Why you need a mix of active and passive MFs | Economic Times

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 becoming harder for large-cap funds to beat index funds on a sustained basis. A decade back, at any point, some 60-80% of actively managed large-cap funds would beat the Sensex and Nifty. Things are different now. For example, over the past five years, a Nifty index fund has ranked 12 out of 49 on SIP returns. 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 anyway 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 give 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. As index funds do not require fund management and research, these have much lower costs, which itself improves performance. Low cost and the guarantee of not underperforming the benchmark means that index funds eventually give the investor 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 is to match the large-cap indexes, 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-cap fund categories have given higher returns than large-cap funds. The difference is not small. Over 10 years, large funds gave average returns of around 11% while small and mid-caps gave 16 %. 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 indexes 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.(The writer is CEO, Value Research)