Should You Move Towards Index Funds?

Investors often wonder if they should consider index funds as their go-to option for investing. There isn’t a strict rule for choosing between the two options. However, the question arises: why opt for index funds over active mutual funds when both choices are available? The article clears the confusion on this issue 

If you have never heard of how Warren Buffett challenged active fund managers or the hedge fund industry, then you shouldn’t miss this story. This ace investor challenged a group of investment firms or hedge funds that charged high fees for managing funds to beat the index. Following this challenge, a company called Protégé Partners LLC accepted the same, and both sides bet a million dollars. This bet revolved around the difference between the two ways of investing: active investing, where you actively seek to choose the best available investment options, and passive investing, where you simply track the S&P 500 without making many changes. 

Buffett used his own money and selected Vanguard’s S&P 500 Admiral Fund (VFIAX), while Protégé Partners opted for the average return of five funds-of-funds. These funds-of-funds’ managers select the best hedge funds and take a share of the profits. At the beginning of the bet in January 2008, Buffett’s victory didn’t seem certain. Shortly after starting, the market declined significantly, and the hedge funds were able to demonstrate their proficiency in protecting against losses. 

Buffett’s index fund lost 37 per cent of its value, while the hedge funds lost less, around 23.9 per cent. From 2009 to 2014, Buffett outperformed Protégé Partners each year, but it took him four years to finally accumulate more overall profit than the hedge funds. In 2015, Buffett lagged behind his hedge fund rival. However, in 2016, Buffett gained 11.9 per cent while Protégé Partners only gained 0.9 per cent. Another downturn could have potentially given the advantage back to Protégé Partners, but that didn’t happen. 

By the end of 2016, Buffett’s index fund bet had gained 7.1 per cent per year, totalling USD 854,000, in contrast to Protégé Partner’s picks, which gained 2.2 per cent per year, totalling just USD 220,000. According to Ted Seides, co-founder of Protégé Partners, they admitted defeat even before the official end date of the bet in December 2017. Buffett’s main argument was that when considering all the fees and expenses, an S and P 500 index fund would generate more profit than a carefully chosen group of investment funds over 10 years. 

Active Funds and Passive Funds
If you are wondering about both active and passive funds, let’s briefly understand each. Active mutual funds are managed by experienced fund managers. They aim to capitalise on market opportunities by actively buying and selling shares. Investors entrust their money to these managers with the expectation of achieving impressive returns, ideally surpassing benchmark returns. However, it’s important to note that active mutual funds usually charge higher expenses for their active management. This is unlike passive mutual funds whose operating costs are much lower. On the other hand, index funds are passive mutual funds designed to replicate popular market indices. The fund manager takes a non-active role in selecting industries and stocks to construct the fund’s portfolio, opting instead to invest in all the stocks comprising the chosen index. The allocation of stocks within the fund closely mirrors the weightage of each stock in the index. 

Investors’ Dilemma
Investors often wonder if they should consider index funds as their go-to option for investing. There isn’t a strict rule for choosing between the two options. However, the question arises: why opt for index funds over active mutual funds when both choices are available? One significant difference lies in the higher fees charged by fund houses to their holders irrespective of the fund’s performance, which are generally lower for index funds compared to active mutual funds. This was also highlighted in the aforementioned challenge between hedge funds and Warren Buffett. So, which strategy helps investors make more money? 

Some might think that a professional money manager could outperform a basic index fund. But that’s not often true. When we look at their performance based on numbers alone, passive investing usually ends up being more profitable for most investors. Numerous studies conducted over many years consistently reveal that active managers who aim to beat the market frequently don’t achieve the expected level of success. A report published by S and P Global in the first half of 2023 found that performance differed among Indian active managers in various categories. 

Most Indian equity Large-Cap funds did not surpass their benchmark as 58 per cent of actively managed funds were unable to beat the S and P BSE 100. Furthermore, an analysis shows that more than 80 per cent of Mid-Cap schemes did not outperform their benchmarks within both three-year and five-year periods. In essence, the majority of active mid-cap schemes were unable to beat the benchmark and provide higher returns compared to their respective benchmarks. 

