Volatile markets have taken a toll on mutual funds. After three years of breathtaking performance, the law of averages seems to be catching up with actively managed funds.

On the one hand, active fund managers are being beaten down by sleepy index funds managers, who just wake up once in a while to tweak their portfolios in line with the benchmark indices. And on the other, the number of fund managers beating the Street are getting fewer by the day.

The alarming growth in the number of new launches also puts investors in a fix. Where to invest? Trust the winners of today? Or settle for the average, by choosing an appropriate index fund, which will at least give what the market as a whole delivers?

Fund managers still feel that the underperformance of funds in the past few quarters should not be taken too seriously. Because in the long-term, India being a growth story, will offer immense opportunity for the smart managers to beat the Street.

Index trailers

For the past one year ended August 2, 2006, the category that produced the best returns among mutual funds was index funds. While equity diversified funds delivered returns of 27.58 per cent, index funds delivered 32.98 per cent. A close second were technology funds that delivered 32.97 per cent.

But more disturbing is the fact that the performance of actively managed funds have been slipping. Over the past one year ended June 2006, only 42 out of the 111 equity diversified funds beat the Sensex, which delivered 47.5 per cent returns.

Similarly, only 61 funds beat the 50-share Nifty, which gave 40.9 per cent. This does not compare well with past performance. For instance, in the previous year, 62 per cent of funds managed to beat the Sensex and 71 per cent managed to beat the Nifty.

One of the reasons for funds lagging behind the Sensex is the high level of concentration in the index. For instance, Reliance Industries [Get Quote] which has a 10.84  per cent weightage in the Sensex, has been a stunning performer delivering a return of 76.5 per cent.

But fund managers were underweight on the stock. But then, the writing is still clear, as demonstrated in the performance comparison against Nifty that fund managers' show has been less exhilarating over the past one year.

Question of consistency

Moreover, an analysis of the data during the past one year shows that fund houses show a mixed performance. You cannot completely rely on one particular fund house as all the schemes of one fund house do not perform equally well.

There are schemes that have delivered superior returns, but there are others who have not managed to deliver even as much as their benchmark.

For instance, if one compares the past one year returns of diversified equity funds, one can see that two of Tata's funds, the Tata Growth Fund and Tata Midcap Fund, are amongst the worst five funds and one fund, Tata Infrastructure Fund, is in the top-five list.

Similarly, most of SBI [Get Quote] Mutual's equity schemes have registered good returns except the Magnum Emerging Businesses Fund and the Magnum FMCG Fund.

Over the past one year, the Magnum Emerging Business Fund registered only 10.9 per cent returns whereas the equity diversified funds category delivered about 27.6 per cent returns during the same period.

The Magnum FMCG Fund  registered just 10.4 per cent returns whereas the equity FMCG category delivered about 26.8 per cent returns during the same period.

An unlucky investor would be the one who invested in these two schemes. So, despite the fund house delivering an excellent performance over the past one year, this investor would be at a loss.

N Sethuram, chief investment officer, SBI Mutual Fund, mentioned two specific reasons for the underperformance: "The emerging business fund portfolio was predominantly mid-cap-oriented and mid-caps generally underperformed during the last six months."

Also, the fund had been overweight on textile stocks as Sethuram thought the quota relaxation in the textile sector in 2005 would be beneficial and textile stocks would beat the market. "The textile stocks did not live up to expectations and the fund was impacted," says Sethuram.

"Currently, mid-caps are at a discount to large caps, but once market stabilises, these will look up again and the disparity in valuations will be restored," he adds, indicating that the underperforming schemes may only be a temporary phenomena.

Explaining the underperformance of the FMCG Fund, Sethuram says, "As FMCG stocks were worst performers in 2003-04, we faced high redemption pressures in 2005 and our fund size was almost nil. Due to this, we could not participate in the FMCG rally, which had an impact on the fund's performance."

Also, UTI Mutual Fund's Infrastructure Fund, India Select Fund and Master Plus 91 delivered returns better than the benchmark. On the other hand, some of the schemes like UTI India Advantage Fund, UTI Master Value Fund and UTI Mid-cap Fund registered poor returns.

