Fund managers: The mystery of the vanishing alpha

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Is this the beginning of the end for active fund managers? Read Part 1 of this series here

Every year, we have fund managers saying that this is going to be a year for ‘stock picking’. This keeps our hopes and their jobs alive, until, at the end of a poor year for equities we hear them say that the market environment wasn’t conducive and that the market didn’t differentiate between good stocks and bad. This can even happen during good years when a stock they do not own or under-own drives the market—for example, Reliance Industries, since 2017. Success is attributed to stock picking ability and failure to the macro-economic environment. Success is skill and failure is bad luck.

A fixed fee model also means that irrespective of whether as an investor you gain or lose, the asset management company (AMC) stands to gain. But with intense competition from passive funds globally, companies such as Fidelity have opted to introduce a ‘fulcrum fee model’, which has a basic fixed fee charge and another layer of performance fees added to it, but it’s not the simplest to understand and hasn’t really caught on yet.

For the time being, it does not seem like these structures are likely to find their way into the Indian mutual fund industry anytime soon, so there has to be a better way for AMCs to tell everyone that their outcome is linked to yours too. Some of them have voluntarily ensured that their key personnel invest in their own fund; others with part of their own company capital are invested in their scheme; and yet others have mandated that fund managers and employees invest only in their own AMC schemes.

Despite the show and tell, investors really only care about whether they’re actually making money. Investors who have seen the past record of some marquee funds and joined in (late) have not been so lucky, as successful funds often become victims of their own success—a ballooning asset base takes away the advantages that made it successful. With equity market returns not seeing the same highs of the mid 2000s, along with a rise in indexed investing worldwide, even Indian investors are wondering what their next move should be.

What changed for active managers? Did markets mature and get more efficient in pricing in all public information?

To borrow from Howard Marks, if efficiency is the speed at which information gets reflected in the market, then yes, it has become more efficient; but if efficiency is about stock prices being close to fair value, behavioural finance has thrown our cognitive flaws wide open, and told us that we don’t make rational investing decisions. We’ve moved away from traditional financial theories to realise that markets aren’t just made up of information but also emotions, which cause all the ‘mispricing’ to happen and opportunities for investing. So, if there’s still ‘inefficiency’ in the market, what ails active fund management then?

The fact is that collectively, active fund managers cannot beat the market. And it’s not a new phenomenon. As this Stanford Business School article from 1996 says, the key word here is 'collectively', because there are active fund managers who have proven that they can find value and deliver the goods. So, looking for them isn’t a complete waste of time. However, if you’re buying 10 equity mutual funds, thinking you’re diversifying across different investing styles, you could be just buying the market and then you may be better off just buying the index.

The Indian equity markets are still grappling with inefficiencies, of both market depth and behaviour, but the pool of investors is slowly getting bigger; the number of actively traded stocks will rise. For now, the advantage still lies with active fund managers in India. But things will change.

Only recently did they not only have to deal with regulatory changes to ensure stricter (and what they say is better) and standardised classification as per market capitalisation, but they also had to be benchmarked against a Total Return Index, which takes dividends into account. But we have to remember that the mutual fund industry has done a lot of good and continues to. Even if you complain about higher costs (which isn’t necessarily true), and lack of alpha (in certain segments of late) they have democratised investing by educating investors, and by providing easy accessibility to be shareholders of public companies. For now, the cult of active mutual funds will continue.

The writer is, Co-Founder of Investography, a financial wellness company based in Bengaluru. He can be reached at nithin@investography.in. 

Is this the beginning of the end for active fund managers? Read Part 1 of this series here

The thoughts and opinions shared here are of the author.