Myth of Predictable Alpha

A look at consistency of out/underperformance of Active Fund Managers in India

"Wall Street's favorite scam is pretending luck is skill." - Ron Ross, Ph. D. Economist In our study titled "Myth of Eternal Alpha" we tracked outperformance of actively managed large cap mutual funds, in India, as a group. The data clearly shows that in the aggregate they have underperformed on three year rolling return basis over the past two years. We felt that with such indisputable data the case for indexing is settled in favor of passive investing. However we have experienced that investors/advisors have always argued and reiterated that aggregate underperformance does not concern them-as they can yet pick future winners mainly using past performance among other parameters! We have always believed that being in top quartile is a random event and that past performance is a poor indicator in picking future winners. Hence we decided to do a systematic study of predictability of fund manager outperformance. Our study answers two basic questions (1) How consistent are top quartile/top half of the actively managed mutual fund schemes? Is top quartile slot a random event or can it be predicted with any degree of consistency by using past data? (2) What percentage of future top quartile schemes come from prior periods 4th quartile (or Top quartile) and also from 3rd, 2nd, 1st quartile (or Bottom quartile) -those schemes which are often ignored by financial advisors or consultants. METHODOLOGY: (A) All Diversified Equity Schemes with at least 3 calendar years (as of Dec 31, 09) track record are considered. (Total 163 Schemes: Large Cap Schemes 111 & Mid Cap Schemes 52). (B) Calendar year absolute returns upto past 3 years have been considered. (C) All the performances are calculated for growth/dividend reinvestment plan. ANALYSIS 1: PERFORMANCE PERSISTENCE OVER THREE CONSECUTIVE 12-MONTH PERIODS. If fund management is a skill, which can be repeated, then most of the top quartile fund managers shall be in top quartile next year and year after that. But if we assume it is a random event then laws of probability shall apply. In such a scenario only 6.25% of total funds should repeat top quartile performance a year later and 1.56% of the original sample should remain in top quartile three times in a row. For example, if there are 200 schemes considered for analysis, then at the end of first year 25% (or 50 schemes) of the total schemes should be in top quartile. By law of probability, 25% of the 50 schemes (which were in top quartile at the end of first year) i.e 12.5 schemes or 6.25% of the total schemes should be in the top quartile at the end of the second year (25% * 50 Schemes = 12.5 Schemes & 12.5 schemes as percentage of 200 schemes = 6.25%). 25% of the 12.5 schemes (which were in top quartile at the end of second year) i.e 3.125 schemes or 1.56% of the total schemes should be in the top quartile at the end of the third year (25% * 12.5 Schemes = 3.125 Schemes & 3.125 schemes as percentage of 200 schemes = 1.56%). The actual results prove that amongst the large cap group less than 5% of the total schemes under analysis could repeat the feat of being in top quartile in subsequent year and less than 1% in the year after that. Mid Cap group is even worse than large cap.

A similar analysis for top half is also very close to its probabilistic value. Of the entire sample, the number of funds, which repeat the feat in the subsequent year, shall be 25% and those that did thrice in a row will be 12.5%. The actual figures are very close to that. Thus it clearly shows that fund returns are random and independent of prior returns. Past performance clearly has little or no predictive value going forward. Superior performance has more association with luck; is a matter of chance and has less correlation with skill. Note: 4th quartile is the top quartile and 1st quartile is the bottom quartile. Analysis 1 : Performance Persistence over Three Consecutive 12-Month Periods Mutual Fund Category Diversified - Large Cap + Mid Cap Funds Diversified - Large-Cap Funds Diversified - Mid-Cap Funds Fund Count on Dec-07 163 111 52 % Remaining in Top Quartile Dec-08 4.91% 4.50% 5.77% Dec-09 0.00% 0.90% 0.00%

Mutual Fund Category Diversified - Large Cap + Mid Cap Funds Diversified - Large-Cap Funds Diversified - Mid-Cap Funds
Source: MFI Explorer & Internal.

Fund Count on Dec-07 163 111 52

% Remaining in Top Half Dec-08 23.31% 24.32% 26.92% Dec-09 11.04% 13.51% 11.54%

Note: (a) Diversified Equity schemes include Diversified as well as Tax Planning schemes as per classification of MFI Explorer. (b) Large Cap & Mid Cap scheme classification is as per MFI Explorer which is based on Dec.31, 09 portfolio of the schemes under analysis. ANALYSIS 2: PERFORMANCE OVER TWO NON-OVERLAPPING ONE-YEAR PERIOD. The data from analysis 1 suggests that almost none of the top quartile funds in the prior period managed to consistently retain their top quartile position or rank. Since the repeat performance rate of top quartile schemes is very low or negligible, the logical question which arises is: from where do future top quartile performers come from?? To answer this nagging question we decided to screen the top quartile funds so as to find out the prior periods top and lower quartiles funds contribution to future top quartile funds. The table shown below (Analysis 2) confirms that only 9.76% (4 out of 41 funds) Large Cap plus Mid Cap funds taken together with a top quartile ranking over one year ending Dec. 08 could maintain top quartile ranking in the subsequent year ending Dec. 09. This also implies that around 90% (37 out of 41 funds) of the top quartile Large Cap plus Mid Cap funds taken together as on Dec. 08 slipped to lower quartiles as on Dec. 09. Only 17.86% (5 out of 28 funds) Large Cap funds and 7.69% Mid Cap funds (1 out of 13 funds) with a top quartile ranking over one year ending Dec. 08 could maintain a top quartile ranking in the subsequent year ending Dec. 09, which also means that around 82% (23 out of 28 funds) of the top quartile Large Cap funds and around 92% (12 out of 13 funds) of the top quartile Mid Cap funds as on Dec. 08 slipped to lower quartiles as on Dec. 09. Note: 4th quartile is the top quartile and 1st quartile is the bottom quartile.

