The Indian mutual fund industry has seen consistent growth over the past 20 odd years. Moreover, recent years have seen large inflows, both through the one-time as well as the Systematic Investment Plan or SIP route, showing a growing appetite for equities among Indian investors. Given the wide variety of fund houses and schemes on offer, how do you narrow down your choices?
Unsurprisingly, the primary factor that influences an investor’s decision is past return, which is (against the advice of all disclaimers) taken as a proxy for future returns. Beyond absolute returns, the only aspect that may receive some consideration from potential investors is whether the fund has beaten its stated benchmark, which is typically a market index like Sensex, Nifty or BSE-200.
However, what actually drives returns is something that is closely studied in academic circles but largely ignored by retail investors. One factor is somewhat easily understood: the fund manager’s skill and track record. Another factor that has received some attention is diseconomies of scale. For two schemes that are exactly the same, the smaller one will deliver better returns due to its relative nimbleness in entering and exiting the market. In comparison, the larger fund would suffer from higher impact costs and more illiquidity. But can competitive intensity – as measured by the number of funds investing in the same segment with the same objectives – be a factor influencing returns?
Professor Nitin Kumar, an expert in the Finance area at the Indian School of Business, working alongside co-authors Professors Gerard Hoberg from the Marshall School of Business at the University of Southern California and Nagpurnanand Prabhala from the Robert H. Smith School of Business at the University of Maryland set out to answer this question. In the course of their research, these researchers have helped develop counterintuitive and valuable insights on the business of managing mutual funds and more importantly, the optimal strategies for investing in them.
Mutual fund performance has to be seen in light of peer group performance. Traditionally, peer groups have been thought of as those with similar investing styles and preferences. According to Professor Nitin Kumar, “style definition for funds has largely been constant for over 25 years now. The investment management industry has changed a lot in this time and hence new ways to bucket funds seem overdue.”
However, according to the authors, how a fund should be classified and compared is not as straightforward as some investors, or even mutual funds themselves, assume. Even the broad market benchmarks that are used to compare fund returns are not realistic. This drove the authors to answer the key questions:
- How do you define competition or the peer group?
- How can competitive intensity be reliably measured using objective metrics?
- Does competitive intensity influence returns?