Mutual Fund Performance Consistency: Myth or Reality

I was recently reading an academic paper on persistence of mutual fund performance published in a well known finance journal in the US. The research conclusion of the authors of the paper was that, performance consistency of fund managers is a myth. On the other hand, we have also seen examples of fund managers deliver outstanding returns on a fairly consistent basis. We know that, past performance of a mutual fund scheme does not guarantee future performance. Since mutual funds are subject to market risks, the returns of mutual funds are linked to market performance. In rising markets, a fund manager can beat the benchmark by taking more risks (higher beta). But the same fund will underperform in falling markets.

We have discussed a number of times in our blog that, alpha, which is the excess portfolio returns above benchmark, for the same amount of risk is a true measure of fund manager value add. A fund manager who can deliver high alphas in different market conditions will outperform the benchmark and the peers in both up and down markets. The question is whether delivering high alpha (on a relative basis) simply a matter of luck, or is it possible for fund managers, within certain probabilistic boundaries (there can be no certainty, as we know, in equity markets), to deliver higher alphas consistently, relative to their peers. In simple terms, the question that I asked myself was, is there any statistical evidence of a fund manager or managers delivering consistent out-performance on a relative basis. We have examined this question in the context of Indian market, because our market is different from the US market in a number of respects.

To examine the statistical evidence of consistent out-performance of mutual fund schemes, we have sorted equity mutual fund schemes, by categories into quartiles, based on 5 year trailing returns. We then analyzed the quartile performance of these funds in each year over the last five years. A fund may be top quartile fund today (based on 5 year trailing returns), but was it a top quartile fund (or top 2 quartiles fund) in 2011, 2012, 2013, 2014, 2015 and YTD 2016 also? We will discuss the statistical evidence of relative performance consistency in today’s blog post. Let us discuss quartile ranking and performance consistency of diversified equity funds.

Diversified Equity Funds

We looked at 5 year trailing returns quartile rankings of diversified equity fund using our quartile ranking tool. For the benefit of readers who are not familiar with quartile rankings, quartile rank is a measure of how well a mutual fund scheme has performed against other schemes in its category. Mutual funds with the highest percent returns in the chosen time period are assigned to "Top Quartile", whereas those with the lowest returns are assigned to "Bottom Quartile". Quartile rankings are compiled by sorting the funds based on trailing returns over a period chosen by the user. Funds in the top 25% are assigned the ranking of "Top Quartile", the next 25% are assigned a ranking of "Upper Middle Quartile", the next 25% after that are assigned a ranking of "Lower Middle Quartile" and the lowest 25% are assigned the ranking of "Bottom Quartile".

We looked at 5 year trailing returns quartile rank of each fund and saw how they performed on a relative basis each year i.e. 2011, 2012, 2013, 2014, 2015 and YTD 2016. Essentially what we wanted to determine was, whether a high quartile rank was a result of exceptional performance in one year or consistent performance over the years. By looking at 2011, 2012, 2013, 2014, 2015 and YTD 2016 quartile rankings of a fund (based on its annual returns), we determined how much time the fund spent in each quartile over the last 5 – 6 years and how that mapped to the current quartile ranking of the fund (based on 5 year trailing returns). If a fund spent more time in the top 2 quartiles, it implied that the fund was more consistent than peers who spent lesser time in the upper quartiles. Please note that, in this post we will not discuss individual scheme names; our analysis is at a category level.

The table shows the average time spent by funds in different quartiles over the last 5 years and the mapping to their current quartile rankings (based on 5 year trailing returns).

Source: Advisorkhoj Top Consistent Mutual Fund Performers

You can see in the table above that, funds which are currently ranked in the top quartile (based on 5 year trailing returns) spent 73% of their time in the top 2 quartiles from 2011 to YTD 2016; in other words, on an average, these funds were highly consistent performers. Therefore, the analytical evidence suggests that the outperformance of these funds on an average is no flash in the pan, but a result of consistent outperformance over the years.

Funds in the bottom quartile (based on 5 year trailing returns) spent 77% of their time in the 2 lower quartiles. In a sense, these funds also showed consistency, but not the kind investors would like. The funds in the 2 middle quartiles also showed some consistency, but they were not as consistent as funds in the top quartile.

Let me reiterate that, we are discussing results on an aggregate average basis. There may be top quartile funds, which did not display the consistency, which most of its peers delivered, but they are the exceptions.

Large Cap Funds

Let us now look at large cap funds. Like in the previous analysis, we looked at 5 year trailing returns quartile rank of each fund in the large cap category and saw how they performed on a relative basis each year i.e. 2011, 2012, 2013, 2014, 2015 and YTD 2016. The table shows the average time spent by large cap funds in different quartiles over the last 5 years and the mapping to their current quartile rankings (based on 5 year trailing returns).

Source: Advisorkhoj Top Consistent Mutual Fund Performers

You can see in the table above that, funds which are currently ranked in the top quartile (based on 5 year trailing returns) spent 78% of their time in the top 2 quartiles from 2011 to YTD 2016. Funds in the upper middle quartile spent 66% of their time in the top 2 quartiles in the last 5 – 6 years. Funds in the two lower quartiles spent 72 – 73% of their time in the lower quartile. Like in diversified equity funds, we can see evidence of performance persistence in large cap funds too. Let us now look at midcap funds.

Small & Midcap Funds

Like in the previous two analyses, we looked at 5 year trailing returns quartile rank of each fund in the small/midcap funds category and saw how they performed on a relative basis each year i.e. 2011, 2012, 2013, 2014, 2015 and YTD 2016. The table shows the average time spent by small/midcap funds in different quartiles over the last 5 years and the mapping to their current quartile rankings (based on 5 year trailing returns).

Source: Advisorkhoj Top Consistent Mutual Fund Performers

You can see in the table above that, funds which are currently ranked in the top quartile (based on 5 year trailing returns) spent 76% of their time in the top 2 quartiles from 2011 to YTD 2016. Funds in the upper middle quartile spent 55% of their time in the top 2 quartiles in the last 5 – 6 years. Funds in the two lower quartiles spent 77 – 80% of their time in the lower quartile. Like in diversified equity and large cap funds, we can see evidence of performance persistence in small/midcap funds too.

Conclusion

Contrary to findings of the academic paper that I mentioned at the beginning of this post, our analysis of relative performances of Indian mutual funds over the last 5 – 6 years showed that, fund managers were able to deliver relative performance consistency. Some academicians and researchers have examined whether mutual fund outperformance is a result of skill or luck? Our analysis suggests that, outperformance consistency of top performing mutual fund schemes in percentage terms (as discussed above) in the Indian context cannot simply be a matter of luck. The results of this analysis did not come as a surprise to me, since I have seen a number of examples of top performing funds in India displaying strong performance persistence over a number of years.

Indian equity market is more inefficient compared to the US and it is possible for exceptionally good fund managers in India to exploit price / value gap and deliver superior relative returns compared to their US counterparts on a more consistent basis. While superior fund management expertise and experience of the fund manager are important factors, investment discipline, research capabilities, risk management and governance mechanisms of the fund house are also contributing factors in outperformance persistency. In our blog, we have stressed the importance of performance consistency in fund selection for your investment objectives. In the Indian context, consistent performance is not a myth but reality.