Can Active Funds Still Generate Alpha?

There has always been a tug of war between active and passive investors. There are dozens of studies carried out around the world that say that it is very difficult for an active fund manager to beat the index consistently. So, does this in any way mean that you should scrap the idea of investing in an actively managed fund? The report provides insights into this issue

Due to the low-cost structure of the passive funds, passive investing has gained huge popularity in developed markets such as that of the US. The global assets in passive products passed USD 5 trillion, with over 7,000 passive products as of March 2020. The US has a market share of 68 per cent with USD 3.6 trillion in assets and over 2,000 products. This is followed by Europe and Japan with 16 per cent and 6.5 per cent of market share, respectively. Though the numbers are far more modest for India, the growth has been encouraging.

The total assets under management (AUM) in passive products with the scenario of five years ago when in India the AUM was a mere USD 2 billion with 57 products. And a decade back it was far less with USD 1 billion in assets and 26 products in the market. In that sense, the progress made by India is remarkable, especially in the faster-paced active investing market. Two years ago, the exchange-traded fund (ETF) market constituted 2.2 per cent of the mutual fund industry while in December 2019 it stood at 7.5 per cent.

In India, institutional investors and individual investors contribute nearly 92 per cent and 8 per cent of the assets, respectively, in passive products. Passive investing is an investment strategy that is said to maximise returns by minimising trading and investment costs. Index investing is the most common form of passive investing, whereby investors invest in funds that replicate broad market indices.

In the case of actively managed funds, a fund manager charges an ongoing fund management fee to select securities and make investment decisions. While in the case of passive funds the aim is to replicate the performance of a benchmark at a fraction of the cost of active funds. With the number of passive funds increasing in India, we believe that it will have a huge impact on retail investors. The passive investing strategy looks simple, but is it effective as compared to an active one? Let us understand which strategy is better.

The Study

We have carried out a study specifically related to actively managed large-cap funds. The rationale for the same is that there are only a few passively managed mid-cap and small-cap funds with limited net asset value (NAV) history to consider for analysis. Further, we have compared the performance of the actively managed large-cap funds with that of S & P BSE Sensex and S & P BSE 100. Also, we have considered only those funds for study that have a minimum of 10 years of NAV history. The period of our study is from August 1, 2010 to July 31, 2020.

The above graph shows the average NAV movement of large-cap category plotted against the price movement of S & P BSE Sensex and S & P BSE 100. It clearly shows that over a period of 10 years, actively managed large-cap funds have done better than the index. However, this is just NAV or price movement and tells nothing more. Hence, we need to dive deeper to understand the factor of consistency. And for that, we need to test them with rolling returns. But before that, let us understand how the actively managed funds have performed as against indices on a trailing basis.

The above table clearly shows that on a trailing basis it was only over a period of seven years and ten years that the actively managed large-cap funds were able to beat the indices. For the rest of the period, these funds underperformed S & P BSE Sensex as well as S & P BSE 100. To get more insights, let us look at the number of funds that underperformed the two major large-cap indices.

As can be seen from the graph alongside, right from one month to five years, a maximum number of funds out of a total of 16 funds have underperformed S & P BSE Sensex and S & P BSE 100. Only in the seven-year and ten-year periods have the large-cap funds outperformed the index. However, these numbers are based on performance on a trailing basis. Though most of the studies carried out around the globe have been based on trailing performance, this might give you the wrong picture. This is because it takes into account the performance of only one point to a different point period while ignoring the other thousand points.

As such, it does not provide true insights about performance as investors keep on entering and exiting a fund at different times. Therefore, to get the right picture we need to make a comparison based on rolling returns. That would help us compare the average performance of the funds with sizeable number of observations as compared to those in the case of trailing returns.

The above graph reveals that actively managed large-cap funds have consistently outperformed S & P BSE Sensex and S & P BSE 100 on a rolling basis. For this we have considered close to 2,218 observations for one-year rolling returns, whereas for three-year and five-year rolling returns we have considered 1,725 and 1,234 observations, respectively. However, you might argue that this also includes the period before Securities and Exchange Board of India (SEBI) came out with rationalisation of the MF schemes as well, and this is true.

Taking pre-categorisation data can be futile as many funds have changed their fundamental attributes. So, to have a level playing field, let us assume data post-rationalisation of mutual funds and assume only one-year rolling returns for the same. The mutual fund rationalisation circular from SEBI was published on October 6, 2017. Therefore the period under consideration would be from October 6, 2017 to July 31, 2020.

The above graph clearly shows that actively managed large-cap funds are unable to outperform S & P BSE Sensex and S & P BSE 100. We studied almost 670 observations and hence it would be quite early to comment whether or not actively managed large-cap funds are able to outperform large-cap indices, assuming post-rationalisation performance. Nevertheless, one thing is clear: the outperformance is bound to come down as they have to invest minimum 80 per cent of their assets in large-cap stocks where information asymmetry is less and hence has lower chances of generating alpha.

Conclusion

On a trailing returns’ basis, actively managed large-cap funds underperform large-cap indices. But they do outperform on a rolling basis. Performance based on rolling returns is more credible than that of trailing returns. This is because unlike trailing returns we take a lot of instances into account while calculating rolling returns. That said, we cannot deny the fact that the performance of actively managed large-cap funds has not been so impressive post mutual fund rationalisation by SEBI. It was after this that passive funds gained a lot of traction. But India being an emerging economy there would be a lot of opportunities for fund managers to generate alpha over the indices. Hence, actively managed large-cap funds are still in the game and you can benefit out of them.

❝You will almost never find a fund manager who can repeatedly beat the market. It is better to invest in an indexed fund that promises a market return but with significantly lower fees.❞

- John C. Bogle