Index funds or actively managed funds?

Feb 28, 2023

Every meeting, every event and at every gathering, there’s one question that comes up within the first 5 minutes of our conversations. And here’s how it goes: Would you prefer tea or coffee?

For a person like me, who is neither a coffee nor a tea connoisseur, my usual response to this question is ‘Neither’. But I think about what’s going on in the minds of the people who pick one over the other – its like choosing between a caffeinated kick of energy and a more subtle nudge of gentle warmth and comfort. Both the beverages share significant differences. Yet, the choice is always between the two – tea and coffee as they stand head-to-head in battle. It’s never between, say a carbonated drink and tea, or an energy drink and a coffee!

This is extremely relatable, especially when people ask the active versus passive question. We just got one: Are equity index funds superior to actively managed equity funds for long-term (15 years) investors?

The two are starkly different, just like the two warm heart hugging drinks that we’ve all loved ever since we’ve first tasted them! Yet the debate is a never ending one. So how do we choose between tea and coffee, or in this case between active and passive funds?

To put things in perspective, developed markets like the U.S. have witnessed a huge move towards passive investing with low-cost managers like Vanguard ruling the roost for fairly long periods of time before investors began redeeming their investments out of passive funds and investing them in other asset classes/categories. Now another interesting point to note here is that inspite of their growth in the Index and ETF business, Vanguard continued to hold a significant book of business on the active side too.

What passive funds offer in the form of low costs are being eroded in the U.S. markets by advances in technology, consolidation in the industry and heightened competition. But this is an example from a different market that has a matured advisory model, is well penetrated and has witnessed both active and passive strategies thrive.

India is a totally different market altogether. We’re a growing economy that is witnessing growth across asset classes, mutual funds, PMS, AIF’s and Infrastructure to name a few. Passive funds have been taking on a significant position and have witnessed a growth of over 100% in terms of the number of funds in 2022 alone. The total AUM in Index funds stood at Rs 1,28,984.39 cr in December 2022, with inflows into index funds totaling about Rs 85,173.43 cr during the year. Fund houses have been launching index funds across categories like the small and mid-cap, for instance, and these funds have been witnessing a lot of flows too.

While passive investing in a great way to ensure that an investor’s returns are as close to the index as possible, there are a few risks to consider too. For example, passive funds could underperform when the index falls, this is especially true in a volatile market. Similarly, the fund follows the index construct, which is in turn based on the free float market capitalization. This essentially focuses on investing in the largest stocks within the market. Often, indices could become overexposed to a certain stock or set of stocks, and this could have a huge impact on performance.

It’s important for investors to think through your decisions and goals because everything that’s ‘trending’ may not be relevant for a particular investor. While index funds are a great option because they are low cost, it’s important to remember that they replicate the index, thus investing in a lot of stocks, irrespective of their fundamentals. It’s important for an investor to understand these aspects when it comes to investing in passive funds.

There are a few other advantages of investing in passive funds too, with some of the funds focusing on various themes like ESG and Smart Beta. A lot of index funds are used as a building bock for asset allocation and offer innovative solutions. A lot of new indices have also been launched which will possibly offer investors a lot of options to choose from. While we think that the passive funds act as a great addition to an investor’s portfolio, a combination of active and passive funds is what works well, especially over the long term.

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ninan joseph
Mar 5 2023 12:03 PM
Writing this from Nifty 50 Index perspective.

One of the disadvantage of investing in Index fund (nothing major, but a thought which no experts ever tell you), is that as these are rule based, you as a unit holder or a investor are indirectly invested in companies which you may not like to own.

Recent example of Adani Group, Nifty 50 Index has one of the group stock and when the fall happened, a month back, the passive investor can do nothing but just watch the bleeding and this will have its effect on the NAV. If the same was managed by an active fund, the fund manager would have sold the stock, cut the loss and stopped the fall. I do agree that this is a one in a million situation, but think for the last one month, the group was falling, the index investors could do nothing but just sit and watch the fall.

As these rule based, in the next review, Adani Wilmar is getting added into nifty next 50 index and replacing one of the better stock. You could do nothing about this.

The obvious question is when things were going uphill, nobody complained and why rant now. The point is, if it was one of the black swan event, it is accepted, but this Adani event was a downhill for the last one full month and still on and off falling.

The worst is at this point of time, they are adding Adani Wilmar in Nifty next 50. The same thing happened when One communication (Paytm) came out with an IPO, it qualified into Nifty Next 50, although the entire world except the anchor investors knew this was over valued and loss making.

There must be some changes in the rules as Index funds are mainly owned by Retail investor and their interest must be protected.
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