Get active on passive

It was a good run for the three to four decades till it lasted but it's over now. I'm talking about actively-managed large cap equity diversified funds in India. For a long time, this was the go-to category of funds to serve as the core holding of any mutual fund portfolio. Many of the funds had long track records and the companies they invested in were also well-understood. Those days are now gone, probably forever. Actively managed large-cap funds are no longer able to keep up with the Sensex and the Nifty even in a minimally sustained manner.

In a recent study done by our team at Value Research, we looked at 25 actively managed large-cap funds with a long enough history and compared them to the five-year rolling returns of the Sensex TRI index. More than 2/3rds of the funds (17) beat the index 25 per cent or fewer times. For another four, this number was less than 50 per cent. These are disastrous numbers, obviously.

Of course, there are a multitude of reasons for this shift. For starters, the increased efficiency and transparency of the market have made it progressively more challenging for fund managers to find undiscovered value and generate alpha. The proliferation of information, with every small and large investor having access to real-time data, has narrowed the information gap that traditionally benefited the pros. Large-cap companies hold no secrets and there are no undiscovered gems lying hidden here. To some extent, the large and consistent flow of EPFO money into large caps has made this a self-fulfilling prophecy.

Curiously, on social media, there is no dearth of people saying that large-cap investing is dead. This is not true, the problem is much narrower: it's no longer possible for active managers to generate the management fee plus enough of an advantage over the Sensex and the Nifty. But why the widespread misconception? Part of the reason may lie in the amplifying nature of social media, where extreme views often gain more traction than more complex but realistic ones.

The whole point of investing in large-cap stocks (and equity mutual funds that invest in these stocks) is that large-caps are more stable as a business as well as stocks. As businesses, they tend to have a lot more momentum, in the sense that it would take a relatively long time for any reversal of fortunes to take place. Large-cap companies tend to have a much larger floating stock and simply have a much larger set of investors who are invested in them. This makes them widely tracked and analysed, which makes it less likely that any news or fact of importance stays hidden. The larger floating stocks also mean that if you were to try to sell such a scrip even in bad times, it would be much easier and there would be a lower impact cost compared to smaller companies. All these are rules of thumb and while there are certainly exceptions, they are true as a whole. Their very presence and often diverse product portfolios make them less volatile than their mid and small-cap counterparts. In essence, the intrinsic value of investing in large-cap entities remains.

None of this has changed. It's just that investors who have so far avoided this whole active-passive story will have to put in a bit of effort to understand what is what. Actively managed mutual funds strive to outperform the market, aiming for returns higher than a specific market index. On the other hand, index funds, often referred to as passively managed funds, simply try to mirror the performance of a market index. For instance, an index fund mirroring the BSE Sensex would hold stocks of the same 30 companies in the exact proportions as the Sensex. Consequently, investors in such a fund would experience returns mirroring those of the BSE Sensex. The philosophy behind index funds is grounded in the belief that, after accounting for expenses, most fund managers can't consistently outpace the market or that identifying those who can isn't consistently feasible. For a long time, decades actually, this was not true in India. However, that time is now gone, at least for this subset of funds.

Suggested read: Is investing in large-cap active funds still worthwhile?