Passive Or Active Funds: Whats The Right Choice?

There is a massive shift that is happening globally in the investment world. Since 2008, investors are now moving towards passive investment strategies. Worldwide, after the great financial crisis many investors both at the retail level as well as at the institutional level have started shifting their investments from relatively expensive actively managed mutual funds to relatively cheap index mutual funds and exchange traded funds (ETFs), which together come under the term passive index funds. ETFs and index mutual funds are technically different, but they share the fundamental feature that both seek to replicate existing stock indices while minimising expense ratios.

In contrast, active funds employ fund managers who strive to buy stocks that will outperform, which leads to higher expense ratios. Between 2009 and 2020, passively managed funds have witnessed their asset under management (AUM) increasing from USD 6 trillion to USD 22 trillion, showing an annual growth of 13 per cent compared to 10 per cent overall growth witnessed by the mutual fund industry. Passive products recorded their highest growth in the pandemic-affected year. Passive AUM rose by 17 per cent globally during 2020 with strong net inflows and market growth. India has not remained immune to this tectonic shift.

In the last few years we have been witnessing exponential rise in AUM of passively managed funds. These have outstripped growth in actively managed funds. Even in terms of inflows, passively managed funds have seen better inflows than actively managed counterparts. Since the start of March 2020, passively managed funds, including ETFs and index funds, have seen a cumulative inflow of Rs 1.04 lakh crore. Comparatively, actively managed funds in the same period were able to garner little less than half of that at Rs 0.5 lakh crore.

If we look at the monthly inflows we find that out of the last 20 months ending October 2021, in eight months between July 2020 and February 2021 actively managed equity funds saw a continuous net outflow. Whereas in the case of passively managed funds we saw that only in the month of October 2021 was there some net outflow. The AUM of the passively managed funds in the last 20 months has increased by 263 per cent compared to 224 per cent of actively managed equity funds. They are now 31.5 per cent of the total equity-based mutual fund AUM compared to 26.5 per cent at the start of the

Growing Clout of Passively Managed Funds

The rise of passively managed assets in developed markets such as the US was mainly due to the underperformance of active funds compared to their respective benchmarks, the lower cost of passive funds measured through expense ratio as compared to active funds, and the change in regulations and policies that favoured passive investments. The same reasons stand true for Indian investors who are driven to embrace passively managed funds such as index funds and plain vanilla ETFs.



According to S&P Indices versus Active Funds (SPIVA) scorecard for India for the period ending June 30, 2021, over 80 per cent of the funds in the equity large-cap category have underperformed the benchmark over one, three and five-year periods. For a ten-year period, almost 66 per cent of the large-cap funds have underperformed their benchmark. The SPIVA India scorecard compares the performance of actively managed Indian mutual funds with their respective benchmark indices over one, three, five and ten-year investment horizons.

The following table depicts that how many funds within the category underperformed the benchmark in 1-year, 3-year, 5-year and 10-year:



The table shows the comparison of the performance of different fund categories with respect to their benchmarks. It clearly shows that in the last one year most of the equity-based funds have underperformed their benchmarks. The worst underperformance comes from large-cap funds in the last three-year period. On the surface, it looks that actively managed funds are not able to outperform their benchmarks in different time periods – which we will explain why this can be misleading – and hence investors are moving towards passively managed funds.

The second reason why passively managed funds are being widely accepted is due to their low cost structure. Passively managed funds by their construct have lower expense ratio. To manage a passively managed fund, asset management does not need a high paying research analyst or need a frequent churning to generate alpha – all of this goes into savings for passively managed funds and ultimately towards the returns of the fund. So every rupee saved will add to the returns of the fund. In case of actively managed funds, a fund manager is supported by analysts and a research team to carry out research and track the performance of the companies in which investment is being made.

Since the people involved in the process are well-paid, it adds to the cost of the fund management, leading to comparatively higher expense ratios of actively managed funds. Our study of expense ratio for the large-cap dedicated funds shows that index funds and ETFs have much lower expense ratio that helps them to perform better in the long run. It is a well-established fact that expense ratio remains one of the few factors that have a definite impact on the future performance of the funds.



The table above shows that the difference in expense ratio between a regular index fund and actively managed fund is more than 1.4 per cent. This difference may seem insignificant, but over a long period these costs add up. The cost of funds is considered a significant factor in value creation over the long term. For example, if you invest Rs 5,00,000 in a fund that has an expense ratio of 2.1 per cent per annum, then it means that you need to pay Rs 10,500 per year to the fund to manage your money. Also, if the fund returns equal 20 per cent and has an expense ratio of 2.1 per cent, you would get a return equal to 15.9 per cent. The net asset value (NAV) of a fund is reported after deducting all fees and expenses.

