What it takes to be a top performing fund in the long run ?

And general thoughts

I was generally interested to see what kind of outperformance in the Indian context is required on a consistent basis to outperform in the long run. The results will be surprising for most people as the magnitude of outperformance that is required is not so high as what is perceived.

The reasons for this are many and the key reason would be that not too many funds end up performing consistently and most funds and fund managers tend to do well in particular kind of market scenarios. Some fund managers are good in bull markets, some in bear markets and some in none. Most active fund managers tend to do well in bull phases but the key to long term outperformance lies more in protecting the downside in time periods of market declines. The reason for this is human psychology which most investors including fund managers tend not to cut losses during market falls and as such most fund portfolios become stuck as the markets fall. However during market rises fund managers get opportunities to book profits and shift to other stocks.

This also follows from the general enthusiasm levels which fall drastically during bear markets and similarly rise during bull phases.

Let me put out the best performing fund returns over a five year period (5 year CAGR)

Best Fund 29.74%

5th Best Fund 28.04%

10th Best Fund 26.35%

Nifty returns over 5 years 18% and Sensex returns of 19%.

However the important point to note is that due to the power of compounding the difference in absolute returns becomes quite large even with a 10% outperformance. As such the absolute return over a five year period for a return of 19% and 29% would be 138% and 257% respectively. As such to say that the outperformance is small at 10% would not actually be a fair statement.

So what should a fund manager managing an actively managed fund do if he has outperformed the markets by 30% in a year. I believe that if we go by statistics then he should just move to the index and and just ride the markets. If we put it statistically in the context of the actual 5 year returns a 49% return followed by 19% return over four years would yield nearly 200% and be a top ten performing fund.

However obviously fund management psychology does not allow one to do that as outperformance of one year becomes the benchmark for the next year and the pressure to outperform combined with the huge inflows that follow performance leads to misallocation of capital. Typically my experience is that steadily increasing inflows are normally positive for fund performance as the fund manager gets and opportunity of putting more money into his best ideas of that time and as such the overall portfolio composition keeps on improving. However huge inflows disproportionate to the size of the fund normally would lead to misallocation of capital.

The other big subjective factors that are important are the ability to stick to ones convictions as well as the ability to move away from the herd in order to not get pressurized to invest into the momentum sectors of that particular phase. Typically we see that sectoral performance leads to that becoming a greater part of the allocations rather than fundamental analysis of valuations and growth outlook. If we see today stocks of sectors like sugar, tea etc have become large part of the portfolios of lot of funds as these sectors have done very well. However the reality is that both these sectors are more near their tops than in any value range. A bumper sugar crop is a given for next year given the fact that the crop is hugely lucrative vis a vis alternatives today. Tea prices that went up largely due to crop failures in Kenya and Sri Lanka have started coming off sharply as the production is bouncing back sharply in these countries.

Markets are interestingly poised today with strongly improving economic numbers combined with threats of inflation and stimulus withdrawals. Specific to India I have observed an amazing bounce back in the performance o mid tier corporates. Also services industries like banking, IT, construction etc have started hiring very aggressively and as such the employment situation is looking increasingly positive. Pay increases are also coming back in a big way and bonuses should be strong after the skip of last year. This should be positive for consumption led growth. Core economic performance in terms of the investment cycle also seems to be improving sharply given the increase in order bookings seen across a wide swathe of infrastructure and industrial companies.

India should go through the consolidation / correction phase with the global markets over the next few week before making a sharp up move as the growth prospects for next year become clearer. The next two months should be the best for portfolio building to ride the upside likely to unfold over the latter part of the year.

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