Investors need to evaluate the performance of a mutual fund.
The problem, however, is that performance evaluation is not always easy.
Most investors simply compare the returns on their fund with that of the S&P CNX Nifty or the BSE Sensex to validate if the fund has fared well. Is such evaluation optimal?
This article discusses why comparing with the Nifty/Sensex may be useful but not enough.
It provides an optimal framework for evaluating fund managers and also explains why diversified managers have to be benchmarked against the broad-based index such as S&P CNX 500. Logically, all portfolio managers ought to be benchmarked to the S&P CNX Nifty or the BSE Sensex. The reason is not far to seek.
An investor who is taking exposure to the market would typically choose large caps. This is because large caps are actively traded, well researched and represent the largest companies among the industries that drive the economy.
Buying index funds benchmarked to the Nifty/Sensex provides the investor low-cost (beta) exposure to the market.
Suppose an investor instead chooses to take exposure to a diversified fund.
The opportunity cost principle suggests that this active fund ought to deliver more than what the Nifty/Sensex can generate. Otherwise, the investor would have been better off with the index fund.
Perhaps, this is the reason why most asset management firms benchmark their diversified funds against the Nifty/Sensex. But this argument may not always hold good.
Style mandates
Consider a mid-cap style fund. Suppose this fund is benchmarked to the Nifty/Sensex on the opportunity cost principle.
Assume the Nifty returns 20 per cent while the fund generates only 14 per cent.
An investor cannot conclude that the fund manager has underperformed.
The reason is because the fund manager could have still delivered excess returns against her style benchmark.
What if the CNX Mid-cap index, the style benchmark for mid-cap funds, returned 10 per cent during this period?
This means that the mid-cap manager has generated alpha returns of four percentage points (excess returns over the style benchmark assuming a portfolio beta is one).
Yet, the fund lagged the Nifty/Sensex because mid-cap style underperformed the large-cap style.
The investor’s (style) decision to choose a mid-cap fund was wrong; the choice of the fund was, however, right, as the manager delivered excess returns.
Benchmarking against the Nifty/Sensex would needlessly penalise the portfolio manager.
Style rotation
What about funds that do not carry any particular style mandates?
Such funds would carry exposure to large-caps, mid-caps and to value and growth stocks with some style tilts.
How can such a fund be evaluated?
One argument is that the fund can still be benchmarked to the Nifty/Sensex. Why? Suppose the fund has mid-cap tilt and, therefore, outperformed the Nifty/Sensex, the portfolio manager can be said to have delivered alpha returns.
After all, moving from large-cap to mid-cap bias requires skill.
While such a benchmark would be useful during market turns, they become counterproductive in a trending market when mid-caps continually outperform large-caps.
A portfolio manager can continue a near-passive exposure to mid-caps and claim to have beaten the Nifty/Sensex!
An investor would rather take a low-cost exposure to mid-caps in such cases.
An appropriate benchmark index would, hence, be the S&P CNX 500, as the fund manager has unconstrained style exposure.
Only a fund beating this benchmark can be said to deliver alpha returns.
Conclusion
A two-tier approach to performance evaluation appears optimal.
Tier one would compare the fund with the relevant style benchmark or the broad-based S&P CNX 500 to assess the manager’s alpha-generating skills.
Tier two would compare the fund with Nifty/Sensex to validate if the fund has delivered value on opportunity cost principle.
The tier-one evaluation would also tell the investor if the fund manager has delivered returns commensurate with the management fees.
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