“Mutual funds sahi hai” goes the tagline of AMFI’s campaign, advocating mutual funds as the ‘right choice’ for retail investors. Given their inherent benefits of diversification and liquidity, coupled with the potential for high equity-driven returns, mutual funds are positioned as a more optimal investment than other traditional options (bank deposits, gold, and the like).

Data suggests that retail investors have latched on to this idea — as per AMFI’s latest update (April 2022), since the campaign’s launch in March 2017, the industry’s assets under management (AUM) contributed by individuals have increased 2.5x from ₹8.5 trillion to ₹21.6 trillion, with their share in total AUM increasing from 45.9 per cent to 55.4 per cent.

Despite such strong growth, the domestic mutual funds industry is significantly under-penetrated. As noted last year in Aditya Birla Sun Life AMC’s prospectus, India’s mutual funds AUM as a percentage of GDP was a mere 12 per cent in 2020, much lower than in emerging market peers such as Brazil (81 per cent), South Africa (62 per cent), South Korea (38 per cent) and China (18 per cent).

To aid further penetration, SEBI modified its AMC licence issuance norms in December 2020, relaxing the profitability criterion. Several discount brokerages and fintech firms have since applied and set sights on operating their own AMCs, signalling an inevitable rise in the number of players.

For fund managers and investors alike, such increasing buy-side competition from new funds prompts the questions: What impact would it have on fund performance? Would more competition diminish opportunities to generate returns in excess of the benchmark (alpha)? More importantly, can one identify the funds which would outperform in such a scenario? In their paper from 2018, published in the Review of Financial Studies, Gerard Hoberg, Nitin Kumar and Nagpurnanand Prabhala (HKP) address these questions with a unique take on examining mutual fund competition.

Viewing funds via a 3D lens

Most prevailing approaches cluster funds by ‘style’, classifying them into broad buckets (such as large-cap value, mid-cap core, small-cap growth, etc.) based on the characteristics of their constituent stocks. However, companies evolve and change characteristics materially over time, which reveals the pitfall of such style-based clustering.

For instance, a small-cap fund invested exclusively in such stocks may find a year later that most of its investments have appreciated in market value and could potentially be defined as mid-cap stocks. Is it then appropriate to benchmark its performance to other small-cap funds? Or should one pick mid-cap funds as its ‘competitors’ instead? Neither, suggest HKP, and introduce a novel method to identify a fund’s peer set.

First, they define a three-dimensional (3D) style space, with the axes representing size, value and momentum — systematic style factors known to drive returns. They then assign each fund a position in this 3D space, derived by aggregating characteristics of the individual stocks constituting its portfolio.

Given this framework, competition between funds is reflected in the ‘distance’ between them in this 3D style space. Smaller the distance between two funds, higher the similarity in their investment styles, and the more likely they are to be competing. Competitors identified in this manner constitute a better peer set, customised for each fund, as opposed to a general list of funds within the same broad category.

Intensity of competition matters

By adopting a threshold distance to limit peer sets, HKP define the total number of customised peers as a measure of the fund’s competition. They further define a measure of managerial skill — customised peer alpha (CPA), the gross (before expenses) return of the fund less the average gross return of its peers.

For their US-based sample, HKP find that a higher CPA predicts higher future alpha. Moreover, the corresponding outperformance is greater for funds facing lesser competition, implying that future outperformance weakens when competition increases.

These findings are highly relevant to investors, especially those trying to identify potential for outperformance amongst similarly named funds. One observes similar results as HKP for the Indian market — over the next quarter, funds ranked in the top 20 per cent (by 6-month average CPA) generate an annualised alpha 502 basis points (bps) higher than that of the bottom 20 per cent. Further segmenting the funds into three buckets by competition, the corresponding outperformance is 727 bps for funds facing the lowest competition and 200 bps for those facing the highest competition.

In conclusion, as the emergence of new entrants in the domestic mutual funds industry increases buy-side competition, relative outperformance exhibited by existing funds is expected to decrease — unless, of course, their managers can spot a less crowded, yet profitable, niche in the 3D style space to thrive in.

The writer is a Research Associate at the Centre for Analytical Finance, Indian School of Business

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