PERFORMANCE EVALUATION OF ACTIVELY MANAGED MUTUAL FUNDS AND INDEX FUNDS: A COMPARATIVE STUDY

GE-International Journal of Management Research

© Associated Asia Research Foundation (AARF)

PERFORMANCE EVALUATION OF ACTIVELY MANAGED MUTUAL

FUNDS AND INDEX FUNDS: A COMPARATIVE STUDY.

*Sumana B.K, ** Prof B.Shivaraj

* Research Scholar, B.N. Bahadur Institute of Management Sciences,

University of Mysore, Mysore.

** Professor, B.N. Bahadur Institute of Management Sciences, University of Mysore, Mysore.

ABSTRACT

Active management is an important model for investment strategy today. The objective with

active management is to produce better returns than those of passively managed funds. The

Index funds which are passively managed try to replicate the performance of market index.

There is a perennial debate between active management and passive management. This paper is

an empirical study of performance of index funds and actively managed mutual fund from

2012-2015. This study focuses on how portfolios of index funds have performed relative to portfolios of

actively managed funds. The mutual funds have been analyzed on these parameters 1) Jensen`s

Alpha 2) Beta 3) Tracking error 4) Rsquare. The analysis revealed the performance of index

funds and actively managed funds on the above indicators are mixed.

Introduction

Active management refers to a portfolio management strategy where the manager makes specific

investments with the goal of outperforming an investment benchmark index. The aim of the

active management is to beat the market. Active portfolio managers attempt to construct a risky

portfolio that maximizes the reward-to-variability (Sharpe) ratio. Active fund managers pick

managed mutual fund because the fund tries to replicate the performance of a market index. The

fund buys shares in securities included in a particular index in proportion of each security`s

representation in that index. The fund manger does not rely on asset allocation, security selection

of the fund as in the case of active fund management instead the portfolio manager takes the

market index exposure. In India the actively managed funds have consistently outperformed the

index funds. The first publicly available and widely accepted index mutual fund in US was

launched by The Vanguard Group in 1976. It tracked the S&P 500® US stock index. The idea

was spearheaded by Vanguard founder John C. Bogle. There are eighteen index funds in India

and the first index fund was Principal index fund which tracks CNX Nifty in the year

1999(Source: nseindia.com). There are 41 AMC`s in India with Rupees 9,594.14 billion asset

under management (Source: RBI Dec 2014). There is always a debate between active funds and

index funds in terms of performance and fees. Compared to index funds, actively managed funds

have performed better in India. The reasons could be the markets lack depth in India and are not

as developed as US markets. Hence, there are plenty of opportunities outside of the index that an

actively managed fund can tap, as the index does not capture the broad market too well. The

tracking error (and therefore, expenses) in the Indian context is higher as a result of poorly

constructed indices and the difficulty involved in tracking them. The choice of indices is mostly

restricted to Nifty and Sensex. Index funds work well if markets are efficient. Since all

information that may affect a stock’s price is already factored in its price, there is little scope to

gain beyond that. However, in the Indian context, there is a larger group of stocks, especially in

the mid and small-cap segment that sees constant re-rating and price discoveries as information

asymmetry exists. Index funds are used by investors who are risk-averse. In comparison to

actively managed funds, index funds have lower expense ratio, lower transaction costs, better

control of risk through diversification and less prone to risk of fund manager's performance.

Among institutional investors, index funds are used by pension and insurance funds. Among

individuals, investors who do have knowledge of the markets or are averse to sector-specific

risks prefer index funds. Index funds can be either for equity funds or debt funds. Indexing is

popular with investors who prefer steady returns through a conservative, long-term and low risk

Literature Review

Most of the mutual fund studies were during 1960. Fama, Sharpe, Treynor were few researchers

to note the lack of skill by mutual fund managers. According to Jensen (1968) mutual funds were

on average were not able to predict security prices well enough to outperform a buy and hold

policy. Carhart observed that although some funds outperformed, on average, mutual fund

managers did not exhibit superior investment skill. Sharpe (1999) mentions that the before costs

the average actively managed dollar will equal the return on the average passively managed

dollar and after costs, the return on the average actively managed dollar will be less than the

return on the average passively managed dollar. According to the research conducted by NERD

Wallet (an Investment management Company) in 2013, only 24% of the active managers beat

the market over the past ten years. Mercer, an investment consulting firm conducted a study on

Indian Equity mutual fund in May 2011, classified the mutual funds and measured the

performance with appropriate benchmarks. It then analyzed the fund performance vis-a-vis the

newly defined benchmarks and found that 70% of large-cap funds outperformed the BSE-100.

