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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
5.) Active Fund
6.) Pros of Active Funds
7.) Cons of Active Funds
8.) Passive Fund
9.) Pros of Passive Fund
10.) Cons of Passive Fund
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.)Adani Group stocks – Standpoint of Active & Passive fund
15.)Active or Passive Funds: Which one to choose?
16.) Choose Active Funds:
17.) Choose Passive Funds:
18.) Final Remarks:
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 an 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, and 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 return.
Assumptions:
Lumpsum Investment: ₹ 1 lakh
Investment period: 10 years
Index: Respective category index
Returns: Annualized return
Let’s assume the Rs. 1 lakh is invested for 5 years. As Equity investments are suitable for long-term investments, the 10-year time period is chosen.
The below tabular column shows the current value of the investment at the end of the 10-year period after being invested under various categories of funds. The values are as on 06 Jul, 2023.
Let’s take a deep look into each category individually:
Equity Large Cap – 10-year return performance as of 6th July 2023
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) |
| Mirae Asset Large Cap Gr | 100000 | 479460 | 16.96 |
| Nippon India Large Cap Fund Gr | 100000 | 468621 | 16.69 |
| SBI Blue Chip Reg Gr | 100000 | 433482 | 15.78 |
| ICICI Pru BlueChip Gr | 100000 | 417497 | 15.35 |
| HDFC Top 100 Fund Gr | 100000 | 395063 | 14.71 |
| Canara Robeco Blue-chip Equity Reg Gr | 100000 | 392564 | 14.64 |
| ABSL Frontline Equity Gr | 100000 | 392314 | 14.63 |
| Kotak Blue-chip Gr | 100000 | 384139 | 14.39 |
| NIFTY 100 TRI | 100000 | 380437 | 14.28 |
| Edelweiss Large Cap Plan C Gr | 100000 | 379475 | 14.25 |
| Edelweiss Large Cap Plan B Gr | 100000 | 379445 | 14.25 |
In the large-cap category, almost the top 8 funds have outperformed the respective index.
Equity Mid Cap – 10-year return performance as on 6th July 2023
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) |
| Kotak Emerging Equity Sch Gr | 100000 | 732569 | 22.02 |
| HDFC Mid-Cap Opportunities Gr | 100000 | 698241 | 21.43 |
| Edelweiss Midcap Reg Gr | 100000 | 693199 | 21.34 |
| SBI Magnum Midcap Reg Gr | 100000 | 679707 | 21.11 |
| UTI Midcap Gr | 100000 | 660063 | 20.75 |
| NIFTY MIDCAP 150 TRI | 100000 | 649416 | 20.56 |
| Invesco India Midcap Gr | 100000 | 636421 | 20.31 |
| ICICI Pru Midcap Gr | 100000 | 626581 | 20.12 |
| Tata Mid Cap Gr Fund Reg Gr | 100000 | 613327 | 19.87 |
| HSBC Midcap Fund Reg Growth | 100000 | 612032 | 19.84 |
In Mid cap category almost 5 funds have outperformed & 2 more funds have on par performance with the respective index
Equity Flexi Cap – 10-year return performance as on 6th July 2023
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) |
| Quant Flexi Cap Gr | 100000 | 738587 | 22.11 |
| Parag Parikh Flexi Cap Reg | 100000 | 563965 | 18.87 |
| JM Flexi Cap Gr | 100000 | 495821 | 17.35 |
| ABSL Flexi Cap Gr Reg | 100000 | 486189 | 17.12 |
| HDFC Flexi Cap Gr | 100000 | 473697 | 16.81 |
| Kotak Flexi Cap Gr | 100000 | 472068 | 16.77 |
| SBI Flexi Cap Reg Gr | 100000 | 469339 | 16.71 |
| Franklin India Flexi Cap Gr | 100000 | 453010 | 16.29 |
| DSP Flexi Cap Reg Gr | 100000 | 447865 | 16.16 |
| NIFTY 500 TRI | 100000 | 411975 | 15.2 |
| HSBC Flexi Cap Gr | 100000 | 410637 | 15.16 |
In the Flexi cap category, all funds have outperformed the respective indexEquity Small-Cap – 10-year return performance as of 6th July 2023
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) |
| Nippon India Small Cap Gr | 100000 | 1206880 | 28.26 |
| SBI Small Cap Reg Gr | 100000 | 1015682 | 26.06 |
| DSP Small Cap Reg Gr | 100000 | 877396 | 24.23 |
| Kotak -Small Cap Gr | 100000 | 732931 | 22.02 |
| Franklin India Smaller Companies Gr | 100000 | 698297 | 21.43 |
| Sundaram Small Cap Reg Gr | 100000 | 641948 | 20.42 |
| HDFC Small Cap Reg Gr | 100000 | 637711 | 20.34 |
| NIFTY SMALLCAP 250 TRI | 100000 | 567198 | 18.94 |
| ICICI Pru Small Cap Gr | 100000 | 533560 | 18.21 |
| ABSL Small Cap Gr | 100000 | 498060 | 17.4 |
| Quant Small Cap Gr | 100000 | 461647 | 16.51 |
In the Small-cap category, 7 funds have outperformed the respective index.
Passive Fund – 10-year return performance as of 6th Jul 2023
| Scheme Name | Invested Amount | Current Value | Annualized Return (%) |
| NIFTY 50 TRI | 100000 | 3,74,971 | 14.13 |
| UTI Nifty 50 Index Fund Reg Gr | 100000 | 359019 | 13.62 |
| Bandhan Nifty 50 Index Fund Reg Gr | 100000 | 358718 | 13.61 |
| HDFC Index Nifty 50 Gr | 100000 | 357259 | 13.57 |
| ICICI Pru Nifty 50 Index Fund Cumulative | 100000 | 351090 | 13.37 |
| Tata Nifty 50 Index Fund Reg | 100000 | 340145 | 13.01 |
| ABSL Nifty 50 Index Gr Reg | 100000 | 338588 | 12.96 |
| Taurus Nifty 50 Index Reg Gr | 100000 | 337936 | 12.94 |
| Franklin India INDEX FUND NSE NIFTY 50 INDEX FUND IDCW | 100000 | 335454 | 12.85 |
| Nippon India Index Fund Nifty 50 Plan Gr | 100000 | 334202 | 12.81 |
| LIC MF Nifty 50 Index Reg Gr | 100000 | 328158 | 12.61 |
If you look into the passive fund’s rate of returns in the long term, you will find that none of the funds have 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.
Adani Group stocks – Standpoint of Active & Passive fund
The greatest advantage of active funds is that the mutual fund manager can trim their holdings in any particular stock if they expect the price volatility of that particular stock in the near term.
For example, in Jan 2023 when a US-based research agency ‘Hindenburg Research ‘questioned the Adani Group of companies on its governance & accounting practice, stocks of all 9 companies went into a free fall.
Against the backdrop of a steep fall in stock prices, the actively managed funds stayed away from Adani Group of stocks because they were skeptical of its valuation. But that is not the case with active funds as they have to mimic the index.
Adani Enterprises and Adani Ports and Special Economic Zone which are part of the Nifty50 index, have an overall weightage close to 1%. Along with these two stocks, Adani Transmission and Adani Green Energy which are part of the Nifty 100 index, have an overall weightage of 2.1%.
It’s been six months since Adani stocks tumbled due to the allegation. But the impact is still there in the passive funds. Thus, fund managers of active funds have an upper hand over passive funds.
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 to 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 trustworthy Professional Financial Planner who has the competency to select good active funds.
Having a trustworthy 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 been 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.
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