Are your chosen debt funds lagging their benchmarks?

For actively managed mutual funds, the return generated in excess of the chosen benchmark is what determines the worth of the fund. While this is particularly true in the case of equity funds, debt funds are not subjected to this scrutiny for various reasons.

But a close inspection of fund performance relative to benchmark brings out a sharp contrast in the two categories’ performance in recent times. While equity funds’ relative performance has been strong, debt funds have not fared well on this count. Over the past one year, for instance, 49% of debt funds have underperformed their respective benchmarks.

For the same period, just 17% of diversified equity funds failed to beat their benchmark. Over three years, 57% of debt funds have been beaten by their benchmark whereas only 11% of equity funds met the same fate. While debt funds by nature cannot outperform their benchmarks to the same extent as equity funds, the degree of underperformance in the former does raise some questions.


Experts believe lack of liquidity in the debt market is the primary reason for debt funds’ underperformance. Vidya Bala, Head, Research, FundsIndia, says, “Only when the debt market becomes more liquid will the debt funds be able to perform to their full potential.”

The underperformance is visible across short-term and long-term debt funds. However, shortterm debt funds cannot outperform much. They are highly susceptible to redemption pressures arising out of liquidity needs. The fund manager is not in a position to invest optimally for interest accrual. That is why even a minor outperformance in short-term debt funds is considered good.

But there is scope for outperformance in the case of longerterm bond funds, where strategic calls are made in anticipation of interest rate movements. Here, fund managers look to play on duration, which involves shifting to longer-term instruments to gain from a possible decline in interest rates. When interest rates and bond yields decline, bond prices rise, leading to better returns from debt funds because of capital appreciation in their underlying bond holdings.

Longer-term papers are more sensitive to interest rate changes. This category of debt funds can exhibit higher portfolio divergence from benchmark and thus yield a higher return. But often the calls go wrong, which can hurt fund performance. Bala says, “Active duration play can give suboptimal returns if the calls go wrong. This is where some funds may have lost out.” Before the recent surprise 50 basis point rate cut, yields had softened only marginally over many months, which went against expectations.

Jiju Vidyadharan, Senior Director, Crisil Research, says, “A flat trend in bond yields for an extended time, until the recent rate cut, may have spoilt the duration play for long-term debt funds.” Even in the income fund category, funds had exhibited inclination towards longer-term papers, playing the duration strategy.

However, with many of these funds slowly shifting to the accrual strategy— earning income from the interest offered by their bond holdings— their performance might improve in the coming months, reckons Bala. However, some experts insist that relative performance in debt funds should not matter much. Sanjiv Singhal, CEO, Scripbox, argues that a bit of underperformance in debt funds should not be a concern.

“Unlike equity funds, relative performance is not really much of a criterion in the selection of debt funds. A good debt should provide the right balance between safety of capital and reasonable return.”

Meanwhile, equity fund managers have taken full advantage of the flexibility in constructing equity fund portfolios. Their performance is commendable. Not surprisingly, the underperformers mostly belong to the large-cap funds category. Mid- and small-cap funds have comfortably beaten their benchmarks across most time frames.

In fact, all mid-cap funds have outperformed their benchmarks over the 3- and 5-year period. Bala explains, “Large cap funds have little scope to invest outside the benchmark. Mid-cap oriented funds however have more leeway to take benchmark-agnostic bets, and thus generate better return.” Besides, says Singhal, these funds owe their massive outperformance to the huge run-up in the stock market until recently. “Outsized gains in certain stocks have enabled these funds to widen the performance gap vis-avis their benchmark,” he adds.