However, only 55% managed to do so over a five-year period. Among the diversified equity

funds, 63% yielded returns in excess of their benchmark, the BSE-500 Index. This ratio dropped

to 52% for the five-year period.Lubos Pastor et all (2012), argues that active management poor

track record has resulted in growth of Index funds. This has reduced the share of investment in

active management. With the increase in industry size the fund managers find difficulty in

outperforming the benchmark. Narend (2014) studied Indian ETF`s and index mutual funds since

inception till 2013 andthe study reveals that, in India, index funds have done better than ETFs in

terms of a lower tracking error and a higher Jensen’s alpha while ETFs have performed better in

terms of active returns.

Tracking Error

Tracking error indicates how closely the fund is tracking the index. It refers to the ratio of how

close the weights of the stocks in the portfolio are to the weights of the stocks in the index. The

more closely the weights of the stocks are tracked in the index, lower will be the tracking error.

The factors that affect tracking error are inflows or outflows in the fund, corporate actions,

change of index constituents, cost (transaction costs including broker' commission, bid and ask

funds are usually lower than the benchmarked index. Tracking error is defined as the annualized

standard deviation of the difference in returns between the index fund and its target index. The

tracking error is always calculated against the total returns index that shows the returns on the

index portfolio, inclusive of dividend.

Research Objectives

The objectives of the study is to compare the performance of index funds and actively managed

mutual fund from 2013-2015(up to October). The mutual funds have been analyzed on the these

criteria 1) Active return 2) Jensen`s Alpha. R squared and beta is calculated to find how well

both, actively managed mutual funds and index fund track their respective benchmarks.

Tracking error of actively managed funds and also the index funds tracking error is calculated to

find how closely the mutual funds mirror their respective indices.

Research Methodology

In this study, we examine the index funds and diversified actively managed equity mutual funds.

The sample size for the study is eight. Four of which are Index funds and diversified equity

mutual funds. The data is collected from NSE, BSE websites and bluechipindia.com. The daily

closing prices and NAV`s are collected from year 2013-2015(up to October). The limitation of

the study is

The following tables indicate the funds selected for the study.

Index Funds and their Benchmarks

Number Index fund Index/Benchmark

1 HDFC Index Fund (G) BSE SENSEX

2 LIC Nomura Index Fund (G) BSE SENSEX

3 UTI Nifty Index Fund CNX NIFTY

4 IDBI Nifty Index Fund CNX NIFTY

Actively Managed Mutual Funds and their Benchmarks

Number Diversified Equity Funds

(Actively Managed)

Index/Benchmark

1 Birla Sunlife Opportunities

(Growth)

S&P CNX 500

2 Franklin High Growth

Companies(Growth)

S&P CNX 500

3 SBI Magnum Multiplier Fund BSE 200

4 ICICI Prudential Multicap Fund

(G)

BSE 200

Table: 2

The performance of the index funds and diversified mutual funds are measured by comparing

their daily returns with the returns of the respective benchmark. The mutual funds performance is

analyzed using risk adjusted performance measure Jensen`s alpha. Jensen alpha measures the

average return over and above the expected return. Jensen`s measure is the portfolio`s alpha

value. While higher the alpha better it is for the investor. It shows if the portfolio manager has

outperformed the index. Jensen`s alpha for the actively managed mutual fund and index fund is

calculated as follows:

Where,

α

= Portfolio average return

β

Tracking error is calculated as the annualized standard deviation of the difference in returns

between the index fund and its target index.

Data Analysis and Interpretation

The following table No: 1 indicates the Jensen Alpha of the mutual funds under the study.

Among the diversified equity mutual fund (actively managed), The Jensen Alpha of 44.91% in

the year 2014 the highest for Birla sunlife for all the three years. Franklin high growth companies

fund has the Lowest alpha of 0.99% in the year 2014 and -4.56 % in 2015. Among the Index

funds, HDFC index fund has the highest alpha of 0.17 % in the year 2013. In the year 2014, UTI

Nifty Index fund has the highest alpha of 23.16%. In the year 2015 all the Index funds had

negative returns. Whereas the index funds have delivered good returns in the year 2014 as

compared to other years.

