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Two schools of conflicting thoughts!!!
One School of Thought: “Active Funds tend to perform better than passive Funds”.
Another School of Thought: “Passive Funds are prone to less risk while still yielding better results compared to Active Funds.”
This leads us to the question of which is better? Active or Passive Funds?
Firstly we need to delve deeper into Mutual funds to understand what kind of funds would be better to invest in?
Table of Content:
1.) Understand your Requirements First
2.) Understand the Mutual Fund Schemes
3.) The Role of Alpha in Mutual Fund Selection
4.) Basics of Active & Passive Funds
11.) Active Fund Vs. Passive Fund
12.) What is a Tracking difference & Tracking error in the Passive Fund?
13.) Key Observations from the Analysis
14.) Active or Passive Funds: Which one to choose?
Selecting the Right Mutual Funds
Mutual funds are one of the investment products through which investors can grow wealth. There are many types of mutual funds for the investor to pick and choose to invest in.
Understand your Requirements First:
before you start investing in any fund, you must first consider certain factors. Some of the factors include:
- Identifying your financial goals.
- Evaluating your risk tolerance.
- And how long are you planning to stay invested in that particular mutual fund you have chosen?
This will help determine your goals and risk appetite to help you choose the Mutual funds that will fit your needs accordingly.
Understand the Mutual Fund Schemes:
Now, while choosing the funds, it is better to track the past record performance of the fund. It is not enough to look at the recent high performance of the fund to finalize your choice. Your analysis of the past performance should go back to 5, 7, 10, or 15 years to better gauge the fund’s rate of return.
There are some important statistical ratios that help investors to determine the risk-return profile of an investment. They are Alpha, Beta, Standard deviation, R-squared, and Sharpe ratio. But many investors tend to focus exclusively on additional investment return (alpha) with little to no concern for the other metrics that could potentially help them out in the long run.
This might arise the question of why Investors tend to focus exclusively on Alpha?
The Role of Alpha in Mutual Fund Selection:
Alpha represents the excess returns (performance of a portfolio) earned on investment above the average benchmark return. The portfolio manager or the fund manager who manages your active funds measures the performance of the portfolio he himself carefully structured using the Alpha statistical ratio.
Alpha in particular helps to determine if your active fund’s portfolio has managed to beat the market return over a period of time. As a result of actively investing in the funds, the Alpha result may either turn out to be positive or negative.
Whereas Alpha can’t be used to measure the portfolio of Passive funds.
Basics of Active & Passive Funds:
Let us briefly look at what Active and Passive funds are to precisely understand which is better?
Would like to actively invest by letting a fund manager and his team manage your funds or are you ok with passive investing and letting your investments grow at a similar rate to the market?
Let us dive deep to find out:
Active Fund:
Active funds are one kind of fund in which the fund manager and his team invest based on intense research on different types of securities.
A Fund manager along with his team also would consider multiple factors such as company fundamentals, economic trends, and macro-economic factors when making investment decisions that would directly benefit you.
They seek to outperform the benchmark index to gain you profitable returns in the long run.
Pros of Active Funds:
- If you have chosen a good fund manager, he may be able to achieve better returns than the market returns over a medium to a long period of time while also making changes to adjust the fund’s investments in order to manage sudden market events.
- They would also prudently analyze the data which could give them more insight than a typical investor in analyzing new companies to invest in while also monitoring existing investments.
Cons of Active Funds:
- Active funds usually have higher fund management fees (expense ratio).
- The fund manager may be able to generate better Alpha while the market is in the upward market trend. But inherently the success of a fund manager depends on how he manages the losses during the downward market trend.
Passive Fund:
Passive funds are the kinds of funds that aim to track and duplicate the performance of a benchmark index. These passive funds mimic the indices like the Nifty or Sensex.
The fund manager here has no active role except to replicate the index. These funds are also referred to as tracking funds because they try to accurately mimic a set benchmark or index.
Pros of Passive Fund:
- As there is no need of having to actively manage the securities in a portfolio, Passive Funds are lower in cost in terms of an expense ratio than active funds.
- As Passive Funds will however invest in the same proportion in whichever market or index it is tracking, the fund will definitely obtain similar market returns without the additional cost of paying fees to fund managers.
- It also acts as a well-diversified investment.
Cons of Passive Fund:
- As passive funds aim to mimic the index, you would be investing in all the securities on the index regardless of the worthiness of the invested security.
- The fund manager does not have the option to let go of his investment in certain funds in case he wants to reduce the downside risk.
- As you are trying to replicate the index through passive funds, you won’t be able to invest more in highly performing securities specifically to gain better returns.
