Why active mutual funds do not beat the index

Active mutual funds on average (and net of fees) underperform the index because they have less inside information than promoters of companies

Indian active mutual funds (MFs), on an average, underperform the index. The S&P Indices Versus Active Funds (SPIVA) India report, the only robust analysis of Indian active MFs’ performance, has shown this conclusively. For example, it includes funds that have disappeared because they performed badly and hence were merged into better-performing funds. 

To clarify, a minority of active MFs do outperform the index. But that would happen even if all active MFs were run by the random number generator function of a spreadsheet programme. This is an extremely simplified explanation for why active MFs are, on an average, unable to beat the index even though there are many amateur investors in the stock market.

Nobel prize-winning economist William Sharpe has brilliantly explained the simple arithmetic that before fees the average active investor’s return will exactly match the return of the index. And net of fees (or costs), the average active investor’s return will be less than the return of the index (let’s call this insight A).

Let’s now apply this to India. Active investors include promoters (i.e., founders) of companies, professional investors (including active MFs) and amateur investors. Note that active investor and active MF are different terms. And one can think of the index as roughly equal to the Nifty 500 index.

The return of each of these three sets of investors is directly proportional to the amount of inside information each of them has. There are laws against the misuse of inside information. For example, promoters of companies are not allowed to sell or buy shares of the company a few weeks before the company announces its financial results. But some promoters might sell shares based on inside information that the company is going to report poor financial results six months later. It is almost impossible for the government to prove that the promoter did something illegal. The same applies to promoters buying shares.

The amount of inside information possessed by, and hence the average return of each of these three sets of investors, in descending order is promoters, professional investors and amateur investors. The average return of promoters is more than the average active investor’s return. And the average return of professional investors is roughly equal to the average active investor’s return (let’s call this insight B). And the average return of amateur investors is less than the average active investor’s return.  

Combining insights A and B, we can conclude that, net of fees, the average return of professional investors (including active MFs) is roughly less than the return of the index. It is fair to assume that the average return of active MFs is similar to that of other professional investors. Hence, net of fees, the average return of active MFs is roughly less than the return of the index.

So, there are two reasons why clients should avoid active MFs. First, the average return of active MFs is less than that of the index. Further, there is a wide variation in the returns of different active MFs. Hence some clients will earn even lower returns than the average return of active MFs. For example, if a client’s annual return is 1 per cent less than that of the average active MF, then over 30 years her investment will be worth 26 per cent less than that of the average client who invested in active MFs. Hence clients should instead use low-fee passive index funds such as the Nifty 50 index fund (whose fee is even lower than that of the Nifty 500 index fund).

The writer is an hourly-fee financial planner and a SEBI RIA at Fiduciaries.in. He was a private-equity investor for 12 years.