'Alpha' Way to Find the Right Fund
This Article was originally published in The Global Analyst
India’s mutual fund landscape has seen explosive growth thanks to aggressive advertisement, product pushing through banking channels and stock market performance. We see cricket celebrities endorsing the slogan “Mutualfundssaihai” and a website dedicated in that name in order to propel investor interest. The endorsements urge investors to look at mutual funds from needs as varying as children education to retirement planning.
In line with the market structure, large cap funds dominate the landscape ably supported by other categories as well. While we have thousands of mutual funds to choose from, the following data pull from Reuters for equity funds with more than 10-year history is interesting to watch.
It is indeed heartening to notice the explosive growth of this key institutional investor category which is surely a sign of market maturity. Over the years, the number of fund houses, range of funds and systematic investment plans have burgeoned to spoil investors with choices. That’s exactly where the problem starts.
In this context, I am raising some key questions that may concern investors and try to answer them.
1. Do funds generate alpha?
Alpha is simply defined as excess return over the stated benchmark. Fund managers are paid management fees in the hope that they will perform better than the overall market (benchmark). In order to smoothen alpha calculation, we choose to take five year rolling annualized return (also said as Compounded Annual Growth Rate or CAGR) and deduct five year rolling annualized market return to compute alpha. In general, we find that more than 50% of fund managers generated alpha during the period 2015-2020. In some categories like mid cap it can even be higher. The top alpha generators category wise is given below:
2. Is there a Persistence in Performance (PIP)?
We are all familiar with the small print “past performance is not indicative of future results” and the superfast audio that plays this slogan in TV advertisement!. However, product push predominantly happens based on past performance. While we have seen managers generate significant alpha, do they do it consistently is the question. In order to examine this, we rank ordered the top 5 performers each year and mapped them to see who stays and who gets out (called as the churn). We can compute a PIP ratio that divides incumbents with new entrants to the top 5 list. In other words, if the PIP ratio is 60% it means 3 out of 5 managers in that year were existing incumbents. If that ratio is 100%, all the top 5 managers were the same. High ratio implies persistence in performance. The following table provides the PIP ratio category wise.
It is noted that the persistence factor has been coming down over the years for many categories which implies manager churn among top 5 performers. This makes it difficult to bet on winners. The decrease in PIP ratio could easily be due to increased competition.
3. Is there a relationship between performance and market share?
The overall industry has grown nearly 4 fold during the last five years. In this hectic growth, it is obvious that some funds increase their share at the cost of others. Let us see who gained and who lost.
The gainers in the market share did that based on their alpha generation while losers lost out due to negative alpha. The gainers need not be the market leader in that category but represents one that increased their share significantly. In the large cap category, SBI Blue chip fund increased their market share significantly from 2.5% in 2014 to 15% in 2020 on the back of cumulative alpha of 9.4% over the benchmark. On the other side, HDFC Top 100 lost the market share from a whopping 31% back in 2014 to about 11% now. During this period, the fund’s cumulative alpha stood at a negative 14% explaining the loss in market share. It should be noted that the fund’s overall AUM did increase during the period 2014-2020 at an annualized clip of nearly 9% though we notice the loss in market share. Among the losers in the market share, HDFC funds represents three categories while Nippon represents the other two. On the other hand, the gainers are diversified with names from SBI, UTI, Axis, Mirae and Kotak. Increasing market share in an increasing pie size is significant feat indeed. Losing market share in increasing pie can still mean period on period growth.
In the multi cap category, UTI Equity-Growth fund increased its market share from 2% of total AUM to nearly 10% where its cumulative alpha during the period 2014-2020 stood at 22%. On the other hand, HDFC Equity Fund-Growth lost the market share from 36.4% to 15.8% with a cumulative negative alpha of 17%.
In other categories too, we can clearly see a correlation between AUM growth, increase in market share and alpha.
4. Are there any exceptions?
While we saw a clear correlation between performance and growth, we can also notice some inconsistencies where poor performance is accompanied by strong AUM growth and vice-versa. For example, in the large cap category, while Edelweiss large cap fund has shown a cumulative alpha of 10.5% over the period 2015-2020, its AUM level and growth remained very tepid. In the same large cap category, we notice that Nippon India large cap fund’s AUM grew at a CAGR of 57% even though it had a negative cumulative alpha of 9%. Across the board, we find inconsistencies where some funds clocked good AUM growth in spite of negative alpha. This could be due to aggressive selling. However, cases of good performance accompanied by poor AUM level/growth is not clear from a reasoning point of view.
In conclusion, we find that broadly mutual funds significantly outperform the underlying market making them a viable investment option. However, we notice wide variation in performance between leaders and laggards raising a large question as to whether there is persistence in performance. Our research shows that the persistence aspect has come down over the years making it difficult to bet on winners. It is instructive to see who is gaining market share and who is losing and correlate that with their performance. Generally, we observe a strong correlation between market share gain and alpha generation though there are exceptions. It is a good investment strategy to bet on market share gainers with good alpha generation history.