Analysis 2 : Performance Over Two Non-Overlapping One-Year Period (Based on Quartiles). Period 1: Jan 08-Dec 08. Period 2: Jan 09-Dec 09.
One Year Percentages as on Dec.2009 Fund Count on Dec-08 <--------Top Quartile------------------Bottom Quartile--------> 4th Quartile (%) 3rd Quartile (%) 2nd Quartile (%) 1st Quartile (%) Total (%)

Diversified-Large Cap+ Mid Cap Funds 4th Quartile (Dec. 08) 3rd Quartile (Dec. 08) 2nd Quartile (Dec. 08) 1st Quartile (Dec. 08) Large Cap Funds 4th Quartile (Dec. 08) 3rd Quartile (Dec. 08) 2nd Quartile (Dec. 08) 1st Quartile (Dec. 08) Mid Cap Funds 4th Quartile (Dec. 08) 3rd Quartile (Dec. 08) 2nd Quartile (Dec. 08) 1st Quartile (Dec. 08)
Source: MFI Explorer & Internal.

41 41 40 41 28 28 27 28 13 13 13 13

9.76% 17.07% 30.00% 43.90% 17.86% 42.86% 22.22% 17.86% 7.69% 46.15% 23.08% 23.08%

19.51% 39.02% 20.00% 21.95% 17.86% 28.57% 29.63% 25.00% 23.08% 15.38% 30.77% 30.77%

39.02% 19.51% 27.50% 12.20% 35.71% 17.86% 18.52% 25.00% 23.08% 15.38% 30.77% 30.77%

31.71% 24.39% 22.50% 21.95% 28.57% 10.71% 29.63% 32.14% 46.15% 23.08% 15.38% 15.38%

100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Note: (a) Diversified Equity schemes include Diversified as well as Tax Planning schemes as per classification of MFI Explorer. (b) Large Cap & Mid Cap scheme classification is as per MFI Explorer which is based on Dec.31, 09 portfolio of the schemes under analysis. CONCLUSION The phrase "Past performance may/may not be sustained in future" is a common fine print line found in all mutual fund literature. Yet due to either force of habit or conviction, fund pickers consider past performance and related metrics to be important factors in fund selection for picking future winners. The low/negligible count of consistent top performers suggests that using past performance data to pick future winners is roughly equivalent to rolling the dice or even worsen than that. It is the equivalent of hunting for a needle in a haystack. The research report "Myth of Eternal Alpha" concludes that All Active diversified equity funds as a group are underperforming index And this report "Myth of Predictable Alpha" concludes that Outperforming index is a random event and it is sheer luck. Past performance has little or no predictive value for the future. It is the equivalent of driving a car forward by looking into the rear view mirror. Thus the only logical choice for the investor, who is looking to have long-term equity allocation in his /her portfolio, is to use broad market index fund. Note: Benchmark Asset Management Co. Pvt. Ltd. has not classified any schemes which from part of this study. The intention of this study is not to rank the schemes and they do not constitute rankings. This study is for research purposes only.

STATUTORY DETAILS: Constitution: Benchmark Mutual Fund has been set up as a Trust under the Indian Trust Act, 1882. Trustee: Benchmark Trustee Company Pvt. Ltd. Investment Manager: Benchmark Asset Management Company Pvt. Ltd. Sponsor: Niche Financial Services Pvt. Ltd. RISK FACTORS 1. All Mutual funds and securities investments are subject to market risks and there can be no assurance or guarantee that the objective of the Schemes will be achieved. 2. As with any investment in securities, the Net Asset Value (NAV) of the units issued under the Schemes can go up or down depending on the factors and forces affecting the securities market. 3. Past performance of the Sponsors/Investment Manager/ Mutual Fund and its affiliates does not indicate the future performance of the Schemes and may not provide a basis of comparison with other investments. 4. The name of the Schemes does not in any manner indicate either the quality of the Schemes or its future prospects and the returns. Investors are therefore urged to study the terms of offer carefully and consult their Investment Advisor before they invest in the Schemes. 5. The Sponsor is not responsible or liable for any loss or shortfall resulting from the operation of the Schemes beyond the initial contribution made by it of an amount of Rs. 1 Lac towards setting up of the Mutual Fund. 6. Investors in the Schemes are not being offered any guaranteed or assured returns. 7. The Schemes NAV will react to the stock market movements. The Investor could lose money over short periods due to fluctuation in the Schemes NAV in response to factors such as economic and political developments, changes in price, value, interest rates and perceived trends in stock and securities prices, market movements, and over longer periods during market downturns. 8. The returns are not necessarily indicative of future results and may not necessarily provide a basis for comparison with other investments. 9. Past returns may or may not be sustained. 10. Please read the Scheme Information Document and Statement of Additional Information carefully before investing. 11. For Scheme specific risk factors please refer the Scheme Information Document.

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