Why are fund managers unable to outperform the Nifty?

The most important quality for an investor is temperament, not intellect.

Warren Buffet

In the past one year we have observed a very strange and perhaps unique phenomenon in the Indian stock markets. Out of the 289 equity mutual funds (regular) which invest in the Indian stock markets and for which performance data for the past one year is available (source: amfiindia.com, annual performance data from 16 Feb 2018 until 15 Feb 2019), only 63 funds managed to outperform their corresponding benchmarks. In other words only 21.8% of such funds could deliver alpha returns when compared to their benchmarks. This data is shown in summary format below:

Fund Category	Outperformers	Total Funds in category	Outperformer Percentage
Smallcap	14	17	82.4%
Midcap	17	25	68.0%
Contra	1	3	33.3%
Sectoral	17	76	22.4%
Multicap	6	35	17.1%
ELSS	4	42	9.5%
LargeMidcap	2	23	8.7%
Largecap	2	33	6.1%
Value	0	12	0.0%
Focused	0	18	0.0%
DivYield	0	5	0.0%
All	63	289	21.8%

Table 1 : Funds outperforming their benchmark, by category

We can see from the above table that except for Smallcap and Midcap funds, all other equity funds failed to beat their corresponding benchmarks in the past one year. Almost 4 of 5 funds underperformed their own benchmarks. How is it possible that so many experienced, skilled and highly paid fund managers failed to read the markets correctly in the past one year? Granted that the stock markets faced spells of high volatility in the past year, but the benchmarks would have been as volatile as the fund itself. Does this mean that most fund managers panicked during times of volatility and experienced a double whammy thereby getting hit on the way down as well as back on the way up?

Dismal as this picture is, it becomes even more depressing when we change the goalpost slightly and compare each fund’s performance against the Nifty, instead of against its own benchmark. Here is how that picture looks like:

Fund Category	Outperformers	Total Funds in category	Outperformer Percentage
Sectoral	9	76	11.8%
Multicap	2	35	5.7%
Midcap	1	25	4.0%
Largecap	1	33	3.0%
Value	0	12	0.0%
Smallcap	0	17	0.0%
LargeMidcap	0	23	0.0%
Focused	0	18	0.0%
ELSS	0	42	0.0%
DivYield	0	5	0.0%
Contra	0	3	0.0%
All	13	289	4.5%

Table 2 : Funds outperforming the Nifty, by category

This table shows that in the past one year only 13 of the total 289 equity funds outperformed the Nifty. And of those thirteeen, 9 were sectoral funds which were primarily oriented towards the Information Technology sector. The question arises at this point, what was the Nifty return in the past one year. It was a meager 3.14% mind you. And yet more than 95% of skilled, qualified, experienced and highly paid fund managers failed to make more than 3.14% from the stock markets in the past one year! What can we attribute such huge underperformance to? Is there some superior intelligence that is more insightful than the collective intellect of more than 95% of the fund managers in this country? On the face of it, that is what it looks like. The other explanation could be that fund managers in general have a herd mentality and panic collectively during times of high volatility. 

Let’s dig deeper and look at the performance of the Nifty components themselves. Here is a summary of their performance in the past one year:

Performance range	Total stocks
-15% and below	19
-15% to 3.14%	12
3.14% to 15%	5
15% to 30%	8
30% and more	6
Total	50

Table 3 : Performance of Nifty components in past one year

As shown in the above table, of the 50 stocks in the Nifty only 19 outperformed the Nifty during the year. In other words less than 2 in 5 of the Nifty stocks outperformed the Nifty during the year. What this implies is that all fund managers had to do was to have a few of these 19 stocks in their folios in order to compete with the Nifty. Yet a vast majority of them (more than 95%) failed to do exactly this. Was it so difficult to identify at least a few of these 19 stocks at the start of the year? Seemingly it was. It shows that nobody is infallible, regardless of what the mutual fund commercials will have you believe day in and day out with their ‘Sahi Hai’ campaign. 

What to Do

If you are a Mutual fund investor you have to realize that fund managers are not as smart as you wish them to be. The data clearly confirms this fact and it is indisputable. This logic can perhaps be extended to portfolio managers who run Portfolio Management (PMS) schemes as well, but I do not have the data to support that argument at the moment. If you are a PMS investor, your own experience in the past one year with the performance of your fund may confirm my point of view. Either way, in such difficult times it is handy and especially useful to have an open line of communication with your investment advisor. Ask incisive questions about the non-performance of specific stocks in your portfolio to your advisor, understand the reasons for the same and then convince yourself about the way forward. Nobody is infallible including your advisor, but at least a direct conversation between you and your advisor will make both of you aware of the situation and then make him/her work out ways to deal with it going forward. Hopefully both of you will emerge as better investors in the process.