Several mid-cap schemes, such as Axis Mid-Cap Fund, Kotak Emerging Equity Fund, Sundaram Mid-Cap Fund, Franklin India Prima Fund, among others, were unsuccessful in outperforming their benchmarks within both these timeframes. Some schemes like Mirae Asset Mid-Cap Fund, Union Mid-Cap Fund, DSP Mid-Cap Fund and others have shown underperformance over three years. Additionally, Aditya Birla Sun Life Mid-Cap Fund and SBI Magnum Mid-Cap Fund, among others, failed to surpass their benchmarks over a five-year period. 

Let’s now compare the returns across different categories with their respective benchmarks over one, three, five and ten-year time horizons, which will provide a more concise insight. 

The data above compares the average returns from various categories, namely large-cap, mid-cap and Small-Cap funds with their respective benchmark returns. Starting with large-cap funds, only in the one-year period have active funds managed to beat the benchmark return, whereas during longer-term horizons such as three, five and ten years, active funds have been unable to surpass the benchmark returns. As mentioned earlier regarding mid-cap funds, they have indeed disappointed their unit holders in terms of beating their benchmark return. According to the data, none of the timeframes show mid-cap funds outperforming their respective benchmarks. 

Small-cap funds present a different story where they have failed to beat the benchmark return during the one-year and three-year periods but have outperformed during longer-term horizons, such as the five-year and year-year periods. A question arises as to why someone would choose active funds over index funds. It’s evident that active funds are managed by high-profile fund managers, and there’s an expectation that they will generate better returns, outperforming the index returns. Consequently, they charge significant fees to their unit holders. However, the outcome, as per the data, is different. Index funds typically have lower management fees, or a less expense ratio compared to active funds. Given this, why would someone not opt for index funds? 

More to the Story
The report that we discussed in the above paragraph is quite comprehensive in its coverage but it represents a single point of comparison out of many such possible points. Hence, we decided to check the performance of the funds and their outperformance or underperformance compared to the benchmarks on a rolling basis. This will give us good enough points to come to a proper conclusion. For our analysis we took the average returns of the funds on a daily basis and converted them into rolling three-year and five-year returns. Similarly, we did this for their respective benchmarks. 

We did this exercise for large-cap-dedicated funds and mid-cap-dedicated funds and took the regular plan with a longer history. Following this exercise, an entirely different picture appeared in terms of the average performance of funds with respect to their benchmarks. Large-cap-dedicated funds have appeared to perform better than their benchmarks most of the times. For example, out of the total 2,018 instances in large-cap-dedicated funds there were only 337 instances when the funds’ average return was worse than the index return. What seems to be quite clear is that the outperformance of the large-cap funds has been in a declining mode in the recent period. The rolling return graph of the funds against their benchmarks reflects the same. 

In the realm of mid-capdedicated funds over extended periods, such as five years, instances of underperformance are notably scarce. This trend persists due to a prevailing information asymmetry within this category. Compared to large-cap stocks, the mid-cap segment retains a higher degree of information asymmetry and is relatively less scrutinised. 

Consequently, fund managers operating in this sphere have greater prospects to outperform benchmarks. The disparity in information availability means that large-cap stocks, being extensively researched and transparent, offer fewer opportunities for fund managers to generate alpha. Conversely, market inefficiencies within the mid-cap domain present fertile ground for fund managers to discern potential investment avenues, thereby yielding superior returns. This differential in market efficiency substantiates the inclination towards actively managed funds over passive funds, as the former often capitalise on these inefficiencies to produce enhanced performance. 

Index Funds: A Wise Choice?
Now the moot question for an investor is whether he should adopt a passive or active strategy to build his portfolio. Given the Indian context, there is no straitjacketed answer to it. In the large-cap space, one can allocate up to 40-60 per cent towards passively managed funds. The reason for such allocation is that till 2015 many actively managed funds were outperforming passively managed funds. However, the table has turned since then as only a handful of funds have consistently been able to do so. 

Since the expense ratio of the passively managed funds is significantly lesser than the actively managed funds, a more significant allocation can be justified. Nevertheless, in the case of mid-cap and small-cap funds, many of the funds are consistently outperforming the passive funds. Therefore, we suggest building a portfolio which is a mix of both actively and passively managed funds. Beginners would do well to mark large-cap allocation towards index funds and well-managed active funds for broader market-based funds.