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A healthy mix of active and passive

The smart investor looks at passive investing as an available strategy, not a fandom

A healthy mix of active and passive

If you are a mutual fund investor in India, then you are likely to have heard or read about how investing in index funds is now an increasingly attractive alternative to normal mutual funds. It's increasingly harder for large-cap funds to be able to beat index funds on a sustained basis. A decade back, at any point, some 60-80 per cent of actively managed large-cap funds would beat the Sensex and Nifty. Things are different now. For example, over the last five years, a Nifty index fund has ranked 12 out of 49 on SIP returns over the last five years. If you add ELSS funds to the sample, then it's 27 out of 84. You can research yourself more deeply on Value Research Online but any way you look at it, this is middling performance. However, it's still a big change from some years ago and that's something that attracts comment from a lot of analysts and experienced investors.

Not long ago, I wrote how, as passive-investing funds become more and more dominant in many equity markets around the world, many people are alarmed at the self-reinforcing nature of the returns generated by these funds. Certainly, this is a concern at a macro level in those countries where these funds are a big chunk of the markets, but investors will continue to head for such funds as long as it makes sense for them. The question is, does it make sense for them?

Let's quickly see what a passively managed fund is. Normal (actively managed) mutual funds aim to beat the markets, which is a way of saying that their aim is to have higher returns than a market index. In contrast, index funds - also called passively managed funds - aim to just replicate the performance of an index, neither better nor worse. Thus, an index fund that is based on the BSE Sensex should have exactly the same 30 companies' stocks that the Sensex has in exactly the same proportion. Investors who put their money in such a fund would get returns that are identical to the BSE Sensex.

Index funds are based on the idea that fund managers themselves can't beat the markets after costs are taken into account or that it's not worthwhile to try and spot those few who do. Because index funds do not require fund management and research, they have much lower costs which itself improve performance. Low costs and the guarantee of not underperforming the benchmark mean that index funds eventually give investors a better deal than most active funds. In practice, even though some active funds beat index funds, it's hard to predict which ones will do so.

If all you aspire to do as an investor was to match the large-cap indices, then this is fine. However, the fact remains that over long periods of time, not investing in mid- and small-cap stocks is highly suboptimal. Over five- and 10-year periods, mid and small fund categories have higher returns than large-cap funds. The difference is not small. Over 10 years, large funds have average returns of around 11 per cent, while small and mid caps have 16 per cent. That's your money becoming 2.9X vs becoming 4.5X. This is something that index investing is not going to deliver for you, for two reasons. One, because of thin volumes in most underlying stocks, the indices are not tradeable as a whole. Added to that, the differential in performance is so large that there are enormous advantages to constructing a portfolio actively.

What all this means is that at best, a smart mutual fund investor who is also a fan of passive investing could have perhaps half the portfolio in passive large-cap funds, with the rest in chosen actively managed small- and mid-cap funds.

So, is the glass of index investing in India half full or half empty? It does not matter how you look at it, passive can be part of a good strategy but nowhere near the whole strategy.