Mutual funds and randomly walking monkeys

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Mutual funds and randomly walking monkeys 2 comments

PRATEEK SHARMA | 23/02/2016 06:14 PM |

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The often ignored disclaimer, "past performance is not an indicator of future results" is very important for mutual fund investors. A fund that looks the best based on its past performance may not turn out to be the best in the future In 1973, Burton Malkiel, a professor of economics at Princeton University, made an astonishing claim in his best selling book ─ A Random Walk Down Wall Street. He claimed that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts. The implications were profound. It meant that professional fund managers do not create any value for the investors. Unsurprisingly, it was fiercely opposed by the investment professionals and has since been a source of a longstanding debate. This idea, also known as the random walk theory, suggests that stock prices evolve randomly, and therefore, cannot be predicted. If this were true, professional fund managers would have no informational advantage over the retail investors. Consequently, fund managers would not display superior skill in either selecting the best stocks or in timing the markets. In fact, the proponents of the random walk theory believe that the equity investors are best served by investing in lowcost index funds and exchangetraded funds (ETFs) that provide returns similar to that of the overall market. On the other hand, http://www.moneylife.in/article/mutualfundsandrandomlywalkingmonkeys/45585.html

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the mutual fund industry claims to achieve higher returns than the traditional investments. The past performance of equity mutual funds is regularly compared against market benchmarks such as the Nifty and the Sensex, often with mixed results. Some funds underperform the market, whereas others provide better returns than the market benchmarks. It is easy to identify a mutual fund that gave much higher returns than the market in the past one year or five years. Moneycontrol.com provides a free tool to find the top performing mutual funds for the last five years. Consider an investor who would only prefer to invest in the best performing funds. The table below looks at the top performing equity mutual funds at different time horizons, as on 8 February 2016.

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The bestperforming equity mutual funds comfortably outperform the Nifty index. But should you invest in these funds? Careful readers would notice that it is not straightforward to choose the funds based on such an analysis. The choice of the best fund would depend on the time horizon you choose. In the last six months, arbitrage based equity funds have performed the best. In the last two years, funds based on smallcap and microcap stocks have performed the best. If your horizon is the last five years, the best equity funds have been the ones that have focussed on a specific sector, such as pharmaceuticals and logistics. Moreover, there is little overlap between the different time horizons, which suggests that even the best funds do not consistently outperform all others. The often ignored disclaimer ─ “past performance is not an indicator of future results” is very important for mutual fund investors. A fund that looks the best based on its past performance may not turn out to be the best in the future. On the other hand, if a fund manager is really skilful, the fund should be able to generate consistently high returns. Can someone outperform the market simply by being lucky? Absolutely! Note that the return of the overall stock market is a weighted average of the returns of all the individual stocks. As a result, in any period, some stocks would fare better than the market, whereas others would perform worse than the market. Now, consider a mutual fund manager who constructs his portfolio completely randomly, that is, without any investment skill whatsoever. If he happens to allocate more capital to the stocks that do better than the market, simply by chance, the mutual fund would perform better than the market. Conversely, if he allocates more capital to the stocks that do worse than the market, the mutual fund would perform worse than the market. So the past performance of the mutual fund is not necessarily an indication of the skill of the fund manager, but it may simply be a matter of chance. It is important to distinguish between luck and genuine investment skill, because a fund that performed well due to superior investment skill is more likely to repeat its high level of performance in future, http://www.moneylife.in/article/mutualfundsandrandomlywalkingmonkeys/45585.html

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unlike a fund that performed well only due to luck. Our recent study ─ “Testing the skill of mutual fund managers: Evidence from India” attempts to test the skill of Indian equity mutual fund managers. Our findings suggest that the performance of Indian mutual funds is highly inconsistent. For example, we find that the best performing mutual funds (top 25%) for a particular month have a 35% chance of being the best performers in the next month. However, they also have a 31% chance of being the worst performers (bottom 25%) in the next month. In other words, a bestperforming fund of the current period can turn out to be to be the best or the worst performer in the next period with an almost equal probability. To test the skill of equity mutual fund managers, we took a cue from Malkiel’s idea. We simulated a large number of monkeys by generating 10,000 randomly created portfolios with all the stocks listed on the National Stock Exchange (NSE). Then, we compared the performance of equity mutual funds with these “monkey portfolios” over a long horizon (from 1 January 2003 to 31 July 2014). Surprisingly, the average mutual fund did not perform any better than the average monkey portfolio, whereas the best monkey portfolio fared much better than the best mutual fund. Finally, it can be argued that the retail investors benefit from the diversification provided by the mutual funds. This is true, however, exchange traded funds can be used to achieve portfolio diversification with much lower fund management charges than those of the equity mutual funds. (Prateek Sharma is Assistant Professor of Finance at IMT, Ghaziabad)

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Ramesh Poapt 15 hours ago 2016 so far is not good for Eqty funds.Balanced funds may have some solace. A recent category of fund which is slightly riskier than MIP us Eqty saver funds,which benmarked as 30% nifty or 25%MIP blended,here benifit is it is eqty oriented fund and debt oriented fund like MIP. Asset al;location,risk profile and time horizon plays important role.Staggered(SIP/STP)investment is other important tool. Reply »Link » Report abuse

RAVI RAM PV 18 hours ago For choosing the safe option of Index ETFs: Problem is that in India ETFs are not as easily to buy and sell. I had burnt my fingers buying the Bees which is the country's largest ETF. Both ways buy n sell there was loss, as the market value did not reflect the NAV. Reply »Link » Report abuse

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