A three-horse race: Active, passive and smart-beta funds jostle for investor attention

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Fund managers fall prey to their own behavioural biases which hurt investment performance

Mr Spock, as fans of the TV Series/Movie “Star Trek” would know, was an unemotional fictional character. Our economic textbooks as well as academia have long held the ideal of a ‘rational’ human being, one who was solely interested in furthering her best economic interest.

Decades of research by behavioural economists, however, have shown that humans are swayed by emotions, biases and heuristics (mental short-cuts) and that our economic decisions are only partially rational. The real-life economic behaviour of humans hardly mimics that of Mr Spock.

Erroneous decision-making plagues not only the lay consumer/investor but even finance and investment professionals. While the likes Warren Buffett and James Simons have indeed shown that it is possible to earn great returns from the financial markets, the average investment manager has been earning below-average investment returns when compared to the indices and “dumb” index funds.

Many lay consumers/investors have embraced simple rules to govern their asset allocation and have utilised tools such as Systematic Investment Plans/Rupee-Cost Averaging to improve their investment outcomes.

As far as investment professionals go, broadly, these are the reasons ascribed for the lower returns of actively managed funds as compared to passive/index schemes

Average returns minus costs

It is a given fact that 50 per cent of the managers will earn less than the median return and 50 per cent more than the median. This is the nature of mathematics. After all, everyone cannot be above average. A large portion of the people in any field will be below average; the same goes for investment management. The argument goes that as a group, investment managers will earn the average returns minus the costs associated with active management and research. They will hence, as a group, be constantly beaten by passive funds. The cost differential in the Indian context between passive funds and actively managed mutual funds ranges from 0.5 per cent point to 1 per cent point a year.

Rules based approach of passive funds

The other issue with active management is that the end investor in the fund does not know what the manager will do. Many times, fund managers fall prey to their own behavioural biases which hurt the investment performance of the fund. Indices and passive funds, by their very nature, are systematic and rules based and face no such issues.

A question naturally arises as to whether there are some rules and tools that can help the investment professional to fight the battle against the relentless march of passive funds. Short of hiring Mr Spock as the fund manager, what can be done?

Over many decades, a lot of work has been done both by practitioners as well as the academia in terms of identifying factors that lead to outperformance over the broader markets. Among the major factors identified are: value, size, momentum, quality and low volatility and newer factors are being identified almost on a daily basis. A lot of investment managers have embraced a complete factor based approach where the funds are managed on a rules basis keeping in mind the relevant factor and the investment mandate. Other managers are using the methods of systematic investing and rules to improve the manner of working of the humans plus computers team managing the active funds.

The three-horse race among passive / index funds, factor / smart beta funds and actively managed funds is nudging improvements in all the three methods and these are exciting times for investment professionals to innovate and improve.

(The writer Chief Investment Officer & Director PPFAS Mutual Fund)

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