Dalbar, a Boston based analytics group has been studying the US markets for over 20 years and they have been publishing reports which compare the performance of an average Mutual Fund investor as compared to the Market Indices. Important point to note here is that the performance calculated was for the investor in the Mutual Fund and not the Mutual Fund itself which is more readily available.
In their latest study 1 for a 30 year period (ended 31 Dec 2015), the US market (S&P 500) delivered 10.35% compounded annual return while an average equity Mutual Fund investor obtained a return of only 3.7% in the same period. This is not the only study which has shown such a startling gap between the market return and the return that an average investor actually earns. BlackRock which had done a study in 2015 found that over a 20 year period the average investor earned only 2.11% 2. Fidelity which studied investors in its own fund again saw a similar gap between performance of its fund and that of investors in its funds 3.
We tried to do a similar study for the Indian market and found that for a 10-year period up to 31 March 2016 based on Internal Rate of Return (IRR) of inflow into Mutual Funds and outflows reported by Association of Mutual Funds in India (AMFI), the average return for an investor would have been 4.4% (see Chart 1 below). We calculated this as how an individual would calculate his IRR of fund flows in an SIP. Some investors would have done better than this calculated return and some would have done worst. But the IRR should approximate the returns of MF investors as a group. This is substantially below the market and also below the Mutual Fund industry which has done much better than the market. Thus, it’s not a surprise that average investors are not happy with equities as an asset class and still prefer fixed deposits, real estate and gold to achieve their long term financial savings goal.
Chart 1: 10-year Market Return vs. IRR of MF Investor
What is the reason behind such a gap in Underlying Asset Class Performance and Actual Investor Return?
Dalbar study has found that investors are themselves guilty of getting behaviourally biased and investing at the wrong time and also exiting at the wrong time. We have found evidence of the same in India as well. The table below shows that on an average, maximum net flows in to Mutual Funds are seen when the markets according to our valuation estimates was expensive (in excess of 1.25x Price to Fair value) and the least average inflows were seen when the markets were well below our fair value of the market (Sensex).
Table 1: Mutual Fund Inflows
One of the reasons for such an outcome could also be due to the mis-selling that happens by intermediaries. But keeping the fiduciary responsibility and the role of the intermediaries’ aside, investors need to themselves understand risks that are not necessarily apparent while investing in Mutual Funds.
Another Behavioural Aspect is ‘Your Risk is not My Risk’
Most investors are not aware of (or ignore) the fact that there is a big difference in what Mutual Funds perceive as their “risk” and what investors typically think of as their own “risk”. Mutual funds are bothered about the risk of underperformance as compared to their benchmark and peers i.e. Mutual Funds focus on “relative risk”. Thus if market goes down by 50% in a year and a Mutual Fund is down 40%, the Mutual Fund manager would be still be happy as he has managed the relative risk well. An investor is usually bothered about the risk of losing money i.e. “absolute risk”. Thus even though the fund manager in the above mutual fund example would be happy about his performance, the investor in that mutual fund would be losing sleep over such a big fall in value of his investments. Managing/mitigating risk of absolute loss is never the responsibility of the Mutual Fund but of the investor alone. Managing absolute risk is much more difficult than managing the relative risk. More so because an investor would become greedy when markets are doing well ignoring the fact one could see steep drawdowns (i.e. fall from the peak to the trough across cycles). And when there is a sharp correction in the market the same investor would become fearful and try to cut his losses at a time when valuations will be attractive from a risk-reward standpoint. Thus we believe a significant part of the responsibility of risk management remains on the shoulders of the investor and/or his financial advisor.
Investing looking at the Rear View Mirror
A lot of investors invest in Mutual Funds looking at historical performance of individual Mutual Funds. One cannot blame such a methodology as that is the only data point available to investors. But it is rightly said “Past performance is not an indicator of future performance”. We tried to test a methodology of selecting top 5 mutual funds based on previous 3-years performance and how such funds performed over a period of time. For example, top 5 funds were selected in January 2005 based on past 3-year performance (January 2002 to December 2004) and so on. We observed that most of the funds that were selected based on past performance did not end up in the top 10 performing funds in the following 3-year period. In fact some of the funds even underperformed the Mutual fund industry average (as seen in Table 2 below).
Table 2: Top 5 Funds Analysis
To understand Mutual Funds’ performance over long term, we evaluated their return assuming if these best performing funds were held till December 2015. We again observed that very few funds continued to rank in the Top 10 funds over long term. It is difficult for most of the funds to provide consistent performance over long term.
Table 3: Top 5 Funds Long-Term Analysis
This suggests that selecting funds based on past performance might not necessarily assure you of selecting the best performing funds of the future from the medium to long term perspective. When funds are selected solely based on past performance the outcome would be similar to throwing darts in dark and randomly selecting a Mutual Fund. Since over long term, the ranking of the top mutual funds keeps changing and there are chances that the fund might lose its sheen. (To have a look at the data based on which analysis was derived please see the annexures )
Timing the Market:
When it comes to earning a good absolute return, timing the market right seems to be the main driver as compared to selecting the right fund. If your timing is wrong, no matter which fund you select, the performance would be lower than what one would expect from equities as an asset class. For example; if one would have selected funds at the peak of the market in January 2008, the industry average performance is a dismal 6% p.a upto December 2015 (as seen in Table 4 below).
Table 4: MF Industry Average Return
Is there a Solution?
The main culprit behind this poor performance is an innate Behavioural bias. It is very difficult to shake off the biases that force an investor to get “greedy” looking at short term returns/performance and “fearful” when markets correct sharply.