Number Diversified Equity Funds

(Actively Managed)

Jensen Alpha

2013(%) 2014(%) 2015(%)

1 Birla Sunlife Opportunities (G) 14.72 44.91 8.95

2 Franklin High Growth Companies(G) 7.97

0.99

-4.56

3 SBI Magnum Multiplier Fund 4.61 3.15 1.53

4 ICICI Prudential Multicap Fund (G) 2.91 19.62 4.97

Index Funds

5 HDFC Index Fund (G) 0.17 18.06 -9.31

7 UTI Nifty Index Fund -3.67 23.16 -7.89

8 IDBI Nifty Index Fund -1.39 14.34 -8.77

Table: 3

Table No: 4 display the Beta, R square and Tracking Error of the sample mutual funds. Beta for

diversified equity mutual funds is high for SBI Magnum Multiplier fund in year 2013 and ICICI

prudential has highest beta in the year 2015. Birla sunlife has the lowest beta in the year 2014.

Franklin High growth has negative beta in the year 2013. It signifies that the mutual funds have

inverse relation with the index. It signifies that the actively managed mutual funds are less

volatile than its benchmarks. The Rsquared is very low and close to zero which signifies the

actively managed have little or no correlation with the index. Low tracking error means a

portfolio is closely following its benchmark. High tracking errors (TE) indicates the reverse.

Actively managed portfolios seek to provide above-benchmark returns, and they generally

require added risk and expertise to do so. In such cases, tracking error will be high. TE for

Franklin for diversified mutual fund is highest in 2013 and 2014. SBI has the highest TE in 2015.

Among the Index funds HDFC, LIC Nomura, UTI Nifty have negative beta in the year 2013. In

the years 2014 & 2015 beta is very low. The Rsquared is very low for all the index funds, Which

shows there is very little correlation between the Index funds and the Index which is unlikely of

an Index funds. Low R-squared indicates that very few of the fund's movements are explained by

movements in its benchmark index. Tracking error for the UTI index fund is highest in 2013 and

2014. Whereas IDBI has the lowest TE in 2014.

N

o

Diversified Equity Funds

(Actively Managed)

Beta Rsquare Annualized Tracking Error

2013 2014 2015 2013 2014 2015 2013 2014 2015

1 Birla Sunlife

Opportunities

(G)

0.0404 0.01 64

0.178 2

0.0028 0.000 4

0.0390 0.205 26

0.1715 0.1843

Growth

Companies(G)

3 SBI Magnum

Multiplier Fund

0.6883 0.31 06

0.193 0

0.5894 0.093 5

0.0341 0.111 8

0.1544 0.1983

4 ICICI Prudential

Multicap Fund

(G)

0.2509 0.32 00

0.895 2

0.0738 0.094 0.9145 0.199 2

0.1566 0.0445

Index Funds

5 HDFC Index

Fund (G)

-0.0399 0.20 447

0.205 56

0.0015 0.042 4

0.0438 0.254 73

0.1585 0.1909

6 LIC Nomura

Index Fund (G)

-0.0347 0.04 34

0.109 5

0.0012 0.001 7

0.0101 0.250 3

0.1760 0.2155

7 UTI Nifty Index

Fund

-0.0328 0.01 60

0.212 0

0.0010 0.000 0.0455 0.260 2

0.2185 0.1912

8 IDBI Nifty

Index Fund

0.2466 0.35 92

0.209 2

0.0615 0.129 6

0.0440 0.221 1

0.1431 0.1923

Table: 4

Conclusion

The Jensen Alpha for the actively managed mutual funds is better than Index funds alpha in all

the three years. With the Index funds returns being negative in the year 2015. Actively managed

mutual funds have low beta which signifies less volatile than its index. Even the Index funds

have low beta which shows that funds are less risky and is apt for risk averse investors. Rsquared

for few actively managed mutual funds are nearly zero and very low which indicates that the

actively managed mutual funds have no or very less correlation. This highlights that the fund’s

returns cannot be explained fully by the movements in the market, which is the crux of active

funds. However the study has limitations, as the sample considered for the study is eight

diversified equity mutual funds and index funds for a period of three years.

References:

1. Cahart (1997). “On Persistence in Mutual Fund Performance,” The Journal of Finance

Vol. 52, No. 1.

2. Jensen 1986

3. Mercer, an investment consulting firm conducted a study on Indian Equity mutual fund in

May 2011

4. Narend, (2014). “Performance of ETFs and Index Funds: a comparative analysis”,

source: NSE website.

5. Pastor, L. a. S., Robert F (July 23, 2012). "On the Size of the Active Management

Industry." Working Paper.

6. Sharpe, W. F. (1991). "The Arithmetic of Active Management." "Financial Analysts

Journal" Vol. 47: pp. 7-9.

7. Seth C. Anderson and Parvez Ahmed (2005), A good starting point for reviewing early

mutual fund studies is Mutual Funds: Fifty Years of Research Findings, New York,