What do equity fund managers do to beat the index?

What strategies do equity fund managers use to outperform the benchmark indices? Read my article published in Gujarati Mid-day today ...

http://epaper.gujaratimidday.com//epaperpdf/gmd/07032016/07032016-md-gm-16.pdf


The English translation is as under:

How does an equity fund manager generate better returns than the index? This is a question many might have but few seem to ask. The first thing we need to understand, though obvious, is that the objective is to beat the index performance.

With this objective, the fund manager has to have a portfolio that is not exactly replicating the index portfolio. This means, the stocks in the fund portfolio may be different from the index. However, since the fund may be benchmarking against a particular index it tries to beat, the fund manager has to invest in stocks from a similar universe as the index.

A large-cap fund, benchmarking against Nifty must invest only in large-cap stocks. It cannot buy mid-cap (or small-cap) stocks only with an objective of beating the index.

There are two primary strategies that a fund manager may employ in order to outperform the index.

1.     Stock selection: This involves selecting stocks that are likely to perform better than the index over long term and / or avoiding stocks that are likely to underperform the index. The basis for such selection largely is the fundamental strengths of the company. As a variant of the same, the fund managers may employ sector rotation strategy. Mostly, the stocks are selected for long-term holding (though, not always).

2.     Market timing: The fund managers try to predict short-term price movements of the entire markets and accordingly increase / decrease their exposures into the market as a whole.

One such variation includes buying “value” stocks or “growth” stocks. A value stock is one whose market price is too low compared to the estimated value that the fund manager puts on it. The question is: how can such a thing be possible in a market that has access to all the relevant information? The reality is: It happens. However, the fund manager must be doubly sure as a stock trading at discount to its value means that either the fund manager knows something that the market does not or vice versa. The risk here being, “What if the market is right?” On the other hand, if the fund manager happens to be right, there could be lots of money to be made. Some of the legendary investors, e.g. Warren Buffett and Sir John Templeton are known to be value investors. A growth stock is one where the company is exhibiting a very high profit growth. Such companies are favourites of the markets. The market players love such stocks and want to own these. Such attraction means these stocks may be trading in the market at way above their intrinsic value. The risk here is (1) buying the stock too costly, or (2) slow down of the expected growth. However, some of the small and mid-sized companies become big when they continue to grow at high rates for long periods of time. There have been many examples of such stocks in our own markets. Many fund managers in India do not want to be bucketed in anyone of these two styles. They call themselves “style agnostic”. They claim that they would pick up a stock if their analysis suggests that it is a good buy, irrespective of whether it is growth stock or value stock. Academics term this style as “blend” – a mix of value or growth. A sub-style of value investing may be known as dividend yield strategy, in which the fund managers try to pick up stocks, with the main criteria being high and sustainable dividend yields. (Dividend yield is calculated as the dividend in Rupees divided by current market price).

Another variation of the “stock selection” strategy could be to identify a sector of the economy or an industry or a group of industries and own stocks of companies within these sectors. While in the value or growth style, the fund manager starts identifying the companies based on their individual businesses, in this method, they start with identification of sectors and then they search for companies within these sectors. The purists avoid such strategies. The risk here is that not all companies in a sector may be good and one may end up buying low quality stocks simply because the sector is hot.

The market timing is a very different strategy. The market timers, as we mentioned earlier, increase or decrease their exposure to the entire market based on the expected short-term price movements. If the fund manager expects the prices to move up, he would load up the portfolio with stocks. However, if the view is negative, the stock exposure may be reduced and accordingly the portfolio would carry large amount of cash or debt securities. Their idea is to stay away from equity markets if a fall is expected and come back just before a rally starts. This sounds very nice in theory, but is extremely difficulty (almost impossible) to do practically.

While the fund managers may be using both strategies, they primarily use stock selection or it’s variations. Many actually claim that they cannot time the markets and that they employ stock selection strategy, by selecting good stocks and avoiding bad stocks.

Whatever their belief and strategy, the objective is to beat the benchmark index.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.