Active vs Passive Investing for Better Return

In chapters six and seven, we went over the essentials of a mutual fund and how it functions. To sum up, a mutual fund is an accumulated investment vehicle that takes charge of your money, investing and managing it for you. Differentiating one fund from another is mainly down to the management part; there are hundreds of methods that Asset Management Companies utilise and in broad terms, they can be sorted into categories.

• Active
• Passive

An active mutual fund is managed with the goal of outperforming a benchmark index or generating ‘alpha’. Alpha being the excess return that exceeds the benchmark’s performance.

Before continuing, it is vital to understand the necessity of benchmarks. A benchmark essentially serves as a comparison point for gauging investment performance – one cannot evaluate a mutual fund in a vacuum. Each fund is linked to indexes like the Nifty 100, Nifty Midcap 150, and Nifty Smallcap 100 depending on its category. Moreover, benchmarks make us aware of the returns we would have earned had we chosen to purchase the index itself.

The primary objective of an active manager is to generate returns higher than the benchmark. This can be accomplished through a number of strategies, such as Value investing, which involves choosing shares below their intrinsic worth. In contrast, Growth investing entails investing in companies that are expanding at a rate superior to their peers and reinvesting the profits into their businesses. Though there are multiple techniques available, they are beyond the scope of this chapter; however, it should now be clear that the job of an active manager is to beat the benchmark.

An index fund, in contrast to a passive fund, aims to mirror the performance of a benchmark as accurately as possible. Instead of attempting to exceed or fail to reach the benchmark, the fund simply strives to match returns before expenses (expense ratio). Generally speaking, due to mutual funds having costs, the return on an index fund would be the benchmark results minus its expenses.

By investing in a Nifty 50 index fund, you will get returns which match those of the Nifty 50. If it returns 10% this year, your income less the expense ratio will be 10%. It really is that easy.

History

Before getting into the performance of active funds and why index funds are an attractive option, it is helpful to understand their history.

John C. Bogle, more commonly known as Jack Bogle, was the founder of Vanguard and launched the First Index Investment in 1976. This fund tracked the S&P 500 Index and eventually became known as the Vanguard 500 Index Fund. The S&P 500 is made up of the top 500 US companies whose total free float outstanding shares are multiplied by price to create a market capitalization-weighted index. Similar methodology is used for Nifty and Sensex, though with a few minor differences. All in all, it’s quite a fascinating story of how this first index fund came to be.

The launch of the first index fund was a spectacular flop; Jack Bogle had wanted to raise $150 million and ended up with less than 10% of that. Vanguard were unable to purchase enough shares to make up the full index, so they selected a sampling, which proved successful in the end. We can only imagine how history would have gone differently if Bogle had not been persistent in his vision – we may well have had to wait longer for such a useful investment strategy.

When it was launched in 1976, the Vanguard 500 Index Fund did not exceed the $1 billion threshold until 1990. Currently, it holds $500 billion in assets and is now the largest mutual fund globally. It is even bigger than the Indian mutual fund industry combined – that contains around $350 billion in assets. Moreover, Vanguard is the second-largest asset management company (AMC) on Earth with approximately $6 trillion in assets, behind only Blackrock which has close to $7 trillion.

India

IDBI Principal was the first Asset Management Company to introduce an index mutual fund tracking Nifty 50 in India. It grew to become the Principal Nifty 100 Equal-Weight fund. Subsequently, Benchmark AMC launched NiftyBees – an Index ETF which followed the Nifty 50. Benchmark’s reins were later taken up by Goldman Sachs India, who were subsequently acquired by Reliance Mutual Fund and then by Nippon.

The SBI Nifty 50 ETF is India’s largest mutual fund, boasting AUM of over Rs 60,000 crores. It’s worth noting that practically all the money for this fund comes from The Employees’ Provident Fund Organisation (EPFO). Since 2015, EPFO has been investing in equity markets mainly via Nifty and Sensex ETFs. Although index funds seemingly gained a lot of traction recently, their total AUM as of April 2020 is only Rs 8,800 crore.

In comparison, active large-cap mutual funds amount to Rs 119,861crores.

 Definition of an index fund

The active vs passive debate has been a longstanding, opinionated topic in finance. I’ll get to that later. Even the definition of an index fund has elicited varied responses. Nowadays, most funds that follow an index can be categorized as such, hence you can technically establish a G-related index and launch a fund to track it. Yet, the initial design of the S&P 500 was used to set up a market weighting index. According to finance professionals and scholars, however, a true index fund is one which tracks a broad capitalization indexed product like Nifty 50 or S&P 500 etc.

Do index funds work?

You may be asking yourself how index funds make sense when they don’t try to beat the market. Indeed, outperformance is preferable to only achieving what the market delivers. But when we look at it more closely, markets are zero-sum games; meaning that for every winner, there must be a loser. To illustrate this point:

It can be concluded that, given the cost, collectively active managers cannot outperform the market. This is due to being the greatest inhibitor of performance.

