There was a period between 2005 and 2007 when a large number of actively-managed, diversified mutual funds beat respective benchmark indices. This is unusual. Passive index-based investing is popular precisely because actively-managed funds mostly don’t beat the market. A small minority of actively-managed funds will beat the market but index funds tend to perform better as a group.
The high returns for active funds in that three-year period could be largely attributed to price moves in two sectors. The high-performers had large exposures in infrastructure and realty and both industries produced multi-baggers galore. Realty wasn’t well-represented in any index, and many midcap infra multi-baggers were also outside the indices.
The funds that beat the market during the bullrun underperformed in the following bearish phase of 2008-2009. The infrastructure and realty sectors were again the cause. Both sectors lost much more ground than the indices and funds with high exposures to those sectors suffered deep NAV erosion. In short, many actively managed funds had high-risk exposures in two sectors. This offered high rewards while the market trended up and it cost them big when the market trended down. In the longer run, across the decade between 2003-2012, passive index funds have indeed outperformed actively-managed funds as a group.
However, a relatively large number of actively managed funds do beat the market on an annual basis. One can develop many theories about the possible reasons for this although it is difficult to back those up with data.
The efficient markets hypothesis states price movements are random in efficient markets where participants have equal access to information. This makes it difficult to beat the indices consistently through active investing.
It is possible that India didn’t, and doesn’t, really qualify as a strongly efficient market. There is a lot of asymmetry in access to information. So a smart player, or a group of smart players with greater access to information, have an edge.
The primary markets were certainly markedly inefficient in the 2004-2008 period given the multiple scandals. Also, the mutual fund industry had been relatively recently decontrolled when the big bull market started. The UTI hegemony was broken in 2002 and the former monopoly still controlled a massive corpus in 2005. UTI wasn’t very professionally run at the time.
Equity and derivatives markets have become more efficient and the fund industry has become more professional. But it would be a stretch to claim that the Indian equity and derivatives markets are very efficient, even now. The mutual fund industry isn’t very efficient either.
There are lots of questions about corporate governance in listed companies. There’s plenty of anecdotal evidence about information leaks. Any market – efficient or not- is also policy-driven and India’s arbitrary policy-making and crony capitalistic tendencies are always going to cause information gaps. While the fund industry is more professional now, it just hasn’t been able to retain the faith of investors. Assets under management have declined through the last couple of years. Despite the bounce in equity values in 2012, the trend of households pulling their savings out of mutuals has continued. Sebi has also tried to encourage the industry to enter smaller towns but thus far, the results have not been very encouraging.
An investor can complain endlessly about this sad state of affairs. Or he can accept it and try to use it to his advantage. An inefficient market actually offers more chances to make money than an efficient market and I’m not suggesting insider trading. One way to exploit an imperfect market is to track the actions of people who may have better information. As argued above, there is a chance that actively-managed funds that consistently outperform have better sources of information.
Any fund that has beaten the market across 2003-2012 is worth a look. Ideally, the outperformance should be consistent with returns above the benchmark index in at least seven or more years. That way, there is a larger probability that the fund actually has better information.
When you find a fund that regularly out-performed, look at the specific portfolio and analyse changes, quarter by quarter, by relating them to news at the time. If the fund made a fair number of news-based “buys” at the right moment, or it sold off stocks which subsequently saw deteriorating performance, the chances of it having an information edge increases.
Of course, as the market matures, there will be less in the way of information gaps and the advantage for active investors will erode. But if you are going to invest in actively-managed mutual funds, this approach could fetch good results.
