Mutual Funds
Mutual funds and randomly walking monkeys
The often ignored disclaimer, "past performance is not an indicator of future results" is very important for mutual fund investors. A fund that looks the best based on its past performance may not turn out to be the best in the future
 
In 1973, Burton Malkiel, a professor of economics at Princeton University, made an astonishing claim in his best-selling book ─ A Random Walk Down Wall Street.  He claimed that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts. The implications were profound. It meant that professional fund managers do not create any value for the investors. Unsurprisingly, it was fiercely opposed by the investment professionals and has since been a source of a long-standing debate. 
 
This idea, also known as the random walk theory, suggests that stock prices evolve randomly, and therefore, cannot be predicted. If this were true, professional fund managers would have no informational advantage over the retail investors. Consequently, fund managers would not display superior skill in either selecting the best stocks or in timing the markets. In fact, the proponents of the random walk theory believe that the equity investors are best served by investing in low-cost index funds and exchange-traded funds (ETFs) that provide returns similar to that of the overall market. On the other hand, the mutual fund industry claims to achieve higher returns than the traditional investments. The past performance of equity mutual funds is regularly compared against market benchmarks such as the Nifty and the Sensex, often with mixed results. Some funds underperform the market, whereas others provide better returns than the market benchmarks.
 
It is easy to identify a mutual fund that gave much higher returns than the market in the past one year or five years. Moneycontrol.com provides a free tool to find the top-performing mutual funds for the last five years. Consider an investor who would only prefer to invest in the best performing funds. The table below looks at the top performing equity mutual funds at different time horizons, as on 8 February 2016.
 
 
The best-performing equity mutual funds comfortably outperform the Nifty index. But should you invest in these funds? Careful readers would notice that it is not straightforward to choose the funds based on such an analysis. The choice of the best fund would depend on the time horizon you choose. In the last six months, arbitrage based equity funds have performed the best. In the last two years, funds based on small-cap and micro-cap stocks have performed the best. If your horizon is the last five years, the best equity funds have been the ones that have focussed on a specific sector, such as pharmaceuticals and logistics. Moreover, there is little overlap between the different time horizons, which suggests that even the best funds do not consistently outperform all others. 
 
The often ignored disclaimer ─ “past performance is not an indicator of future results” is very important for mutual fund investors. A fund that looks the best based on its past performance may not turn out to be the best in the future. On the other hand, if a fund manager is really skilful, the fund should be able to generate consistently high returns. Can someone outperform the market simply by being lucky? Absolutely! Note that the return of the overall stock market is a weighted average of the returns of all the individual stocks. As a result, in any period, some stocks would fare better than the market, whereas others would perform worse than the market. 
 
Now, consider a mutual fund manager who constructs his portfolio completely randomly, that is, without any investment skill whatsoever. If he happens to allocate more capital to the stocks that do better than the market, simply by chance, the mutual fund would perform better than the market. Conversely, if he allocates more capital to the stocks that do worse than the market, the mutual fund would perform worse than the market. So the past performance of the mutual fund is not necessarily an indication of the skill of the fund manager, but it may simply be a matter of chance. It is important to distinguish between luck and genuine investment skill, because a fund that performed well due to superior investment skill is more likely to repeat its high level of performance in future, unlike a fund that performed well only due to luck.
 
Our recent study ─ “Testing the skill of mutual fund managers: Evidence from India” attempts to test the skill of Indian equity mutual fund managers. Our findings suggest that the performance of Indian mutual funds is highly inconsistent. For example, we find that the best performing mutual funds (top 25%) for a particular month have a 35% chance of being the best performers in the next month. However, they also have a 31% chance of being the worst performers (bottom 25%) in the next month. 
 
In other words, a best-performing fund of the current period can turn out to be to be the best or the worst performer in the next period with an almost equal probability. To test the skill of equity mutual fund managers, we took a cue from Malkiel’s idea. We simulated a large number of monkeys by generating 10,000 randomly created portfolios with all the stocks listed on the National Stock Exchange (NSE). Then, we compared the performance of equity mutual funds with these “monkey portfolios” over a long horizon (from 1 January 2003 to 31 July 2014). Surprisingly, the average mutual fund did not perform any better than the average monkey portfolio, whereas the best monkey portfolio fared much better than the best mutual fund. 
 
