There is a big debate raging currently on Passive vs Active Investing. The supporters for Passive investing believe that creating a portfolio of index funds is the way forward. The key arguments being low costs and that there are few fund active fund managers who are able to beat the indices! The supporters of active fund management believe that India is still a nascent market and hence there are enough and more opportunities to beat the indices! Active funds can help you compound at a higher rate than the index and this can have a huge impact on your wealth creation!Â
I do not think that I can answer this question in a single blog. Hence I have created a four part series on this subject.
Part 1: Active vs Passive: Where should you invest?
Part 2: Active Fund Management Choices: How you can leverage the SEBI guidelines on product Rationalisation and Classification to your advantage!
Part 3: Is your current portfolio positioned for a differentiated differentiated performance than the index?
Part 4: Your investment experience as an Active vs Passive Investor?Â
Let’s get started!
Active vs Passive Investing: Underlying Philosophy
There are several ways to classify funds. But active vs passive is perhaps the most fundamental of all from a philosophical stand-point.
Passive funds replicate indices. Any change in the underlying index would also be replicated by the fund manager. The fund manager has no role to play in selection and weightages of the underlying stocks. The fund manager has practically no role to play as the only goal is to replicate the index.Â
Active Investing brings the fund manager’s capability to the fore. The active fund manager believe that their investment expertise can help outperform the index and hence justify the additional fees that they charge for the same.
Index Funds - A closer look!
Index funds are termed as passive funds. To most investors this means that they do not churn their portfolio. This is not true! Passive funds churn their portfolios when there are changes in the underlying index. If you were to evaluate index funds over long periods of time, you would notice a big change in the underlying stock portfolio in terms of the stocks held and their weightages.
Let me illustrate this with an example. We will look at an index fund that replicates the BSE Sensex. Â The chart below shows the big changes that have happened in the BSE Sensex since its inception in 1978-79. Only 7 stocks from the original list remain in the index. Further, the weightages of the financial sector which was zero in the original list is now over 30% of the index. Index funds represent the collective wisdom of the market. The market capitalization of the stock is the key determinant that is used for constituting the index.
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BSE Sensex: At Inception and Now!
Index Fund Performance
Index funds will perform in sync with the underlying index they are trying to replicated. Let’s look at the example of BSE Sensex Index Fund.
As you would notice, if you invested Rs 100,000 in the BSE Sensex Index on Jan 3, 2000, it would have grown to Rs 715,000 on August 20, 2020. This translates to CAGR of 10.3% per annum. If you invested Rs 100,000 on Jan 1, 2010, your investment would have grown to Rs 220,000 translating into a CAGR of 8.2% per annum.
If you invest today, whatever the BSE Sensex delivers over the next 3, 5 or 10 years; your investment in the BSE Sensex Index Fund would reflect the same performance.
Index Fund will track performances of the underlying index. All you need to do is have a view on what are the potential returns the underlying index are likely deliver in the future! Not an easy question to answer but that’s what it is!
What are the passive fund choices in India?
Index Funds in India are growing rapidly. There are hundreds of indices but it may not be possible for certain reasons to replicate the indices. For example, liquidity is one such consideration. If some stocks are illiquid, how would the fund manager be able to buy/sell these stocks and this could lead to significant tracking error in the funds.
Index funds are available in Open ended or an ETF format. Here is a list that you may find useful:
Large Cap: Senex, Nifty 50, Nifty Next 50, Nifty 50 Equal Weight, Nifty 100
Midcap: Nifty Midcap 100, Nifty Mid cap 150, BSE Midcap Select
Small Cap: Nifty Small Cap 250
Multi Cap: BSEÂ 500, Nifty 500
Sectoral: Nifty Bank, Nifty Private Bank, Nifty PSU Bank, Nifty IT, Nifty Infra
Thematic: BSE Bharat 22, BSE CPSE, Nifty NV 20, Nifty low Volatility 30, Nifty India Consumption, Nifty Dividend Opportunities
International: S&P 500, Nasdaq 100, Hangseng
Why consider active funds?
In recent times, there has been a strong move towards index funds (passive funds) as there is a belief that active funds are unlikely to outperform the passive funds for several reasons. Even if this is the case, there will be some fund managers who will manage to beat the indices. This can have a huge impact on your investments in the long run.
Imagine investing Rs 1 Cr. in an index fund where the underlying index delivered 9% p.a. over 20 years. Your investments would have grown to Rs 5.6 Crores. If the same investments were made in an active fund and the fund manager managed to beat the index by 3% p.a. (In investment parlance, this is termed alpha!), the investments would have grown to Rs 9.6 Crores (a difference of over 72%). The chart below clearly indicates that any outperformance can add up significantly in the long run.
The mutual fund industry is built on the premise that professional money managers add a lot of value to your investments and this value is measured by the outperformance they generate on the benchmark index.
Even if you can beat the index by 1%, it can translate to a meaningful difference in your overall wealth in the long run. Every fund manager comes with their own views and strategies to deliver alpha for their investors. As a result, there are hundreds of equity funds that manage portfolio on an active basis and this does create a big challenge for the investors. SEBI realised that something needs to be done to make it easier for investors to select funds and hence they brought in a regulation in October 2017 to address this issue.
Conclusion
Equity Mutual Funds can broadly be categorised into Active Funds vs Passive Funds.
Passive Funds replicate indices. Since there is no active management involved, these funds come with very low costs. Hence several investors prefer investing in these funds.
On the other hand, fund managers of active funds invest with a view to beat the underlying indices. If they achieve the desired outcome, these funds can add a lot of value to investors.
The rewards of active investing are very compelling and hence it is certainly worth your effort to pick fund managers who can add value through their ability to outperform the indices.
In Part-2, we will go through the SEBI guidelines on “Product Rationalisation and Categorisation of mutual fund schemes” and look at ways investors can use this classification to their advantage!
