ACTIVE VS PASSIVE MANAGEMENT

There is a lot of debate amongst the investing world for active versus passive investing strategies. There are vocal enthusiasts of both on either side of the spectrum. First, let’s see what “Active” and “Passive” Investing really mean.

Active investing means each investment avenue is analyzed for its potential and then invested in. In this case, fund managers or investors analyze each opportunity and invest in the most attractive ones. The motive is to evaluate different companies and to create a blend. Sometimes, the attractiveness of an active fund is seen by if (and by how much) it outperforms an Index. In the India scenario, it could be the Nifty or the Sensex, or any of the other indices.

Passive investing is known as index investment. Fund Managers or Investor replicates the index and matches its returns, not beat it. Passive investment funds simply seek to invest in all the stocks of a certain index, in the same proportions, aiming to make just as much as the index.

Active investment funds have a higher Expense Ratio and thus are costly. This is because of additional costs as analysts and fund managers need to be paid. Passive funds circumvent all of these and seem to be a great starting point for investors. This is why we see an overwhelming move towards Index funds and ETFs across the globe. We should analyze both the equity investment style in the Indian context and before selecting our style.

One will find a lot of data and analysis. But one has to look into a few important points while looking at this analysis. These will give us a precise and clear picture:

1. Investment Horizon for Comparison: Equity instruments, by their virtue, are long-term investments. Equity as an asset class is not meant for short-term investments due to its volatile nature. No truthful advisor will give advice for Equity for an investment horizon of 1 year and comparison in this timeline could lead to an investment bias. A good time period to assess how well an equity fund has performed is over a 5-to-10-year period.

2. Rolling Returns instead of Point to point: It is also important to do an investment style analysis. Commonly, point-to-point data is used to show the returns of any fund. This is easily manipulated. There will be instances when one outcome will be more favorable. Thus, creating investment biases among the general masses and thus this investment style bias can be exploited to skew the actual results.

   1. Point-to-point returns do not show the consistency of performance. Point-to-point returns don’t tell you anything about what happened in the period between their two selected dates. A better method to assess a fund’s attractiveness is “Rolling-returns” or a Rolling-returns analysis

   2. Rolling returns assessments are capable of providing much-improved details of a mutual fund or index fund’s overall performance history. Rolling returns analysis shows us how a fund has performed consistently over a long period of time. Rolling returns neutralize the effect of exceptional periods.

3. Comparison with Index Fund & Not Index: The returns from a managed fund should not be compared to TRI of the Index, instead, they should be compared to a relevant index fund’s returns (for example Large Cap Fund vs Nifty 50 Index Fund). Most index funds are relatively new in India. So, we have considered the Index for our analysis but going further in the future using Index Fund will provide a clearer picture.

Based on the above criteria, we did our analysis. We have taken rolling returns from 01 Jan 2005 to 21 May 2021. We have considered only 3 categories of funds (Large Cap, Mid Cap, and Small Cap). This gives us a clear picture to make our investment decisions. Indices that we have used are NIFTY 50 for large-cap, Nifty Midcap 100 for Mid-Cap, and BSE Small-Cap for Small Cap. Index selection criteria are based on two factors:

1. The index should be old enough to capture the complete business cycle and our calculation horizon

2. The index should be relevant to the particular category of Fund.

Based on our analysis, Actively Managed Funds have outperformed the Index and the Index Funds. But one has to be careful while selecting Mutual Funds. Not all Mutual Fund has outperformed the Index and there is a stark difference between best-performing funds and worst-performing funds.