Finally, it can be argued that the retail investors benefit from the diversification provided by the mutual funds. This is true, however, exchange traded funds can be used to achieve portfolio diversification with much lower fund management charges than those of the equity mutual funds. 
 
(Prateek Sharma is Assistant Professor of Finance at IMT, Ghaziabad)

User

COMMENTS

Ramesh Poapt

2 years ago

2016 so far is not good for Eqty funds.Balanced funds may have some solace. A recent category of fund which is slightly riskier than MIP us Eqty saver funds,which benmarked as 30% nifty or 25%MIP blended,here benifit is it is eqty oriented fund and debt oriented fund like MIP.
Asset al;location,risk profile and time horizon plays important role.Staggered(SIP/STP)investment is other important tool.

RAVI RAM PV

2 years ago

For choosing the safe option of Index ETFs: Problem is that in India ETFs are not as easily to buy and sell. I had burnt my fingers buying the Bees which is the country's largest ETF. Both ways - buy n sell - there was loss, as the market value did not reflect the NAV.

Rating Changes and Debt Mutual Funds
What are the lessons for investors and the regulator in debt mutual funds from the recent downgrades of Amtek Auto and Jindal Steel? 
 
Debt mutual fund investors focus mainly on returns and often ignore the risk. Over the past few months investors have woken up to the credit risk of mutual fund schemes. In August 2015, schemes of JP Morgan Mutual Fund suffered a sharp decline in their net asset value (NAV) as they had a high allocation to the debt paper of Amtek Auto. The credit rating of Amtek Auto was downgraded and soon investors begun withdrawing their assets from the scheme. In February 2016, debt investors faced a déjà vu. The credit rating of Jindal Steel and Power Ltd (JSPL) was downgraded and this affected the schemes of ICICI Prudential Mutual Fund and Franklin Templeton Mutual Fund. The NAVs reported sharp declines thanks to steep downgrades.
 
Downgrade of a credit rating is normal. Yes, it is sometimes a shock when the credit rating is notched down by three or four steps at one go. It essentially makes us think about whether the rating agencies were asleep? I can understand ratings getting ‘withdrawn’ because a company does not give information. Not giving information is something that an agency can ‘smell’, so long as it has a good surveillance mechanism in place. If they take monthly or quarterly information, they should be able to smell trouble the first time there is a problem.
 
CRISIL recently downgraded JSPL from BBB+ to BB+. This is a three-notch downgrade. The hierarchy is BBB+, BBB, BBB- and then BB+. The divide between BBB and BB is huge. Debt papers up to BBB- are considered ‘investment’ grade and anything below is considered ‘speculative’ or ‘junk’ grade. A move from BBB to the BB is not an unusual one, given the sector the company operates in and its leverage. What I question is the wisdom of the reputed fund houses in taking such huge exposures on something that was already a borderline investment grade. If you are a hedge fund or a speculative investor, such high yield papers are fodder for you. But mutual funds have to be more careful.
 
CRISIL says that the earlier rating of BBB+ had factored in the sale of a unit in Bolivia and the receipt of the proceeds before March 31, 2016. They have not waited for the date, but have fairly concluded that it is not happening and pulled the trigger. In a sense, we can debate whether the earlier rating should have anticipated this inflow and if it was such a crucial thing, could the rating have been BBB minus? Not being privy to all the facts that they would have had, I respect their view. I have been part of the organisation nearly 22 years ago and still trust the checks and balances in place. What I can say from my knowledge is that when I buy a ‘BBB’ paper, my risk of losing money is very high. And let me tell you, no rating agency is immune to a structured fraud. 
 
I differ with rating agencies on one aspect of rating - “Structured Debt”. At the time I was working in the agency, I was at the forefront of developing it. However, over time I see more and more complex structures that a rating cannot really bind together. But commercial interests prevail. Securitisation is merely a paper exercise of ‘selling’. In reality, if an originator of loan sells the loan to an investor or a trust, I do not see how they can really collect on it. 
 
The rating agencies have the power to downgrade, suspend or withdraw a rating. If there is high quality surveillance, I do not see a reason for an abrupt downgrade by two or three notches, unless it is the result of a corporate action, where there is some merger or acquisition or the company has suppressed some facts, which came to light later on. Not giving information as agreed is a serious issue and should lead to rating getting withdrawn.
 
