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  • Writer's pictureAkshay Nayak

Do We Have A Winner?

The S&P Indices Vs Active (SPIVA) Scorecard report for a region is the primary source of information for a realistic and unbiased comparison of the performance of actively managed mutual funds against their benchmark indices. This also provides an indication of the performance of passively managed index funds in that region. The report is released twice a year, on a semi annual basis. Findings based on SPIVA data until 31st December 2021 are summarised in the graphic that follows.

Much like the findings of SPIVA reports all across the world over a number of years, the SPIVA India Mid Year 2022 report has found that actively managed funds significantly underperformed their benchmarks over 3, 5 and 10 year periods.

This obviously means that investors would be better off investing in passive index funds rather than actively managed funds. But what are the major reasons why actively managed funds underperform their benchmarks? Why is the data given in the SPIVA report more reliable than most other reports that compare and analyse mutual fund performance? How should the data be interpreted? And does the fact that passive index funds clearly outperform their actively managed counterparts mean that actively managed funds should not find a place in our portfolios? These are the questions I will attempt to answer today.

To set the stage, let us look at the benchmarks indices S&P considers when evaluating mutual fund performance within each asset class. A list of the relevant benchmarks have been given in the graphic that follows.

A brief explanation of the constitution and composition of each of these benchmarks is given in the graphic that follows.

Next, a quick overview of the major findings from the latest SPIVA India report. The SPIVA India Mid Year 2022 report found that 67.4% of actively managed large cap mutual funds in India underperformed the benchmark over the 10 year period ended June 2022. During the same period 63.9% of Indian ELSS funds, 88.5% of Indian government bond funds and 98.1% of Indian composite bond funds underperformed their respective benchmarks. And while Indian mid and small cap funds did manage to beat their benchmarks over the concerned 10 year period, it was only by a slim margin. This is summed up in the graphic that follows.

The figures involved here may make the data look unreliable. But the data in any SPIVA scorecard report is the most reliable data available on mutual fund performance for two major reasons. Firstly, the data is corrected for and therefore free of something known as survivorship bias. The term survivorship bias has been defined in the graphic given below.

When applied to mutual fund performance, survivorship bias manifests itself in performance reports that evaluate the performance of only those mutual funds that were in existence for the entire period of the study. But this may not necessarily represent a true and fair evaluation of performance because there may be a number of mutual funds that may have gone out of business and existence during the period of study. And data on such mutual funds is not included in the results of most studies. Data in any SPIVA Scorecard report also accounts for the performance of mutual funds that went out of existence during the period of study (if any) in each category. This effectively eliminates any survivorship bias in the data.

Along with correcting data for survivorship bias, data in SPIVA Scorecard reports also accounts for a persistence score. In other words, where an actively managed fund in any category beats it's benchmark index in a given period, SPIVA reports check to see how consistently that particular fund has beaten the benchmark. As a general trend, it has been found that a significant number of actively managed funds go out of business over any considerable length of time say 10 or 20 years. Also, where any actively managed fund manages to beat its benchmark, the outperformance is neither too significant nor consistent.

Now let us understand why all of this data represents a very weak case for investing in actively managed mutual funds. The essential factor that causes a lag in the performance of actively managed funds against index funds is the fact that actively managed funds involve higher costs as compared to index funds. These costs are borne by investors on the pretext that superior insights and acumen possessed by managers of actively managed funds would allow them to beat the fund's benchmark index and generate above average returns. But as shown in data analysed above, these claims are grossly off the mark.

And the fact that most actively managed funds fail to achieve the one result that they advertise so aggressively means that investing in actively managed mutual funds instead of low cost index funds is a raw deal for most investors. This is because it means they put in 100% of the capital, bear 100% of the associated risks and costs while ending up with less than 100% of the returns offered by the markets and the funds themselves (thanks to high Total Expense Ratios of 2-3%). Investors in actively managed funds are therefore promised above average performance, but ultimately end up with performance that is decisively below average.

The ultimate question that arises in light of all these facts is whether or not actively managed funds should find a place in our investment portfolios. The most apparent conclusion would be that it is better to build our investment portfolios with passively managed products such as index funds and ETFs. And this conclusion would largely be accurate for most investors, especially those who are investing with a goal based approach for the attainment of various financial goals.

But, it is important to remember that no financial product, including passively managed products are silver bullets that can serve as a universal solution to the needs of all investors. At the same time, no financial product is completely useless or redundant. Those investors who already have a net worth that is well in excess (at least a few multiples) of what they require for their needs and are relatively insensitive to investment costs can consider investing in actively managed strategies and products. In such cases, a limited amount of exposure to well managed active products can actually boost overall portfolio returns over the long term. Those who choose to make use of actively managed products and strategies must ensure that they have the right insights to be able to pick the right ones for their needs.

Ultimately, this means that passive products must be the staple in any investment portfolio, and be used by an overwhelming majority of investors across asset classes, regardless of their financial position or net worth. At the same time, actively managed products and strategies can be used along with passive products to specifically satisfy the preferences of a small niche of investors who have a very high net worth and display relative indifference to costs. This can be achieved when limited exposure is taken to a few well managed products, with a clear strategy. To my common sense this means that the answer to the passive vs active debate is not an either/or where one is a clear universal winner. It is more a case of passive AND active (mainly passive for most, but with a slight flavour of active added in for some)

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