Passive funds fail to cushion market correction, active strategies outperform

Nifty has been on a downward spiral since hitting fresh all-time high on September 26.

Passive investment strategies that were expected to cushion investors’ portfolios in market falls have failed to live up to the expectations during the recent correction.

Low-volatility funds were expected to offer investors a reliable option to navigate volatile markets as they generally provide steady and risk-adjusted returns. However, data says otherwise.

No downside protection

The NSE benchmark Nifty 50 has been on a downward spiral since hitting fresh all-time highs on September 27, 2024.

For example, since the Indian equity market’s all-time high in September, Nifty Alpha Low-Volatility 30 Index has slumped 24.3 percent till February 28, 2025, against -15.60 percent returns given by the Nifty 50 index, shows numbers available with ACE MF.

It was expected that by combining the alpha generation factor with low volatility, Nifty Alpha Low-Volatility 30 Index, would have inbuilt downside protection in a bear market, thus giving better risk-adjusted returns.

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Such smart beta funds combine passive and active investing strategies. Unlike traditional index funds, which track a market-cap-weighted index (for example, Nifty 50), smart beta funds use alternative weighting strategies to improve returns, reduce risk, or enhance diversification.

Data compiled by Moneycontrol showed that many smart beta funds have fared worse than their comparative market-cap-weighted indices in the recent correction.

Other low-volatility funds such as the Nifty Quality Low-Volatility 30 Index and Nifty Alpha Quality Low-Volatility 30 Index have also fared worse than the Nifty50 index.

"The indices are formed based on back-tested data, which is an outcome of past performance of volatility. But it's not necessary that the past performance on volatility plays out in the future as well,” said Kirtan Shah, founder of Credence Wealth.

Data shows that assets under management of passive funds, including index funds and exchange-traded funds (ETFs), have zoomed over the years. The AUM of passive funds stood at Rs 10.91 lakh crore as of January 2025.

Active funds' performance

On the other hand, data available with ACE MF showed that during the recent market correction, the active smallcap fund category beat the Nifty Smallcap 250 index in terms of average returns. Even some quality factor-based index funds failed to beat the average returns of the smallcap fund category.

In the broader markets, some active flexi-cap and multi-cap funds have also beat the returns delivered by the Nifty500 index, which is a benchmark for such funds.

"People make the mistake of thinking that if a fund is passive, it will fall less or do better than active funds. They expect that since there is no fund manager bias and the expense ratio is lower, the performance will be better. In reality, passive funds are not supposed to do anything extraordinary in a bull market or a bear market. Accounting for scheme expenses, passive funds are likely to deliver returns similar to the underlying index," said Amol Joshi, Founder of Plan Rupee Investment Services.

However, over the six-month period ended June 2024, an average of 77 percent of funds across all Indian active fund categories underperformed their assigned benchmarks, according to S&P Dow Jones Indices' SPIVA Global Mid-Year 2024 Scorecard. This has been true for the past few years as well.

Proliferation of smart beta funds

The year 2024 was a period of passives as more than 50 percent of new funds launched during the year were index funds or ETFs.

In the recent past many variations of funds based on the largecap index such as equal weight, value 20 and top 10 equal weight have come up. There are other variations of smallcap and midcap segments as well.

The gush of new funds launched during the last two years has come under criticism from industry watchers.

“An AMC's job is to manufacture and make sure that products are available in the market. It is our job as an intermediary or as a DIY (do-it-yourself) investor to figure out what product fits your risk, return, risk-adjusted expectations, or probably your goal in terms of time,” said Shah.

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“The simpler you keep your investment, the better it is. While there are multiple options available, you might still want to stick to just simple large, mid, small (m-cap category funds) and that might end up doing your job,” Shah added.

Active or passive?

According to experts, every stock that forms part of an index is not worth investing. With active funds, there is an active filtering process and the discretion of creating weightages with the fund manager is a big advantage when the markets go through corrections.

“There is a segment of the market that prefers passive funds. A lot of this is primarily driven by the past underperformance of active fund managers and also the low expense ratio,” said Deepak Chhabria, CEO of Axiom Financial Services.

As per Chhabria, during this current correction, many active funds have outperformed passive strategies. “Many fund managers who have a long track record have managed to prove their method during the fall. However, there will be a period of underperformance with active funds as well. At that point of a time, this strategy will again come into focus,” said Chhabria.

Data compiled by Moneycontrol shows that while the best returns of active funds managed to beat the returns of passive strategies on a long-term basis, the worst returns of a fund within a category have underperformed passive funds. This highlights the importance of fund selection, failing which the experience of active funds can be underwhelming.

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Shah believes that different market strategies will work in different market scenarios.

“A good mix of active and passive can make a great portfolio. For example, in largecaps, I believe that passive is a far better strategy than active. But probably in midcap and smallcap, active strategies will have the upper hand,” Shah said.