Ever since modern risk adjusted performance evaluation came into the picture the claim that active management yields excess returns has come under a cloud. The performance evaluation compares an active managed fund against an alternative "benchmark portfolio" build out of two parts: (a) money in the bank and (b) money in an index fund.

While performance evaluation has its own complexities, investment professionals all over the world believe that around 75 per cent of funds underperform the passive alternative. The evidence hence puts a profound question mark upon the entire field of active management. Going by this evidence, investors should just place their funds in two parts -- (a) a riskless asset and (b) an equity index fund.

There are three basic explanations which have been proposed in explaining the poor performance of active mutual funds. These are: market efficiency, transaction costs and agency conflicts.

As markets become more efficient, active management becomes harder. This is because, it is related to the competition between speculators who seek to identify mispriced assets. When many skilled speculators are present on the market, it becomes difficult to find mispriced assets. The degree of market efficiency on a market is closely related to the transaction costs faced in trading on the market: lower transaction costs are associated with enhanced levels of market efficiency. India's markets have experienced a dramatic drop in transaction costs in last three years which has raised the degree of market efficiency on the market. This makes active funds management harder.Fund management is afflicted by a conflict of interest between employees of mutual funds and the investors they represent. These could be at many levels like manager might not fully exert his mind when making decisions, or a fund manager might tend to be long on securities where he has other interests, or a fund might have a situation in trading whereby some insiders help others to frontrun against the fund. In summery, agency conflicts distinguish the potential trading profits of individual traders (working for themselves, without any conflicts of interests) from those of corporate entities.

Even if market inefficiencies exist which can be exploited by individual traders, the leakages of performance in a corporate entity might make it difficult for active mutual funds to benefit from them. Thus, in order to overcome the hurdle of relative efficiency of the market faced by the fund managers, it is necessary that fund managers adopt some effective strategies like: becoming aware of the market efficiency, frequent performance evaluation, avoiding highly competitive stocks while not getting stuck with illiquid portfolios and using index funds.

The solution in this context, which is unfortunately not yet practical in India, is to use index futures, which allow a full delinking of the two objectives -- choice of stocks and choice of overall equity exposure. Once index futures become available, it would become safe to focus on less researched, illiquid stocks, since the beta of the fund could always be modified using the futures if needed. The index fund assures no prospect of outperforming the index, but will make the top quartile of mutual fund universe.

High tracking error in Indian funds: A further problem, specific to emerging funds markets, and certainly to Indian local funds i that the risk numbers are very subject to NAV reporting practices and portfolio evaluation methods. Tracking error is very high for Indian funds, running in a range of 11 to 15 against 4-6 in Thailand and 8-11 in Taiwan.

Need for better reporting standards: Performance evaluation of mutual funds -- anywhere between New York and outer Mongolia -- is always undertaken with some objective or other in mind, and that objective will determine the appropriate methodology and performance measurement yardstick.

Unless reporting standards in the mutual funds industry are of a sufficient standard to permit the calculation of the raw ingredients, there can be no evaluation. The degree of difficulty varies from place to place and if this basis level of disclosure is not there as a matter of course, the uncertainty increases the risk and this renders the fund less attractive.

Fund performance in India is no different to performance evaluation anywhere else. There is however, a great need for a better established set of reporting requirements and standards of performance reporting practice. If NAV in India were reported weekly to the national stock exchanges, this would result in a transparency which would help attract overseas local investor. The perfect example in Asia is Thailand where all 70-plus funds value NAVs on Friday and report the following Monday (Tuesday, if late) release full portfolio holdings monthly, and have dividend information readily available. The fund holder takes the risk, and pays the fund management fee, therefore surely has a right to the basic information which would allow a reasonable assessment of risk and return. The most important need for the progress of the mutual fund industry in India is a well established reporting standards.

(Extracted from "The future of fund management in India 1997", edited by Tushar Waghmare)

The author is an assistant professor at the Indira Gandhi Institute of Development Research

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.