Index funds have many benefits, but don't skip actively managed funds

Some are even solely relying on a passive strategy to build a portfolio.

Passive investing is the most basic form of putting one’s money in mutual funds and the purpose of this style of investment is to mirror the index and not beat it.

Two common ways of investing passively in the equity market are to either opt for an index fund or an index exchange-traded fund (ETF). Both essentially mirror an index.

It’s only in the past five years that asset management companies (AMCs) have started focusing on passive funds.

According to industry estimates, the total assets under management (AUM) of schemes under the passive strategy is roughly 11-12% as on date, and of this, equity forms the bulk of the AUM, contributing about 85% of the total passive AUM.

“We believe a big reason behind this is the inability of large-cap equity funds to outperform the Nifty50 index. If you look at the last five-year returns, large-cap funds have provided approximately 12% returns vis-à-vis Nifty50, providing around 15% returns," said Anand Nevatia, fund manager at Trust Asset Management Company.

The latest S&P Indices Versus Active (SPIVA) India Scorecard, which was launched in April 2021, revealed that over the one-year period ending December 2020, 81% of Indian equity large-cap funds, 67% of Indian equity mid- or small-cap funds and 65% of the Equity-Linked Savings Scheme (ELSS) funds have underperformed their respective indices.

Moreover, among all the categories evaluated in the SPIVA India Scorecard, the Indian equity mid- or small-cap category fared the best for active fund managers over a 10-year investment horizon. However, in the same time frame, 68.42% of the actively managed large-cap equity funds in India, underperformed the benchmark.

Another key reason in terms of growth for passive funds is that certain large institutional investors have preferred these passive strategies, particularly the Employees’ Provident Fund Organization (EPFO).

The big advantages of a passive investment strategy are low expense ratio, tax efficiency and unemotional investing, which takes away the behavioural biases of fund managers.

Moreover, in passive investing, investors don’t have to choose from over 5,000 funds that are available in the market.

However, investors shouldn’t get into passive funds just because of their low cost as they also need to see and evaluate what works better for them and then make a decision.

A major disadvantage of a passive strategy is that you will not get above-market returns.

Vidya Bala, co-founder, Prime Investor, a mutual fund research portal, doesn’t agree with the argument that somebody picking a passive strategy is at a disadvantage.

“I don’t agree with it. You can’t say being content is a bad thing. If you are content with market returns, you go with passive funds. Moreover, the chance of you going wrong doesn’t happen because you are going with the collective wisdom of the market," said Bala.

“So, if an investor decides that he or she doesn’t want to actively manage the portfolio, assess performance and cost matters, and is not worried about the extra bit of returns that a fund manager might manage to deliver, then he or she can go with passive funds," Bala added.

However, she is of the opinion that an investor can go with an active fund if he or she believes that certain strategies of a fund manager or asset management company are good, and that these can be trusted to deliver alpha over the market.

According to experts, while on the large-cap basis, active funds haven’t been able to beat Nifty50, there are ample opportunities that exist in the mid-cap and small-cap spaces. “Investors would do we well do get into actively managed funds, specifically on this side," said Nevatia.

Financial planners are also of the opinion that when it comes to small-caps and mid-caps, there is a huge gap in terms of passive strategy.

“Whenever there is a good stock that is available at a right valuation, and is out of the index, the alpha that it might generate will not get captured by passive funds. A lot of small-cap and mid-cap stocks that may give good returns may not be in an index, so investors might lose out on the alpha that an active fund might deliver," said Nishith Baldevdas, founder of Shree Financial and a Sebi-registered investment adviser.

Another criticism that passive funds have faced over the years is that this strategy, as it mirrors the market, is not well-equipped to handle crashes such as the one witnessed in March 2020 after the covid-19 pandemic broke out.

According to Bala, March 2020 was an extraordinary period and investments were down as much as the market. “Maybe a fund manager might contain downside better than the index, but you need to identify such managers, and if you don’t know how to identify such funds, then passive makes sense," she said.

Therefore, it would be prudent for investors to not go with any one type of investing strategy.

“Every investor must have a core and a satellite portfolio in a 60:40 ratio. So, out of the 60%, investors should have 30% invested into passive funds, but these should be limited to large-cap themes," said Baldevdas.

Therefore, a good wealth generation strategy needs to have a mix of equity, debt and other asset classes, and within that a mix of both active and passive strategies.

“The mix has to be driven by the risk profile and the stage of life at which the investments are being made. In terms of fund houses, one should really look at AMCs, which have defined and structured investments approaches," said Nevatia.