Erratic at the short end but much better in the long run

Less than half of the equity mutual funds have beaten benchmarks in the last 12 months, but their performance gets better in the long haul

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The performance of mutual funds (MFs) aren't that rosy over a one-year time frame, if you compare the performance to the gains they made against the benchmark - a key factor in evaluating a fund's performance. Out of 139 MFs of the top 10 equity MF houses by assets under management, only 59 could outperform their benchmarks in the past year.

At first look, these numbers should paint a grim picture. In the previous bull markets, more funds beat their benchmarks. This time, say analysts, performance has been concentrated in a select few sectors and stocks. On the other hand, funds have been keeping a more diverse holding in their portfolios, even from sectors that have not participated in this market rally. That's been keeping their performance in check.

It's no secret that funds find it difficult to beat the benchmarks in the short run. Actively managed ones tend to take positions in several sectors or stocks that might not participate in the market. Nobody knows in advance which sectors are going to perform. Hence, most funds choose to stay diversified. The indices also have a different composition, while a fund might not have similar stocks in the same proportion in its portfolio. (BEATING THE HEAT)

Funds also face redemptions and so have to keep some of their money in liquid counters. This tends to impact performance.

Says Dhruva Chatterji, senior consultant, Morningstar India: "This time, the Sensex is not painting the right picture. A select few stocks and sectors have been rising. MFs, because of the diverse holdings, have not been able to show a benchmark beating performance."

However, the performance over three years gets better. Nearly 60 per cent of the existing funds of the top houses have beaten their benchmarks. Time plays a crucial role in this outperformance. The more a fund stays invested in a sector or stock, the better its returns can get. Says Chatterji: "The number of funds underperforming goes down because markets go through cycles. Those that take a little more risk tend to do well in the short run. But over market cycles, the good funds stand out."

Performance over the past five and 10 years gets even more impressive. It shows the returns getting progressively better. In those two time spans, 68 per cent and 93 per cent of the funds managed to beat their benchmarks. This exercise suggests that over a short time-frame, funds aren't able to beat their benchmark; but over the longer one, more of them can easily do so. Says Dhirendra Kumar, CEO, Valueresearchonline: "The reason for the outperformance is that most of the indices are large-cap in nature, while funds might have a portfolio not so large-cap dominated. But other stocks give them the advantage to outperform in the longer run."

Then, why are so many investors dumping their funds instead of staying put for the long run? Among the many reasons are that investors look at just the very short-term performance of funds. They are not eyeing long-term returns.

Unfortunately, some of the other indices have also been underperforming in the recent past. For instance, the BSE Sensex has made a gain of just 9.2 per cent in the short run of one year, but it has gained 15.5 per cent (CAGR) in the past 10 years. Similarly, mid- and small-cap indices have lost -6.6 and -14.9 per cent in the past year. But look over the past 10 years and you see a strong outperformance of 12.5 and 12.6 per cent.

While benchmarks do help gauge a fund's performance, experts also say one need not put too much emphasis on funds that beat these, though it helps as a good starting point.

Studies have found that a combination of good funds with better risk-adjusted returns can give you a much better performance for the same amount of risk. Kumar says that in the long run, it is about having the right combination of funds as well. He says: "Somebody who wants to invest for the long run should not worry about the benchmarks. Investors should follow their diversification needs and then invest."

Experts say if one selects a few funds with a good diversified focus, then they can also beat the benchmarks even if one of these funds are not doing well in the short-run. A combination of mixing and matching between different segments of the market, such as large- mid- and small-cap funds is a better way to buy MF investments. However, even if more of your funds are not working in the short run, there is a greater chance that given enough time, more of these will deliver better returns.