Do Indian Mutual funds with high risk adjusted returns show more stability during an Economic downturn?

Do Indian Mutual funds with high risk adjusted returns show more stability during an Economic downturn? Kalpakam. G, Faculty Finance, KJ Somaiya Institute of management Studies & Research, Mumbai. India. P.G. Gopalakrishnan, Principal, SIWS College of Commerce and Economis, Mumbai, India. Abstract The various performance parameters like returns, risk adjusted returns, risk, etc do not indicate the ranking of top performers and poor performers in the same order and they are contradictory. This paper is an attempt to develop a different way of exhibiting the risk adjusted returns of midcap mutual funds in India. The present study examines whether past high alphas in a fund can show better stability during a downturn. This study covers a period of seven years with two bull and bear phases each. The results indicate that there is hardly any relation between the returns and alpha except the midcaps which also invest partly in largecaps and therefore extremely difficult for an investor to predict the performance of a midcap fund in an economic downturn in an emerging market like in India. The past good performance does not promise any better performance during an economic downturn. 1

1. Introduction A mutual fund company s website apart from exhibiting the Net Asset values (NAV) of its schemes, also exhibits various information about past performance like returns, several risk adjusted returns like Sharpe ratio, Treynor ratio, Jensons alpha, risk measures like beta and standard deviation, etc. The various parameters of performance give a contradicting opinion making the choice of investment very confusing. Mutual funds are a primary vehicle for channelising savings of small investors into financial markets. Given that the size of the industry is growing and its implications for financial markets, it is important to comprehensively evaluate the schemes offered by these mutual funds. Midcap mutual funds stand out in emerging markets like in India and particularly in a rising market where investors are opting for midcap funds due to outstanding performance in recent times. The performance evaluation will throw light on mutual fund managers who generate better alphas due to better security selection skills and whether that this ability persists, allowing astute investors to predict performance from past results. From an academic perspective, the existence of any relation between two parameters can enhance portfolio disclosures. It is well documented in finance literature about mutual fund persistence. Hendricks Hendricks, Patel, and Zeckhauser (1993), Goetzmann and Ibbotson (1994), Brown and Goetzmann (1995), and Wermers (1996) find evidence of persistence in mutual fund performance over short-term horizons of one to three years, and attribute the persistence to "hot hands" or common investment strategies. Grinblatt and Titman (1992), Elton, Gruber, Das, and Hlavka (1993), and Elton, Gruber, Das, and Blake (1996) document mutual fund return predictability over longer horizons of five to ten years, and attribute this to manager differential information or stock-picking talent. Contrary evidence comes from Jensen (1969), who does not find that good subsequent performance follows good past performance. Funds with past high alphas demonstrate relatively higher alphas and expected returns in subsequent periods Carhart on persistence in Mutual Fund Performance. The present study examines whether past high Alphas in a fund can show better stability during a downturn. The period under study is 78 months between January 2008 till June 2014 wherein there are two up markets and two down markets in Indian mutual fund industry. The objective of this paper is to determine empirically if there exists any relation between the performance parameters such as the returns generated by a fund and other risk adjusted returns. Can we as investors relate one parameter to the other? This study specifically examines the following propositions. Is there a relation between returns generated by a fund and the risk adjusted returns viz Jensons Alpha? Does a past cumulative high Alpha predict a 2

future performance in a economic downturn? Do the abnormal returns generated during a galloping market by a fund manager protect the investors wealth in the worst times which is more important given that these funds are highly risky? Do the trading strategies of the fund manager good enough to tide through bad times in the market? The study contributes to the literature in two ways. Firstly, it provides evidence about the relation of returns versus risk adjusted returns during the different phases of the stock market. The study covers seven years in the immediate past with two bull and bear phases each in an emerging market like India. Secondly this study provides a new way to look at the risk adjusted returns. As of now Asset management companies exhibit returns for the past 1 year, 3 year, 5 year and since inception cumulatively but not for risk adjusted returns. This evidence can help the regulators to introduce a different method of exhibiting risk adjusted returns ie. cumulatively 2. Data and Methodology The 2014 NAVIndia mutual fund database of Capitaline India was used to extract monthly NAV under growth option for the period between January 2008 to June 2014 for Indian equity mutual funds. Midcap equity mutual fund data for two types of funds were chosen viz. schemes that invest in mid and smallcap companies and secondly schemes that invest in mid and large cap companies were selected for this study. Six schemes in each of these two categories were selected based on star ratings of at least four or five with a large Assets Under Management (AUM) in the respective category. These schemes contribute to more than 60 percent of AUMs in the category implying that a large number of investors decision is impacted by this study. This resulted in a sample for 78 months covering 12 schemes. For performance comparison, the CNX Midcap was used as a proxy for the domestic market portfolio, and the monthly return on the 91 day RBI T-Bill was used as a proxy for the risk-free rate. 91 day T Bill rates have been used as it is the practice in the industry. Monthly returns on the CNX Midcap and the RBI T-Bill were obtained from National Stock Exchange website and T-Bill rates from RBI websites respectively. Proclamations of mutual fund performance, especially when equity funds outperform a widely quoted benchmark, abound in the popular press. However, the need to surpass the return on the benchmark may incline the manager towards a risky portfolio. Risk-adjusted measures of performance are therefore more appropriate in the assessment of returns generated by mutual funds. Jenson s Alpha a risk adjusted measure and annualized returns were used in this study. A line chart with the CNX Midcap data was drawn to indicate the 3

