consider a 3 year or even a 5 year period for analysis then nearly 70-80% of the mutual funds have failed to beat the index. That means; you would have been better off staying invested in an index fund or an ETF rather than being invested in an active equity fund. What does this mean for investment strategy and how to approach this kind of a challenge?

Have Indian funds really failed to beat the index?

The table below captures how three categories of equity funds have performed vis-à-vis the index under different time frames. The numbers show the percentage of underperformance versus the relevant index benchmark.

Fund Class  Benchmark   1-Year (%)   3-Year (%)   5-Year (%)   10-Year (%)
Large CapBSE 10076.67%82.93%65.71%61.34%
ELSSBSE 20080.95%83.33%51.35%45.71%
Mid/SmallMid Cap Index18.92%47.83%26.98%48.84%

  Data Source: Morningstar

Tighter SEBI classification norms

SEBI mutual fund regulations 2018 made an important shift in terms of reclassification. SEBI was clear that the fund names should reflect the investment strategy and funds should not use misleading names and multiple fund nomenclatures to confuse the investor. For example, large cap funds had to keep an exposure of 85% to large cap stocks while a mid cap fund had to keep an exposure of 75% to mid cap stocks. Hence, the flexibility that fund managers enjoyed in the previous scenario to flexibly manage the asset mix did not exist any longer.

Stock performance is concentrated in a few stocks

In technical parlance this is called skewness. You can easily see that in the Nifty and Sensex heat charts. The action is all concentrated in a handful of stocks. Stocks like HDFC Bank, HDFC, Infosys, TCS, RIL, ICICI Bank and HUVR explained most of the gains in the last one year. That is where the real problem comes in. Fund managers can only hold so much in these star stocks. When fund managers get into sectors like autos, pharma and metals perforce, their funds underperform. That has been a key factor responsible for fund managers struggling to outperform the index. When a handful of companies are the stars, it is neither possible to pinpoint winners nor to allocate all the funds to these stocks. Now you see why funds have underperformed.

Costs are steep and that is making the difference

The TER (total expense ratio) ranges from 2.42% for large cap funds and mid cap funds to 0.48% for index funds and still lower for ETFs. Even if you had taken a direct fund instead of a regular fund, you have saved at least 100 bps cost and that would make a difference to your returns.

In the bull market scenario, costs don’t really matter because you are getting fancy returns anyways. As market volatility starts to bite, investors begin to feel the need to lower cost. An active fund has, on an average, to outperform an index ETF by 200-220 bps just to be at par in terms of effective net returns. That is pulling investors towards passive funds.

Answer could be passive funds

The last two years have marked a return to reality. In the year 2018, the median passive equity fund generated 2.3% returns compared to negative returns by the median active fund. In 2019, the median passive fund generated an average return of around 9.3% while the median active fund struggled to give 5.3%. In the last 2 years passive funds like index funds and ETFs are surely getting it right and you need to increase your exposure to such passive funds as part of your portfolio strategy.

AUM growth in the passive investing space has been rapid in the last few years. However, in terms of AUM / GDP India still lags. Consider these statistics. India’s AUM/GDP ratio is currently around 7%. This compares with 91% in the US, 53% in Canada, 70% in France, 49% in Germany and 30% in Japan. Even China at 11% is better off. For the next round of growth in MF AUMs, the answer could be in passive funds.

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