Don't dump your fund in haste even if it underperforms in short-term

Active funds charge a higher fee from investors than their passive counterparts. Investors are willing to pay this fee because in India fund managers are able to beat their benchmarks. But, this also means that the performance of active funds should be evaluated annually.

The hit ratio tells you the percentage of funds that have outperformed their benchmarks in each category. It is a good measure of the level of satisfaction that investors have derived from their fund investments. Even if the markets have done well, you would not be completely satisfied unless your fund has beaten its benchmark.

Equity-linked saving schemes (ELSS) performed the best among all categories, mid- and small-cap funds were laggards, while large- and multi-cap funds put up a middling performance.

Broad market rally: In 2017, the markets rallied strongly but the hit ratio of funds across categories was lower than in years such as 2014 and 2015. According to fund managers, the breadth of market performance made fund managers' jobs difficult this year. “The rally wasn't driven by a single sector. A very large basket of stocks performed last year. Except for large-cap IT and pharma, most other sectors did well. That is one reason why funds weren't able to capture the entire market performance,” says Sachin Relekar, fund manager-equity, LIC Mutual Fund.

Avoiding risky bets: In the mid- and small-cap category, outperformance may have been low because fund managers were steering clear of risky bets. According to Vidya Bala, head of research, Fundsindia.com, “If you look at the nature of stocks that rallied in 2017, especially in the mid- and small-cap space, many are momentum plays. Many of these stocks wouldn't have fitted into the fundamental filters of fund managers. The latter would also have turned wary of high valuations. They would also be unwilling to invest in illiquid stocks that are difficult to exit.”

Another reason for underperformance was impact cost (the phenomenon of buying and selling by large players driving costs up or down). With a lot of liquidity chasing a limited float of stocks, the impact cost became high, especially in the mid- and small-cap space. “When a fund tries to book profits, the returns come down significantly from the start to the end of the process. A stock may have run up 200 per cent, but by the time the fund manager is able to sell and exit it, the returns could dwindle to 120 per cent,” says Bala.

In the large- and multi-cap categories, funds that took concentrated bets outperformed. On the other hand, funds that took contrarian bets on sectors like IT and pharma underperformed, as these bets will take time to play out.


Lock-in helped performance: 84 per cent of ELSS funds managed to beat their benchmarks. They were helped by the three-year lock-in these funds enjoy. “In ELSS funds, the fund manager knows that the investor has come in for three years. The former can, therefore, take longer-term investment calls and wait for a longer time for his calls to play out,” says Ritesh Jain, chief investment officer, BNP Paribas Mutual Fund. The outperformance of ELSS funds is also due to the fact that 17 of the 43 funds in this category are benchmarked against large-cap indices such as the Sensex and Nifty, even though these funds take considerable exposure to mid- and small-cap stocks (they are multi-cap in nature).
  
 Outperformance by large-caps may reduce: Once Sebi's new classification norms become operational, outperformance by active funds may reduce in future. “Fund managers will be allowed to invest in the 100 largest stocks by market cap, while there are 50 stocks in the Nifty 50. There will be a lot of overlap between any large-cap fund and the Nifty, making outperformance difficult. That won't be the case in mid- and small-cap categories, where the universe of stocks is larger, and therefore the skill set of fund managers will remain a decisive factor,” says Nikhil Banerjee, co-founder, Mintwalk. The introduction of total return index (in place of price return index) is also expected to affect outperformance in the large-cap segment more.

What should you do? One year is too short a period to judge the performance of an equity fund. “If you have chosen a fund with due care and it has a good long-term track record, be patient with it even if it underperforms in the short term,” says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor (RIA). Adds Mumbai-based financial planner Arnav Pandya: “The numbers (see table ‘Percentage of Outperformance’) make a strong case for investing in equities for the long term, as the percentage of funds that outperform increases significantly with time.” Bala adds that if your fund has underperformed this year, it could be because the fund manager is staying away from momentum plays to protect downside risk.

In India, the case for investing in actively managed funds still remains strong. “In the US market, index funds have outperformed active funds significantly since the financial crisis. But in India the market is still inefficient. Therefore, fund managers are still able to outperform their benchmarks over the long term. The case for investing in actively managed mid- and small-cap funds will remain strong even in the future,” says Banerjee.