Why India's active managers are struggling

You’ll usually find an exception to the rule — pretty much any rule, in fact — if you’re determined to find one. The rule that investors are better off investing in passive, rather than active, funds isn’t any different. There will always be outliers — spectacular losers as well as winners — especially in the short term. That’s just the law of averages.

So, writing and sharing articles as I do about evidence-based investing, I’ve become used to responses beginning, “But what about..?” “Ah, but what about Neil Woodford?” was once especially common (enough said about that). Another popular retort used to be “What about India?” OK, very few active managers can outperform a well-researched market like the US or the UK, the argument went, but a skilful manager can add value in a market like India.

It was, for many years, a valid argument. As recently as 2017, respectable analysts such as Morningstar pointed to evidence of persistent outperformance by Indian equity funds.

But active fund performance has tailed off markedly in recent years, and 2020, which provided stock pickers with a golden opportunity to prove their worth, was an especially disappointing year.

Outperformance elusive

In the five-year period ending 31st December 2020, on an absolute-return basis, 88% of Indian equity large-cap funds underperformed the S&P BSE 100 index. (1) 97% of composite bond funds underperformed the S&P BSE India Bond Index over the same period. (2) Also, just 60% of Indian government bond funds managed to survive the full five years.

In other words, outperformance by active funds has been just as elusive in India as it has been in the US and the UK, where the poor performance of active funds has been well documented.

So what is going on here? It is, of course, theoretically possible that India’s active managers have become less skilful in recent years, or less lucky. But a more plausible explanation for these is that alpha in the Indian financial markets has simply become harder to find.

Alpha is shrinking

A book I recommend to anyone who wants to get a handle on active and passive investing is The Incredible Shrinking Alpha by Larry Swedroe and Andrew Berkin, now in its second edition. The book’s title says it all: The amount of alpha out there is declining.

There are several reasons why that is, but here are the four main ones:

1. What was once considered alpha has now become beta. In other words, investors can now tilt their portfolios towards factors that are known to produce higher long-term returns — e.g. small size, value and momentum — with funds that are broadly passive and very much cheaper than traditional active funds.

2. The pool of victims is shrinking. Most market trading today takes place between investment professionals, and there’s now a far smaller proportion of ordinary investors whose lack of knowledge or ill-discipline active managers can exploit.

3. The competition is getting tougher. Fund managers are better resourced now than they have ever been, and they are aided by technology that’s improving all the time. As a result, they have more, and better, information at their fingertips than they ever used to.

4. The amount of assets competing for alpha is growing. Assets under management have grown hugely, and the very act of exploiting market mispricing’s makes them disappear, shrinking the available alpha over time as anomalies are uncovered and exploited. In other words, there’s more money chasing fewer opportunities to generate alpha.

What we’re seeing in India

All four of these things have been happening in developed markets for decades. Although emerging markets, by definition, are newer, they are still subject to exactly the same effects. What we’re seeing in India, and indeed in markets like Russia and Brazil, is markets becoming more efficient and alpha harder to come by.

So what does the future hold? Will active fund performance in India improve? The answer, surely, is no. It hasn’t in countries like Britain and America, so why should it improve in India? Yes, active managers will carry on claiming that their fortunes are about to change — we wouldn’t expect them to say otherwise — but the pool of available alpha will continue to shrink.

And what about the future for passive investing in India? It has grown fast in recent years, but it started from a very low base. Total assets under management in passive products currently stand at US$24 billion, compared to just $1 billion in 2010. In other words, indexing in India still has huge potential for growth.

India, then, is an exceptional country in many ways — the strength of its Test Cricket team being one of them. But active money management? Alas, it’s much the same story in India as anywhere else.

ROBIN POWELL is Editor of The Evidence-Based Investor and runs Regis Media, a boutique content agency for financial advisers.


References:

(1) S&P BSE (Bombay Stock Exchange) 100 index is designed to measure the performance of the 100 largest and most liquid Indian companies.

(2) S&P BSE India Bond Index is designed to track the performance of local-currency denominated government and corporate bonds.