This article was published in The June 2014 issue of the Global Analyst
Mutual fund investors generally prefer a fund due to its historical performance. In the context of an equity fund, the primary expectation is that the fund manager should outperform his stated benchmark. For eg., if his benchmark is that of Nifty 50 or Sensex, the fund’s performance should be better than the benchmark to justify investor confidence in the fund. The extent to which the manager outperforms the benchmark is the second important element of attraction.
In an attempt to beat the benchmark, the fund manager is always in pursuit of winners and tactful in avoiding losers while selecting stocks. Where the winners outnumber the losers and where the fund manager’s commitment to winners (in terms of allocation) is better than the losers, he or she will generate out performance or what is technically called as alpha (excess performance over the benchmark). In other words, where a fund manager generates superior performance through consistently beating the benchmark, he/she is good at picking winners and avoiding losers. While this assessment sounds simplistic and hence reasonable, more often than not this 2 dimensional approach to assessing fund manager performance may not be enough.
In my view, the issue of fund management in the context of equity revolves around the concept of bets. There are bets that the fund manager sticks with and there are bets that he avoids. Hence, we need to view the issue from a 4-D perspective:
Dimension 1: Persistent Bets: These are bets that the fund manager is sticking with resolutely and believes in them strongly. A simple way to figure this out is to see if a particular stock is present at the beginning as well as end of an evaluation period. The reason why he persists with these stocks can be borne out of a thorough research and fund managers’ conviction about its future ability to perform. If the stock price of persistent bets move up, the manager gains and vice-versa.
Dimension 2: Discarded Bets: These are bets that the fund manager has lost faith in and therefore sold out. A way to find this out is to see if a particular stock figures in the beginning portfolio but not in the end period portfolio. In this scenario, if the stock price gains after the manager has discarded them, the manager tends to lose out on performance.
Dimension 3: Missed Bets: These are bets that the manager did not take or we can call it as “failed to buy” scenario. These bets will not figure either in the beginning portfolio or end portfolio. In such cases, where the stock price moves up, the manager loses out in terms of opportunity gain and vice-versa.
Dimension 4: New Bets: These are bets that the manager took recently. A simple way to figure them out is when such stocks are present in the end period portfolio and not in the beginning period portfolio. Like persistent bets, the manager gains when such stocks move up and vice-versa.
Case Study: HDFC Top 200 Fund
Let us run through this 4D concept through the evaluation of the performance of HDFC Top 200 fund, one of the most popular equity funds in India.
As we can see, the fund has underperformed the benchmark albeit slightly during 2013. However, dissecting this further, we can perform a 4-D analysis on this.
Dimension 1: Persistent Bets:
The manager persisted with 55 stocks in his portfolio that figured both in the beginning and end portfolios. The above table provides the list of top 10 arranged in terms of weight. As we can see, most of these persistent bets are large cap blue chip heavy weights and are reputable names in the Indian stock market. Excepting for a few like ICICI Bank, SBI, HDFC Bank and Bank of Baroda (all bank stocks incidentally!), all others have done well especially TCS and Infosys (IT stocks incidentally!). The weighted average performance of persistent bets is 6.71% which is commendable.
Dimension 2: Discarded Bets:
During the year, the fund manager sold out (or discarded) 19 stocks while the table presents the top 10 in terms of weights. In some cases, the fund manager was right as in the case of LIC Housing finance, Tata Power, Titan, etc. But in many cases the fund manager paid a penalty of discarding some stocks whose performance later turned out to be very good. Good examples include Hindustan Lever, Sun Pharma, CMC and Britannia. The weighted performance of discarded bets is 0.49%. In other words, had he not discarded them, he would have added 0.49% to the portfolio performance.
Dimension 3: Missed Bets:
Here is a list of stocks that the fund manager did not look at all and in this case it runs into 125 stocks. However, a perusal of the top 10 among them in terms of weights reveal some interesting stuff. The greatest miss has been HCL Tech that performed more than 100% during 2013. Given the names like TCS and Infosys in the persistent bets list, it is surprising to see HCL Tech missing. The list of missed bets is a mixed bag with many posting negative performance ( NTPC, Ultratech, BHEL, etc). The weighted performance of this list is 2.55% which is quite significant. In other words, had he pursued these bets, the portfolio performance would be better by 2.55%.
Dimension 4: New Bets:
This list is the smallest comprising in all 6 stocks. The biggest new bet is that of Sesa Sterlite that performed just 3% while block buster performance of 61% of Idea Cellular did not benefit much due to low weight. Similarly disastrous performance of stocks like Jaiprakash Power and Jet Airways did not hurt much due to lower weights. The total weighted performance of new bets is 0.09%.
In summary, we can tabulate thus:
While the portfolio benefited hugely through the persistent bets, it also suffered due to missed bets while the impact of discarded bets and new bets has not been pronounced.
Caveat: In hindsight things always look very clear. Secondly, this analysis was performed taking into account the portfolio composition at the beginning and end of the evaluation period (2013). The performance of a portfolio is also affected by several transactions that happens in the intervening period and hence may cloud the analysis.
Having highlighted the caveats, the idea of this research is to take the literature of fund manager performance one step higher by looking at the opportunity cost of missing something and also the opportunity cost of sticking with bad choices which can take a heavy toll on the portfolio performance. What makes a fund manager stick with a bet, discard a bet, miss a bet or take a new bet is a combination of several factors including his ability to pick stocks, ability not to get distracted by peer group pressure, ability to have sound advice and being vigilant. In the end, the aim of any active fund manager is to generate alpha which is the only reason why investors are ready to pay management fees. In the absence of such a proposition, an Exchange traded fund (ETF) can simply do the job. In an ETF scenario, there is only one bet i.e, Index composition!.
The author thanks Karthik Ramesh and Rajesh Dheenathayalan for their assistance