The Hindu Business Line : Beating the benchmarks

An investor's success is often judged by his ability to pick stocks that are `outperformers' — that is, those that beat the average return generated by the market as represented by such benchmarks as the Sensex or the Nifty. In India, there are several good active fund managers who have been able to do this over a long period. How do they do it? Their skill comes from their understanding of the way the indices are constituted.

For one, managers take overweight or underweight positions on specific stocks or sectors depending on their view of their performance relative to the benchmark index. For instance, close to 40 per cent of the Sensex's returns in 2006 was due to the strong performances of Reliance, Infosys and ICICI Bank. None of these stocks returned as much as ACC or Grasim, but their contribution was higher because they have a 30 per cent weightage in the benchmark index. Funds that managed to beat the index in 2006 would have had some allocation to these stocks. Or they could have been overweight in ACC, which was the top performer last year among the Sensex stocks; the manager may have invested 10 per cent of his portfolio in ACC although it has only a 1.5 per cent weight in the Sensex.

There are times when index heavyweights such as Reliance or Infosys turn out to be under-performers. In such a case, those who avoided such stocks or restricted their exposure to them would have outpaced the market. But more often, fund managers outperform the market by picking stocks outside the Sensex and Nifty. While these bellwether indices are considered as barometers of the economy, in reality, much of the action may happen outside of the stocks constituting the Sensex or the Nifty.

For instance, the IT, banking and oil and gas sectors account for more than 50 per cent of the Sensex. But sectors such as capital goods and infrastructure, which have been the flavour of the season, have a low weightage in these indices.

Other emerging sectors such as media, retail, logistics and tourism barely figure in the Sensex or Nifty basket. If you load up your portfolio with some of these high-growth sectors, you could have greater success in beating the indices.

Given the increasing depth of the market in the form of new sectors and the growing number of quality mid-cap stocks, holding a diversified portfolio across sectors and market cap ranges not only makes sense as a prudent risk-controlling measure but also delivers index-beating returns.

This is why active investing — seeking investment opportunities outside the indices — has been known to deliver healthy results in the Indian context. In developed markets such as the US, investment advisors often advocate index funds — those that passively mirror an index — because they deliver reasonable returns with low fees.

Such a strategy may not deliver equally good results for Indian investors. Over two-thirds of the equity funds in operation have managed to beat the indices over a five-year period, through active investing.

(Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.)