The next big factor that is favouring the rise of index funds or ETFs is government policies and the beneficial regulatory environment that promotes passively managed funds. First, in 2017, Securities and Exchange Board of India (SEBI) came out with the re-categorisation and rationalisation of mutual fund schemes, according to which fund houses are required to manage only one product offering in each style category and also the investment universe. Earlier, a large-cap dedicated fund would have invested only 50 per cent of its net assets into large-cap stocks and rest into mid-cap and small-cap stocks still benchmarked to a large-cap index. This would make large-cap funds’ performance better than their benchmarks in the long run assuming that the broader market stock performs better than the large-cap stocks.

Now with rationalisation and categorisation such inconsistencies have been weeded out and apples are being compared to apples. This has enhanced transparency since investors can easily compare the performance of fund offerings in each style category. At the same time, it has made it difficult for large-cap funds to show outperformance. SEBI also mandated that fund managers should benchmark the performance of equity funds against total return indices (TRI) and not the price return index (PRI). This was done in order to emphasise the importance of dividend payments in addition to capital appreciation when evaluating portfolio returns.

Assuming dividend yield of 1.5 per cent, it increased the threshold level for a fund manager by similar percentage to outperform their benchmarks. This has also helped passive investment strategies as now even a lower number of funds can show outperformance. Besides, the government launched disinvestment drives through ETFs. This announcement helped create large awareness and interest in ETFs. In 2015 it even allowed Employees’ Provident Fund Organisation (EFPO) to invest in equities through large-cap ETFs. The total EPFO allocation in ETFs was Rs 1.03 lakh crore as of March 31, 2020.

Caveat Emptor

The report by SPIVA is quite comprehensive in its coverage; however, it represents a single point of comparison out of many such possible points. Hence we decided to check the performance of the funds and their outperformance or underperformance compared to the benchmarks on a rolling basis. This will give us good enough points to come to a proper conclusion. For our analysis we took the average returns of the funds on a daily basis and converted them into rolling three-year and five-year returns. Similarly, we did this for their respective benchmarks. We did this exercise for large-cap-dedicated funds and mid-cap-dedicated funds and took the regular plan with a longer history.

Following this exercise an entirely different picture appeared in terms of the average performance of funds with respect to their benchmarks. Large-cap-dedicated funds have appeared to perform better than their benchmarks most of the times both in a three-year and five-year timeframe. For example, out of the total 2018 instances in large-cap-dedicated funds there were only 337 instances when the funds’ average return was worse than the index return. What seems to be quite clear is that the outperformance of the large-caps fund has been in a declining mode in the recent period. The rolling return graph of the funds against their benchmarks reflects the same.





Nevertheless, in case of mid-cap-dedicated funds in a longer period of five years, we did not see any single period of underperformance by them. Nevertheless, in a three-year period there were some instances of underperformance by the funds. The reason why mid-cap-dedicated funds on an average do better than their benchmarks is because of information asymmetry that still exists in this category. As compared large-cap stocks, there is very less information asymmetry and they are well-researched so that a fund manager has little chance to generate alpha. Hence, where there is inefficiency in the market, it gives opportunities to fund managers to identify investment opportunities and generate superior returns, resulting in a higher preference for actively managed funds versus passive funds.

Passive versus Active

Now the moot question for an investor is whether he should adopt a passive or active strategy to build his portfolio. According to Prashant Joshi, Co-Founder and Partner, Fintrust Advisors LLP, “Given the Indian context, there is no strait-jacket answer to it. In the large-cap space, one can allocate up to 40-60 per cent towards passively managed funds.” The reason for such allocation, as he puts it, is, “Till 2015 many actively managed funds were outperforming passively managed funds; however, the table has turned since then as a handful of funds have consistently been able to do so. Since the expense ratio of the passively managed funds is significantly lesser than the actively managed funds, a more significant allocation can be justified.” Nevertheless, in the case of mid-cap and small-cap funds, Joshi is of the opinion that “many of the funds are consistently outperforming the passive funds.”

However, a few deliver significant alpha over more extended timeframes of three and five years. As a result, it may make sense to veer away from passively managed funds and rely more on an active investing style as there is a huge room for alpha creation in the mid and small-cap space. We believe that the Indian equity market and investor are yet to mature as a developed market and till that time actively managed funds especially dedicated to the broader market still stand a good chance to generate better returns than their benchmarks. Therefore, we suggest building a portfolio which is mix of both actively and passively managed funds. Beginners would do well to to mark large-cap allocation towards index funds and well-managed active funds.