Market Walk

Active Funds – The majority of equity funds struggle to beat the benchmark indices

Equity funds - Tradeplus blog

A recent report by Standard & Poor, has once again highlighted how active funds are struggling to beat the benchmarks. The latest S&P report has once again highlighted the limitations of active funds.

Short term performance

If the large-cap funds are compared to the benchmark based on 1-year returns, then just about 50% of the funds have managed to outperform the index. The ratio is at around the same level if you look at the ELSS funds or the alpha focused small-cap and mid-cap funds. In all these cases, the percentage of funds that actually outperformed the index is around 50%. That is not really much of a worry since you could attribute this to the typical flip of a coin probability risk.

Longer-term is the worry

The problem is with the longer term. For instance, when these large-cap funds are evaluated against the benchmark indices over a 5-year period, nearly 85% of these active funds actually did worse than the index. That is more of a worry because equity funds are supposed to be long term wealth creators and this data belies the confidence of investors. There are several reasons. Firstly, stock performance was limited to a handful of stocks and MFs have limits on how much of a stock they can own. Kurtosis worked against them. One more factor is finer and more efficient pricing, which leaves little alpha scope for managers.

Coincides with passive growth

It is hardly a coincidence that the MF space has seen rapid growth in the passive and rule-based space in recent times. For instance, as of Mar-22, the combination of hybrid funds and passive index funds and ETFs jointly account for about 27.5% of the total mutual fund AUM. This is almost comparable with over 30% investor allocation to active debt funds and active equity funds. The combination of simpler formula, index driven approach and lower costs has made passive funds a lot more attractive in the last few years. That surely has a lot to do with the way Indian funds as a whole are underperforming the index related benchmark. What does it imply?

Focus on asset allocation

If you are planning for your long term goals, you need to have a solid portfolio of mutual funds. The moral of the story is to focus more on asset allocation and not try too hard to beat the benchmark indices. The learning in the last few years has been that if you manage your asset allocation well, you are bound to earn more than inflation and index returns. The other challenge is how to select funds in a mixed performance scenario. One thing you would observe in India is that the top performers in various mutual fund categories have been consistent in their outperformance. The secret is to just go with long term return leaders if you want alpha!

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