ETFs Vs Actively Managed MFs

Q) I am 35 years old and have been investing in debt for the past few years. However, I now wish to earn higher returns by investing in equities. As my job involves a lot of travel, I do not have the time to pick the best stocks. I would like to invest in ETFs as they have lower costs than mutual funds and invest in safe stocks in the Nifty or the Sensex. Please advise me on my investment plans.

- Subhan Talukdar

A) You appear to be a fairly conservative investor as you wish to invest in stocks in the Nifty or the Sensex. ETFs are one way to participate in the equity markets, but you could also look at other alternatives such as large-cap mutual funds.

ETFs invest in securities in an index such as the Nifty. As an ETF is passively managed, it simply mirrors the index and the fund manager only needs to buy or sell securities (when the index constituents change). In contrast, the fund manager of an actively managed mutual fund seeks to outperform the market by stock-picking and/or sector-picking based on comprehensive evaluations of companies and industries. The manager may frequently rebalance the portfolio to benefit from opportunities in the market. In fact, an actively managed large-cap fund may not mirror the index and may frequently buy & sell securities in its universe of large-cap stocks. Therefore, an actively managed fund may have higher expenses than an ETF as the fund house charges for professional management services.

Large-cap funds invest in stocks of well-established blue-chip companies in the Nifty and Sensex, and are diversified across sectors. These funds can deliver higher returns than the benchmark indices, especially in the long run. In contrast, ETFs effectively cap upside returns as they only try to match (and not exceed) the benchmark returns.

The following graphs compare the returns from actively managed large-cap funds with those from ETFs, the Sensex and the Nifty. On a long-run basis, the actively managed large-cap funds significantly outperformed the Sensex and Nifty as well as the ETFs. On a three-year basis, post-expenses, Franklin India Bluechip and ICICI Pru Focused Bluechip have generated more than twice the returns generated by the Sensex or Nifty. On a five-year basis, HDFC Top 200 was one of the best-performing large-cap funds and generated post-expense returns of almost eight per cent, while those of the Sensex and Nifty were less than one per cent.

Note: GS Nifty Bees = Goldman Sachs Nifty Exchange Traded Scheme. Kotak Sensex ETF was launched in June 2008 and ICICI Pru Focused Bluechip was launched in May 2008[PAGE BREAK]

Managers of actively managed funds use in-house research teams to identify undervalued stocks or sectors. These are stocks of companies with good fundamentals, but which are currently trading below their intrinsic values. This strategy may help actively managed funds outperform ETFs when the market is ‘overheating’.

Fund managers may use a bottom-up approach to invest in stocks by focussing on a specific company rather than on the industry in which the company operates. Alternatively, fund managers may use a top-down approach to determine which sectors are likely to outperform the broader market.

For example, during economic booms, stocks of companies in cyclical sectors such as banking, infrastructure, and automobiles typically generate higher returns than defensive stocks. An active fund manager who uses a top-down approach can generate higher returns for investors by increasing the exposure to banking and infra stocks when the economy is growing rapidly. However, the fund manager of an ETF must maintain the same sectoral allocation as the index and cannot increase the exposure to certain stocks unless the underlying index does so. Therefore, a top-down approach can help actively managed funds outperform ETFs.

The opposite holds true in a recession, when defensive stocks such as FMCG and pharmaceutical stocks usually outperform cyclical stocks. During periods like that seen in 2008, actively managed funds (unlike ETFs) can limit losses by reducing exposure to cyclical sectors and investing in FMCG and pharmaceutical stocks.

In 2008 and 2011, Indian equities saw a bear market. In both years, actively managed large-cap funds generated negative returns but still outperformed the Sensex and the Nifty. On the other hand, in 2009, when Indian equities had a bull run, the Sensex and Nifty delivered 76 per cent and 71 per cent respectively, while HDFC Top 200 Fund generated a considerably higher return of 91 per cent.

Actively managed funds can limit downside risks by taking defensive measures and having lower allocations to certain stocks or sectors than the benchmark indices. On a three-year and five-year basis, actively managed large-cap funds had lower downside risks than passively-managed ETFs.

In conclusion, you can benefit from higher returns and simultaneously limit downside risk by investing in actively managed large-cap funds such as ICICI Prudential Focused Bluechip, Franklin India Bluechip, HDFC Top 200 and DSP Blackrock Top 100. These funds have greater potential to add value to your portfolio than ETFs.