NAV Date 6/1/2007 9/1/2007 12/1/2007 3/1/2008 6/1/2008 9/1/2008 12/1/2008 3/1/2009 6/1/2009 9/1/2009 12/1/2009 3/1/2010 6/1/2010 9/1/2010 12/1/2010 3/1/2011 6/1/2011 9/1/2011 12/1/2011 3/1/2012 6/1/2012 9/1/2012 12/1/2012 3/1/2013 6/1/2013 9/1/2013 12/1/2013 3/1/2014 6/1/2014 Proceedings of the First Middle East Conference on Global Business, Economics, Finance and Banking trend from January 2008 till June 2014. The entire period under this study gives us two spans of bull market and two spans of bear markets as given in graph 1 below. 12000.00 10000.00 8000.00 6000.00 Graph 1: CNX Midcap Trendline CNX Midcap 4000.00 2000.00 CNX Midcap 0.00 Since the midcap mutual fund portfolio being evaluated is a diversified portfolio (meaning that the unsystematic risk has been eliminated), and because a diversified portfolio's main source of risk is market risk (or systematic risk), beta is an appropriate measure of that risk. Alpha is used to determine by how much the realized return of the portfolio varies from the required return, as determined by CAPM. The formula for alpha is expressed as follows: α = Rp [Rf + (Rm Rf) β] Where: Rp = Realized return of portfolio Rm = Market return Rf = risk-free rate The annualized return and risk-adjusted performances ie Jensosns alpha of the two samples were compared in up and down domestic markets. The ability of the fund managers to adjust their portfolio in response to market conditions was investigated. 3. Tests and Results Table 1 shows the returns and alpha of some of the best funds in the midcap with largecap category. It can be observed that the ranking of Returns and Alpha are not in same ranking for this sample. It is matching to some extent during 2008-09 downturn as well as December 2010-12 downturn but very different during the other two periods. 4

Table 1: Fund Returns & Alpha of Midcap with Largecap equities Birla Sun Life Frontline E F (G) HDFC Capital Builder - (G) HDFC Equity Fund - (G) ICICI Pru Dynamic Plan (G) Quantum Long-Term Equity Fund (G) Annualised Returns SBI Magnum Multiplier Plus 93 (G) Jan 2008-Mar2009-56.07-68.20-61.25-50.72-51.42-65.55 Rank 3 6 4 1 2 5 Apr 2009-Nov2010 58.89 65.30 73.71 54.35 65.67 58.40 Rank 4 3 1 6 2 5 Dec 2010-Jan2012-21.63-22.59-27.42-17.50-17.98-27.12 Rank 3 4 6 1 2 5 Feb 2012- jun 2014 27.29 26.27 29.15 27.25 25.93 26.56 Rank 2 5 1 3 6 4 Jensons Alpha Jan 2008-Mar2009-0.53-11.75-1.01 8.02 4.18-11.78 Rank 3 5 4 1 2 6 Apr 2009-Nov2010-3.43 14.49 13.91 13.66 10.80 1.72 Rank 6 1 2 3 4 5 Dec 2010- Jan2012 7.20 5.82 4.18 7.74 6.55 4.55 Rank 2 4 6 1 3 5 Feb 2012- Jun2014 6.32 6.15 4.07 7.68 5.09 6.56 Rank 3 4 6 1 5 2 Source: Navindia of Capitaline Similarly Table 2 depicts the Annualised Returns and Jensons Alpha of midcap schemes with investments in mid and smallcap equities. The two performance evaluation measures are in no way synchronized with each other. 5