- The fund manager does not analyse the balance sheet or company or the stock, blindly replicates the index. The strength of the portfolio is not justified by the research and analysis of the fund management team.
Active Fund Vs. Passive Fund:
Both active and passive funds have their own merits and demerits, which might make you wonder which one is the most ideal to invest in?
Let us do a thorough analysis using data points to analyze which fund is better to invest in:
Firstly, we will compare active funds in each category index to gauge their rate of returns.
Assumptions:
Lumpsum Investment: ₹ 1 lakh
Investment period: 7 years
Index: Respective category index
Returns: Annualized return
Let’s assume the Rs. 1 lakh is invested for 7 years. As Equity investments are suitable for long-term investments, the 7-year time period is chosen.
The below tabular column shows the current value of the investment at the end of the 7-year period after being invested under various categories of funds.
Let’s take a deep look into each category individually:
Equity Large Cap – 7-year return performance as of Jun 2022
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) | |||
| Mirae Asset Large Cap | 1,00,000 | 2,52,194 | 14.12 | |||
| Canara Robeco Blue-chip Equity | 1,00,000 | 2,48,984 | 13.91 | |||
| Axis BlueChip | 1,00,000 | 2,38,130 | 13.18 | |||
| ICICI Pru BlueChip | 1,00,000 | 2,33,540 | 12.87 | |||
| Kotak Blue-chip | 1,00,000 | 2,28,012 | 12.49 | |||
| SBI Blue Chip | 1,00,000 | 2,23,291 | 12.15 | |||
|
NIFTY 100 TRI |
1,00,000 |
2,23,105 |
12.14 |
|||
| Nippon India Large Cap | 1,00,000 | 2,22,142 | 12.07 | |||
| Navi Large Cap Equity | 1,00,000 | 2,22,094 | 12.06 | |||
| Invesco India Large Cap | 1,00,000 | 2,21,891 | 12.05 | |||
| India bulls Blue Chip | 1,00,000 | 2,21,343 | 12.01 | |||
In the large-cap category, almost 6 funds have outperformed the respective index.
Equity Mid Cap – 7-year return performance as of Jun 2022
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) | |||
| Kotak Emerging Equity | 1,00,000 | 2,99,246 | 16.94 | |||
| PGIM India Midcap Opportunities | 1,00,000 | 2,95,722 | 16.74 | |||
| Quant Midcap | 1,00,000 | 2,74,573 | 15.51 | |||
| Axis Midcap | 1,00,000 | 2,70,869 | 15.29 | |||
| Edelweiss Midcap | 1,00,000 | 2,69,490 | 15.2 | |||
|
NIFTY MIDCAP 150 TRI |
1,00,000 |
2,69,415 |
15.21 |
|||
| Invesco India Midcap | 1,00,000 | 2,66,542 | 15.02 | |||
| Nippon India Growth Fund | 1,00,000 | 2,60,404 | 14.64 | |||
| HDFC Mid-Cap Opportunities | 1,00,000 | 2,53,076 | 14.17 | |||
| DSP Midcap | 1,00,000 | 2,50,865 | 14.03 | |||
| SBI Magnum Midcap | 1,00,000 | 2,49,480 | 13.94 | |||
In Mid cap category also 5 funds have outperformed the respective index
Equity Flexi Cap – 7-year return performance as of Jun 2022
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) | |||
| Quant Flexi Cap | 1,00,000 | 3,39,534 | 19.06 | |||
| Parag Parikh Flexi Cap | 1,00,000 | 2,96,823 | 16.80 | |||
| PGIM India Flexi Cap | 1,00,000 | 2,70,154 | 15.24 | |||
| SBI Flexi Cap | 1,00,000 | 2,43,618 | 13.55 | |||
| JM Flexi Cap | 1,00,000 | 2,43,215 | 13.53 | |||
| Edelweiss Flexi Cap | 1,00,000 | 2,41,547 | 13.42 | |||
| Canara Robeco Flexi Cap | 1,00,000 | 2,41,333 | 13.40 | |||
| ABSL Flexi Cap | 1,00,000 | 2,39,403 | 13.27 | |||
| Kotak Flexi Cap | 1,00,000 | 2,38,763 | 13.23 | |||
| DSP Flexi Cap | 1,00,000 | 2,36,579 | 13.08 | |||
|
NIFTY 500 TRI |
1,00,000 |
2,28,109 |
12.50 |
|||
In the Flexi cap category, all funds have outperformed the respective index
Equity Small-Cap – 7-year return performance as of Jun 2022
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) | |||
| SBI Small Cap | 1,00,000 | 3,78,116 | 20.91 | |||
| Nippon India Small Cap | 1,00,000 | 3,77,719 | 20.89 | |||
| Kotak -Small Cap | 1,00,000 | 3,39,052 | 19.04 | |||
| Axis Small Cap | 1,00,000 | 3,36,354 | 18.90 | |||
| L&T Emerging Businesses Fund | 1,00,000 | 3,29,408 | 18.55 | |||
| Quant Small Cap | 1,00,000 | 3,00,061 | 16.98 | |||
| HDFC Small Cap | 1,00,000 | 2,94,766 | 16.69 | |||
| DSP Small Cap | 1,00,000 | 2,84,782 | 16.11 | |||
| ICICI Pru Small Cap | 1,00,000 | 2,55,434 | 14.32 | |||
| Franklin India Smaller Companies | 1,00,000 | 2,39,886 | 13.30 | |||
|
NIFTY SMALLCAP 250 TRI |
1,00,000 |
2,26,816 |
12.40 |
|||
In the Small-cap category, all funds have outperformed the respective index.
