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B. Venkatesh

ALL mutual fund advertisements carry a warning: "Past performance does not indicate the future performance of the fund." Ordinary investors for long, thought that such a disclaimer was a mere formality, dictated more by SEBI, than any real note of caution. But an analysis of the 31 mutual funds suggests that this disclaimer should indeed be taken to heart!

If you invest in growth funds based on past performance, chances are you will be disappointed. Why? The analysis suggests that the funds that beat the benchmark index may have done purely by chance. For instance, a fund that loaded banking stocks in 2002 will have outperformed the index by a long margin.

But if you were to invest based on the fund's performance in recent times, you would presume that the fund has demonstrated its skill in picking stocks or timing the market — something, that may not be entirely justified; for the fund may have just been lucky in timing the market cycle that trended towards banking companies.

In fact, 24 of the 31 funds that were analysed for the period 1999-2003 carried positive alpha, while the remaining carried negative alpha. What does this mean? Alpha is the measure of risk-adjusted excess returns delivered by the portfolio manager over the portfolio-beta-adjusted benchmark index.

For instance, take a portfolio with a return of 21.5 per cent, portfolio beta of 1.5, and index returns of 10 per cent. The portfolio-beta-adjusted return is then 15 per cent (1.5 times 10 per cent). Assuming a risk-free rate of 5 per cent, the excess beta-adjusted return is 10 per cent (15 per cent less 5 per cent). The actual risk-adjusted return generated by the portfolio manager is 16.5 per cent (21.5 per cent less 5 per cent). The difference between the actual risk-adjusted return and the beta-adjusted return is 1.5 per cent. This is alpha.

A positive alpha means that the fund has outperformed the index, while a negative alpha means it underperformed the index by that measure.

Of the 24 funds that carried positive alpha, only six had alphas that were statistically significant (see Table).

Technically, this means the portfolio managers of the eight funds beat the index due to their skills in picking stocks or market timing. Logically, then, we ought to conclude that 18 of the 24 funds that generated excess returns did so by chance. All the funds that carried negative alpha were statistically insignificant.

Interestingly, of the eight funds that showed positive alpha, only one (Zurich India Equity) managed to deliver a statistically significant alpha between 2000 and 2003. Incidentally, this period saw a bear phase of the market. The difference in fund performance suggests that most funds deliver positive alpha when the market trends up, and under-perform when the it trends down.

This suggests that funds do not consistently deliver economically meaningful excess returns to the investors. To be very sure that funds consistently generate skill-based excess returns, we should have data for a longer period. Since the mutual fund industry in India is young, that exercise is not feasible at present.

Based on the sample study, the conclusion is this: Many funds may comfortably beat the benchmark index by a long margin. A statistically insignificant alpha, however, suggests that in the long run these funds may perform only as well as the broad market. That is, if their performance were due to chance, luck will eventually run out. In statistics, there is an exotic term to such a phenomenon. It is called ergodicity.

The conclusion from this sample study may not come as a surprise to many. In the US, studies have proved that portfolio managers do not consistently beat the market. Of course, some might say that such argument may not be tenable in India. The reason: Since our market does not efficiently price stocks (read price manipulation), an astute fund manager can always pick the "right" stocks, generating excess returns for the investors.

True, but consider this: If the benchmark index is representative of the market, the universe of portfolio managers can only perform as well as the index. The reason? All of them invest in stocks, the sum of which represents the entire market.

The sum of returns of all portfolio managers will, hence, equal the market returns. That is, some fund managers will outperform, but some others will under-perform. The total returns will, hence, equal market returns.

But the above analysis suggests that most portfolio managers' out-performance may be due to picking the "right" stocks by chance. Since we cannot easily differentiate the lucky managers from the skilful ones, we may find it difficult to pick the "right" fund.

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