Why do some mutual funds outperform markets while others don't - Motilal Oswal

Why do some mutual funds outperform markets while others don't

If you scan through the mutual fund performance of various AMCs, you are likely to see a vast variance in the performance of these funds. The returns vary vastly among equity funds and among debt funds; the latter being a little more surprising. To get a better understanding of this variance, we have taken the last 5 year returns of different categories of funds in India and plotted their returns based on maximum returns, minimum returns and the category average. Only top-20 funds have been considered..


Nature of FundCategory AverageMax ReturnsMin ReturnsReturn PeriodLarge Cap14.7%32.6%4.6%5-Year CAGRSmall & Mid Cap13.2%37.0%16.1%5-Year CAGRInfra Funds17.7%27.1%12.5%5-Year CAGRIndex Funds8.2%20.5%11.5%5-Year CAGRBalanced Funds11.5%20.1%9.9%5-Year CAGRLong Term Debt6.6%11.1%4.1%5-Year CAGRLiquid Funds7.1%8.2%4.9%5-Year CAGRGold Funds(0.6%)(0.3%)(1.1%)5-Year CAGR

Source: Moneycontrol


What emerges from the above table is that there is a wide dispersion in the above funds between the best performer and the lowest performer. In fact, when you look at the category average, you get an idea of how wide the variance is. Except in case of gold funds and, to an extent, in case of liquid funds there is dispersion in returns across all the other categories of mutual funds. Why does this dispersion arise? Why do mutual funds underperform market and what is the percentage of mutual funds that beat the market. When a study of mutual funds outperforming the market was done in the US, it was found that over 80% of the fund managers actually underperformed the benchmark. For now, let us focus on why some funds outperform and others underperform. There are 6 key reasons..


Equity Funds - Taking on concentration risk
One of the methods of active management is to increase exposure to sectors that are likely to outperform. If you look at the portfolios of funds they tend to overemphasise on private banks and tend to underemphasize on pharma and IT. Essentially, funds take on concentration risk to outperform the market. Having a fully diversified portfolio at all times is unlikely to help you outperform. Fund managers do make an attempt to ride the trends. That is why you must not go purely by returns but also by the Sharpe and Treynor ratios which tell you about the return per unit of risk.
Equity Funds - Churning the market within the cycles

Should mutual funds churn their portfolio in the market? There is a trade-off between being a smart churner and adding to your trading and statutory costs. But good fund managers are quick enough to spot opportunities in the market and also move out before negative news strikes. For example, the fund that outperformed would be those who exited PSU banks the moment the PNB fiasco became public. Irrespective of costs, being smart in trading opportunities does make a difference to your portfolio returns.


Equity Funds - Staying fully invested for the long term

We have seen that equity generally tend to outperform over the long term if you identify quality growth stocks and have patience to hold on. In the case of mutual funds also equities have given good returns if held for the long term. If you compare the consistent outperforming AMCs over the long term you will find that they are the ones who have managed to hold on to quality stocks for the long term. A corollary of this point is to stay fully invested or close to fully invested at all times. Cash has zero expected returns and hence sitting on cash is never a great strategy. Outperforming funds typically tend to stay fully invested and only keep cash to the extent of liquidity required.


Equity Funds - Consistency of fund management strategy

Consistency of the fund management strategy comes from a long standing team. You will find that funds that keep fleeting across strategies or where the teams keep churning tend to underperform. That is because there is no consistency or calibrated approach to managing the funds. At the end of the day fund management is the art of doing the right thing consistently. That is only possible if you team is truly consistent and your fund managers and traders have been around long enough to understand the fund DNA.


Debt Funds - Managing the fund more dynamically over the longer term

Variance in equity fund performance is understandable but what about variance in debt funds. What explains this variance in returns in debt funds as shown in the table above? It is all about being in the right place at the right time. For example, if interest rates are falling then it makes sense to be overinvested in long dated securities and if rates are rising then you can shift to liquid or variable rate bonds. That is what dynamic fund management is all about and that is what leads to outperformance in debt funds.


Debt Funds - Exposure to debt paper of dubious quality
When exposure to Amtek Auto almost resulted in a default by J P Morgan Mutual Fund 3 years ago, it was an example of what can happen to funds that are exposed to bonds of dubious quality. Going down the rating curve is a standard strategy among debt fund managers, especially when the spread widens. But this strategy is also fraught with risk as we found out in the case of Amtek Auto. Smart fund managers ride the rating curve to the extent of gaining outperformance without exposing the core portfolio to too much risk.
As can be seen from the table, only in case of gold funds and money market funds, there is a tendency towards low variance. Otherwise, there is scope for outperformance!

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