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May 2009
Myth of Eternal Alpha
A look at trend of out/underperformance of Active Fund Managers in India
In many classic active versus passivedebates in Indian media and privateinteraction, proponents of active fundmanagement have always claimed thatIndian markets are different and Indianfund managers will always be able tooutperform the benchmark or generateAlpha.The arguments given are manifold. Themost common one is that Indianmarkets are inefficient and the fundmanagers are privy to information or their level of intellect is much higher than the market (of which theythemselves are part).This argument is in direct contrast withthe reality of developed markets, where,over the long-term nearly 80% of actively managed funds under performthe indices. Hence indexing is a corestrategy for both institutional and other sophisticated retail investors. In fact amajority of fee based financial plannersin the US make use of index funds only-for financial / investment planning.We commissioned a small study toexamine the truth and the trend. Theresults are similar to the prognosis of decoupling of markets. It falls flat on itsface.
Methodology
It has often been argued that individualactive fund managers are consistentlyable to exploit anomalies & aberrationsthat may exist in the market and whileconsidering out performance/ under performance one should look at longer periods.Argument accepted and therefore welooked at three year periods for rollingreturn analysis in order to avoid anyaberrations. The schemes have beenselected by applying two filters. Firstlythe scheme should have been inexistence for the past five calendar yearsas on December 2008. Secondly thescheme should have as its Benchmarkone of the broader indices (S&P CNX Nifty or BSE Sensex or BSE 100 or CNX 100). We have compared these fundswith Nifty BeES because (1). Nifty BeES
Captures dividends unlike pure niftyindex and (2) Nifty BeES also hasmanagement expenses like other mutualfunds.After applying these filters, we were leftwith 60 schemes for further analysis.We took simple average of returns of theschemes selected. For simplicity we havetaken only growth plans or dividendreinvestment plans assuming no pay out.The period of investment commencesdaily from December 2003 and ends onMay 2006. The last observation date is19
th
May 2009. Thus over 500 datapoints have been considered for analysis.
Results
The graph below depicts, that theaverage out performance of large capdiversified active funds is consistentlydeclining over last few years and hasnow gone into underperformance zonetouching more than 6% per annumunder performance.
Please note that thisis three year CAGR % and hence inabsolute term it is around 18%underperformance excluding load and ifwe included load then it results in20.25% underperformance over threeyears.
Also if we compare each of the 60scheme
’
s performance vis-a-vis NiftyBeES, we can see from the below graphthat the no. of funds outperforming (in% terms) Nifty BeES has beencontinuously decling and has reachedthe rock bottom of around 8% to 12%recently i.e out of the 60 schemesconsidered for analysis only 5 to 7schemes were able to outperformNiftyBeES.
Source: MFI explorer & Internal
Analysis
Is it an aberration or a paradigm shift?How does one explain thisphenomenon? We believe that thistrend is here to stay and our reasoning isbased on same factors which areresponsible for indexing doing relativelybetter elsewhere.Stock market investment is not a zerosum game i.e. when markets are up,every one wins and when markets aredown every one looses (Except shorts).However outperformance is zero sumgame i.e for some investors to outperform the average others by defaulthave to underperform. In other words,as investors, all of us as a group earn the
Active Funds Outperformance Over Nifty BeES
-8-6-4-202468
2 2 - D e c - 0 6 2 2 - F e b - 0 7 2 3 - A p r - 0 7 1 3 - J u n - 0 7 0 3 - A u g - 0 7 2 6 - S e p - 0 7 2 9 - N o v - 0 7 1 2 - F e b - 0 8 2 4 - A p r - 0 8 1 6 - J u n - 0 8 0 6 - A u g - 0 8 2 9 - S e p - 0 8 2 6 - N o v - 0 8 2 1 - J a n - 0 9 1 7 - M a r - 0 9 1 3 - M a y - 0 9
( % )
020406080100
( % )
Absolute % Outperformance - LHSNo. of funds Outperformed (%) - RHS
stock market’s return
-hence in the
aggregate we are ‘average’ (fund
managers included). This is beforededuction of costs. Each extra returnthat one of us earns (including theindividual active manager) will meanthat the other member (s) of the group(managers included) has to suffer areturn shortfall of the same proportion.This is the zero sum equation i.e. beatingthe market before costs are a zero sumequation and net of costs it is a los
er’s
game. This iron clad and a fundamentalmathematical law that governs the stockmarket, has been aptly put by WilliamF. Sharpe, Nobel Laureate in Economics,1990
, "
Properly measured, the averageactively managed dollar must underperform the average passively manageddollar, net of costs. Empirical analysesthat appear to refute this principle areguilty of improper measurement
."
The above explains the gradual under performance of many individual activemanagers and also as a group-providedthe correct comparison andmeasurement is done.However the absolute skills of fundmanagers remain the same but their skills relative to markets arediminishing. In an increasinglyinstitutionalized market dominated byprofessional managers all of them as agroup are becoming a larger and larger portion of the market. The directconsequence of this is the emergence of an efficient market where pricediscoveries are faster. Also fund corpuseshave grown bigger and it has becomedifficult to add zing to consistently out
perform by discovering ‘ten baggers’.
Implications for Investors
One of the risk factors highlighted in
mutual fund documents is “Past
performance is no guarantee of future
performance”. This is true for out
performance as well. The most commonmethod by which the majority of investors invest into a fund is based onpast performance or past outperformance. The results from studyshow that this method is highlyunreliable.An investor seeking long-term exposurein equity is likely to get disappointed byremaining under an illusion that Alphaor out performance is easy and thatevery fund manager will deliver it-consistently.Of course, at any given point in time-some funds out of the many availablewill out perform-however this israndom. Sadly, a typical fund investor will not be able to identify the
individual ‘alpha’ –
in advance-except byluck. A deeper analysis of such fundsmay force us to come to conclusion thatsuch outperformance is largely due toluck rather than skill.If this is the harsh reality then how doesone select the fund which willoutperform for next five years i.e. inadvance? Indeed it is difficult to decideand hence internationally large investorslike pension funds, insurance companiesetc. eliminate this guesswork by making
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