Should You Go By Rolling Returns Or The P2P Model? 

Rolling returns capture the market events, volatility and skills of fund managers.

There is not only a fervent debate between active and passive fund management, there is a conscious shift happening in favour of passive. For valid reasons, investors prefer to save on the fund management expenses, particularly if outperformance against benchmark is not happening in active funds. Having said that, let us look at it in perspective. The usual way performance is measured, to compare actively managed funds with benchmark, is point-to-point (P2P) returns over time periods like 1 year, 3 years, 5 years, etc. Over these time periods, the returns delivered by an actively managed fund is compared with the total return index (TRI) benchmark. The outperformance or underperformance is easy to make out, which is given by the return differential. However, there is another angle to it.

There is a study by Union Mutual Fund on relative performance of active funds with their respective benchmarks. This study is done on the basis of daily rolling returns rather than P2P returns. Daily rolling means take the NAV (net asset value) of that day, compare with the NAV of previous day, compute one day’s return. Follow the same process for the benchmark returns, and do the performance comparison of fund-with-benchmark for each day. The difference between the two methods of comparison is that P2P is a “single date” approach whereas rolling method takes all the dates in that period in consideration. In this context, “single date” means today’s NAV is taken, the NAVs 1 year ago, 3 years ago and 5 years ago are taken, and the comparison is done. It ignores the data throughout the year and throughout the time period. In the multiple interim periods, the fund may have outperformed or underperformed the benchmark. Rolling returns capture the market events, volatility and fund manager’s skills, that are ignored in the P2P method.

The result of the study shows that till 30 September 2021, on the conventional basis of computation, more active funds underperformed their benchmark. To give some numbers, considering all MF (mutual fund) schemes, on 1-year horizon, only 36% funds could beat the benchmark, over 3 years 41% did better than the benchmark and over 5 years, only 29% did better. The outcome is upended on rolling return method of computation. Till 30 September 2021, considering all MF schemes, on 1-year horizon, 53% funds beat the benchmark (against 36% mentioned earlier), over 3 years 58% did better (against 41% earlier), and over 5 years it is as much as 62% against 29% in the conventional method. For more details, in the large-cap funds category, less than 50% funds could beat the benchmark over 1, 3 and 5 years. There is a reason for this: in the large-cap category, the playing arena for the fund manager is limited to 100 stocks and it is only so much that they can do to outperform. In other fund categories, more than 50% funds have outperformed, which upends the result of the P2P approach. In particular, small cap funds category stands out: over 1, 3 and 5 years, 71%, 81% and 86% funds, respectively, have outperformed the benchmark on rolling returns basis.

What does this mean for you? It is not a one-to-one correspondence that in a passively managed fund e.g. index fund or ETF (exchange-traded fund), you are better off because you are charged lower fund management expenses than an actively managed fund. There is an advantage though; in an active fund, the fund manager, to beat the benchmark, has to do as much better to recover the higher expenses and then outperform. To be noted, the data given above is on fund NAV which is anyways net of fund management expenses. Hence the active funds that have done better than the benchmark index, have done so after making up the handicap of expenses higher than passive ones.

Another difference between active and passive is that actively managed funds may have a relatively higher cash-equivalent component, as a fund manager decision, during frenzied market conditions. In passively managed funds, the cash-equivalent component is on the lower side, say less than 1%. Allocation to cash is a drag on performance in a bull market, but is handy when the market is correcting.

What should you do? In the large-cap funds category, since less than 50% funds have outperformed the benchmark even on rolling return basis, you may allocate to the better-performing actively managed funds and ETFs/index funds. In the small-cap category, the canvas for stock-picking is much bigger; it is about the fund manager’s skills in active funds. In other categories like mid-cap, large-and-mid-cap, more than 50% funds have outperformed the benchmark on a rolling basis. Hence, in categories other than large-cap, you may have a larger allocation to actives.


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