Forget what we had discussed previously, and now let’s focus on the costs associated. An active mutual fund has a goal of outperforming the index, which is no easy feat and requires resources to help achieve this. A team of analysts, a Chief Investment Officer (CIO) able to make astute decisions, excellent research capabilities as well as advanced tools and technology must be put in place to succeed. All of these investments can prove costly.

To get a better understanding of expense ratios, it is advised to compare active large-cap mutual funds and index mutual funds. Moneycontrol offers category average expense ratios which can help you to get an idea. The direct plans of active large-cap mutual funds have an expense ratio of 1.28%.

In comparison, index funds have an average of 0.31%.

The typical expense ratios for regular mutual fund plans are usually much higher.

Coin is a wise investment, and with its savings calculator, investors can calculate the long term cost of fees. A difference as small as 1% on a Rs 10,000 investment made over 20 years will cost you a staggering Rs 12.8 lakhs. With Coin, you’ll make sure that the amount that reaches your pocket is the one you actually expect it to be.

Assuming a fund charges 1.5% and is benchmarked to the Nifty 50, for instance, it stands at a disadvantage as the index fund has lower costs of 0.10%. To keep up with its benchmark, this active fund needs to generate an additional 1.4%. Outperforming the benchmark, of course, requires even more effort.

Index funds and ETFs are economical investments, especially when compared to SBI Nifty ETF which charges 0.07%. This is because they don’t require expensive fund managers, research teams, etc. That’s all they do- replicate an index.

 Historical Performance

Let’s compare the historical performances of active funds and index funds. We can check out past returns displayed by AMC websites, Value research and other sources. S&P – the leading index provider releases a semi-annual report named SPIVA® scorecard. This report compares the performance of active funds against a standardised benchmark for 1,3,5,10 years. To get an understanding of how Indian active mutual funds stood at the end 2019, let us take a look at this report.

For the past 5 years, 82% of large-cap funds have failed to perform better than the S&P BSE 100 index. This index includes India’s top 100 businesses based on market capitalization.

The performance of mid and small-caps looks encouraging, yet there is a shift in the air. With its recent categorization exercise, SEBI has outlined the scope of stocks asset managers can invest in, which may make it more difficult to outperform market benchmarks. Until recently, ETFs were available to invest in mid-cap indices; however they lacked liquidity. Over the past year or so, several AMCs have begun launching index mutual funds for mid-caps.

I wouldn’t advise investors to put money into small-cap funds, either actively or passively managed. The prices can be very volatile – rising and falling quickly – which is extremely discouraging for those who are trying to stay invested. This rollercoaster of a ride adds further risk of buying high and selling low.

Bottomline

In terms of large-caps, you have a mere 50:50 chance at picking an actively managed fund that will achieve consistent performance. This is becoming increasingly difficult as Indian capital markets continue to develop, with each of the 40 asset management companies offering a large-cap fund possessing access to the same information and portfolios limited to the top 100 stocks. Not just that, index funds also act as a cost disadvantage for these funds.

This phenomenon of funds closely following the benchmarks is commonly known as closet indexing. This means most funds don’t have much variance from its index, and, after accounting for the expenses, they are certain to underperform in comparison.

Examining the situation from a different perspective, Michael Mauboussin, who is a renowned researcher, had referred to it as the paradox of skill.

When two or more players have a similar skill level—whether it is advanced or basic—chance becomes the major factor that determines the result. This involves athletes, investors and business executives. Lately, in investing and other competitive spheres, participants’ abilities have increased significantly in an absolute sense yet declined comparatively. In contrast to previous years, today’s investor has access to much more knowledge and training. The issue is that, as a group, investors have become much better, meaning the disparity between the highest and average skill levels is not as wide as before.

Fixed income (Debt)

When it comes to index funds, I was initially referring to equity index funds. They have experienced tremendous growth globally over the past 5-10 years. 

The Indian debt market is extremely small and relatively illiquid. Apart from G-Secs and top AAA-rated bonds, other instruments are rarely traded. Unlike equities which are traded on an exchange with visible price discovery, most bonds are exchanged off the market over the counter (OTC). Even in the US where the debt market surpasses equity, this holds true.

Indexing debt is challenging, but as the markets continue to develop, we could see a shift. Firms like Tradeweb are striving to move bond trading onto electronic platforms.

Active or passive (Conclusion)

You might be debating whether to go for active or index funds. But actually, you don’t have to choose one over the other, you can use both in your portfolio and figure an allocation in accordance with your risk capacity. What’s more, make sure you select funds with a long-lasting track record and that stick to their mission statement. Prior to SEBI’s scheme recategorization exercise, there were no limitations on the way funds could invest. In some instances, large-cap labels were attached to funds which invested in mid-caps and small-caps to get better returns. Thus, it’s important that you pick a fund whose manager follows through on his commitments; funds overseen by cowboys are likely just waiting for disaster to strike.

I have also discussed exchange-traded funds (ETFs) in this chapter, though they bear resemblance to index funds, there are certain distinctions. In the following chapter, we’ll delve deeper into ETFs. Additionally, ‘smart-beta funds’ are another popular type of fund that has seen widespread adoption in the last 10 years. Despite its name, this is really a rule-based option and we will cover the basics in brief too.