Why diversified equity schemes continue to be the best way for investors to participate in stocks

You can pity Indian fund managers. They spend days poring over data, run dozens of checks, meet promoters and visit plants before picking a stock for their fund's portfolio. But all this effort apparently goes in vain. A study by the S&P Dow Jones Indices says a majority of the large-cap actively managed funds in India underperformed the S&P BSE 100 index in the five years ending 31 December 2014. In the threeyear period, almost 58% of these funds could not keep up with the index. The S&P Indices Versus Active Funds (SPIVA) study suggests that instead of active management, an indexbased ETF could have earned better returns. Actively managed funds may outperform the benchmark in the short term but it becomes difficult for fund managers to maintain the performance over longer periods.
However, the SPIVA study has several flaws. For one, all the funds have been benchmarked against a common index, the S&P BSE 100. Secondly, it has used the total returns index (TRI), which includes the dividends received by the stocks in the index.

But the most glaring problem is that the study assigns equal weight age to all funds. A large-sized outperformer like HDFC Equity has been given the same weightage as a tiny underperformer like Sahara Super 20 Fund.

HDFC Equity's AUM was `5,395 crore in January 2010 and the fund gave annualised returns of 20.54% in five years. The Sahara scheme had an AUM of `2.46 crore and gave 9.43%. The analysis should have removed the outliers or included a weighted average so that bigger fuund performance is not eclipsed by smaller fund's underperformance or vice versa.

If we give equal weightage to both funds, their average return is less than 15%. But if we factor in size into the calculation, it is a better indicator of how much the average rupee invested in the two funds earned. Then the average falls marginally to 20.53%. "Not using asset weighted returns gives an untrue picture of the investor experience," agrees Dhirendra Kumar of Value Research. 

To be fair, the SPIVA studies conducted in other markets give both equal-weighted as well as asset-weighted returns. But in India, paucity of data was a hurdle. In India, funds report their AUM on a quarterly basis so we don't know the exact picture. We need a black and white figure to be able to comment, 
This explains but does not justify the inference that funds find it difficult to maintain their performance in the long term. Our research shows that the asset-weighted returns of mutual fund categories are significantly higher than the equal-weighted returns. This indicates that the large-sized funds, which accounted for a sizeable portion of the total AUM in equity funds, have done better than the index. In other words, the average rupee invested in mutual funds has grown faster than the index .. 
The SPIVA study hints that index-based ETFs, which invest only in index stocks in the same proportion, are a better alternative to actively managed diversified funds that can invest in any stock. This is vehemently denied—by experts as well as empirical data. Investing in index-based funds works in mature markets like the US, not in developing markets like India where many stocks are priced below potential. Even in the US, Warren Buffett is living example that the efficient market theory is not true. In India, actively managed diversified equity funds are the best investment vehicle for small investors. The top five funds with a 10-year history have given over 20% returns compared to 16.34% delivered by the index. 
We chose five funds on the basis of their popularity 10 years ago. Investors would have earned significantly more by investing in these actively managed schemes instead of going for an index-based ETF. Not all of them were great performers. Reliance Vision, for instance, was a well regarded fund before it lost its way. Even then, it managed to deliver more than the Goldman Sachs Nifty ETF. Actively managed funds will always beat the index.