Table 2: Fund Returns & Alpha of Midcap with small cap equities DSP BR Small And Mid Cap Fund Franklin India Prima Fund HDFC Mid- Cap Opportuniti es Fund ICICI Pru Value Discovery Fund Reliance Equity Opportunities Fund Annualised Returns UTI-Mid Cap Fund Jan 2008-Mar 2009-75.46-83.66-64.36-66.07-70.98-79.52 Rank 4 6 1 2 3 5 Apr 2009-Nov 2010 78.82 71.94 70.16 77.45 74.64 71.28 Rank 1 5 6 2 3 5 Dec 2010- Jan2012-29.33-24.40-18.24-22.33-20.22-25.95 Rank 6 4 1 3 2 5 Feb 2012- jun 2014 33.04 33.15 33.56 35.83 30.84 35.74 Rank 5 4 3 1 6 2 Jenson s Alpha Jan 2008-Mar 2009-18.12-18.44-9.02 1.58-7.24-12.92 Rank 5 6 3 1 2 4 Apr 2009-Nov 2010 8.31 2.44 18.34 17.91 13.57 5.03 Rank 4 6 1 2 3 5 Dec 2010- Jan 2012 12.74 7.86 15.77 7.38 14.35 12.92 Rank 4 5 1 6 2 3 Feb 2012- jun 2014 7.35 11.77 11.09 12.69 8.57 12.62 Rank 6 3 4 1 5 Source: Navindia of Capitaline The correlation coefficient and its significance was calculated to study whether the annualized returns and the alpha generated by a fund are related and to what extent, Table3 shows the correlation between the annualized returns and alpha for the two rising markets and two downturn markets between 2008 and 2014 for Equities: Midcap and Largecap covering a period of 78 months. The Pearsons correlation is O.959 during the downturn from January 2008 till March 2009 and p=0.002 indicating that the relationship between returns and alpha is statistically significant and therefore reject the null hypothesis that Returns and Alpha are not related. In other words, during a downturn as in 2008, returns and alpha go together. Investors can rely on any of them and take a decision. In the period between April 2009 and November 2010 when the markets were rising the correlation was only 0.434 which is not very strong and the null hypothesis is not rejected to mean that there is no relation between returns and alpha. Investors will find the two parameters confusing. 6

Table 3: Correlation of Equities:Midcap and Largecap Returns with Alpha January08-March 2009.959(**) Sig. (2-tailed).002 April 2009-November 2010.434 Sig. (2-tailed).390 December2010- January 2012 February 2012-June 2014 *Is significant at the 0.05 level **it is significant at the 0.05 level.911(*) Sig. (2-tailed).012 -.422 Sig. (2-tailed).405 The correlation is high at 0.911 during the downturn between December 2010 and January 2012 and is significant with a p value of 0.012 implying that returns and alpha go hand in hand. It can be observed that there is very little negative correlation in a rising market as in February 2012 to June 2014. In short the returns and alpha go together in a downturn while there is hardly any correlation during a rising market. Can this mean that the returns are commensurate with the risk taken by the fund manager during a downturn? The largecap equities provide the needed stability during a downturn. We now analyse equities Midcap with smallcap. Table 4 gives the correlation between the annualized returns and alpha for the two rising market and two downturn markets between 2008 and 2014 Table 4: Correlation of Equities: Midcap and Smallcap Returns with Alpha January 2008-.773 March 2009 April 2009- November 2010 December 2010- January 2012 February 2012- June 2014 Sig. (2-tailed).071.155 Sig. (2-tailed).770.280 Sig. (2-tailed).591.758 Sig. (2-tailed).081 The Pearson s correlation in the downturn of 2008-09 is 0.773 which is a high positive correlation but it is not significant (p=0.071). Similarly there is neither correlation nor is 7

