Why equity MFs could well outperform the market for a while

With the Bombay Stock Exchange Sensex hitting new highs at regular intervals - it closed above 28,000 yesterday (12 November) - equity mutual funds have been seeing a steady increase in inflows from investors this financial year.

According to a Business Standard report , equity funds saw inflows of Rs 38,770 crore in April-October 2014, the highest since the boom-boom period of 2007-08 which was followed by a crash after the Lehman bust.

Are retail investors again about the make the same mistake they did in 2007, by entering equity just when the market may be about to peak?

I don’t believe so, for there is still some steam left in the bull run; and, in any case, if we expect overall GDP growth to revive and interest rates to fall, we are merely at the end of the first stage of a multi-year bull run, not at its absolute end.

So investors who are not market experts would thus be right to invest in equity mutual funds. Not only because this is safer, but because in India equity funds can, and do, outperform the market. Given their low share of the overall market capitalisation, their investments do not rock the markets, which makes it easier for good fund managers to outperform the broad indices.

According to publicly available net asset value (NAV) data compiled by the HDFC Mutual Fund, two-thirds of mutual funds (including debt and equity) have outperformed their benchmark indices over the medium to long term. Over the last three years, 67 percent of schemes outperformed their benchmarks; over a five-year period, 75 percent scored better; and over a 10-year period, 64 percent outperformed.

This means even if you blindly choose a mutual fund, you could be right two out of three times - though there is no guarantee of that. Not for nothing do they keep reminding you that “equity funds are subject to market risks, etc, etc.” However, broadly speaking, if you choose three different, well-run mutual funds to spread your investments over, you could outperform the markets in your portfolio as a whole.

However, there is no need to blindly invest in any mutual fund as there are rating agencies like Crisil and Value Research who rate mutual funds on the basis of long-term performance. Choosing some of the best schemes from these ratings should therefore be a good enough guide for the ordinary investor. (For the current ratings of various schemes and categories, find out from here , here , and here ).

However, one thing should be kept in mind: the performance of Indian mutual funds is an exception to the global rule where 70-80 percent of funds actually underperform. And the reason is simple: mutual and pension funds are so large in the US that they more or less constitute the market. This means their investments tend to mirror the indices. Given their size, very few manage to actually outperform the indices. This is one reason why index investing - where mutual funds try and mirror the underlying stocks in in their benchmark indices - is such a big thing in the US.

In India, the scenario is just the opposite. According to Prashant Jain, CIO and Executive Director of HDFC Mutual Fund, “all mutual fund schemes are tiny in India. In fact, HDFC Equity Fund, the largest equity scheme, with (around) Rs. 16,000 crore of assets under management (AUM), is only 0.17 percent of market capitalisation….it is large compared to other schemes, but it is small relative to the market.”

Jain said in a recent interview to IIFL, a broking and financial services company, that as at the end of August, around 80-90 percent of equity schemes had been outperforming their benchmarks.

The point is this: as long as the overall size of all equity funds does not grow to a size where they impact market prices significantly and thus affect their own returns, they can show significant outperformance compared to the overall market.

This means in the foreseeable future - say, four to five years - the mutual fund will be a good vehicle for the aam investor.