Was the EPFO ahead of the curve in its preference for passive funds?

Illustration by Binay Sinha
The Employees’ Provident Fund Organisation’s (EPFO’s) dependence on low-cost passive funds is starting to look smarter with each passing day, as active fund managers struggle to meet benchmark returns.

An analysis of the data from Value Research, a fund tracker, shows a majority of active funds have failed to beat their benchmarks in both the large-cap and mid-cap space. Small-cap funds are the only ones where active funds have outperformed.

The EPFO’s equity allocations have been made to passively managed funds, which seek to mimic the benchmark, instead of beating it. 

This means their returns closely match the index. This is unlike actively managed funds, whose returns can differ from the benchmark because of the fund manager’s calls. Till recently, these calls have helped Indian fund managers outperform. This may be changing.

A Business Standard analysis looked at actively managed, open-ended equity schemes and compared their performance to their respective benchmarks. These were divided into large-cap, mid-cap and small-cap funds. Returns were considered for direct schemes over one-, three- and five-year periods for 58 schemes.

A majority of the schemes examined in the analysis have underperformed their benchmarks over the last year. Only 44.4 per cent of mid-cap schemes outperformed their benchmarks over the past year. Only a third (33.33 per cent) did so over three years. It is 88.9 per cent at the five-year mark. 

This seems to indicate the underperformance is a more recent phenomenon. Fund managers are finding it more difficult to outperform than they did earlier. Their outperformance at the five-year mark is because of higher returns in earlier years.

This trend had already made itself felt in the large-cap space. Only 13.3 per cent outperformed in the last year. The figures at the three-year and five-year marks are 46.7 per cent and 83.3 per cent, respectively.

The small-cap space is the one where active fund management has managed to add significant value. All the schemes under examination beat benchmarks over the last one year, improving  their performance over previous periods. 

The median outperformance is in double digits for small-cap funds over the last one year. It is negative for mid-cap and large-cap funds over one- and three-year periods.

The findings are contrary to active fund manager’s documented outperformance in emerging markets. 

A paper by the University of California noted significant difference in returns over passive funds. “…actively managed mutual funds yielded superior average 3 year net-of-fees returns of approximately 2.87% over passively-managed ETFs,” said the 2012 paper, authored by Klemens Kremnitzer. 

Research has previously suggested that emerging markets may simply be less efficient. Information is less readily available; there are fewer companies that receive wide coverage. This allows fund managers to outperform the market.

Experts say that while active funds may have underperformed on a point-to-point basis, this may be a short-term phenomenon.

Dhirendra Kumar, chief executive officer of Value Research, agreed that the index is representative of an inefficient marketplace in emerging markets like India, which makes it easier to beat. 

This would also mean that active fund managers can continue to add value, although this may not be reflected in the short term. “It is not possible for fund managers to get (it) right every year,” he said.

Vidya Bala, head (mutual fund research), FundsIndia agreed, while noting that the margin of outperformance had been shrinking for large-cap funds. “In my opinion, the passive versus active can be very much an active debate in the large-cap space. In the mid-cap space and in the multi-cap space, I think there are enough returns being generated by active investing that cannot be easily made up by any passive nor semi-passive strategy,” she said.

Note: Return as on 2 July 2018. Direct plans of schemes for which returns over one, three and five-year periods were available have been considered. The analysis looked at a total of 58 such schemes in the small, mid and large-cap categories.

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