Globally it is true that most fund managers underperform
the asset class that they are investing in. This is largely the result
of limitations inherent in the concept of mutual funds:
Fund management costs: The costs of the
fund management process that includes marketing and initial costs are
charged at the time of entry itself in the form of load. Then there are
the annual asset management fee and operating expenses. The performance
of a scheme net of these expenses lead to a relatively lower performance
vis-à-vis the index stocks.
Churning cost: The portfolio of a fund
is never static. The extent to which the portfolio changes is a function
of the style of the individual fund manager i.e. whether he is a buy and
hold type of manager or one who aggressively churns the fund. Such portfolio
changes have associated costs of brokerage, custody fees, registration
fees etc. which lowers the portfolio return commensurately.
Large size: When a large body like a mutual
fund transacts in securities, the concentrated buying or selling results
in adverse price movements. This causes the fund to transact at relatively
higher entry or lower exit prices.
Time lag for investment: Most mutual funds
receive money when markets are in a bull run and investors are willing
to try out mutual funds. Since it is difficult to invest all funds in
one day, there is some money waiting to be invested. Further, there may
be a time lag before investment opportunities are identified. This causes
the fund to realize lesser returns vis-à-vis the index stocks.
Also for open-ended funds, there is the added problem of perpetually keeping
some money in liquid assets to meet redemptions.
Change in composition of index stocks:
The composition of the indices has to change to reflect changing market
conditions. The BSE Sensex stock composition has been revamped twice in
the last 5 years, with each change being quite substantial. Another reason
for change of index composition could be Mergers & Acquisitions.
Herd mentality: Apparently, the only way
a fund can beat the index is through investment of some part of its portfolio
in some shares where it gets excellent returns, much more than the index.
This will pull up the overall average return for the scheme. In order
to obtain such exceptional returns, the fund manager might have to take
a strong view and invest in some uncommon stocks. Unfortunately, if the
fund manager does the same thing as several others, chances are that he
will produce average results.
The tendency of the fund managers to buy the popular stocks,
which are favourites among their peers, leads only to average performance
as the index.