Longterm, we have a bull ride on

Indian equity markets are dancing to subprime tunes, giving investors sleepless nights. But if you are a mutual fund investor, you might as well take a vacation. In the past five years, 81% of diversified equity funds managed to outperform (give higher) Sensex returns. This is an encouraging statistic, underscoring the need for investors to look at a long-term investment horizon.

For short-term investors though, there are lots of grey areas. In fact, there is only bad news, since the extent of outperformance has been widely fluctuating. In 2007, 68% of equity funds have managed to outperform the Sensex. This is an improvement from the 21% level in 2006 and 40% in 2005.

A historical study reveals that fund managers have traditionally relied on mid-caps to beat the Sensex. So equity funds gave higher returns than the Sensex whenever mid-cap indices outperformed large-cap indices. Mid-caps, as measured by the S&P CNX Midcap, gave higher returns than the Sensex in the calendar year 2002, 2003 and 2004. And in all these years, the extent of outperformance was high, with upwards of 90%.

But subsequently, in 2005 and 2006, the Sensex ended up giving higher returns than mid caps. This led to many equity fund managers, especially those heavy on midcaps, underperforming the Sensex. Only 40% of equity funds managed to beat the Sensex returns in 2005 and 21% in 2006. During 2007, midcaps have managed to give slightly higher returns than the Sensex so far and the extent of outperformance has improved tremendously.

Is the fact that equity fund performance is linked to mid-cap performance a cause for concern? Not really for long-term investors. While over the single year periods, there has been greater vacillation in performance, the statistics are encouraging over the long-term periods. For instance, in the past five years, 81% managed to beat the Sensex returns. It is 59% and 58%, respectively, for one and three year periods.

Another interesting trend has been that of fund managers finding it relatively easy to beat the Sensex in a bull run than in a bear run. In the past 15 years, there has been four years of 10% plus correction in Sensex values in 1995, 1998, 2000 and 2001. And except during 1998 — when the outperformance was 90% — in all the other years, the outperformance figures were 50% or lesser. With bearish phases existing in the current market, this is a cause of concern for the short-term investor.

With the launch of many variants of equity funds, outperformance might become a tad tougher. This is because a mid-cap fund would be benchmarked with a mid-cap index and not Sensex or BSE 200. Similarly, a broad-market fund would benchmark with a broad-market index like BSE 200 and not a large-cap index like Sensex. While there used to be only one equity fund in the past, which invested across market caps, now there would be a greater focus. Expect lot of action ahead for active fund managers in the equity market.