The Mutual Fund Show: How Active Funds Fared Against Benchmarks

SPIVA is actually an acronym for S&P indices versus active funds. This is a biannual report, which is published in 10 markets by S&P indices. It compares the performance of active funds against S&P benchmarks in these markets. The first time, this report as you mentioned was published in the U.S., back in 2002, and the India report is also more than six years now. So, we have a robust and relatively long history to offer. You can think of SPIVA as an objectives score keeper in the active versus passive debate, and the aim is to just equip investors in more information in their portfolio construction decisions. The SPIVA India specifically looks at the active funds domiciled in India in three categories in equities and two bond categories.

The three equity categories we consider are the large-cap, the mid-cap, small-cap, and the ELSS category. The first section of the report talks about the percentage of underperformance. In this report we see that if I were to pick up the large cap category, over a five-year period we have seen more than 80% of the funds underperforming the S&P BSE 100 total return benchmark. So just to give you a sense here and maybe dissect how we arrived at that figure. So, five years back, I think we had almost 92 funds in the large-cap category. In these 92 funds there were 17 funds that failed to survive the investment horizon- either because they were liquidated or much during this five-year period. Another 57 funds survived the investment horizon but underperformed the S&P BSE 100. So there were just 18 of these 92 funds which is roughly 20% that survived and outperformed the S&P BSE 100 and that’s how we arrived at the 80.4% figure- where we see that such a huge number of funds have actually underperformed the benchmark. These figures are not unique to this SPIVA scorecard. You’ve seen that over longer periods active fund managers are finding it increasingly difficult to beat the benchmark. The reports if you were to pick up from the other markets as well resonate the same message.

So again, these are snapshots in points in time and this is the snapshot that looks at a 10-year period from says June 2010 to June 2020. Whereas, if I were to pick up a report five years back, we would look at the period from June 2005to June 2015.

That is true. Just to give you a sense there’s another section in this report where we look at the asset weighted and the equal weighted performance of the funds as well. So just to quickly explain what this is, we’re just trying to calculate the average fund performance across different time horizons. We had one-year, three-year, five-year or ten-year in each of these categories. The first one is based on the equal weighted approach and the second one is based on the asset weighted approach. I think both of these are important to look at because in case in a category over a particular period, if the asset weighted return is higher than the equal weighted return that implies that the funds that have higher AUM in that category have managed to beat their relative peers in that category. So, if I were to pick up data points from this particular report and if I were to pick the 10-year period in the mid and small cap category, we see that the asset weighted returns was 9.67%, and the equal weighted was 10.2%. So, the equally weighted was slightly higher by about 50 BPS, implying that the smaller size funds outperformed the larger size peers. We see that difference has been narrowing between the you know the asset weighted and the equal weighted returns vis-à-vis the benchmark, all with the previous scorecards. So, our viewers can go and pick up the oldest scorecards and see this trend where this difference between the returns is actually diminishing over time.

Equal-weighted essentially is just taking a simple average of all the funds for example in the large-cap category whereas the asset weighted approach weighs the performance based on the assets or the AUMs of each fund house. So, why asset weighted is important because it gives you a sense for every dollar or every rupee invested in that category and what were there turns that the market saw in that category. This is where the difference lies between the two.

So, over the longer horizons. We see that in the large cap category, the asset weighted returns and equal weighted returns are not very different but in the mid, small-cap category we do  the smaller size funds are doing slightly better than the large sized no peers.

So that could be one of the factors, but it may be difficult to attribute just to this particular factor. There could be other factors such as the skill of the fund manager himself and other aspects as well.

So, that’s true. Again, if I were to look at the figures, just for the five years basis we see that in the large cap category 80% of the funds have actually underperformed whereas in the mid small cap category, it’s roughly about 50% of the funds that are outperforming and underperforming. I think the reason may be that the large cap category in general, the markets are becoming more efficient. I think in the mid, small-cap category I think there are still opportunities for active fund managers to generate alpha. Let me also take this opportunity to mention a couple of important factors that are driving the push towards passive investing. First and foremost, there are two set of factors one could consider. One is the global factors that have globally helped push off passive investing. There is a second set of factors which are more local. Coming to a first set of factors which are globally affecting the growth of passive investing, first and foremost is the cost. Inherently, active fund managers incur higher cost be it in terms of stock and industry research, management fees, etc.

