Active vs Passive Funds: 7 Key Findings on Returns, Costs and Fund Selection

Active and passive investing continue to be debated among Mutual Fund investors. Active funds aim to outperform their benchmarks through stock selection and portfolio management, while passive funds seek to replicate an index at a relatively lower cost. A recent data-driven analysis suggests that neither strategy has a clear overall advantage, with outcomes varying across market segments, fund selection and costs.

The analysis examined monthly rolling three-, five- and seven-year periods from January 2013, when direct plans were introduced. It covered active direct-growth Equity Funds across seven categories and around 44,500 fund-window observations. Each active fund was compared with its benchmark after deducting 0.20 per cent annually from the benchmark return to reflect the cost of investing through an actual Index Fund.

The findings showed that passive funds have an advantage in Large-Cap, Mid-Cap and large & mid-cap categories. Active funds outperformed their benchmarks in only 30 per cent to 52 per cent of rolling three-, five- and seven-year periods across these categories. These segments contain relatively well-researched stocks, with extensive analyst coverage making it harder for fund managers to consistently identify opportunities to beat the index.

For investors, this suggests that index funds can be considered for the large- and mid-cap core of an equity portfolio, particularly when keeping investment costs low is a priority.

The picture changes in segments with a broader and less-researched investment universe. Active funds outperformed their benchmarks in 57 per cent to 65 per cent of rolling periods across flexi-cap, focused and value categories. However, the median advantage was less than 1 per cent a year, indicating that a higher probability of outperformance does not necessarily translate into a large return advantage.

Small-Cap funds were the standout category. Active funds outperformed their benchmarks in 90 per cent of seven-year rolling periods. The broader stock universe and relatively lower research coverage in this segment may provide fund managers with more opportunities to generate alpha through stock selection.

However, category-level performance can hide significant differences between individual funds. In seven-year periods, the flexi-cap fund at the 5th percentile underperformed its benchmark by 4.3 per cent, while the fund at the 95th percentile outperformed its benchmark by 5.8 per cent. This represents a gap of roughly 10 percentage points, compared with a median active advantage of only 0.6 per cent a year.

This highlights the importance of fund selection. Investors choosing active funds are not only taking exposure to the underlying market but are also relying on a particular fund and its investment strategy to outperform. A strong category-level track record therefore does not mean every fund within that category will beat its benchmark.

Costs also have a significant impact on the outcome. For flexi-cap funds, active funds outperformed their benchmarks in 63 per cent of seven-year windows for direct plans, compared with 47 per cent for regular plans. In large-cap funds, the corresponding figures were 30 per cent and 11 per cent, while in mid-cap funds they were 46 per cent and 28 per cent.

The difference was also visible in small-cap funds, where active direct plans outperformed in 90 per cent of seven-year windows, compared with 78 per cent for regular plans. Commissions and other expenses can therefore reduce the benefit generated by active management.

For investors, the findings suggest using index funds for the large- and mid-cap core of a portfolio while considering active funds in segments such as small-caps, where active management has historically shown a higher probability of adding value. Fund selection remains critical because the difference between a strong and weak active fund can be substantially larger than the average advantage of active management.

Investors considering active funds may also prefer direct plans, particularly when the additional cost of regular plans could reduce potential outperformance. Overall, active funds do not consistently outperform passive funds across all categories. The better choice depends on the market segment, the fund selected and the costs paid by the investor.

Disclaimer: The article is for informational purposes only and not investment advice.