Invest in a combination of active and index funds instead of sticking to one3 min read . Updated: 08 Oct 2020, 10:37 PM IST
Decide the proportion of active and index funds depending on your risk profile
Comparisons between passively-managed index funds and actively-managed equity diversified active funds are common these days. There are those who think that active funds should be replaced with index funds as they have outperformed active funds for a long time. The popularity of index funds and the inclination of investors towards these funds have increased not just because they are expected to outperform active funds in future, but also for their lower expense ratios.
To be sure, index funds mimic benchmarks where the companies that the fund invests in and their weightage are based on market capitalization and no other criteria. Most of the cost in index funds are administrative.
On the other hand, the expense ratios of active funds are higher as these funds look at a much broader perspective when it comes to the companies and various catalysts that can unlock growth potential. These funds have dedicated research teams to study and identify such companies, and hence, their expense ratios are higher than index funds.
There are more than 100 equity diversified funds, excluding index funds. As much as 69% of these funds have outperformed index funds over 10 years. This number drops considerably in three- and five-year periods (see graph). One of the reasons for this underperformance of active funds is that few stocks in the index have had a phenomenal run in last couple of years and pulled up the overall performance of the index funds. On the other hand, active funds either had limited or no allocation in these companies as per their process and philosophy.
The valuations of these companies were high for a long time. However, during the recent market correction, active funds got the opportunity to add some of these companies at attractive valuations in their portfolios. This has started reflecting in the percentage of active funds outperforming index funds in the last one- and two-year periods.
In the last five years, more than 50% of active funds have underperformed index funds, creating a strong case for the latter.
But there is a flip side too. Index funds maintain same weightage of companies in their portfolios just like their benchmarks. Any changes in the weightage of companies due to change in market capitalization lead to changes in the index funds as well. A detailed analysis shows that 26% of companies that were in the top 50 as per market capitalization in December 2017 went out of the top 50 by June 2020, according to data provided by the Association of Mutual Funds in India (Amfi). Hence, it is not necessary that index funds will always have a stable and low churning portfolio. However, their churn would be lesser than most of the active funds during the same period.
Yes Bank continued to be in the benchmark indices for a long time because of market capitalization and index funds did not have a choice but to hold it in their portfolios. Despite the uncertainty around it and knowing well the possible impact it could have on their portfolios, index funds had to follow the mandate and mimic their benchmarks. Such events can force index funds to remain invested in companies till they completely exit the benchmark.
So do index funds work for you? They certainly have the potential to generate good returns for investors, but the consistency of index funds outperforming active funds over a long period depends on the maturity of the economy and the depth in the market. In developed countries, index funds tend to do better because most of the companies are at a matured stage and they have gone past emerging and growth phases. In an emerging market like India, there are opportunities for businesses to improve their efficiencies. The potential to invest in such companies will usually be more through active funds until these companies become a part of benchmark indices. Hence, prudently-managed active funds would have better potential to outperform index funds until Indian markets mature further.
Having a combination of both active and index funds, based on the investors’ profile, can work better than just investing in either of them because both have their specific opportunities and challenges. A higher allocation in index funds because of their stable investment in established blue-chip companies can work better for first-time and risk-averse investors. Investors with medium or higher risk profile can have limited allocation in index funds and more in active funds as these funds invest in companies with high growth potential along with the well-established ones with marginal higher risk.
Harshad Chetanwala is a certified financial planner at Mywealthgrowth.com