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The Mutual Fund Show: The Three Reasons Why A Scheme Underperforms

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Is the performance of mutual fund schemes linked to that of benchmark indices?

If an index isn’t performing then there’s a limit to which an asset manager can protect on the downside or generate on the upside, said Aashish Somaiyaa, chief executive officer at Motilal Oswal Asset Management Companies.

The Nifty Midcap Index and the Nifty Smallcap Index declined 10 percent and 20 percent, respectively, so far this year, according to Bloomberg data. That compares with a 7 percent rise in the NSE Nifty 50 Index during the period.

“Just as equity return doesn’t come in a straight line, even alpha isn’t generated in a straight line,” Somaiyaa said on BloombergQuint’s weekly series The Mutual Fund Show.

There are three reasons, he said, that may have led to underperformance of mutual funds this year.

  • The underlying current or broader market participation.
  • A divergence in select stocks drove indices higher, while the broader market underperformed.
  • A selective value rotation in terms of money flowing into the technology and pharmaceutical sectors.

Somaiyaa, however, advises long-term investors to stay the course to create wealth and not worry about the fall in indices.

Watch the full show here:

Also Read: Panel Suggests To Link Mutual Fund Fees To Performance, Assets

Here are the edited excerpts from the conversation:

When benchmarks are performing negatively, is it very difficult for any mutual fund manager to give positive returns?

Aashish Somaiyya: The way the broader markets are doing, that definitely matters. If the Nifty Midcap is down 10 percent, it basically means that the top 100 stocks of the Nifty Midcap are down. If the broad markets in which we are participating don’t do well, then there’s a limit to how much we can protect from the downside and there’s a limit to how much we can actually generate in terms of positive returns.

Last year, the small-cap index was up 57 percent and the midcap index was up 48.5 percent. This year, both the indices are down. Both these conditions are difficult for mutual funds. Last year it was difficult to outperform because the whole market was running up. This year it’s difficult to give positive returns because apart from 7-10 stocks on the Nifty, nothing is positive. When people are evaluating our performance, they should know the context in which we are operating. There should be empathy for the situation under which funds are being managed.

Will the nature of moves happening make it difficult to pit schemes against one another?

Somaiyya: The operating context matters. Till recently, if you had companies whose earnings were consistently growing, if you stayed with growth and quality, you were able to generate performance.

In the last six months, there has been a relative value movement. Suddenly there has been this feeling that IT and pharma are cheap so money should move there. Just because IT and pharma has attracted some money inflow and those segments have done well, it does not mean that every I.T. company has become TCS and it doesn’t mean that every pharma company has become Sun Pharma. So sometimes there are relative value rotations in the market and if we are sticking with quality, sticking with growth, sticking with certain assumptions on fundamentals, we may not have the stocks which suddenly catch fancy of the market. Sometimes, there may be rotations in the market and you may not be parked in those destinations. So you stay with your hypothesis and fundamental preparations and eventually the market will reward that.

For the next six-nine odd months, we have a busy global events calendar, busy local events calendar. Does that lead to higher volatility and therefore unpredictability on returns that people will get from mutual funds?

Somaiyya: There are three reasons why pretty much every one is underperforming. One, you are measuring most funds against the Nifty and barring the last few days, the Nifty has been concentrated in the IT and a couple of corporate sector-oriented banks. So, it becomes difficult to outperform. Second, the Nifty versus the broad market. Most of us, we do some bottom-up picking and portfolios might have various combinations of mid caps and large caps. So when the broad market does very badly, and only the Nifty does well that is another reason for underperformance.

Third, the sectors which have contributed to market performance has also rotated in a very big way. Last year we were with quality and growth, this year I.T., corporate-oriented banks and some commodities have done well. So, because of this huge rotation, what we are trying to do is looking to hold a portfolio where earnings will double in four years.

What should an average mutual fund investor do in the current scenario? Do you still stick to equity funds or may shift to debt funds, wait for the tide to settle, to revert to equities, or SIPs might still be safer?

Somaiyya: I find it quite funny that whenever people discuss wealth creation, then they talk of long-range examples. All the folklore around wealth creation always has been long-range stories and these stories have had ups and down. If you hit a rough patch, if you hit an air pocket and you want to react to it and you want to bail out, then please don’t discuss these long-range wealth creation stories, you are not going to be able to participate in it. Whenever people talk of wealth creation, they talk of 10-20 years. I am not a fan of bailing out when things get bad. I think you just remain invested. Over the last one year, most of the funds have given positive returns.

The other thing, I am not very worried about is the index falling. I hope the index keeps falling because that gives me my outperformance back. Ultimately, all phases of markets come and go. Investors have a choice, but to evaluate over four to five years.

I think you should never forget that the best time to invest is when the past looks bad. That’s the biggest mistake. Your investment will get mistimed at different points, but if you are really keen on timing then make sure that the best timing is when the past does not look good.

What you are trying to say is that if you compare mutual funds under various categories and compare them with the benchmarks and look at the benchmark returns, that gives you an idea as to why these schemes would have underperformed and why people should not be worried?

Anant Ladha: Small- and mid-cap mutual funds and indices both have not performed. So we can’t say that just because my small- and mid-caps mutual funds are not performing, I wont be comparing that fund to the Sensex or the Nifty. This is what usually new investors are doing. This is one thing which we have to take care of. Second, the bigger problem is that even large caps and some of the focused funds are also not performing. So that is a bit of a worry for investors.

So what do you tell people who ask you these questions?

Ladha: When we have a deeper look into the Sensex, we see that of the 30 stocks, there are just seven to eight stocks which form more than 50 percent of the Sensex and only these stocks are performing. It isn’t necessary that each and every mutual fund will be having these stocks in their portfolio and that too in the same amount and same capitalisation that index is having. So we have to be very diligent in comparing funds. After every bull run in small- and mid-cap indices, a time has come when these funds underperform and there are just few stocks which perform in the market.

. Read more on Mutual Funds by BloombergQuint.