Performance evaluation of indian fixed income mutual funds

Abstract

Mutual funds (MFs) are the oldest pooled investment vehicle. They have emerged at the forefront of the professional asset management industry due to the increasing complexity of individual investors’ investment products, processes, and cognitive and behavioural constraints. Its growth and popularity, including in India, are synchronous to financial markets. Although the worldwide open-ended MF asset under management (AUM) is skewed towards equities, the AUM over the years in the case of Indian open ended MFs is skewed towards fixed income securities. Performance evaluation of MFs goes beyond mandatory performance reporting and it is essential for different stakeholders such as investors, asset management companies (AMCs) and capital market regulators. However, scholarly research on the performance evaluation of MFs has focused more on equity MFs in developed economies. There is a lack of studies evaluating the performance of fixed income MFs from emerging economies such as India. This study contributes to the scarce but growing literature on performance evaluation of fixed income MFs, and presents Indian fixed income MFs as a case study using a comprehensive dataset. Seminal works that comprehensively evaluate equity and fixed income mutual funds’ performance have shown that actively managed funds fail to outperform their benchmarks post expenses. The Sharpe ratio, Treynor ratio and Jensen’s alpha that incorporate both risk and return of a mutual fund are widely used to measure of MF performance. Research on the performance evaluation of fixed income MFs can be segmented into six broad themes: (1) performance evaluation, (2) determinants of performance, (3) securities selection ability, (4) market timing ability, (5) performance persistence and (6) investment style analysis. Fixed-income funds exhibit negative, limited or absence of securities selection ability. Prior studies offer evidence of positive and negative timing ability. Similarly, there is a lack of scholarly consensus on performance persistence as prior studies provide contradictory evidences. The literature pinpoints the superiority of applying style analysis to classify mutual funds and unearth factors affecting their performance. It also shows how the performance of actively managed mutual funds can be replicated as a portfolio of passive investment indices and, how to relate style analysis with risk-adjusted performance and performance persistence. In doing so, the literature on fixed income MFs calls for further research that focuses on performance of fixed-income funds on emerging markets. Given the research gap highlighted in the literature concerning emerging markets, this thesis evaluates selection ability, timing ability, performance persistence over a short time horizon, investment style, and the relationship of investment style consistency with risk-adjusted performance. The sample consists of 242 Indian fixed income MFs encompassing 16 mutually exclusive and collectively exhaustive categories, and 22 widely followed fixed income indices between April 2015 and March 2020. Research frameworks established in seminal works are the basis for empirical analysis. Single and multi-factor models are used to assess selection ability, while the Treynor Mazuy model is used to assess timing ability. Further, the recursive portfolio formation test is used to assess short-term performance persistence, while quadratic programming is employed for return-based style analysis (RBSA). Lastly, the relationship between investment style consistency and risk-adjusted performance of Indian fixed income MFs is examined using Pearson correlation coefficient. Empirical results pertaining to the single-factor model show that on average, Indian fixed-income funds exhibit negative securities selection ability and significantly positive market risk. The 14.88% of funds with significantly negative alpha outnumber the 9.92% of funds with significantly positive alpha. Results about the multi-factor model further reinforce outcomes from the single-factor model. The 31% of funds with significantly negative selection ability far outnumber the 2.07% of funds with significantly positive selection ability, and only 24% of funds exhibit positive selection ability. The positive selection ability as shown to some extent in single-factor estimations diminishes when adding factors such as excess benchmark return, term spread and credit spread. On average, funds exhibit a strong positive significance for excess market return, significantly negative term spread risk and significantly positive credit spread risk. Empirical evidence of neutral to positive market timing ability is found for a few Indian fixed-income funds. Only, 13% of Indian funds exhibit significantly positive market timing ability, and it is more evident in relatively intermediate duration and longer duration funds. These results suggest that only a few Indian fixed-income funds managers can add value to fund performance with their market timing ability. The characteristics of those certain funds may be offering scope for such market timing ability. The results for the performance persistence analysis indicate economically and statistically significant positive performance persistence for relatively best and worst- performing funds for a holding period of one to three months. The findings for the style analysis show that many funds in all categories except overnight funds, liquid funds, short duration funds and long-term funds, deviate from benchmarks indicating that the risk-return characteristics of the funds are different from the stated investment objective or style. These deviations are expected to generate better risk-adjusted performance but the evidence indicates that the situation applies to only 14.46% of funds. Such a large-scale style deviation raises questions about the effectiveness of the SEBI’s prescription for fund categorization and the prevailing performance evaluation practices in the Indian mutual fund industry. At an aggregate level, the style analysis results indicate that the security selection ability of Indian fund managers does not create value, and adherence to style consistency leads to better risk adjusted performance. Future research on performance evaluation of Indian fixed-income funds can be undertaken for a more extended sample period and can also use conditional performance measures. There is scope to examine the relation of timing ability and fund characteristics. Timing ability can also be examined using multi-factor Treynor-Mazuy and holding-based models. There is also scope to investigate the impact of investment style consistency on performance persistence. Performance persistence may also be studied using different statistical methods such as contingency table (chi-square analysis), rank correlation test or AR (1)-GARCH (1,1) models. Future research can be undertaken to examine the association of governance practices of an asset management company and the investment style consistency of its funds.