Why diversified funds underperform

Fund houses continuously chasing the same stock universe tend to underperform.

Business Line recently carried the findings of a study conducted by CRISIL and Standard and Poor's on the performance of Indian mutual funds. The study concluded that half of the diversified funds surveyed underperformed the broad-cap S&P CNX 500 Index over three and five-year periods. The question is: Why do diversified funds underperform their benchmarks?

This article explains how active funds generate excess returns. Then, it explains why active funds that have high correlation with peers underperform their benchmarks.

Active funds have a mandate to beat their benchmark (generate alpha). The portfolio managers of these funds are within their mandate to hold large-cap, mid-cap and small-cap stocks.

Diversified funds generate alpha in two ways. One, portfolio managers' overweight sectors that they believe will outperform the market (sector allocation). For instance, health-care has nearly 2.5 per cent in the Nifty.

A portfolio manager who believes that health-care sector will outperform the Nifty may take, say, 6 per cent exposure to the sector; the portfolio would then be overweight by 3.5 percentage points on the sector.

And, two, portfolio manager overweight stocks (security selection) that they believe will outperform others in the sector. Take the technology sector, which has nearly 13 per cent weight in the Nifty. Suppose the portfolio manager believes that Infosys will outperform other technology stocks. The manager may take, say, 12 per cent exposure to Infosys instead of 9 per cent weight the stock has in the index.

Now, all diversified funds can successfully generate alpha through sector allocation and security selection only if a portfolio manager has a model that identifies sectors and/or stocks that outperform the benchmark with a high degree of probability. And importantly, such a model should enable the fund-house buy stocks well before their peers do.

Diversity

It logically follows that alpha can be generated only through unique strategies. This poses several problems. One, strategies do not remain unique for a long while. As institutions exploit asset mispricing, alpha becomes beta. And, two, active strategies — whether unique or otherwise — are subject to high risk of failing, leading to underperformance.

The risk of underperformance comes about because of lack of unique strategies. A manager may have carefully crafted a portfolio using proprietary model. Yet, if several diversified funds were to have similar portfolios, the peer fund universe is not diverse. And lack of diversity causes two problems.

One, alpha fades quickly as more funds “chase” the same universe of stocks. This means that funds typically generate market returns before fees but underperform after fees. And, two, when alpha fails due to security selection error, funds perform badly because of high correlation among peers.

In some ways, this is the same problem that epidemiologists face when fighting communicable diseases. Lack of genetic diversity increases outbreak of communicable diseases. Likewise, lack of portfolio diversity among funds causes underperformance.

The diversity problem arises because the Indian mutual fund industry has seen a proliferation of funds and fund-houses. Based on the January 2011 AMFI monthly report, there were 323 equity funds presumably “chasing” stocks within the investable universe of the S&P CNX 500 Index (or the BSE 500 Index).

Besides, the generic investment objectives stated in the offer documents and the newsletters gives an impression that all funds do not have well-thought investment philosophy. This essentially means active funds tend to buy similar stocks for, perhaps, different reasons, subjecting the portfolio to “alpha contamination”.

Conclusion

Two pointers emerge. One, mutual funds having neglected stocks in their portfolio that are intrinsically valuable. Two, mutual funds that buy same stocks well before their peers do would be able to outperform the benchmark.

The key then lies in identifying funds that continually innovate to have low “alpha contamination” with peer funds.

(The author is the founder of Navera Consulting. He can be reached at >enhancek@gmail.com)