The Professional Touch Won't Always Do Wonders For Your Equity Portfolio. And Here's Why

Most investors prefer to construct equity portfolios by selecting stocks that they feel will offer a higher return than the market. Doing this requires them to answer two fundamental questions : 

1.  Which stocks to buy? 

2.  How much of each stock to buy? 

Investors typically lack the knowledge and/or competence to answer these questions effectively. It is therefore widely advertised that investors are better off investing in equity through mutual funds. Mutual funds are managed by professionals who are considered to be better equipped to answer these questions. But I firmly believe that professional management of equity portfolios gravely hurts our chances of achieving outperformance. And in today's post I will explain the reasons behind this. 

The Costs Behind Professional Management 

Professional management of equity portfolios almost always implies active management through product selection. The professional’s acumen and decision making capabilities play a central role in such cases. And they obviously need to be more than handsomely compensated for their efforts. The compensation for professional management is a major contributor to the exorbitant costs behind such strategies. 

But these costs pull our net returns down significantly. The average Portfolio Management Service (PMS) offering carries average annual fees of 1.5% to 2.5%. Regular plans of the average actively managed mutual fund in India carry annual expense ratios of 1.5% to 2% per annum. Annual costs of direct plans are typically around 1% to 1.5% on average. The impact of such costs are subtle over the short term. But they can have a devastating impact on portfolios over the long term. Consider the following hypothetical example to understand why. 

Assume that a 25 year old investor has Rs 100 lakh available with an investment horizon of 30 years. The amount is invested in an actively managed mutual fund that carries a cost of 1% per annum. Assume that post tax returns match inflation over the tenure of the investment. The amount available for investment after accounting for costs for the first 3 years is calculated as shown below :

Year 1 : 100(1-0.01) = 100(0.99) = 99 

Year 2 : 99(0.99) = 98.01 

Year 3 : 98.01(0.99) = 97.03 

Over 30 years, the amount available for investment after accounting for costs can be calculated using the mathematical function shown below :

100(0.99)^30 = Rs 73.97 lakh (effectively Rs 74 lakh) 

So over 30 years, 74 lakhs out of the initial capital of 100 lakh would remain invested. This implies that Rs 26 lakh is paid out in costs over this period. This represents 26%, or more than a quarter of the initial capital. 

This means that returns would be earned on just 74% of the initial portfolio. Most active management strategies cannot generate long term post tax returns that justify their exorbitant costs. And the very few that do cannot sustain such returns once they are achieved. 

Highly Efficient Equity Markets 

Information drives stock prices in equity markets. Positive information impacting a stock creates demand for it. This causes the market price of the asset to increase. Negative information induces increased supply. This causes the market price of the stock to drop. One school of thought believes that the prevailing market price of a stock may not fully reflect all the information available about it at a given point of time. This implies that there may be gaps between the prevailing market price of the stock and its actual value. Investors who can spot such gaps would be able to earn better returns than the market as a whole. 

It is this theory that gives active portfolio management most of its relevance. But we must first gauge the veracity of this theory in light of today's realities. Digital media, social media and Artificial Intelligence (AI) are the new normal. So information on any subject is very easily available. And it spreads very quickly. So all available information about a stock would be available to every participant in the market. And it will be available as soon as it is released. Therefore all participants in the market would act on the same information at the same point of time. 

This greatly increases the likelihood of the information being fully reflected in prevailing market prices. The possibility of gaps in market prices and actual value is significantly mitigated. This leaves very limited scope for the market return to be beaten. The veracity of the notion that Indian markets are fully efficient is fiercely debated. But Indian markets are definitely a lot more efficient than they were 2-3 decades ago. Indian investors would therefore be better off behaving as if markets are fully efficient. This fundamentally leaves very little scope (if any) for outperformance through professional management of equity portfolios. 

