Know This Before Going Active
It is now widely known that there are broadly two major approaches when it comes to investing in mutual funds. These being investing in actively managed mutual funds, or passive index funds. Actively managed mutual funds try to make use of the superior insights and skills of their fund managers to try and deliver returns that are higher than a chosen benchmark index. This is usually achieved through selection of the most attractive securities and effective management of these securities over time. Actively managed mutual funds are therefore often associated with higher costs for investors, to compensate for the skill of the fund manager.
But, the higher costs associated with actively managed funds ultimately eat into investor returns, since these costs are collected from investors' pockets. This led to the conception of index funds, which mimic the constitution and returns of a particular benchmark index. Owing to this, the role of a fund manager's acumen with respect to impacting fund returns is severely restricted in the case of index funds. Consequently, the costs associated with an index fund are significantly lower relative to an actively managed mutual fund.
This has seen investors in India slowly make the shift from actively managed funds to passive index funds, and rightly so. But there is a significant portion of Indian investors who continue to prefer and invest in actively managed mutual funds. While the decision to choose active over passive mutual funds is largely a personal one, there are a few aspects about actively managed funds that must be understood before making the choice. And today, I am going to throw light on these aspects so that those of us who choose to invest in actively managed mutual funds make an informed choice.
First and foremost we must understand that though actively managed mutual funds are advertised to beat the returns generated by the indices they are benchmarked against, the majority of them underperform their benchmarks. The most reliable source for this data is the S&P Indices Vs Active (SPIVA) India report. As per the latest SPIVA India report (SPIVA India Mid Year 2022 report) available 67.4% of actively managed large cap funds, 63.9% of Indian ELSS funds, 88.5% of Indian government bond funds, 98.1% of Indian composite bond funds and almost 50% of Indian mid and small cap funds have all underperformed their respective benchmarks. A summary of these results are laid out in the following graphic taken from the report.
I have discussed the findings of the SPIVA India Mid Year 2022 report in greater detail in an earlier piece, Do We Have A Winner? But the central takeaway from these findings must be that the fact that more than half of the universe of actively managed mutual funds underperform their benchmarks across asset classes makes a very poor case for investing in actively managed mutual funds. This is even more true when costs involved with investing in active funds are factored in. Also, the report has found that in the case of the slim portion of the active fund universe that outperform their benchmarks, the outperformance does not last for long, making the prospect of investing in actively managed mutual funds that much more unattractive.
Past fund performance and star ratings given to mutual funds are two other major factors that induce individuals to invest in actively managed mutual funds. But the truth is that past performance is of very little relevance at best, when it comes to assessing the quality of a mutual fund. And star ratings are a sophisticated marketing tool rather than a measure of fund quality. In fact, most actively managed funds tend to enjoy their best period of past performance and the highest star ratings right before they go through a prolonged period of underperformance.
So those investing in actively managed mutual funds based on parameters such as past performance and star ratings invariably end up getting a raw deal and a highly uncomfortable investment experience. Also, such an approach would see investors constantly switching from one fund to another in an effort to hold the best funds in their portfolios at all times. All this would do is unnecessarily clutter their portfolios, with insignificant exposure to a large number of funds. Investors may therefore end up with portfolios that are identical to an index fund, but at much higher costs.
Finally, given that outsized gains from actively managed funds do not last for long, portfolio rebalancing becomes that much more important for those who invest in active funds. Shifting gains from volatile assets such as equity into more stable assets such as debt and cash as per a set plan and asset allocation strategy locks in outsized gains whenever they arise. Of course, rebalancing is a non negotiable requirement even when portfolios are built with passive funds. But the psychological benefits of regular rebalancing cannot be denied.
Therefore investing in passive funds is a much better option for most investors. The only thing that must be kept in mind when investing in passive funds is that the reason for investing in them should not be the desire for better returns. It should rather be to negate fund manager risk, which is inherent with active funds. And as shown today, investing in actively managed mutual funds is quite a challenging prospect, even after accounting for risk of picking a fund helmed by an incompetent manager. Therefore the decision to invest in active funds must only be made in complete cognisance of the demands involved with adhering to the approach.