Where to Invest? Active Mutual Funds or Passive Mutual Funds

Trust us this topic was definitely in our bucket list, and in this article we will try to answer this frequently asked question through some interesting facts and numbers. So let’s get started! 

Before directly jumping to conclusion, let’s brush through some of the fundamentals of mutual fund investing.

Mutual funds can be of 2 types – active funds and passive funds

• Active funds are those funds in which fund managers try to outperform the broad market by aiming to generate returns higher than the benchmark. However this usually comes with a higher expense ratio.

• Passive funds are the funds that simply try to mimic or copy the benchmark returns by keeping the same composition and weight of the securities as of a benchmark. Therefore expense ratio for a passive fund is usually less than actively managed funds.

Now of course, by the definition you might have understood by now that index funds fall under passive funds as they try to copy and generate returns similar to the underlying index. 

Some examples of Indian indices are BSE sensex, Nifty 50, Nifty Next 50, etc.

Now the main question arises, in which type of funds should you invest – active or passive? 

SPIVA Report

We will first try to answer this question purely on the basis of some numbers from the SPIVA report. Now to those who don’t know what SPIVA report is, it stands for S&P Indices Versus Active Funds (SPIVA). It’s a semi-annual report published by S&P Dow Jones Indices covering underperformance of active funds against benchmark indices. Over the years, SPIVA has been publishing the report by expanding scorecard coverage into Australia, Canada, Europe, India, Japan, Latin America, South Africa, and the Middle East and North Africa.

The SPIVA India Scorecard compares the performance of actively managed Indian mutual funds with their respective benchmark indices over 1-, 3-, 5- and 10-year investment horizons.

As the scope of this article is investing, we will take into account numbers for 5 and 10 years respectively. 

Year Wise Performance

5 YEAR PERFORMANCE

In all the 3 categories i.e. Indian equity large cap, Indian ELSS and Indian equity mid/small cap, more than 50% of the active funds underperformed the benchmark returns, with Indian equity large cap the highest with 82% of the funds. 

10 YEAR PERFORMANCE

This time also, In all the 3 categories i.e. Indian equity large cap, Indian ELSS and Indian equity mid/small cap, more than 50% of the active funds underperformed the benchmark returns, with Indian equity large cap the highest with 67% of the funds. 

Now, of course the % of funds underperformed are less in comparison to the 5 year time horizon, however the number is still significant and more than 50%. 

In such a scenario, to select a fund that is likely to outperform the market becomes extremely important, but we understand it’s not that easy. Also, fund performance keeps on changing and does not guarantee outperformance. Therefore fund outperformance in 1 year can also be followed by subsequent underperformance. 

The Conclusion

Thus, index investing becomes an ideal choice.

Also over and above numbers, qualitative factors also support index investing.:

• It is only possible for active fund managers to outperform the benchmark returns when the markets are inefficient and price discovery has not taken place, leaving scope for picking undervalued stocks. However the Indian market is an emerging market with more and more participants joining, leaving little room for inefficiency.
• Also as the AUM of the mutual funds keeps on increasing, it equally becomes difficult for an active fund manager to deploy such large funds in undervalued stocks due to liquidity issues, thereby leaving them with no other option than large cap companies. Thus further limiting their scope for outperformance. Here again index investing emerges as a preferred choice.

Thus the above pointers clearly highlights index investing as a winner. However this does not mean active funds are totally a failed concept. There still exist funds with consistent performance, great ethics, sound framework and experienced fund managers, but if you want a simple, hassle free way and peaceful sleep, index investing is for you 🙂

Until next time!