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“Active vs Passive management” – no simple answers 

The debate on “active vs passive management” has garnered significant attention in the investment community as proponents on both sides continue to build exhaustive arguments supporting their respective approaches. While the number of conflicting articles and reports on the topic remains overwhelming, to say the least, majority of them remain confined to developed markets.

The choice of active versus passive funds plays a significant role in determining portfolio returns over the long term. Hence, it is extremely important for Indian investors to get a clear perspective on both the approaches, particularly with reference to the Indian markets.

Introduction to Active and Passive funds

Actively managed funds are funds where the fund manager actively manages the portfolio with an objective to outperform the benchmark. Passive funds are funds whose portfolios replicate the constituents of a benchmark index and returns of these funds closely track the returns of the benchmark.

The “why” behind the debate

The argument in favour of passive investing is based on the concept of the efficient market. In an efficient market all investors have equal access to all the necessary information about a company, therefore making it extremely difficult to gain an informational advantage over any other investor. Hence passive investors believe that it is not possible to outperform the markets consistently over a long period as securities are always priced fairly based on all available information. Thus, passive investment proponents believe that reducing investment costs is the key to improving net returns and favour passive funds which have lower costs compared to active funds.

Active management proponents on the other hand, believe that markets are not always efficient and stock prices may not always truly represent the underlying fundamentals of the company due to the irrational behavioural and emotional biases of market participants. Active managers believe that with the right research and methodology (technical and fundamental analysis), a good fund manager can identify undervalued securities to invest in, therefore, adding additional return over their respective index. 

Passive funds gaining popularity across developed markets 

Historically, it has been observed that as capital markets mature and become more efficient, it becomes increasingly difficult for active funds to consistently outperform their benchmark over long periods of time. A majority of academic studies and literature overwhelmingly support passive management and these trends have been observed in developed markets such as the US where a significant proportion of active funds have underperformed the index. As a result, passive funds in developed markets are gradually capturing market share from active funds and gaining popularity amongst investors.

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Source: AMFI

The curious case of Indian Passive funds

However, passive funds in India have not enjoyed the popularity of their western counterparts. As of 31st January 2015, the combined size of equity ETFs and index funds stood at ~INR 9,000 crore and accounted for less than 3% of the total equity asset size of INR 3.5 lakh crore.

The primary reason being that unlike in the US, a significant majority of actively managed funds in India have outperformed their benchmark indices comfortably in the past. As seen below, for all time frames ranging from 1-10 years more than 80% of the equity diversified funds have outperformed their index returns.

More than 80% of active funds have outperformed passive funds across various time periods

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Source: MFIE, only diversified funds are considered, as on 25-Feb-2015. We have considered only the funds which are currently in existence. While it may be argued that the data may be susceptible to survivorship bias, the absolute number of funds which outperform their benchmark is also reasonably high thereby lending credibility to the performance superiority of active funds over passive funds in India.

But why is the Indian market different?

The Indian equity market is still in its nascent stages compared to developed markets like the US, Europe etc. The domestic retail participation remains dismally low and is majorly dominated by FIIs (Foreign Institutional Investors) thereby making the Indian markets significantly vulnerable to FII views and flows. Further a large number of companies still remain small in size and do not garner major interest from broking houses, domestic investors and FIIs implying the possibility of information arbitrage in select pockets across the small and mid cap segment.

The markets are yet to become fully efficient and the emergence of new sectors, volatility in prices due to FII flows, under researched small and mid cap segment etc. provide sufficient opportunities which can be identified by good fund managers and consequentially become a source of return generation.

However as time progresses we believe the degree of efficiency in our markets would gradually improve on the back of

1) More widespread investor participation – especially domestic retail investors
2) Larger number of fund managers and investment professionals leading to increased coverage and information about various companies
3) Better regulations
4) Technology improvements allowing better access to information

The way forward

Logically, the first signs of efficiency in domestic markets should be visible across the large cap category which is the most actively tracked. Given the high expense ratio of large cap funds (around 2-3%) compared to Index Funds (1-1.5%) going forward, large cap funds may find it increasingly difficult to outperform their passive peers. As this trend gradually plays out across the entire market, passive fund returns due to their low costs can become significantly competitive versus their actively managed peers.

Passive funds..still some time away

However, at the current juncture, the verdict is still clearly in favour of active funds in India. That being said, passive funds continue to find a place in portfolio construction and can be deployed in various strategies which take advantage of their lower expense ratio and shorter exit load period.

R Arun Kumar
Arun Kumar is a member of the research team at Wealth Advisors. He specializes in portfolio construction, asset allocation and fund research.
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