The recent downgrades of a couple of papers, its impact on the mutual funds that invested in those have been the subject of an acrimonious debate. Here I blame the agencies as well as the fund houses. Fund houses should be using the rating as an additional input and not as a primary input. They should be having the skills to evaluate credit. Yes, a rated paper can help you to find companies you have to shortlist. Beyond that, there has to be an internal analysis that approves the paper. Often, the analysis is cursory and we do not see a single ‘debt’ research report. Hopefully, the analysts read the “rating rationale” that accompanies every rating.
 
The impact of the downgrade on a paper is dependent on the extent of exposure a scheme has, to such paper. A 3% exposure of a scheme in to the paper of JSPL, impacted the NAV of the scheme by nearly half a percent. In a sense, if an income scheme has a carrying yield of 7%, nearly 14 days of interest accruals on the entire scheme has gone! And the mark to market to junk, would mean that the fund is unlikely to fetch the marked price in any sale, as no one would immediately buy the paper. So, the actual impact could be higher! 
 
When MFs are handling retail money, in an environment that is thriving on mis-selling, we need to see some reforms in the industry. Maybe the regulators could consider:
 
 i) Allow retail money to be invested only in those schemes where no paper has a rating lower than AA. Not even AA minus, at the point of inception. There should be a clear mandate that if any paper is downgraded, it should be offloaded within 15 days. That would minimise the retail risk somewhat;
 
ii) Schemes that have lower rated papers, should be RED labelled and the minimum investment amount could be hiked to Rs50 lakh kind of threshold. That implies that those with this kind of surplus understand risks better. 
 
iii) Multiplicity of rating agencies has been an issue. Regulations say that ratings from any ‘recognised’ rating agency is acceptable. Unfortunately, the quality of the rating agencies differs. I will not name the culprits, but every debt fund manager knows about it. Maybe the trustees can insist on two ratings as a minimum requirement. Even in the debt market, companies with the same rating do not enjoy the same pricing. Markets do make a distinction.
Valuation of debt papers is always a contentious issue. Some papers cannot be traded unless offered at a discount to comparable paper. 
 
The retail investors, coming into debt mutual funds, come in for capital protection as well as a perceived tax advantage. Many of the small investors who put in a few thousands, are outside the tax bracket. These are the investors who need regulators to offer protection. We have seen how miserably the regulators have failed when it comes to insurance company products. Will mutual funds also go the same way? 
 
There are some folks who say that so long as everything is ‘disclosed’ in the offer document, the investor should not mind. I have yet to meet any average investor who is even aware what such a document contains. At the time of NFO, a four pager is all that is sometimes given. Of course, everything is ‘available’ online. Why cannot SEBI design a simple one pager that goes with every scheme- on the web page, on the application form and with the account statement? I will be glad to help design it.

User

COMMENTS

Ramesh Poapt

2 years ago

ML-discussion on the topic proceeded nicely. You have knowledgeable readers. Good one indeed!Request more such goood articles!

Avinash

2 years ago

Agree with most of points made in the article. However, instead of placing restrictions on retail participation in debt markets, which would hurt the efforts of broadbasing capital markets, I have a few suggestions:

1. Credit funds which invest in papers rated lower than an acceptable benchmark (say, AA) should be demarcated with a separate risk rating
2. Risk-Return indicators like Sharpe ratio, sortino ratio and standard deviation (ofcourse, in a language that a novice would understand) must be mentioned for (a) the scheme, (b) aggregate of similar schemes of the fund house, (c) category average across industry. A legend should accompany this disclosure to help investors interpret the numbers
3. An abridged version of the Mutual Funds SID must accompany all application forms (if physical) and should be displayed prior to concluding the transaction (if electronic). This one-page document must at-the-least contain the risk rating, risk-return indicators, Fund manager, benchmark index etc.
4. Efforts on curbing mis-selling must continue unabashed.

Fixing responsibility on rating agencies and ensuring their 'skin-in-the-game' needs to be handled separately as ratings are used by institutional investors and retail investors alike.

