Market meltdown shows Mutual Funds run with the bulls, get mauled by the bears

• During the past month, when the Sensex crashed by 25.4 per cent, the average fall in 158 diversified equity funds was 28.9 per cent—an underperformance of 3.4 percentage points. Only one out of 10 funds managed to beat the Sensex in this period.

• In the past two weeks, when the Sensex fell by 12.8 per cent, the funds on an average, fell by 16.6 per cent, an underperformance of 3.8 percentage points, with just 16 of 161 funds being able to beat the Sensex. In other words, just 9.9 per cent of funds were able to deliver returns better than the Sensex.

• A study of 161 diversified mutual funds over the past week, two weeks, one month, three months, six months, 12 months and 36 months shows that on an average the funds have been lagging the Sensex in all but the 36-month period.

The level of underperformance is worrying—the funds have lagged the Sensex by between 3.5 percentage points (in the one month period) to 8.7 percentage points (12 months). The margin of underperformance is wide. This means investors would have been better off with index funds, which essentially replicate the movements of indices they track.

But it is not merely the level but the extent of underperformance that’s disturbing. Barring 36-month comparisons, in all other time frames, the percentage of funds that has lagged the Sensex has ranged from 74.6 per cent for 12-month performance to 96.3 per cent over one week—which means more than nine out of 10 funds delivered below benchmark returns.

Now, the industry is likely to say that when you invest in an equity mutual fund, it is not for weeks or months but years. Which is right. Over a three year period, between June 2003 and June 2006, when the Sensex rose by 40.7 per cent per annum, 52 out of 61 funds (or 85.2 per cent) outperformed. On an average, the funds outperformed the Sensex by 9.6 percentage points, rising 50.3 per cent per annum during the period (SBI Magnum Global and SBI Magnum Umbrella dished out returns of 82 and 79 per cent, per annum).

Two scheme that have delivered great returns during this crash period are Prudential ICICI Blended Plan and Principal Global Opportunities Fund, which stand strong and consistent at No. 1 and No. 2 slots in one week, two week, one month and three month periods.

The former is an arbitrage fund, buying companies as well as futures with a minimum 25 per cent debt exposure, and because of which its volatility, and hence the underperformance, is low. The latter invests in international equities, with exposures to companies like 3M, Atlas Copco AB, BASF AG and so on.

On the other end of the spectrum, the one fund that consistently figures among the three worst performers is Taurus Discovery Stock, whose objective is to “identify and select low priced stocks through price discovery mechanism” to bring long term capital appreciation. Its top holdings include J P Associates, NDTV, SRF and Reliance Capital.

The problem with many underperforming funds is really their exposure to mid-cap and small-cap stocks. These stocks are neither liquid enough to sell in quantities, nor do they have futures to hedge with (only 142 actively traded shares do). As a result, when a fall comes, funds are unable to exit on time or in quantities as the stocks hit lower circuits.

Should, therefore, investors benchmark the funds against midcaps? Even if they do, the results are only marginally better in the seven day, one month or one year period, with average outperformance of barely 1-2 percentage points.

Much of which points to the direction of investments in the last leg of the bull run, that began in April 2003. Fund managers have not been seeking value or growth but riding momentum, that is, following the latest fast-growing fad and moving to the next. Something like a stocks staccato.

A strategy that has worked well for them on the rise. But today, when the bulls are taking a much needed breather before stampeding on the 8-10 per cent GDP growth highway, the short-term weak links are showing that while funds can match the Indian bull march, they’re in a Canadian forest when it comes to dealing with the Grizzly.