Active Funds Vs Passive Funds: The Race Intensifies!

"If a statue is ever erected to honour the person who has done the most for American investors, the hands-down choice should be Jack Bogle," wrote legendary American investor Warren Buffett in one of his letters to shareholders. 

For the uninitiated, Jack Bogle is the founder of Vanguard Group that transformed investing in general, and particularly in mutual fund. He introduced index funds to the world. If you are new to mutual fund, index fund tries to replicate the performance of the index that the fund is tracking. For example, if an index fund is based on Nifty, the constituents of the fund will be the same as the constituents of Nifty, with the same weightage as in Nifty. They passively track a market index (such as Nifty, Sensex) and have much lower fees than actively managed funds. This remains the biggest differentiating factor between actively managed funds and passively managed funds. 

Other important breed of passively managed funds that have made a meteoric rise over the years since their inception in 1990 are the exchange traded funds (ETFs). In a span of less than 30 years, ETFs account for 16 per cent of the total US equity assets compared to 61 per cent by actively managed funds and 22 per cent by passive mutual funds like index funds. 

Indian markets have also followed the global trend and have seen a spectacular rise in the passively managed funds. Since the start of FY14, the passively managed assets in India have almost doubled every year, up to FY18. It has increased from Rs 2,431 crore at the end of FY13 to Rs 75,261 crore at the end of FY18. The growth in index fund has, however, been lagging. The AUMs of ETFs has grown at an astounding pace of 118% annually since the start of FY14. This growth has made India world’s second fastest growing ETF market after Japan. 

So, what is pushing investors to embrace passive investing in India? One of factors that has led to growth of ETFs in India is the support of the Central government. The government came out with innovative ways of disinvestment of their holdings in the public sector units (PSUs) through ETFs. The government launched two ETFs, namely Bharat 22 ETF and CPSE ETF, which now have combined assets under management (AUMs) of Rs 10,567 crore. Besides, the government also allowed pension funds to invest in Nifty and Sensex-based ETFs, which has resulted in the rise in their AUMs. Therefore, in India, the government has been providing the required impetus for the growth of passive funds, especially the ETFs. 

Globally, however, one of the reasons for the popularity of passive funds is the inability of the actively managed funds to beat their benchmarks on a consistent basis. According to a study by Morningstar, an investment research and investment management company, its rated fund on an average had not outperformed their benchmarks (net of fees) since the financial crisis. 

Even our own (DSIJ) study shows that most of the actively funds have failed to beat their benchmarks, especially the Nifty and the Sensex. If we take the total return variant of the index, which includes dividend too, the actively funds further lose ground in term of returns. The fact is that the stock markets are becoming more and more efficient, which means that, at any point in time, share prices incorporate all the price sensitive information. 

This would mean that opportunities to outperform would diminish. This also means that you could essentially get a ‘free ride’ on the research efforts of others by simply buying a passively managed index fund, confident that the prices are fully incorporating any information that matters. 

One factor that has kept actively managed funds to underperform their benchmark is their higher expenses owing to commission, fees, administrative and other expenses related to managing funds. On an average, at the end of April 2018, the passively managed funds have expense ratio of 0.91 per cent as compared to 2.09 per cent of actively managed funds. The picture further deteriorates if we use median to measure the expense ratios. For actively managed funds, the median is 2.32 per cent as compared to 0.85 per cent of passively manged funds. The expense ratios of actively managed funds are almost four times that of passively managed funds. This has shifted the entire narrative of active versus passive to high-cost versus low-cost funds. 

What Should You Do? 

Going ahead, we believe that there will be a place for both active and passive management of funds. Looking at the current trend and various directives issued by the SEBI and initiatives taken by the fund houses, the expense ratios are likely to come down for actively managed funds. This will help improve their performance. As an investor, you can use index funds tracking large-cap index as your core investment for the long term, while you can add active funds that track sectors as your satellite holdings that will add zing to your portfolio. This will have a synergistic effect on your entire MF portfolio, where the whole would be greater than the sum of parts.