The Battle For Returns: Active Management Versus Passive Management

Investors should understand the specific nature of the funds they are considering whether they are active or passive. Some investors prefer the aggressiveness of active funds and are willing to pay higher costs for the potential of earning extra returns. On the other hand, investors who value simplicity and are cost-conscious may find passive funds more suitable. The article highlights the pros and cons of both channels of investment

In the dynamic world of investment, mutual funds have emerged as a popular choice for investors seeking a diversified and professionally managed portfolio. One key decision that investors face is choosing between actively managed funds and passively managed funds. This decision can significantly impact the long-term performance and risk profile of an investment portfolio. Actively managed funds involve a hands-on approach, where fund managers make strategic decisions to buy or sell securities with the aim of outperforming the market or a specific benchmark. [EasyDNNnews:PaidContentStart]

The fund manager’s expertise, research and market insights play a crucial role in shaping the fund’s composition. While this approach seeks to generate alpha, or excess returns, it comes with a higher level of involvement and often higher fees. One of the challenges of active management is the need for continuous research, monitoring and decision-making. This can lead to higher portfolio turnover and increased transaction costs, ultimately affecting the fund’s overall performance. Despite the potential for outperformance, studies suggest that actively managed funds may struggle to consistently beat their benchmarks over the long term. 

Here are certain factors with regards to actively managed funds:

1. Cost: Quality often comes with a price, and the expertise of a fund manager is no exception. Investors opting for actively managed funds will incur charges, specifically in the form of expense ratios, to compensate for the fund manager’s skills and decision-making. Active funds are generally costlier when compared to passive funds.
2. Risk: Actively managed funds aim for higher returns, consequently exposing investors to increased risk compared to passive funds. The elevated risk is attributed to the human element in decision-making processes, which can be susceptible to errors. 

Passive funds, on the other hand, take a more hands-off approach by tracking a specific index, such as the Nifty 50. The goal is to replicate the performance of the chosen index, rather than actively making individual investment decisions. This strategy tends to result in lower fees and reduced portfolio turnover, making passive funds an attractive option for costconscious investors. The lower expense ratios associated with passive funds can lead to significant cost savings over time. These savings can compound, contributing to improved total returns for investors. With less reliance on active management, passive funds require fewer resources for research and trading, making them a more cost-effective choice for long-term investors. 

Here are some factors that investors need to keep in mind as regards passively managed funds:

1. Cost-Effective: Passive funds, such as ETFs or index funds offer a more economical investment option as their expense ratios are significantly lower than those of active funds.
2. Extensive Market Exposure: Passive funds provide investors with a broader market exposure. For instance, indices like the Nifty Small Cap 250 encompass portfolios with 250 stocks, offering a comprehensive perspective of the Indian stock market. 

AUM Trend in 2023 

The assets under management (AUM) of the Indian mutual funds industry increased significantly from Rs 39.62 lakh crore to Rs 50.77 lakh crore in December, reflecting an impressive growth of 28 per cent. In parallel, active funds experienced a surge of 28 per cent in their AUM, rising from Rs 32.66 lakh crore to Rs 41.74 lakh crore during the same period. Conversely, passive funds demonstrated a growth of 31 per cent, increasing their AUM from Rs 6.64 lakh crore to Rs 8.74 lakh crore, as illustrated in the graph above. 

The two charts above illustrate the inflows in both active and passive funds throughout the year 2023, spanning from January to December. Notably, there was a slight decrease in the growth of active funds’ AUM during the year. This decline can be correlated with the chart above, revealing that the outflow in active funds was registered in four different months within the year, contributing to the reduction in AUM growth for active funds. Conversely, in the case of passive funds, despite the amount being less compared to the inflows of active funds, there were only inflows recorded, and none of the months experienced an outflow of funds. 

The Risk Factor

Risk is associated with every investment avenue, regardless of the category. When discussing different funds or stocks, they are often categorised based on their sizes, which not only indicate their scale but also reveal their inherent risk. As commonly understood, Large-Cap funds tend to be less risky and exhibit lower volatility compared to Small-Cap funds, which also means that large-cap funds have fewer chances to generate excess return in comparison to the small-cap category 

Indeed, both active and passive funds offer diversification though their approaches to risk management differ. Actively managed funds may take concentrated positions in specific stocks or sectors in an attempt to generate alpha. While this can lead to potentially higher returns, it also introduces additional risks. Passive funds, in contrast, typically maintain broad exposure to the entire market or a specific index. This approach aims to minimise individual stock or sector risk, providing investors with a more stable and predictable investment experience. Lower portfolio turnover in passive funds can contribute to a more tax-efficient strategy, further enhancing long-term returns. 

Furthermore, the relative performance of active and passive funds can be influenced by market conditions. In periods of high market volatility or when stock correlations are low, active managers may have more opportunities to add value through stock selection and tactical asset allocation. Conversely, during periods of low volatility or high correlations, passive funds may outperform due to their low costs and broad exposure. 

The relative performance of active and passive funds can be influenced by market conditions. In periods of high market volatility or when stock correlations are low, active managers may have more opportunities to add value through stock selection and tactical asset allocation. Conversely, during periods of low volatility or high correlations, passive funds may outperform due to their low costs and broad exposure. 

Return Battle

To arrive at a decision on which investment channel is more favourable and to determine where one should initiate their investment journey, it is imperative to assess their respective performances over the past years. Active mutual funds can be deemed as high-performing funds only if they succeed in surpassing their benchmark index. For instance, if the benchmark index yields a return of 12 per cent in a given year, and an active fund manages only a 10 per cent return during the same period, it is considered underperforming as it fails to outshine its benchmark index. 

The simple logic one should apply is that if they are unable to beat its benchmark index then why should one pay extra charges to them. However, this is not always the case, as fund managers have the authority to buy and sell securities using their skills, knowledge and expertise. They can generate impressive returns and beat the benchmark index easily.

If we analyse these returns, they may look impressive, but we must refrain from stating that their performance is good until and unless we compare it with the benchmark. Let’s compare them with their respective benchmarks. 

Now the picture changes when we consider the initial data, where only returns were displayed, creating an impression of a flawless performance, and signifying the good returns generated by active funds. However, when we compare these returns to their respective benchmarks, a different narrative emerges. Over the long term, most of the funds have neither delivered an impressive return nor beaten the benchmark returns. 

Conclusion

Determining the better investment option can be challenging, as both active and passive funds offer viable choices. Investors should understand the specific nature of the funds they are considering whether they are active or passive. Some investors prefer the aggressiveness of active funds and are willing to pay higher costs for the potential of earning extra returns over the benchmark. For them, the cost is not a significant concern if it translates into rewarding returns. 

On the other hand, investors who value simplicity and are cost-conscious may find passive funds more suitable. While predicting the future is inherently uncertain, having at least one passive fund in a diversified portfolio is a wise decision.

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