Passive Fund – 7-year return performance as of Jun 2022
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) | |||
|
NIFTY 50 TRI |
1,00,000 |
2,23,127 |
12.15 |
|||
| HDFC Index Sensex | 1,00,000 | 2,22,790 | 12.11 | |||
| Tata Index Sensex | 1,00,000 | 2,20,292 | 11.93 | |||
| Nippon India Index Sensex | 1,00,000 | 2,19,624 | 11.89 | |||
| IDFC Nifty Fund | 1,00,000 | 2,19,259 | 11.86 | |||
| UTI Nifty Index | 1,00,000 | 2,18,553 | 11.81 | |||
| HDFC Index Nifty 50 | 1,00,000 | 2,17,512 | 11.73 | |||
| Tata Index Nifty | 1,00,000 | 2,16,950 | 11.69 | |||
| Taurus Nifty Index | 1,00,000 | 2,15,853 | 11.61 | |||
| ICICI Pru Nifty Index | 1,00,000 | 2,15,791 | 11.6 | |||
| SBI Nifty Index | 1,00,000 | 2,15,557 | 11.59 | |||
If you look into the passive fund’s rate of returns in the long term, you will find that neither fund has outperformed the index. The tracking difference of the fund is high when compared to the index.
What is a Tracking difference & Tracking error in the Passive Fund?
Tracking difference is the absolute difference between the returns of the fund and those of the benchmark at the end of the chosen investing period. It measures the actual underperformance or outperformance of the fund compared to the underlying reference index.
Tracking error, on the other hand, is a measure of how well the fund tracks the benchmark during the investment period and how closely it replicates the index. If a passive fund has a very high tracking error, it can defeat the entire purpose of passive investing.
According to the circular issued by the market regulator, SEBI on 23 May 2022, a ceiling has been prescribed for the tracking error (TE) of Index funds and ETFs other than debt ETFs/ Index funds at 2%.
Along with TE, tracking difference (TD) shall also be disclosed on the website of the AMC and AMFI on a monthly basis for tenures of 1 year, 3 years, 5 years, 10 years, and since the date of allotment of units.
Key Observations from the Analysis:
From the above analysis, it is evident that active funds tend to outperform passive funds in the long run.
There are also studies claiming that over the last decade active funds have outperformed the Index. In fact, recent studies have also uncovered the fact that the Alpha generation potential is higher in India than that of any other
Developed market.
Active or Passive Funds: Which one to Choose?
The decision to invest in either active funds or passive funds boils down to the Individual’s goals, risk tolerance and circle of competence.
Choose Active Funds:
You can choose to invest in active funds if the ability of select good active funds is within your circle of competence.
But, in case you are new to mutual funds and you have a higher risk appetite, you can hire a trust-worthy Professional Financial Planner who has the competency to select good active funds.
Having a trust worthy professional Financial Planner with a good track record over the years would definitely be an advantage in navigating the market as even if the risk of loss comes up, he would be able to minimize it considerably.
Active funds from the perspective of the research analysis have shown to generate positive Alpha making it an investment worth the risk.
Choose Passive Funds:
When you are new to the concept of active and passive funds and have a low-risk appetite and also not have a trust-worthy professional Financial Planner on your side, then passive funds might be a better choice for you.
This choice helps you by eliminating the payment of higher fees that comes with actively managed funds. Also, similar to the Index return is guaranteed.
Final Remarks:
You can either choose to actively invest through a competent Financial Planner to achieve better returns or passively invest and gain similar to index returns. The decision to choose is solely based on your individual goals, risk tolerance and your circle of competence.
If you have any comments or questions, write them in the comment box below.
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