Myths About Alpha

June 18, 2010

Myths About Alpha

The fact that index funds outperform the majority of actively managed mutual funds has been widely accepted in many areas of the market. Only the most ardent supporters of active management cling to arguments suggesting that the average active manager adds value in areas like large-cap U.S. equities.

As you move away from the most efficient markets, however, active proponents get bolder. The less liquid and less efficient the market, they say, the more opportunity there is to outperform. From corporate bonds to emerging markets equities, they argue, active management still makes sense.

These arguments are echoed within the Indian media and the Indian investment management industry. Proponents of active fund management in India variously claim that Indian markets are inefficient; that Indian fund managers are privy to information not available to the rest of the market; or that the intellect of active fund managers in India is much higher than that of the market as a whole.

In short, they argue, Indian fund managers will always be able to outperform their benchmarks and generate alpha. Moreover, they suggest, it is easy to choose good managers in India.

The data, however, suggest otherwise. This study substitutes data for myth, examining the actual performance of active managers in India over significant time periods. In addition, it looks at the consistency of manager outperformance. In both cases, the data increasingly favors passive funds.

This study may have significant repercussions for Western investors looking at emerging market allocations. After all, if domestic managers with firsthand knowledge of a market as complex as India are unable to add value, what chance do Western managers have of doing better?

Part 1: The Myth Of Eternal Alpha
It has often been argued that individual active fund managers in India are consistently able to exploit anomalies and aberrations that exist in the market. To test this theory in the Indian markets, we examined the three-year rolling returns of all active fund managers in India, subject to two screens.

First, to be included in the study, funds must have been in existence for at least six calendar years as of the end of December 2009. This screen ensures that we have sufficient performance data to study. Second, funds must have a broad index (the S&P CNX Nifty, BSE Sensex, BSE 100 or CNX 100) as their benchmark, to ensure appropriate measurement.

We compared these funds with the performance of the Nifty BeES—an ETF launched by Benchmark Asset Management Company Pvt Ltd. that tracks the S&P CNX Nifty Index. The ETF was chosen because: 1) Nifty BeES captures dividends unlike the pure Nifty index; and 2) Nifty BeES also has management expenses like regular mutual funds.

After applying these filters, we were left with 57 funds for further analysis. We took a simple average of returns of the funds selected. For simplicity, we have taken only growth plans or dividend reinvestment plans assuming no payout.

The period of investment commences daily from December 2003 and ends December 2006. The last observation date is Dec. 31, 2009. Thus over 650 data points have been considered for analysis.

Figure 1 shows that the average outperformance of large-cap diversified active funds has declined over the period studied. At various points in time, the level of underperformance has neared or exceeded 6 percent per annum; as of December 2009, it stood at roughly 1 percent per annum. Compounded over three years, that 1 percent per year underperformance translates into more than a 3 percent gap for the average actively managed fund.

If we compare each fund’s performance with that of the Nifty BeES, we can also see in Figure 1 that the number of funds underperforming (in percentage terms) the Nifty BeES has varied, but has been generally positive. As of December 2009, 57 to 60 percent—or 32 to 35—of the funds have underperformed the Nifty BeES. While active management had a strong run for the three-year periods ending between December 2006 and February 2008, more recently, those funds have trailed.

Myths About Alpha


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