Saturday, October 21, 2006

Where all are above average

The Business Standard has published a grotesquely shoddy study on the performance of Fund Managers in India. Really, you expect better from this paper.

Indian equity fund managers have managed to beat the benchmark indices hands down, despite the stock markets going through tumultuous times over the past decade and a half.

The first-ever ranking of fund managers, based on performance throughout their career, reveals that 90 per cent of the fund managers had a 50 per cent rate of outperformance versus the benchmark Nifty index. In other words, of the 32 equity fund managers ranked, 29 bettered the Nifty at least half the time.

This may be meaningful because

“Apart from their skills, a key reason for the large-scale outperformance is that mutual funds are a tiny fraction of the whole market in our country, while in the US, mutual funds are the market itself, limiting the scope of fund managers bettering the market,” added Kumar.

Translation: these dudes have been thriving on the mistakes of the retail investors who swarm our markets while, in the US, one Fund Manager can outperform only at the expense of another.

While every one of the leading fund managers seemed to have a unique style of investing, a common thread was a bias towards growth. “Since most companies in India have still not attained their full potential, focusing on growth can bring in rich rewards,” said Subramanian of Franklin Templeton.

Meaning: we take more risks, which pay off in a rising market, but can sink us if the market turns against us.
However, the number one reason for this performance has not been explicitly presented: Sample selection bias.

The study ranked only equity managers with a minimum five-year track record and debt managers with at least two years of experience. The detailed methodology and results have been covered in the magazine, along with the profile of the five leading managers in the two categories.

Simply put, what do the authors want me to take away from such a study? That it is possible to beat the market over the long term, that its particularly easy to do this in India, and so I should hand my money over to these Fund Manegers. Now, they may be right, but this study inspires no confidence.

What they should have done is to look at all the Fund Managers who were in business 5 years ago, and then seen how they performed over these years. That would have given us a feel for how easy it is for these particular professionals to outperform, given the large number of amateurs mucking about in the marketplace.
The way they have conducted this study, all the Fund Managers who went out of business in these past 5 years have not been counted- hence the conclusion that "90% of the Fund Managers has a 50% rate of outperformance versus the benchmark Nifty at least half the time."
This article has a nice section on how the Fund Mangement industry manages to make itself look good.

There are a number of ways that active fund managers have been able to promote the illusion that as a group they are adding investment value. The investment management industry has many tricks to make it appear as if everyone is doing better than average.

For a start they can load the dice by opening to the public a lot of historically profitable funds. Fund managers introduce creation bias into the equation by starting a lot of aggressive new funds. The way this trick works is they give seed capital to a number of promising young portfolio managers every year. These managers then invest and trade aggressively for the next year or two, establishing a track record. The fund managers that didn't do well get the flick, their money gets plowed into the more successful fund and then the investment company opens the new fund to the public and puts enormous marketing hype behind it. In this way managers can ensure that all new funds (that the public hear about) have excellent track records.

There are studies that have found that brand new funds often underperform their own track records, and as a group seem to do worse than more established funds, this is probably why. Note that these new funds don't do any better than average following their launch, but they do get to brag about impressive past performance.

The second trick is to bury the evidence if one of their public funds ever falls behind. Survivorship bias is introduced when fund managers close or merge their less successful funds with more successful ones. By continually weeding out the weaker funds, a fund manager can present a prospectus showing the entire range of investment options being market beaters. Similarly, when a fund is culled it is usually deleted from most databases, so history is rewritten by the winners. Professor Burton Malkiel, author of the excellent book A Random Walk Down Wall Street studied this phenomenon and estimates survivorship bias could add as much as 1.5%pa to the performance of the median fund manager. Investors do not benefit from survivorship bias, real world investors do lose money on funds that are deleted. All that improves is the historical average performance of fund databases.

Third trick is to throw a lot of hype behind high performing funds. There is little evidence that winning funds are able to sustain their high performance over the long term, so this can only be seen as a cynical marketing exercise, cashing in on last year's luck. Naturally funds that don't perform well don't advertise much, so all you see are ads showing high performance. (Rajeev: rather as your colleagues at work would are more likely to tell you about the winning stocks that they purchased, not the losers they have on their portfolio)

The fourth trick is as scurrilous as the rest, even a very poor fund that has underperformed over the longer term can have a good year or two, so as long as these funds only talk about recent past performance they can avoid the prickly question of longer term past results.

Similarly, funds can always brag about past glories, proudly displaying the fund manager of the year ribbon they won 3 years ago on every advertisement, and brag about a high long term performance even if the last few years have been dreadful.

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