Skewed Stock Returns And Imprecise Human Decisions 

Only a select set of stocks within an index are likely to beat the index over a period of time. So long term stock returns may not resemble a bell shaped curve which is representative of a normal distribution. This invariably means that stock returns do not cluster around the average or median return. They usually tend to be skewed, most often towards the right. This means that active fund managers would have to identify outperforming stocks in advance during each period. They would also have to gain adequate exposure to them in their funds. This is the most reliable way they would be able to outperform the index. But this is extremely hard to do correctly and consistently. Consider the following hypothetical case study to understand this point.

A particular hypothetical stock market index consists of 4 stocks. Individual weights and returns from each stock are laid out below.  

Weighted average returns are next calculated for each stock by multiplying the returns of each stock with its weightage. The weighted average return for the index is then arrived at by adding up the 4 resultant figures. Underlying calculations are laid out below. 

Weighted Average Index Return = (10%×40%) + (12%×30%) + (8%×20%) + (11%×10%)

= 4%+3.6%+1.6%+1.1%

= 10.3% 

Now assume that the manager of an active fund benchmarked to this index allocates 20%, 10%, 40% and 30% to each of these stocks respectively. The fund carries an annual cost of 1%. Underlying calculations for the returns generated by the fund manager are laid out below : 

Weighted Average Fund Return = (10%×20%) + (12%×10%) + (8%×40%) + (11%×30%)

= 2%+1.2%+3.2%+3.3%

= 9.7%

It is therefore clear that the fund manager has underperformed the index by 0.6% (10.3%-9.7%). The fund manager has a significant allocation to the worst performer in the index. The negative impact is further compounded because he has also opted for a minimal allocation to the best performer. This shows that the underperformance has been caused as a result of imprecise fund management decisions made by the fund manager. Also remember that the fund carries an annual cost of 1%. This means that the net return enjoyed by an investor in this fund would be even lower. Underlying calculations for the same are laid out below. 

Net return for the investor = Weighted Average Fund Return - Annual Investment Costs 

= 9.7% - 1%

= 8.7%

Net underperformance for the investor versus the index = 10.3% - 8.7%

= 1.6%

This makes it mathematically clear that investors often bear the brunt of the manager's imprecise decisions. Investors pay incremental costs on active management strategies expecting better long term post tax returns than the market. But such strategies invariably see their portfolios do worse than the market. We must remember that every man made decision has an inherent 50% chance of going wrong. Therefore the key to effective equity portfolio construction is to limit the influence of human decisions and intervention. And this points to the recurring conclusion that outperformance through professional management is extremely hard to achieve and sustain.

Where Does One Go From Here? 

Active management by professionals promises outperformance but rarely delivers. This is further borne out by the SPIVA India Mid Year 2026 report. The report arrives at the following underperformance rates for various categories of actively managed equity mutual funds for the 10 year period ended June 2026 : 

Large cap funds - 74%

Mid and small cap funds - 67% 

ELSS funds - 80%

Opting for professional active management strategies implies that we are playing a game where the odds of victory are not in our favour. It therefore represents an unreasonable risk for most of us. There are no awards to be won for having enjoyed blockbuster returns on our portfolios. But there are severe consequences to be faced for not having enough money to meet our goals. And taking unreasonable risks is one of the most likely ways to end up facing such an eventuality. 

A select few products that rely on active management by professionals will definitely outperform the market during any period under study. But such outperformance is likely to be attributable to coincidence and luck rather than discernable skill. It would therefore be better for most investors invest in avenues where the risks and rewards on offer are reasonable and understandable. Given the realities discussed until now, most of us would be better served by portfolios that do each of the following : 

1.  Keep investment costs as low as possible 

2.  Leverage the benefits of market efficiency 

3.  Demand limited effort and intervention on the path of the investor 

Most of us are therefore likely to be better served opting for the passive approach to money management. Doing this would increase the likelihood of us being in better control of our equity portfolios. We are also much more likely to be at peace with our money. This naturally gives us a reasonable chance of achieving intended outcomes through our portfolios.