Mutual Fund

Rise of Indexing: The Tale of Diminishing Alpha!

“By periodically investing in an index fund, the know – nothing investors can actually outperform most investment professionals.”Warren Buffet

Summary:

  • This article is part of series on mutual funds, where we discuss and analyze the queries we receive on various investing approach
  • In Investing there are no absolute answers therefore it is important to keep our approach adaptable and mind open enough to embrace for the new approach
  • We analyze both the quantitative and qualitative aspect to help you take the informed decision by understanding the possible pros & cons of your choice

In 2018, I have flagged that one should have the Core portfolio of funds for long term and suggested the options of Large Cap, Index funds, Multi-cap Funds or Aggressive Hybrid Funds. Though we have constantly getting the request to confirm that most people have been suggesting to opt for an index fund, is that a right approach? I have also noticed over the last few months that Index funds have become the main choice of advisers in India market. Is that because of their recent superior performance or some other reasons? I am not sure but we will try to figure it out in today’s article. The whole premise of suggesting the index funds is based on the pillars of below arguments:

  • The Low cost of Index funds vs active funds makes is difficult for active funds to outperform the index consistently
  • There is no consistent way to identify the best fund for future based on it’s historic data
  • The number of active funds out performing the index funds are <50% in most years
  • You can not predict the market returns of future so the best approach is to take the index fund and be happy & probably few more…

Indian mutual fund industry has grown to US$ 400bn+ in terms of assets under management (AUM), Though the AUM of equity funds is still less than half (<US $ 170bn). The Top 3 equity categories by AUM are the ones suggested for the Core Portfolio; Large Cap, Multi-cap and Aggressive Hybrid Equity. These categories contribute 36% of the equity AUM in the mutual fund industry. For today’s analysis, we have taken Top 5 funds based on AUM in each category to compare with the Top 5 index funds.

We have used Regular funds for analysis so we have the longer history available for analysis. We looked at the data from Jan 1, 2010 to Dec 23, 2020 for almost 11 years. The Index funds used are mostly large cap indexes due to the longer data history availability, we do not have Nifty 100 or Nifty 500 Index funds with longer history available.

Returns: In my personal experience one thing I have realized is that the quality of advice is always measured by the returns in the end by investors. No matter how much awareness, industry has brought towards other parameters returns still probably remain the most influential parameter. Let’s analyze our funds on this parameters. If we have invested 10,000 in any of the mentioned funds below is the comparison of final value investment in the Large cap funds & Index funds:

Based on the above chart, you can see that the investment in any of the active fund would have outperformed the investment in index fund. All the values are already post expenses so yes absolute gains. All three categories of large cap, Multi cap and aggressive hybrid funds have outperformed the index funds. (The similar conclusion was published in March 2020 in HDFC Hybrid Equity.) Though before you conclude that active funds always outperform, you should note my protest against using the words “Always” or “Consistent” as there is no constant in Investing world.

The landscape of Mutual fund industry is continuously evolving with new regulations, the limits have been placed for each category of funds investible universe, which makes it difficult to outperform the indexes. It is important to understand the trend of returns, for which I looked at the one year rolling returns of the active funds and compared them with the rolling returns of index funds. Below chart shows the trend that active funds have outperformed the index by large margins in the period 2013-2015 but in other years their returns were closer to index funds with +/- 5% of index returns. “In conclusion, we can not say that active funds outperform or underperform the index funds consistently.

Risk: Any investment decision should not be purely based on returns but the returns in reference to the risk fund has taken. Also, how the fund has fared in bull & bear scenarios. We need a fund, which gives us better returns in bull scenario, saves us in bear scenario and matches the index in normal course of period. Looking at the below table, you will notice that the Standard deviation of index funds has been lowest. In terms of maximum return on a one year rolling basis, Multi cap funds top the chart and in adverse scenario Aggressive Hybrid funds have the lowest -ve returns. In case of maximum draw down also, Hybrid Aggressive funds take the crown. Conclusion based on the below historical data is “Active funds have higher volatility/ risk though the higher risk is translated into the better mean returns.

Alpha: If you have your basic knowledge of investments in place and you want to trounce me for calling the Alpha as difference in returns of active funds vs index funds, Let me remediate the problem. We have discussed earlier the Capital Asset Pricing Model and for sake of simplicity assume that beta is the only factor. If we adjust the returns of the funds for beta & calculate Alpha, the results do not change drastically. We still have the periods of outperformance by active funds and periods of underperformance, though the both sides becomes equally likely and symmetrical. This is where most of the index proponent will thump the table & conclude “If we adjust for the additional risk taken by active funds, their outperformance is simply by luck similar to a coin toss.

Based on the analysis so far and looking at the quantitative factors, There is no absolute advantage of active funds over passive funds. Though the suggestions by advisors or other investors for a particular category of funds is more emotional in nature. The researchers found that, following a competition, athletes who won bronze appeared to be significantly happier on average and that silver medalists: “They compare themselves to the gold medalist and thereby think of what they didn’t achieve; the bronze medalists also focus on what didn’t happen: They didn’t come in fourth and fail to get a medal”. (Link) Since most of the people investing or advising active funds put lot of effort in selecting a good fund, they inherently expect their fund to be the best performing fund and are open for disappointment if another fund generates better return.

