The topic of this article has been taken up from one of the panel discussions for the upcoming Morningstar Investment Conference 2012.
At the conference, a distinguished panel of experts comprising Rajiv Anand, MD and CEO, Axis AMC; Sandesh Kirkire, CEO, Kotak AMC and Sanjiv Shah, MD and CEO, Goldman Sachs AMC will take part in a discussion titled "Active or Passive? The Debate in the Indian Context" moderated by Morningstar's Joel Bloomer, talking about the topic in detail.
To know more about the Morningstar Investment Conference 2012, click here.
We have witnessed the rise of the exchange-traded fund in the West--a $1-trillion market in the U.S. These mostly-passive, low-cost products are generally bought for the ease with which they can be traded and their strategy to track an index and offer nearly the market's return.
But the rise of passive products such as index funds and ETFs has its roots in an investment philosophy that has developed over decades.
The reasons for the popularity of passive products are several. Many investors have witnessed the advice of the legendary John Bogle play out, who says it is difficult for fund managers to beat the market over long periods of time.
That why a lot of fund managers are unable to beat their benchmark indexes over the long term is debatable in itself: the answers range from the fact that developed markets like the U.S. have become extremely efficient thanks to the wide research and information symmetry that exists on them, to the point that returns have been so dismal for developed markets for a long time now that when you take into account the higher fees that actively-managed funds charge, the funds are not able to beat the benchmark.
In fact, several Morningstar studies have pointed out that in the U.S., lower costs are often the single differentiating factor between better-performing funds and the ones that do not do as well.
Some investors may still also be believers in the popular-in-the-80s efficient market hypothesis, which believes that more returns in investing can only be achieved by taking on more risks.
Today, the second-largest fund by size in the world (after the Bill Gross-run PIMCO Total Return bond fund) is in fact SPDR S&P 500 ETF, which tracks the popular bogey.
Passive management in India
Contrary to the West, where many investors would gladly take a product that is able to efficiently track the market's return, index funds and ETFs do not have too many takers in India.
The reason could partly be the fact that several fund managers in India have handily outperformed the market over the long term: over a period of 10 years, the difference between the top-performing fund and the Nifty is as much as 11.83% annualised.
So even as a recent study concluded that more than half of large-cap mutual funds underperformed their benchmark indexes over one-, three- and five-year periods, Indian investors would generally still prefer to take up the promise of trying to get that extra return over the benchmark (or alpha, as it is known in investing parlance).
The case for indexing
Here than are a few points that work for passive management.
Don't discount the value of low fees: While costs are rarely foremost on the Indian investor's mind, it must be remembered that an actively-managed fund that charges over 2% as expense ratio and an ETF that charges about 0.5% could often be the final difference on the margin over the long haul.
What has risen could fall: Consider the case of the formerly mighty Fidelity Magellan in the U.S., which at its peak commanded over $100 billion in assets, and whose recent performance is not a shade on the one delivered when it was run by the legendary Peter Lynch. The performance of perhaps the world’s best-known actively-managed fund tells you the story of active funds--a fund that has been outperforming can start underperforming for several reasons: change in manager, investment strategy or simply that the investment strategy plied before does not work in a new market environment. With an index fund or ETF, you won't be at risk of being right or wrong with your fund picks.
Don't lose more than the market in volatile times: If you are a holder of an index fund or an ETF, you will mentally be sure your investment's return would be close to the benchmark's (unless the fund manager does a poor job of tracking the index). Such a product will offer peace of mind during bear markets, where several funds underperform the market. As was the case in the 2008 crash, the funds that outperformed the most in a thriving bull market are often the ones that underperform when it comes to an end, as they likely took on the most risk.
Don't make it an either-or scenario: You don't have to be either for or against passive investing. Index funds/ETFs could either be core or satellite holdings in your portfolio with active funds also playing a part as per your asset-allocation strategy.