- Objective criteria vs Subjective criteria: This can be addressed by following a valuation driven asset allocation strategy which is focused on absolute return as well as the absolute risk management rather than getting involved in a performance derby.
Focusing on valuations from a risk-reward standpoint (i.e. upside vs downside) and not just the upside helps in objective decision making and mitigating the noise in the market. Valuation metrics like Price/Earnings or Price/Book Value of the Equity Indices (e.g. Sensex, NIFTY) are publicly available and can be used to develop a simple asset allocation strategy. For a slightly more sophisticated investor, valuation and fundamental analysis can be done at individual Mutual Fund level as well. Such investors could dig deeper into the quality of the businesses that the MF portfolio is holding. By quality we mean – high return on capital employed, good cash flow generation and low leverage of the businesses in the Mutual fund portfolio.
- Prudent Close-end structures best protects the client’s interests: Behavioural biases can be reduced by focusing on investment structures that demotivate short term actions. Close ended funds that have some sort of a lock-in are frowned upon, but inherently they protect the investor against himself (if the manager is prudent) from entering and exiting at the wrong time. One can see the merit of close ended structures in the returns of an ELSS (Equity Linked Savings Scheme) investor as compared to a normal equity MF investor. Since investments in ELSS are locked in for 3 years, the investors behavioural bias has limited influence (may be only to the extent of inflows in ELSS). If you see in the chart below IRR of ELSS is much better than IRR based on net inflows into Equity Mutual Funds.
Systematic Investment Plan (SIP) is another example of such a structure. SIPs might not be the most efficient ways of investing, but certainly better than leaving absolute risk management and asset allocation to individuals. A monthly SIP in NIFTY would have done much better as can be seen from the chart below.
Chart 2: IRR of Investment Structures
- Focus on underlying Investment Process and not just Past Returns: As discussed earlier, selecting the best performing mutual fund is a difficult exercise by evaluating past performance and might be likened to throwing darts in dark. We feel investors should focus and try to understand the process that the fund manager or the Mutual Fund is following. The following parameters should be looked at:
- Portfolio turnover (i.e. how much of the Portfolio is being churned) which highlights whether the fund manager is investing or trading in stocks. High portfolio turnover (in excess of 50%) would also reduce reliability of past performance and make any analysis of present portfolio futile.
- Number of companies in the portfolio – An over diversified portfolio (beyond 30-40 names) might not necessarily reduce risk and might suggest that conviction on individual companies could be low.
- Drawdowns – This is a very important parameter as it shows the quality of the businesses that fund manager owns at any given point. A portfolio focused on good quality companies would generally have lower drawdowns relative to its benchmark and industry average. As good quality companies tend to fall less in sharp down trending market and also more importantly tend to recover quickly when market participants are calmer.
These criteria, along with the usual past performance evaluation of the fund would give some understanding about whether there is some process that has been followed to generate the numbers or whether luck is significant contributor to the past performance.
If investors avoid the self-inflicted wounds (behavioural) by understanding the “absolute risk” in Mutual Funds and put a little effort in evaluating them, it would help them to stay invested in equities longer and get the underlying return of equities as an asset class.
This document has been solely prepared for educational and illustrative purposes. The information contained herein does not constitute any guidelines or recommendations on any course of action to be followed by the investor. The information is prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Multi-Act Equity Consultancy Private Limited (MAECL) does not solicit any course of action based on the information provided by it and the investor is advised to exercise independent judgment and act upon the same based on its/his/her sole discretion based on their own investigations and risk-reward preferences. The information is meant for general reading purpose and is not meant to serve as a professional guide. MAECL, its associates or any of their respective directors, employees, affiliates or representatives do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information and consequently are not liable for any decisions taken based on the same. This information is not intended to be an offer or solicitation for the purchase or sale of any security or financial product. MAECL is not responsible for any error or inaccuracy or any losses suffered on account of any information contained in this document. Neither MAECL nor any of its associates, directors, employees, affiliates or representatives shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information provided by it.
General risk factors
a. Securities investments are subject to market risks and there is no assurance or guarantee that the objective of the investments will be achieved. b. Past performance of the Portfolio Manager or its affiliates does not indicate its future performance. c. Investors are not being offered any guaranteed or assured returns i.e., either of principal or appreciation on the Portfolio. d. As with any investment in securities, value of the Client’s Portfolio can go up or down depending on the factors and forces affecting the capital market. e. External risks such as war, natural calamities, and policy changes of local / international markets may affect stock markets. f. The Portfolio Manager has renewed SEBI PMS registration effective October 14, 2014 and has commenced its portfolio management activities with effect from January 2011. However the Portfolio Manager has more than 10 years of experience in managing its own funds invested in the domestic market.
IRR of MF Investors has been calculated using IRR of Monthly net inflows into Equity MFs, opening and closing Equity AUM as reported by AMFI. IRR of ELSS has also been calculated in a similar fashion.
For the study on historical performance and ranking of Mutual Funds, we selected 172 Equity Diversified Growth Options Open Ended Mutual Funds as classified by ACE MF. Out of which we removed funds with AUM below INR300cr. Analysis published above and in the annexure is based on this Universe.
- http://www.dalbar.com/Portals/dalbar/cache/News/PressReleases/QAIB%202016%20Press%20Release%20v1.pdf ↩
- https://www.hubbis.com/articles-content/5078/articles/Mind+the+(behaviour)+gap ↩
- http://www.businessinsider.in/Fidelity-Investments-Did-A-Study-On-Which-Client-Accounts-Did-Best-And-What-They-Found-Was-Hilarious/articleshow/41738344.cms ↩