The Hindu Business Line : Performance, with style and index

Fund-houses should look to exploiting mispricing in assets through not-so-greatly exploited investment strategies. This would mean adopting hedge-fund-like strategies within the constraints of long-only strategies. Of course, funds can also combine derivatives with the spot market to capture the benefits of long-short strategy.

THAT index funds have been a preferred vehicle of investing in the US is not surprising. Empirical evidence shows that active portfolio managers on an average do not beat the benchmark index. The situation has, however, been different in India; active funds comfortably beat the benchmark index. This can attributed partly to lack of style benchmarks.

Portfolio performance is compared to a generic benchmark such as the S&P CNX Nifty or the BSE Sensex. Active managers can simply overweight, underweight or exclude stocks to outperform the generic benchmark. Small wonder then that diversified equity funds beat the benchmark index by over 15 percentage points last year. Passive investing has, hence, become passé in India. But that may not be the optimal approach to portfolio management. If the performance pattern of equity funds is anything to go by, it appears that a combination of index funds and style funds could enhance portfolio returns. Here is why.

Need for indexing: An analysis of equity funds in India since 2000 shows that active funds had a high degree of co-movement with the BSE 200 and the S&P CNX Nifty. Yet, these funds generated returns by taking active risk, which is captured by portfolio alpha. Market return comes from exposure to portfolio beta or policy risk.

The point is that all funds displayed strong relationship to the benchmark index. This suggests that the movements in the generic benchmark can explain much of the fund returns. This read with positive alpha means that only a small proportion of the total portfolio generates excess returns to compensate for the active risk.

Take Tata Select Equity. The movements in the BSE 200 explain approximately 81 per cent of the fund returns. Yet, the fund sported an alpha of 0.69. This means that some or all of the 19 per cent of the unexplained returns helps the fund generate alpha. Other equity funds displayed similar behaviour. The problem is that some of these funds also displayed negative skew. That is, these funds generated number of positive gains but their losses were large and infrequent. Moreover, some of them had skew that was higher than that of the generic benchmark. This suggests that fund selection and market timing is important for an investor to generate returns in excess of the benchmark. Investor should look to moderating fund selection and market timing risk. Fortunately, the pattern in fund performance suggests that investors can construct a strategy to lower these risks and yet hope to capture active returns. Such a strategy would entail investing 75-85 per cent of the total portfolio in index funds. The balance has to be either managed directly or through a fund that specializes in security selection.

Active returns: Security selection is important if 15-25 per cent of the portfolio has to outperform the benchmark index. A value fund should combine well with index funds to enhance portfolio returns. But this strategy may suffer from problems of inconsistency.

A portfolio manager may find it difficult to consistently generate alpha if the market knows his or her investment strategy. For then, other portfolio managers can replicate the strategy to generate excess returns. When the market is able to replicate the strategy, excess returns become market returns.

That is, portfolio alpha becomes portfolio beta, as the market cost-effectively replicates the once-unique strategy. The problem is that typical value strategies such as low price-earnings ratio, price-book ratio and high dividend yields are well known market strategies.

Perhaps, fund-houses should look to exploiting mispricing in assets through not-so-greatly exploited investment strategies.

This would mean adopting hedge-fund-like strategies within the constraints of long-only strategies. Of course, funds can also combine derivatives with the spot market to capture the benefits of long-short strategy.

Direct investing may be optimal for disciplined investors. Market timing and exit are important in generating active returns, as is security selection. It is moot if retail investors are competent in all these areas of portfolio management.

(Feedback can be sent to bvenky@thehindu.co.in)

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