70% actively-managed MFs underperform: Should you exit?

Active funds versus passive funds, which ones are better, has been a hot topic globally. The point of debate is whether active funds are able to generate returns above their benchmarks in order to justify their fees.

In India, trailing returns data shows that on an average, over 70% equity mutual funds have underperformed their benchmarks in the five-year period. Does this suggest that actively-managed mutual funds have lost their charm? Well, a study by Union Mutual Fund shows, not really. Here’s a look at the data and the results.

The easiest way to see whether actively managed funds have outperformed their benchmarks is to compare returns vis-à-vis benchmarks on any given day. See the table below. As per this comparison, the majority of the schemes have been unable to beat their benchmarks over different time periods, as on September 30, 2021.

However, the above comparison does not give a complete picture. “Investors can invest on any day of the year, this ‘single-date’ analysis does not explain how the funds have performed throughout the previous years,” says the report by Union Mutual Fund. Also, on the particular date that is chosen, the performance could be impacted by abnormal events, adds the report, like the Covid-led crash in March 2020 or the ensuing rally till September 2021.

The Right Way

A better way to compare the performance of active funds vs their benchmarks is ‘rolling returns’. A rolling return is the average of a series of returns over a long period of time. It is like a daily SIP for a certain interval and then taking an average of the series of returns during that interval.
Understand this with an example. Assume a person wants to invest in the Sensex for five years. Assuming he wants to test five-year returns over 15 years, he can note the daily price of Sensex on an excel sheet. Next, he needs to calculate the returns if he invests in Sensex on April 01, 2004, for five years, which means his SIP will end on March 31, 2009. Again, calculate returns if he starts SIP the next day, that is, on April 2, 2004, for five years, which means her SIP will end on April 01, 2009. Again calculate five years’ SIP returns if starting date is April 03, 2004. Continue this over 15 years. This will give almost over 3,800 sample five-year returns of Sensex over 15 years. The average of these is the rolling five-year return, rolled daily over 15 years.
Returns can be rolled on weekly and monthly basis as well. Rolling returns are available with research houses or data aggregators.

Now, if the same study is conducted assuming that an investor randomly chooses a fund in a particular category on any date during the year, what are the chances of the fund outperforming the benchmark? The report by Union Mutual Fund calculated the returns of all funds in a category using rolling returns. The returns were rolled on a daily basis. It calculated the returns for periods ended January 1, 2012, then January 2, 2012, then January 3, 2012, and so on, to see how many funds in the category outperformed the relevant benchmarks on each date. An average was taken across time periods to ascertain the outperformance in a category. The final outcome for all categories as on September 30, 2021, is given in the table below:

As can be seen, except for the large-cap category, the majority of the schemes have outperformed their benchmarks. The actively-managed schemes are able to generate alpha. Also, the extent of category outperformance is higher over longer time periods.

However, we are aware that passive investing is emerging as an important part of investor portfolios. Experts believe that passively managed schemes have already taken centre stage in the large-cap category. A report by Finity, an online investment platform, says traditionally, actively-managed large-cap funds used to dominate the core of every investor’s mutual fund portfolio. However, this is getting replaced with passive index funds and ETFs due to increasing inability of active large-cap funds to outperform the index, lower cost of passive funds and rising awareness about passive funds.

Also, with the entry of fintech companies in the asset management industry, the number of passive funds being launched is rising, resulting in healthy competition and product innovation.

The AUM of passive investments as percentage of overall AUM of the mutual fund industry was 10% at the end of March 2021 as compared to 2% at the end of March 2016. This represents 5X growth in five years. Passively managed funds continue to attract interest on the back of sharp rally in equity indices. In October 2021, four index funds and three other ETFs were launched; these cumulatively raised Rs 1,119 crore. “We are positive on passive investment products because they are simple for a common investor to understand and are low cost while giving returns that match the index. We expect that the AUM of passive assets will more than double over the next two years,” says Abhilash Joseph, Business Head of Finity.

Should a mutual fund investor move out of an actively-managed mutual fund if it underperforms its benchmark or category average? The answer is not simple. There may be some temporary periods of underperformance in actively-managed funds. The key is to see if a good fund is going through a period of underperformance or a weak fund is going through underperformance. Arun Kumar, Head of Research at FundsIndia, gives a list of questions to check whether it’s time to move out of your underperforming scheme. Whenever a fund is underperforming the benchmark over three-year, five-year and seven-year periods, check for the following:

1. Consistency in underlying investment strategy and process. Does the fund continue to stick to the strategy?

2. Is the underperformance also seen in other funds following the same investment style?

3. Does the fund have a long track record (10+ years) of outperformance?

4. Has the fund been a consistent performer in the past - What % of times has it outperformed the benchmark on five-year and three-year rolling returns basis over the last 10-15 years ?

5. Does it fall lower than the benchmark during market declines? (A rough proxy for understanding the risk in the fund)

6. Is there a change in fund manager?

7. Has the fund become too large and is facing size constraints?

8. Does the fund communicate clearly the reason for its underperformance?

Usually, in case of a good fund (satisfying all the above conditions) going through temporary underperformance, you can give it a three-five year runway to check for improvement in performance. If the fund continues to underperform or if you find an alternative fund following the same investment style but with better performance consistency, says Kumar, you can exit.