Investors gravitate towards index funds, ETFs as equity funds underperform

Fifteen of the 16 debt categories have beaten diversified equity funds over a three-year period, data shows

Diversified equity funds have underperformed several debt categories in the past three-, five- and 10-year periods, uncharacteristic for an asset class that is expected to outperform over longer timeframes. 

The polarisation of Indian equities since 2018, something which has become more acute in the past year, has affected the performance of equity funds, particularly large-cap ones.

The crash in mid- and small-cap stocks in 2018 hit returns of funds that invest predominantly in these stocks. Several debt categories, on the other hand, have benefited from the fall in interest rates over the past few years.

Bond prices vary inversely with rates of interest. Fifteen of the 16 debt categories have beaten diversified equity funds over a three-year period, the data from Value Research shows.

Long-duration funds and 10-year gilts have been the top performers in this period, with returns of 9.25 per cent and 10 per cent, respectively. Large-cap funds were the best performers in the equity category, with returns of 4 per cent. Over the five- and 10-year periods, too, several debt categories have outperformed equity funds. For instance, over a five-year period, 10 debt categories have beaten returns of small-cap funds (6.9 per cent).

All debt categories barring credit-risk funds have beaten returns of 7.7 per cent given by large-cap funds over a 10-year period.

“None of us realised that seven-year returns can be wiped out in two months. This concept of what constitutes ‘long-term’ and whether equity always outperforms debt over longer timeframes has to be re-evaluated,” said Swarup Mohanty, chief executive officer, Mirae Asset Global Investments (India). The 10-year government securities are currently ruling at 5.88 per cent and have slid 146 basis points since January 1, 2018. The Nifty 50 is up 11.5 per cent and Nifty 500 is up 1.5 per cent during this period. The Nifty 50 has gained 93 per cent and 44 per cent in the past five and 10 years, respectively. 

The latest S&P Indices versus Active India scorecard also underscores the lacklustre performance of equity funds over a longer horizon. More than 80 per cent of large-cap funds, for instance, have underperformed their benchmarks over three- and five-year periods, and over 67 per cent have done so over a 10-year period.

Disillusioned by past performance, investors have begun gravitating towards index funds and exchange-traded funds (ETFs), which are passive and mimic the underlying benchmark indices.

“The myth of generating alpha has been debunked in the past one year. Investors are willing to allocate 5-10 per cent of their equity portfolio to index funds and ETFs, which earlier was not there,” added a senior industry official.

However, not everyone believes that equities’ long-term potential is under a cloud. For starters, the above returns are point-to-point, and could vary significantly if the start and end-periods are altered. Rolling returns are a better gauge because they look at not just one block of three, five or 10 years but several such blocks at various intervals.

“Market cycles vary quite a bit. The underperformance in the past two years has dragged down long-term equity returns even as debt funds have benefited from the fall in interest rates,” said Dhaval Kapadia, director, portfolio specialist, Morningstar Investment Advisers India. “It is unlikely that debt will outperform equity in the next five-10 years, given that interest rates have fallen sharply.”

His advice to investors: Do a proper asset allocation and invest through systematic investment plans where one can benefit from rupee cost averaging. Savvy investors, he says, can also invest in international equities through global funds to diversify their equity portfolio.