Are Active Funds a better bet than the Index Funds?

"The one thing in the world, of value, is the active soul"- Ralph Waldo Emerson

The importance of being active couldn't have been explained better. Yes, it is indeed imperative to be active in one's daily life to be successful and also create alpha. This is because sometimes being passive can just lead you to make ordinary success, and not help you create an alpha.

While investing too, the returns on your portfolio depends upon what kind of investing strategy you have chosen - active or passive. Very often the dynamic behaviour of the equity markets encourages many to follow the active style; but the exuberance created by the pink papers / business channels / brokers etc. often steers in making incorrect investment decisions which helps in making absolutely ordinary returns or sometimes even erode their wealth. It is noteworthy that active investment strategy is aimed at trying to create wealth on your portfolio by generating alpha (i.e. superior) returns and not only ordinary returns. It involves:

• Assessing the economic environment
• Analysing investment mood in the equity markets 
• Evaluating promising themes in the equity markets
• Selecting stocks within the theme and across which can outperform the markets
• Undertaking in depth company analysis to project sales and earnings growth
• Legitimate portfolio churning

But many a times, discussions on equity markets and stocks at several social gatherings or while commuting, reveals that investments are approached in a rather very rudimentary way (with strong views though!), and without paying enough attention to thorough research; which we believe is needed while following an active investment strategy.
 
Actively managed Funds

For investors' who are novices to equity markets or even to the strategy of active investment management, but are willing to take risk for investing in the equity markets, could opt for equity mutual funds as they offer the benefits of diversification and professional management through skilled research professionals and a fund manager appointed by the mutual fund house. However while investing in mutual funds, you need to be careful and select appropriate ones which suit your ability to bear risk as well, in their attempt to outperform their respective benchmark indices and generate superior returns or alpha for you.

It is noteworthy that diversified equity funds following an active investment strategy are in a constant search to cite promising investment opportunities - across various sectors / themes and market capitalisations in their objective to generate superior returns or alpha against their respective benchmark indices. The fund managers along with research professionals take active participation in discovering stocks which can create value for investors in the long run by controlling the overall risk on their total portfolio. While there's a risk involved if the fund manager makes a bad choice or follows an unsound theory of investing; the same can be controlled if one selects funds which follow strong systematic investments process and systems. Moreover, this would also result in you having funds which clock luring risk-adjusted returns.

However due to the trait of being an actively managed fund, if the fund manager engages in aggressive portfolio churning to boost returns, the level of risk which one is exposed to can be also be elevated. While some actively managed funds do show high conviction towards the stock bets taken by them (thus resulting in keeping portfolio churning moderate), a high expense ratio incurred by the fund not only elevates risk but also leads to high cost for investors.    

Hence, while investing actively managed funds one needs to aware of their trait, and in case if you aren't willing to take very high risk and are merely interested in replicating the broader benchmark indices; then the answer is index funds which typically follow a passive investment strategy.

Passively managed funds

Passively managed funds are aligned to a particular benchmark index such as the S&P CNX Nifty, BSE Sensex, S&P CNX 500 or even for that matter a sectoral index such as BSE Bankex. The endeavour of these funds is to mirror the performance of the designated benchmark index, by investing only in the stocks of the index with the corresponding allocation or weightage. Hence, investing in passively managed funds is less cumbersome as compared to investing in actively managed funds. Also they carry with them a low expense ratio along with a low risk (as compared to actively managed mutual funds), make market timing irrelevant and low portfolio churning also adds to their merit. The fund manager in an index fund exits a certain stock only when a respective stock exits from the index and is replaced by another one.

However despite the inherent benefits, passive managed mutual funds / index funds have not caught retail investors' fancy; and interestingly this is completely in contrast to the trend in the developed economies such as the U.S., where passive managed funds / index funds are considered as a staple diet for retail investors.

Performance of Active and Passive Funds

(Returns are in %, NAV as on October 15, 2012) (Returns over 1-Yr are compounded annualised)
(Only Diversified Equity Funds have been considered to calculate the average returns of actively managed funds)
(Source: ACE MF, PersonalFN Research)

The table above reveals that as far as the performance is concerned, actively managed funds have consistently outperformed the passively managed funds. Moreover, they have also managed to beat the broader market indices such as BSE 200. This indicates that the active management style has helped generate superior returns. Having said that the active fund management has generated desired results in last 10 years, we also need to figure out the success rate of the actively managed funds. 

Success Rate of Actively Managed Funds

(Only Diversified Equity Funds are considered while arriving at the number of schemes on offer)
(Source: ACE MF, PersonalFN Research)

Majority of actively managed funds have outperformed BSE 200 across timeframes. Notably on a 3 year time period the number of funds outperforming the BSE 200 have been the highest. And during this period the broader markets have remained lacklustre for most of the time. Hence the potential of outperforming the broader market indices exhibited by the performance of diversified equity funds seems to be one of the main important reasons why passively managed funds have not caught investors' attention in India. Moreover, not many investors are willing to settle for an index fund that will only yield the market return. Another area where the passively managed funds do not score above the actively managed funds is return potential vis-à-vis expenses. Actively managed funds often have an expense ratio higher than that of the passively managed funds but also have the higher return potential. Usually, the passively managed funds have an expense ratio of 1.00%-1.50% which eats into the returns which are almost identical to that of the benchmark index. 

The verdict

The debate over active versus passive investing has raged for years with no conclusive evidence in favour of either. As seen above there are merits and demerits to both - actively managed funds as well as passively managed funds. Hence it is imperative that you assess the following amongst other points before making a choice:

• Your risk taking ability
• Your investment objective
• Age
• Income and Expenses

Those who have a longer time horizon and ability to take risk may be better off in actively managed diversified equity funds. However it is important to be careful about the selection of the fund as not all actively managed funds would always outperform the benchmark. 

PersonalFN is a Mumbai based Financial Planning and Mutual Fund Research Firm