Such funds follow a sound investment strategy, reduce downside in bad times and deliver superior returns when markets go up

Investors include equities in their portfolios because they know, or they have been told, that is the best way to generate higher extra returns. But in the last five years, equity has underperformed other asset classes, including fixed income and gold. Nifty Index has delivered 3.54% returns in the last five years as on June 7.

The CRISIL SPIVA report for December 2011 points out that 65% of the large-cap equity mutual funds have underperformed Nifty during the period. In such a scenario, investors often wonder whether it really makes sense to invest in actively-managed funds and pay a higher fee to a fund manager to take care of the money when he or she can't even beat the index. Information asymmetry remains a peculiar feature of Indian markets, which gives ample scope for active management of fund. You should invest in well-managed equity funds with a long track record for reasonably high returns than the index over the next five years.

Don't laugh at that statement. In fact, there are around 13 diversified funds that have delivered double-digit returns during the last five years.

For beginners, an actively managed fund prefers to buy stocks using an investment strategy — it could be value, growth, quant or mix of all — to generate returns in excess of the markets.

An active fund manager aims to bring in alpha — excess returns over market returns — by sector selection and stock selection after rigorous research. By modifying allocation to particular sectors, the fund manager can increase the beta of the portfolio to help the fund participate in rallies. Towards the end of CY2011, some fund managers picked up infrastructure companies at attractive valuations, which moved much faster than the market when the market turned up in the first quarter of CY2012.

If the fund manager senses weakness in the market, he may choose to reduce the beta of the portfolio to contain the downside. He may choose to look at defensive sectors in such times. For example in early 2011, some seasoned fund managers preferred to go overweight on FMCG stocks to defend their portfolios. Of course there is a more aggressive strategy too.
A fund manager can occasionally take cash calls, too, if he senses a steep correction. When the market is moving down, keeping some part of the portfolio in cash certainly limits downside. Of course, the fund manager has to be careful with cash calls, as a sudden rally in stocks can pull down the scheme's performance. Many funds restrict their cash exposures to a maximum of 10% to limit this risk.

A good actively managed fund should reduce the downside in bad times and deliver superior returns than the market returns in the long run. In most cases, a value-oriented investment strategy should work better than a momentum-chasing one. The 13 schemes that have offered double-digit returns over the last five years include six schemes that have clearly defined their investment strategy to be value-driven. Disciplined approach towards money management seems to deliver for most of these schemes.

The investing community, too, has taken cognizance of this performance and has rewarded the winners. The days when each new fund offer would raise a few hundred crores are long gone. Nowadays, schemes that have a good track record and are managed by a fund house that has got its processes in place gets most of the new investments. Six of the 13 schemes that have performed well over the last five years have more than . 1,000 crore assets under management. HDFC Top 200, the largest equity diversified fund in India with . 11,381 crore in assets, also appears on the list.

The abolition of entry loads on mutual funds has left distributors with trail commission as the only reliable source of income. To earn consistently, professional distributors prefer to be with schemes that have shown good performance.

It is the time to steer clear of schemes showing occasional spikes in performance. As the markets show some signs of recovery on talks of possible improvement in liquidity and cash flows to India from developed world, investors would be better off being with time-tested actively managed funds to ensure long term wealth creation.