The future is Passive

The big news this week was about the inflow into Vanguard, the world’s largest mutual fund company which attracted $198.4 billion in the first eight months of this year drawing money from Active Mutual Funds and even Exchange Traded Funds as investors poured money into its low cost Index funds.

On the other hand, we in India recently had a SIP day when more than 30,000 investors signed up (in other words, parted with their money) to active funds in the hope that these funds will deliver more than what passive investing will return.

While I am a believer in ETF’s being the future, for now, one cannot dispute the fact that a lot of active funds have generated better returns (historical) than a passive Index. But the question that is rarely asked is

1. How are Indian Mutual Fund Managers generating Apha even as American Mutual Fund managers have a hard time catching up with the passive returns?
2. Secondly, the bigger question is, how long this out performance will sustain. Will the next 30 years be similar to the previous 30 years?

Lets first address the first part – the Alpha generating Fund Manager. A lot of funds have indeed generated Alpha over the last ‘n’ number of years but as the recent experience with HDFC showcased, if the fund manager bets wrong (and bets big on it), one would be destined to under-perform for a pretty long period of time. So, basically it boils down to fund managers being able to pick right and sit tight (not that most do as you can see from their churn ratio’s, but that is the basic idea).

The reasons for managers to generate Alpha is many, but one key fact is that the Indian Markets is still dominated by Retail investors. As Aashish P Sommaiyaa, CEO of Motilal Oswal tweeted, the number of Share holders in RIL, RCOM, SBI etc is greater than most MFs investor base.

In United States on the other hand, Institutions dominate the landscape. In markets, its common knowledge that the retail investor (includes us) are the weak hands while Institutions are the strong hands. As long as the ratio is maintained, funds can and will beat the passive indices comfortably.

But competition is brewing in the fund industry itself with more funds being launched and more monies being collected. With there being just around 400 or so stocks that funds invest in, as time goes by, it would be tougher to beat the rest of the pack unless a manager makes some serious bets and then comes a winner.

Take for example, the number of Mid Cap funds over the last 10 years. On ValueResearch I find that there are only 18 funds with a track record of 10 years or longer. But if you come down to 1 year, you find as many as 40 funds in the same Universe. Assets under Management too has exploded significantly while the number of stocks they can invest in hasn’t caught up in a similar way.

This is also showcased by the difference in returns between the best and the worst funds. On a 10 year time frame, the best fund has generated twice the returns of the worst surviving fund. Among funds with 5 year track records, this difference is 2.5X and for those with 1 year track record it spirals to 5x.

But lets get back to United States and the developed markets. Let me quote from an in-depth study by S&P Dow Jones Indices here

“There is a widely held belief that active portfolio management can be most effective in less efficient markets, such as emerging market equities, as these markets can provide managers the opportunity to exploit perceived mispricing. However, this view was not substantiated by our research, as over 70% of active funds underperformed their benchmarks across all observed time horizons.

In the U.S., the performance of equity markets remained solid, albeit weaker than previous years. However, over 84% of U.S. active funds underperformed the S&P 500® over the past one-year period. This poor performance continued over the longer term, as over 98% of active funds trailed the benchmark over the past 10 years.”

Let me put that in perspective. If you had invested in any mutual fund in US in 2006 (when it was still very much a bull market), you had a 2% probability that you will come out a winner in 2016. While I don’t think Indian funds will match such numbers over the next 10 years, its very much a possibility as you extend the time frame.

In 1995, a news paper reported this on the Pager Industry and its future growth prospects

“Just as microchips moved in the 1980s from the computer into washing machines, toasters and telephones, so tiny paging microchips are being developed for lighting, cars, vending machines, and notebook computers. “We’re at the tip of the iceberg of paging applications,” said Jeff Hines, paging analyst at brokers Paine Webber.”

While the paging industry did touch Indian shores, by the time people became aware, the Cell Phone had arrived and made it obsolete. Investors in United States are realizing only now that not all active funds are created equal and most funds find it tough to beat a simple index despite (or is it thanks to) their staggering fees / research.

I have no doubt that the Mutual Fund industry will continue to grow in size since there is plenty of money out there looking for avenues to invest but that doesn’t mean that they will all perform. Some will, most will not and many in between will just perish.

Its hence important that you analyze the facts carefully and take a call based on your reading of the situation and how it can / could develop from hereon.  As a saying goes “”The past is history. The future is a mystery. The present is a gift.”

Today, the average investor has access to information that wasn’t there a decade back. The one’s who will thrive in the future are the one’s who make the best of the opportunities that such information / knowledge provides.