A K Sridhar, chief investment officer, UTI Mutual Fund, says, "The underperformance is because the mid-cap segment and value stocks were beaten down over the past six months."

Some fund houses, which have been relatively consistent are HDFC [Get Quote] Mutual, Franklin Templeton and Reliance Mutual. Even in these, the returns across schemes vary though the difference is not as stark.

The dilemma

If schemes belonging to the same fund house with different mandates show widely divergent returns, there is an equally big divergence in the returns generated by schemes with same themes across various fund houses.

Also, a fund house with a good track record does not guarantee good performance in future and that too across all the schemes. With such low predictability, it is very difficult for a common investor to identify which of the many schemes would deliver and which ones would not.

Ironically, even though investing through mutual funds is supposed to save investors the trouble of picking stocks, creating a portfolio and keeping track of it, the reality is, they spend time and energy tracking the many schemes from various fund houses. And even after all that one may not be sure of what returns one could end up with.

Are index funds then the best way out? Index funds invest in a basket of predefined stocks of an index, like the Sensex or the Nifty, in exactly the same proportion as the benchmark index.

Thus, they deliver returns in line with the chosen index. Also, the costs associated with index funds are less than actively managed funds since portfolio decisions are automatic and transactions are infrequent.

Be active

Even as index funds have emerged as the best equity fund category over the past one year, most market experts are of the view that over a longer horizon, active fund management will give better returns than passively managed ones.

A Balasubramanian, says "It has been observed worldwide that over a longer period of about 3 to 5 years, diversified equity funds outperform index funds," says A Balasubramanian, chief investment officer, Birla Sun Life Mutual Fund.

According to Abhay Aima, country head, equity and private banking group, HDFC Bank, the benefit of diversified equity funds over index funds is that you get a well-diversified portfolio of stocks.

In case of index funds, the portfolio is restricted to the number of stocks of the particular index. The risk appetite also plays a major role while investing. A risk-averse investor would be happier with less returns and more safety. On the contrary, a risk taker would demand higher returns in exchange for the higher risk he is willing to assume.

"Index funds are suitable for investors who do not want to take the risk of investing in individual stocks and who don't mind average returns," says Sethuram.

The mantra is growth

Besides, there are other reasons why active management can deliver better returns. One key reason being the long-term growth story of India. Experts are of the view that the Indian economy is on a growth path.

With the economy doing well, the stock markets too will benefit from it and active management will help earn higher returns. Some volatility is expected in the short term due to uncertainty in interest rates and oil prices, but over the long term, they are positive on the Indian markets.

"Good corporate results and a good monsoon are a positive sign for the markets," says Balasubramanian. But according to Aima, markets will be range-bound till the next quarter results, which makes active investing even more important.

According to Sridhar, markets will remain volatile for the next two to three months and it will react very sharply to every news that comes. But he says, "This volatility should be considered as an opportunity to pick stocks."

With the market so volatile in the short term, one would be curious to know what to invest in and what should be avoided. Due to the infrastructure-led economic growth, Sethuram is positive on infrastructure-related sectors like engineering, construction, capital goods and cement.

He is also positive on IT stocks as the sector as a whole is performing well. Similarly, Sridhar is also positive on infrastructure and IT. "The guidance given by IT companies is encouraging and they have always lived up to their guidance. So, I feel the growth in the sector will continue," says Sridhar.

But that may not mean investing in tech funds will be the best strategy. In fact, Aima is also not in favour of sector funds. He says, "It is better to invest in a well-diversified portfolio than sticking to one particular  sector as over a longer period diversified equity funds would give better returns."

Balasubramanian is of the view that the domestic growth story is strong, so sectors such as auto, FMCG, pharma, banking and infrastructure will perform well.

The only sector that everybody is cautious about is oil and gas due to uncertainty in oil prices and absence of free-market product pricing. Otherwise, have an active fund portfolio to keep fit.