it statistically significant in the up market during April 2009 till November 2010. During December 2010 till January 2012 and February 2012 till June 2014 the p values are 0.591 and 0.081 respectively. The null hypothesis that returns are not related to alpha is not rejected in any of the four periods. The results described above shows that the returns generated by a fund cannot be related to the excess returns like alpha in respect of Mid and smallcap funds but shows better relation during downturn with respect to mid and largecap funds. As compared to the benchmark CNX Midcap and the risk taken by the fund, the returns may or may not be commensurate. Fund managers try to make the most of it for generating returns without much consideration to its benchmark. The study attempted to establish a new performance parameter viz. cumulative alpha for the period under study which sufficiently covers a long horizon of seven years. The total monthly alpha generated over the entire period under study was calculated for each fund under both the categories ie. equities with Mid and largecap and equity funds with Mid and smallcap. The cumulative monthly alpha is compared to the returns for each period. Funds with past high alphas, can they show better stability during a downturn? Academically it should because funds that generate high alpha should do better or rather lesser losses during a downturn. This can help investors to limit their losses in the most risky times. Table 5 shows the Spearman s correlation between the cumulative alphas and the returns with its significance with respect to Mid and Largecap funds. The results show that during the downturn in 2008-09, the correlation is not significant statistically as the p value is >.05 at 0.208 and the null hypothesis is not rejected. Similarly during the down markets in 2010-12 the p value is 0.468 which is not statistically significant. It can be inferred that the cumulative alphas do not indicate the likelihood of a fund performing more stable during a downturn. 8

Table 5: Spearman s Correlation of Equities: Midcap and Largecap Returns with Total Alpha Total alpha with returns January 2008- March 2009 Correlation Coefficient.600 Sig. (2-tailed).208 April 2009- November 2010 December 2010- January 2012 February 2012- June 2014 Correlation Coefficient.486 Sig. (2-tailed).329 Correlation Coefficient.371 Sig. (2-tailed).468 Correlation Coefficient.029 Sig. (2-tailed).957 An analysis of the results of funds in mid and smallcap category as in Table 6 shows the Spearman s correlation coefficient shows 0.543 and not statistically significant during 2008-09. Therefore we do not reject the null hypothesis. The other three periods also do not indicate that they are statistically significant. Table 6: Spearman s Correlation of Equities: Midcap and Smallcap Returns with Total Alpha Total Alpha with returns January 2008- March 2009 Correlation Coefficient.543 Sig. (2-tailed).266 April 2009- November 2010 December 2010- January 2012 February 2012- June 2014 Correlation Coefficient -.143 Sig. (2-tailed).787 Correlation Coefficient.257 Sig. (2-tailed).623 Correlation Coefficient.771 Sig. (2-tailed).072 4. Conclusion In this paper an attempt was made to evaluate the relation and direction of the two mutual fund performance measures viz Annualised returns and excess returns generated by a 9

portfolio -Jenson s alpha for two types of funds ie. Midcaps with largecap and midcaps with smallcaps, The findings reveal a good relationship and show a significant relation for midcaps funds with a largecap component only during the downturn while there is no relationship between the two for midcaps with smallcap investments. The largecap component generates better returns (lesser losses) during a downturn which is not the case for midcaps with smallcaps because of their low beta and provide the much needed stability. The cumulative alpha which measures the long term excess return of a fund does not seem to show any direction in the funds performance either during downturn or during the up markets which indicates that for funds in emerging markets like in India there is hardly any evidence that past good performers show more stability during a downturn. As for the investors, when there is a contradiction, ultimately if the returns are decent during the past years, investors would do well to pick such funds and alphas would be taken care. References Bollen, N. and J. Busse, 2005, "Short-Term Persistence in Mutual Fund Performance", Working Paper. Brown, S., and W. Goetzmann, 1995, "Performance Persistence", Journal of Finance, 50, 679-698. [ISI] Carhart, M., 1997, "On Persistence in Mutual Fund Performance", Journal of Finance, 52, 57-82. [ISI] Daniel, K., M. Grinblatt, S., Titman, and R. Wermers, 1997, "Measuring Mutual Fund Performance with Characteristic-Based Benchmarks", Journal of Finance, 52, 1035-1058. [ISI] Elton, E., M. Gruber, S. Das, and M. Hlavka, 1992, "Efficiency with Costly Information: A Reinterpretation of the Evidence for Managed Portfolios", Review of Financial Studies, 6, 1-22.[ISI] Goetzmann, W., and R. Ibbotson, 1994, "Do Winners Repeat? Patterns in Mutual Fund Performance", Journal of Portfolio Management, 20, 9-18. Grinblatt, Mark, S. Titman, and R. Wermers, 1995, "Momentum investment strategies, portfolio, performance and herding: A study of mutual fund behavior, American Economic Review, 85, 1088-1105 [ISI]. Gruber, M. 1996, "Another Puzzle: The Growth in Actively Managed Mutual Funds", Journal of Finance, 51, 783-810. [ISI] Hendricks, D., J. Patel, and R. Zeckhauser, 1993, "Hot Hands in Mutual Funds: Short- Run Persistence of Performance, 1974-1988", Journal of Finance, 48, 93-130.[ISI] 10

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