Let me summarize my recommendation based on the above analysis:

  • There is no sure shot way to find the best return generating fund, which consistently outperforms the Index on risk adjusted basis. (Yes, Accept this)
  • There is no point of jumping between the active funds for better returns, You might get lucky but chances of lagging the mean performance will increase for the people jumping between the funds
  • Advisors of Index fund can never be blamed as their suggested funds will mirror the index returns so no questions or large underperformance. (Advisor never wrong is a great advisor)
  • If you want to simplify your portfolio decisions, Indexing is a simple approach as you can save all the time you spend on searching the best funds and use that time to grown in your career or spend the time with family/ friends or take care of your health. Always remember, “The time in the day is finite, be mindful of how you spend it
  • A better way to get additional risk adjusted returns is by managing the Asset Allocation and re-balancing the portfolio regularly
  • If you can control your monkey mind and not lose your sleep by comparing the performance of your fund vs other funds then It is completely fine to buy a decent active fund and stick with it for long term to reap the benefits. In the end, higher volatility is a temporary risk which reduces with investment horizon

I, Personally, have been an investor in active funds and primarily into the aggressive hybrid funds. The main reason of mine is three fold; I love the whole process of analyzing the funds/ creating the portfolios, Over the long term the higher mean returns will stick but the volatility would reduce and lastly, I only lose sleep if my portfolio is accruing absolute large losses which are relatively protected by Aggressive Hybrid funds. Now going forward the alpha of active funds might diminish but as I often say, “When the facts will change, I will change my approach.” Till then, Active Investing is good for me.

In personal finance, your investing approach should personal than just following the rational best approach. Do write to us or comment about your preference of active vs passive funds and it’s reason. Happy Investing & Happy New Year!

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Investment Objectives & Advice

Efficient Frontier & Asset Allocation!

Couple of weeks back, i wrote about how do i select a fund for my portfolio. That has got quite a few review/ feedback, though few people also requested to share my approach on asset allocation. Today I am trying to put together my thought process, The real process is more or less meet these steps in principal for long term goals (5yrs & beyond). You might find this tedious but this is typically a once in few years exercise and If you find it tedious than stick with typical simplified thumb rules (I will summarize it in the end).

I typically segregate my portfolio in two sections, first which holds risky assets like equity & gold and second which has debt investments.

Step 1: The selection of equity funds was covered in detail in the last article (Please read: Link). I analyse the list of potential funds with there risk & return profile and then pick the fund which has a better return per unit of risk. This process can also be called as formation of Efficient Frontier. This is the line of selected funds in a manner that each fund has the best return for the same unit of risk. The funds which are not on the Efficient Frontier like ICICI Pru Bluechip or SBI Large & Mid cap etc are not considered. Based on my risk profile, I pick one fund from the funds on this frontier line.

Efficient Frontier

Step 2: There is an advantage of adding gold with equity funds which does reduces the volatility of the portfolio given the -ve correlation between gold and equity.  This was reflected in the earlier articles Gold: to buy or not to buy! & Modern Portfolio Theory I personally like to keep (10% – 20%) of risky asset portfolio in gold depending on the valuation cycle of equities. You can see from the below chart that portfolio 3 outperforms most of the time with lowest risk among portfolios. I personally prefer the Portfolio 2 which has similar return profile but slightly higher risk. The main reason to do so is that a good multi-cap fund mostly will have 60-30-10 split between Large cap, Mid-cap and Small cap. Instead of me looking for 3 different funds.

Portfolio 2 = Gold 10%, Large cap 54%, Midcap 27% and Small Cap 9%

Gold &amp; Equity

Step 3: The last step is to decide the split between the risky assets and risk free assets. Risk free assets are your fixed deposits, EPF, PPF etc where the returns are fixed and not highly volatile. Debt funds does carry various risks like counter party risk, interest rate risk etc. (Read: How to build your debt portfolio.) The mix of debt investments is to reduce risk in your investments. Let’s see the possible range of returns i expect at the various portfolio mix.

Portfolio Returns_V1

So even if you are defensive investor, you should keep at least 10% investment in Eq+Gold and if you are a super aggressive investor, still i would suggest to keep 20% of your investments in the Debt instruments. I personally hop between three asset allocations 80% Debt/ 50% debt or 30% debt and rest in equity + gold based on Valuation Index. I have been in the 80-20 split for last 2 years and now moving towards 50-50 split, The last 10yrs CAGR of the portfolio is still >10% including the double digit returns in FY 19-20 even after the recent drop in equity markets.

Now, I can understand that doing all these things together can be too complicated for a simple investor. What is the simplified approach? A portfolio like below is widely suggested and it has its merit of being moderate in approach as well as can be suggested to a wider population. Follow a 60 : 40 Portfolio and keep re-balancing it half yearly, you will outperform most of the portfolios.

Asset Allocation

Please note that most of these analysis are on the past returns/ historical data so there is no guarantee of similar return profile in future. As i mentioned, I personally follow Dynamic Asset allocation mostly for the risk management and engagement in managing my portfolio. let me know if this was helpful, looking forward to your comments/ feedback. 

Happy Investing!