Active VS Passive Investing

The one thing that can cleanly draw a wedge between equity aficionados in India is the debate between active and passive investing. Although on this blog, earlier we have gone on record to say that passive investing or index funds can indeed produce better results, is that an absolute statement? Does it mean that passive investing is the only messiah to good investing making all costs the enemy and all fund managers obsolete?

There we think there needs to be a bit more of a nuanced view on passive investing. Like with anything, index funds and actively managed funds can play very different roles in an evolved investors’ portfolio. So, read on for a short checklist that can help you decide when to consider index and when to let active funds into your investing fold.

Some situations where index funds are a solution

There are good reasons why passive investing is all the rage in mature markets and is making a name for itself in India, too.

1. When the underlying index is small

India’s two biggest, most oft-quoted, and generally considered market representative indices are Sensex and Nifty 50. Sensex has a mere 30 stocks or well-known companies that are known to be wealth creators over time. Similarly Nifty 50, as the name suggests, has 50 stocks that are no brainers of providing value to investors.

In such cases, you know that the twin processes of equity markets growing and these indices creating wealth for their investors are symbiotic. One will not happen without the other. Hence, a fund manager might provide limited value add in this instance.

No wonder then that Nifty is the most popular index when it comes to passive funds with all possible permutations and combinations being tried by fund houses. While there are plain vanilla Nifty 100 and Nifty 50 options, it doesn’t stop there. There is the ICICI Prudential Nifty 100 Low Volatility 30 and then there is Nippon India Nifty 50 Value 20 Index Fund. Then there are options in the Nifty Equal Weight Index Funds whereby the Nifty companies are represented in equal measure. So if you thought that index funds meant a simple choice, that’s not really true anymore.

2. When the cost difference is substantial between an index fund and category funds

Most large-cap index funds have an expense ratio in the range of 0.10 – 0.20% (Direct Plans). On the other hand, there are quite a few AMCs with high expense ratios of more than 1% on their direct plans. This includes players like UTI, Nippon, Invesco, Aditya Birla, HDFC, etc. In these instances, the actively managed fund is always playing a catch-up game, where it may or may not be able to make up for the inherent gap in the cost structure.

3. When you would rather avoid the confusion of choice

When you look at the 1-year returns for Large Cap funds, it is possible that you see a lot of active funds performing far better than the index. However true that may be for the one-year period, know that it is like a game of roulette. The fund rankings on the basis of performance keep shifting. When you choose a fund on the basis of past performance, the probability of being stuck at that fund style’s down cycle is higher.

On the other hand, with a passive fund, once you know the index you are confident of then it’s mostly about the cost. Even when you track performance, the knowledge that you are getting benchmark returns is far better than a short-term high of beating it or worse underperforming it for any period.

When should you go for actively managed funds?

In some instances, actively managed funds end up pulling their weight and providing value to investor portfolios.

1. The category requires you to be choosy

There is a reason why smaller indices like Sensex and Nifty are most popular for passive investing. Only the best companies make it to such hallowed listings. On the other hand, the mid-cap index has 150 constituents. It is a mixed bag out there with some companies chomping on their bits in their hurry to join the big league while some that in the next few years could fizzle out of their promise.

With Small Cap stocks the terrain gets even trickier. The universe comprises thousands of stocks. The index itself has a mind-boggling 250 stocks. Unlike S&P 500 in the US, where even with 500 stocks most companies are good bets, India’s small-cap landscape is littered with landmines.

Hence, in such cases where you need to pick and choose and not engulf all the stocks that fall under the belt, actively managed funds prove to be a better bet.

2. Fund structure does not have a matching underlying index or fund

Although with the SEBI fund categorization, most funds follow a straight path there are some that try to mix things up. As you read in our post on foreign equity, today some mutual funds in India have some exposure to foreign equity for a good mix leading to geographical diversification.

Not just that. There are fund categories like Large & Mid Cap or ESG funds where even with an index to benchmark against, there may not be passive funds mirroring it. India is still just warming up to the idea of passive investing. So, today there are still gaps that can be plugged only by active funds.

3. When the cost is low enough to justify trying it out

In the mid-cap space, currently, Motilal Oswal and Nippon offer index funds at a Direct expense ratio of 0.20%. On the other hand, there are many active Mid Cap funds in the range of 0.40-0.65% with a high-performing history to boast like Mirae, Kotak, Axis, and PGIM.

Even in Small Cap, Motilal Oswal and Nippon have their index funds at a Direct expense ratio of 0.30%. On the other hand, in the range of 0.40-.065% there are actively managed funds like UTI, Axis, Tata, Kotak, and Canara Robeco.

In the instances quoted above, the cost difference (which is one of the biggest attractions of passive investing) is slim. Also, the indices themselves have many constituents making the choosiness of fund managers worth the difference in cost. As you can see, even in investing it’s really not as black and white as is often painted. There are shades of grey and nuances that work differently for each investor. So the next time you are stuck between active and passive investing, mull over these factors and make an evolved choice.