Gupta

2 years ago

After the Amtek fiasco, CRISIL proudly released a press release with nice looking statistics that none of its investment grade rating (BBB- or better) has been downgraded by more than 1 notch and hence the quality and stability of CRISIL ratings is much better than others. While I don't disagree with that claim (on a relative basis given the weaker quality of other rating agencies and not because CRISIL is a holy cow), CRISIL may have wanted to be more circumspect. JSPL is a much larger company with much larger debt and should have had stronger surveillance. CRISIL has been found sleeping at the wheel (or with JSPL because JSPL pays for the rating) with this 3 notch downgrade. Any banker or MF fund manager who understand JSPL can say that Bolivia was an irrelevant chapter in JSPL's history and certainly can't be the reason for even a 1 notch downgrade, forget 3. CRISIL is simply hiding behind it to cover up for being cosy with its "customer" for too long. It is once again proven that rating agencies always downgrade after the event and predictive ability of credit ratings is ZERO. While stock prices have nothing to do with credit ratings, they are far better tools to predict what is going on with the "credit". The conflict of interest between borrowers and rating agencies is deep and since rating agencies only give opinions and don't have to lend on their own ratings, the problem will never be solved. Worth considering if RBI would mandate rating agencies to invest their rating fee in the debt of the issuer for a period of 12 months and if there is a downgrade of more than 1 notch, then pay a penalty of 10 times that fee to a consumer protection fund. Radical thought it may be, but we need something to resolve the conflict of interest. RBI did something very similar with Asset Reconstruction Companies few years ago by banning 100% SR buyouts and forcing a cash component.

REPLY

R Balakrishnan

In Reply to Gupta 2 years ago

Fully agree. Name recognition seems to have played a bigger role..

Nilesh KAMERKAR

2 years ago

Those who cannot stomach few basis points of volatility, for them mutual funds is not the place to be. For absolute Capital protection there are Bank Fixed Deposits.

Selling debt paper within 15 days of it being downgraded is a sure way of losing capital.

Even with the most noble intentions some debt papers will still deteriorate in quality. In this deterioration lies risk as well as opportunity.


REPLY

R Balakrishnan

In Reply to Nilesh KAMERKAR 2 years ago

The only solution, Nilesh, is to forget the NAV impact and hold to maturity? That would be a cross subsidisation and lead to gaming by big punters

Nilesh KAMERKAR

In Reply to R Balakrishnan 2 years ago

Dear Sir,

Please do consider the foll:

1) The scope for gaming the system shall be far higher if funds are forced to liquidate debt instruments within 15 days of being downgraded, resulting in substantial losses as not much can be salvaged in such situations.

2)Sir you shall agree when investors jump the scheme immediately after NAV is impacted, they turn notional losses into real losses.

3)Investors would do themselves a great favour if they wait to exit, till such time that their returns from the income fund is say 1% better than FD rates, then purpose of investing in debt mf would have been served .

4)For 3 above to happen investors ought to worry about NAV linked returns rather than scrutinize the portfolio. - That is best left to the professional fund manager

5) Debt downgrades and defaults have happened in the past too. And investors in open ended debt funds,(& not FMPs) who chose to continue have come out unscathed with reasonable returns to boot.

R Balakrishnan

In Reply to Nilesh KAMERKAR 2 years ago

You are right, Nilesh. But you underestimate the idiots in the world. logically, I do not see the need for this instrument to exist at all. Equities and liquid funds good enough for me. Maybe a savings account . Bond funds is for those who build a bridge to nowhere.

R Balakrishnan

In Reply to Nilesh KAMERKAR 2 years ago

Any downgrade will have a loss of capital. Whether u sell it today or after one year. Problem is if we have a discipline or a rule book, we should play by it, when retail money is involved. Retail who come in from the FD markets

R Balakrishnan

In Reply to Nilesh KAMERKAR 2 years ago

Yes, Nilesh. You understand. I too understand. A few out there who do not. Bulk of investors are like that.

Dynamic Debt Schemes: Timing the Market Is Not Easy

Dynamic schemes had a high allocation to long-term debt that led to sub-par returns over the past one year

 
Fund houses, often, lure investors with products that aim to time the market. Similar to dynamic equity schemes, fund houses offer dynamic debt schemes. For these, the fund manager varies his allocation to long-term and short-term debt, depending on his views on...
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