I think lower cost is one of the simplest explanations as to why passive management wins. In some categories investors may actually be able to save up higher than hundred BPS in management fees by choosing a lower cost alternative. Another important point that I can make and that should also help explain the question that you were looking at also to, the institutionalization of research. As markets have matured over time, we have seen that the share of institutional holding of public equity has increased. Also, as investment research becomes more and more institutionalised, we have more and more research analysts entering the market, chasing the same set of stocks to generate alpha. What happens is, they are because of this reason, this alpha has been diminishing over time. I think one potential way for active fund managers to stay relevant would be to try and consider reducing product costs for the investor so that they have higher net takeaway returns. If I can just maybe quickly also talk about some of the local factors also that have been pushing the growth of passive in India, I think first and foremost the EPI first started investing in equity markets through passive products based on large cap indices in India. Initially they started with 5% incremental flows coming into EPIs. This was later bumped up to 15%. I think apart from that we have also seen the Government of India divest stakes in select PSU and CPSE companies and through products based on indices.

So, I think apart from that, we have also seen some changes being made by the regulator where they have standardised style and size definitions in the market. They also mandated that there should be one product offering in each category. So, how this helps is, it becomes very easier for an investor to compare two products in the same category from two different fund houses. I think, apart from that there was another important development which was the switch from price return indices as a benchmark to total return indices as a benchmark. What happens is, I think we all understand now that total return indices is a more apples to apples comparison, as against a price return index because total return indices do take care of the dividends accrued during the investment horizon.

Yeah, I think the simplest explanation is that the beauty of passive investing is, it’s available at a low cost. It is systematic, transparent and with a clear objective laid out for an investor who is participating or taking exposure to a passive product. On the active side I think the challenge is, you have a couple of active managers who have a growth philosophy- a few may have a value philosophy to invest in. There may be different styles of investing from the active fund manager and therefore they would go from periods of outperformance to underperformance as well. That is a challenge for a lot of investors and it is very difficult to essentially time them. If I can allude to one of the research pieces that we did earlier as well, in which we were trying to assess which market cycles actually active fund managers generate outperformance or they generate underperformance- what we did is we broke the market cycles into three. The bear phase which was essentially a fall of 10% from the top of the market to the trough, the following 12 months was considered as a recovery phase and the falling period from that point on to the high of the market was considered as a bull phase. What we noticed interestingly is, the alpha generated during the bull phase of the market in at least the large cap category was very modest. This may be very counter-intuitive because you would expect active fund managers to be able to generate alpha as they are skilled at stock picking to have sizable alpha during that period. On the contrary, we see the highest alpha is generated in the beta phase of the market. We also noted that they had lower portfolio betas which essentially means they may either be allocating to cash or maybe low beta stocks for that matter. Where they suffer the most is during the recovery phase of the market. This is when the market sees a sudden V shaped or which ever shaped recovery. In that condition, I think that the active fund managers may either be sitting on cash or low beta stocks and have not been able to align their portfolios well in time to ride this rally that may have happened. I think all of these disadvantages are taken away when you take a passive route to investing or there is no timing in the markets per se- what you’re getting at a broad based exposure depending on which particular index that you’re looking at. Also I think a very important point if I can just quickly touch upon is, this is again by no means an asset allocation recommendation but if I were to just pick up a general asset allocation mix which would be say 50% equities, 40% debt, 10% cash and an investor for that 50% equity allocates to a mutual fund, who in turn, allocates 10% of the AUM into cash. What happens is, at an investor level, my cash allocation jumps from 10% to now 15% and my asset allocation decisions may go for a toss. Therefore, I think if you take a passive route to investing, you must at least ensure that you’re capturing market beta and there may be no laggards or underperformance because of allocation decisions, essentially.

So that is true. It could potentially be one of the reasons that may have actually seen this mix to favour slightly towards the active fund managers but I would probably stress upon the point that investors or market participants in general should try and look at longer term horizons and the results from the longer term periods that we get. We all know that the first half of 2020 has been a volatile period globally and therefore, if I can also highlight an important point that we saw in our report is, we saw that the equal weighted returns were higher again than the asset weighted returns in all of the equity categories. More than 60% on the active funds managed to outperform their respective benchmarks. So, this for the short period, it did manage to outperform but if I were to look at the longer term trends, I think the message is fairly clear that it is very difficult to be at the benchmark index.

So, if I were to use this SPIVA score card as my guiding tool, at least in the large cap category, I can see very clearly that active fund managers in this category are finding it really difficult to beat the benchmark. In that case, I think an investor may look at allocating higher to passive products in the large cap category. In the mid, small cap category on the other hand, where we do see still a few mid and small cap active funds generate outperformance. A core and satellite approach is something that they could potentially consider where either your core of your portfolio can be passive and the satellite will be active or vice versa as suited for the investor.