Based on the research of Gerard Hoberg, Nitin Kumar and Nagpurnanand Prabhala.
Though mutual funds are increasingly popular as investment vehicles, the factors that drive their returns are not fully understood. How can investors better understand how well a fund has done relative to its competition? Research by Professors Nitin Kumar, Gerard Hoberg and Nagpurnanand Prabhala answers these questions.
The Indian mutual fund industry has seen consistent growth over the past 20 odd years. Moreover, recent years have seen large inflows, both through the one-time as well as the Systematic Investment Plan or SIP route, showing a growing appetite for equities among Indian investors. Given the wide variety of fund houses and schemes on offer, how do you narrow down your choices?
Unsurprisingly, the primary factor that influences an investor’s decision is past return, which is (against the advice of all disclaimers) taken as a proxy for future returns. Beyond absolute returns, the only aspect that may receive some consideration from potential investors is whether the fund has beaten its stated benchmark, which is typically a market index like Sensex, Nifty or BSE-200.
However, what actually drives returns is something that is closely studied in academic circles but largely ignored by retail investors. One factor is somewhat easily understood: the fund manager’s skill and track record. Another factor that has received some attention is diseconomies of scale. For two schemes that are exactly the same, the smaller one will deliver better returns due to its relative nimbleness in entering and exiting the market. In comparison, the larger fund would suffer from higher impact costs and more illiquidity. But can competitive intensity – as measured by the number of funds investing in the same segment with the same objectives – be a factor influencing returns?
Professor Nitin Kumar, an expert in the Finance area at the Indian School of Business, working alongside co-authors Professors Gerard Hoberg from the Marshall School of Business at the University of Southern California and Nagpurnanand Prabhala from the Robert H. Smith School of Business at the University of Maryland set out to answer this question. In the course of their research, these researchers have helped develop counterintuitive and valuable insights on the business of managing mutual funds and more importantly, the optimal strategies for investing in them.
Mutual fund performance has to be seen in light of peer group performance. Traditionally, peer groups have been thought of as those with similar investing styles and preferences. According to Professor Nitin Kumar, “style definition for funds has largely been constant for over 25 years now. The investment management industry has changed a lot in this time and hence new ways to bucket funds seem overdue.”
However, according to the authors, how a fund should be classified and compared is not as straightforward as some investors, or even mutual funds themselves, assume. Even the broad market benchmarks that are used to compare fund returns are not realistic. This drove the authors to answer the key questions:
- How do you define competition or the peer group?
- How can competitive intensity be reliably measured using objective metrics?
- Does competitive intensity influence returns?
The present way to classify funds in the industry and academia is to bucket funds into nine categories based on the characteristics of the stocks held by the funds. The two common characteristics used are size and valuation measures, such as price/earnings ratio. Thus, each fund is labelled as Large Cap Value, Small Cap Growth and so on. But more importantly, all Large Cap Value funds are thought to compete with each other.
In contrast, in the authors’ classification, each fund has its own set of competitor funds. The number of competitors around a fund measures the competitive intensity around a fund. So a fund facing less competition may have 25 competitors, while another fund facing stiff competition may have 150 competitors. Further, one can measure a fund manager’s skill in a more precise way, by comparing the manager’s performance with its customised benchmark competitors, unlike a common benchmark for all funds like Nifty 50 or Large Cap Value funds.
Based on the above insights, the authors define two metrics for each fund: (1) customised peer alpha (CPA) which measures the performance of a fund relative to its close competitors, and (2) competitive intensity around a fund. Two questions arise: Does past CPA of funds predict future returns generated by funds? And further, does competition affect the ability of high CPA funds to generate high returns in future?
Based on the research, the answer to both questions turns out to be ‘Yes’. According to the authors’ analysis, successful funds that have a track record of delivering CPA do seem to be better positioned to deliver it in future as well. This is interesting for investors since it is traditionally thought that past performance is not a reliable indicator of future returns. However, if we follow the classification methodology of the authors, predictions about which fund will perform better than its peers become a little more reliable.
On the second question, much as we expect lower competition to boost profits of incumbents in most other sectors, mutual funds too seem to benefit from fewer competitors in their focus segment. This seems logical if we think about funds as competing with each other to buy undervalued securities. Funds in low competition segments are able to accumulate more shares before other funds are attracted by the value on offer. Slower and less aggressive trading in segments with lower levels of competition literally seems to provide an early mover advantage to funds.
The research thus helps the investor by providing objective measures to compare historical performance. Most of the 40+ asset management companies (AMCs) in India have literally dozens of equity schemes each on offer to the public. Objective comparison measures become essential in this crowded space. This research improves upon fund classification and proposes better methodologies for the benefit of investors. The most tangible benefit of this outcome is in setting up realistic benchmarks for different types of funds beyond the traditionally used market indices. The customised peer groups and resultant benchmarks can help investors make a truer evaluation of fund returns. Further, the research provides a rigorous and validated basis for measuring the level of competition for segments in which mutual funds operate.
The research is particularly timely given the maturing of the Indian mutual fund industry. Indian funds have been able to enjoy relatively higher returns till now due to the lower level of competition as compared to developed markets like the US. As Kumar says, “India has around 40 AMCs while the US has perhaps 10 times that number. This kind of industry and academia validated research will help investors here to think objectively, deeply, and scientifically about how to evaluate returns.”
So the next time you are looking for a fund to invest in, pick the ones that don’t have many competitors.
About the Researchers:
Nitin Kumar is Assistant Professor of Finance at the Indian School of Business.
Gerard Hoberg is Professor of Finance at the Marshall School of Business, University of Southern California.
Nagpurnanand Prabhala is Finance Department Chair and Professor at Robert H. Smith School of Business, University of Maryland.
About the Research:
Hoberg, Gerard, Kumar, Nitin and Prabhala, Nagpurnanand, 2018. “Mutual Fund Competition, Managerial Skill, and Alpha Persistence,” Review of Financial Studies (forthcoming).
About the Writer:
Ujval Nanavati is a Chartered Accountant, Chartered Financial Analyst, and has completed the Post-graduate Programme in Management from ISB, Hyderabad. He works as an independent writer and research analyst.