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  • Writer's pictureAkshay Nayak

SPIVA India Full Year 2022 : The Fallacy That Is Active Outperformance

The S&P Indices Vs Active (SPIVA) India report is the most reliable source for data on the performance of actively managed mutual funds and passive index funds in India, and provides the most comprehensive database of evidence in support of its findings. For more on how SPIVA reports work, why the data in them is so reliable and inferences that investors can draw from past trends in SPIVA report data, have a look at one of my earlier articles Do We Have A Winner? The most recent edition of the semi annual SPIVA India report was released earlier this week.

And sure enough, continuing the overarching trend revealed by past editions of the report, the findings of the SPIVA India Full Year 2022 report show that index funds clearly outperform actively managed mutual funds, owing to the fact that most actively managed mutual funds fail to beat their respective benchmarks over the 10 year period ended December 2022. As per the report, 67.9% of actively managed large cap equity funds, 63.9% of Indian ELSS funds, 50% of mid and small cap funds, 68% of Indian government bond funds and 98.2% of Indian composite bond funds underperformed their respective benchmarks over the 10 year period ended December 2022.

And the story largely remains the same across 1 year, 3 year and 5 year time periods across fund categories. The underperformance rates of actively managed funds for various categories in each of these time periods is laid out in the graphic that follows.

What's more, similar results have been observed across various geographical regions such as North America, Latin America, Australia, Europe, Japan and so on. And longer the period of study, the more glaring the underperformance. So the underperformance of actively managed mutual funds extends into more of a worldwide trend. And while managers who handle actively managed mutual funds may still argue in favour of active management, it cannot be denied that there are a few systemic factors that take any apparent performance advantage away from actively managed funds.

The first of these factors are the costs that are inherent to actively managed mutual funds. The average actively managed mutual fund in India has a Total Expense Ratio (TER) of 2-3% per annum when offered under the regular plan. When offered under a direct plan, actively managed funds tend to have expense ratios of 1% to 1.5%. Index funds on the other hand tend to have expense ratios of 0.2% to 0.5%. This differential excess of 1.5 to 1.8% in costs between actively managed and index funds ultimately eats into and drastically reduces investor returns over a long period of time say 10, 15, 20 years.

Today, actively managed mutual funds account for an overwhelming majority of assets managed by the mutual fund industry in India. This in turn means that the number of managers of actively managed funds would be high. This makes active fund management a highly competitive exercise. While this may seem like a good thing, it actually turns out to be another reason why outperformance by actively managed mutual funds is a misconception. This is because the high degree of competition within the active fund management space means that active fund managers not only have to beat the performance of the chosen benchmarks of their respective funds, but also the performance of other active fund managers within the industry.

And given that most fund managers within the industry all have access to the same information and similar insights, the performance of most active fund managers in the industry would be similar. This means that there would be no inherent source of outperformance available to active fund managers. Fund managers who lack competence would naturally be decisively beaten by benchmark returns over a period of time. So the only source of outperformance available to a competent active manager today would be the underperformance of other active managers around them.

This effectively means that any outperformance achieved by actively managed funds is more likely to be attributable to coincidence and luck rather than the actual skill of the manager of the fund. And therefore, when an active fund or an active fund manager achieves true outperformance, it does not sustain for long periods of time. This has also been established by SPIVA data through the SPIVA Persistence Scorecard. For the American markets, the latest edition of this data is available in the U.S Persistence Scorecard Mid Year 2022. To the best of my knowledge, similar data for the Indian markets is currently unavailable.

But even so broad persistence trends in India are likely to be similar to those in the United States of America. It is also important to remember that while the maximum downside for a stock is 100%, the upside is limitless. Moreover, only a select set of stocks within an index are likely to beat the returns of the index over a period of time. This means that long term stock returns are unlikely to perfectly resemble a bell shaped curve which is representative of a normal distribution. This invariably means that stock returns do not cluster around the average or median return, but usually tend to be skewed, most often towards the right.

This means that active fund managers would have to identify these stocks in each period and gain adequate exposure to them in their funds to be able to outperform the index. But the exercise of identifying and managing exposure to the select few outperforming stocks is something that is extremely hard to do correctly and consistently. And this ultimately points to the recurring conclusion that outperformance in actively managed mutual funds is extremely hard to achieve and sustain.

The higher costs associated with actively managed mutual funds are mainly meant to compensate for the skill of the fund manager. But as shown by the data from the latest or any SPIVA report, active fund managers achieve outperformance more through luck and coincidence than skill, and cannot sustain outperformance if they do manage to achieve it. So investors compensate their fund managers for something that very few achieve, and almost none achieve consistently when they invest in actively managed mutual funds. This just proves that parking money in active funds is a raw deal for investors, since outperformance in actively managed mutual funds is nothing more than a fallacy or a false notion. And that should be the most important takeaway for investors from the latest or any other SPIVA India report.

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