November 30, 2022

The Professional Times

Excellence in Every Word

Overglorification of Passive Funds – Investments Insights

In recent times, in the Mutual Funds space a lot is written and talked about passive mutual fund schemes and not surprisingly this increased attention is drawing many investors towards this category of Mutual Funds. This is the outcome of something called popularity bias.

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The popularity itself is assumed as good enough to choose a product without doing any analysis. This is the same as the impact of smart marketing which draws people to a product through the effect of communication. Is such a mistake of picking the wrong product alright while someone invests the hard-earned money for years together with the belief of it yielding great returns? Definitely not

Investments need to work harder than you do to yield more for you. So can a passive fund do that hard work for you. By name itself it is passive and by definition these are funds which have very passive participation by the Fund Manager and these mostly are index based funds where the fund invests in line with the components of a particular index.

As a hard working person deserves better results than a lazy person, isn’t an active fund expected to deliver better than a passive one?

 The discussion of passive funds mushroom whenever select set of index stocks decide the market’s direction. Globally and locally there have been phases of time when select few stocks steered the market movement.

In the US there have been the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Alphabet (formerly known as Google)) which dominated the markets. In India during the 2017-18 the acronym HRITHIK (HDFC Bank, Reliance Industries, ICICI Bank or ITC, Tata Consultancy Services, HDFC Ltd, Infosys Technologies and Kotak Mahindra Bank)stocks used to be popular in the Stock Market circles as these stocks defined the market movement for a while then.

Then there were the SALMAN(State Bank of India, Axis Bank, Larsen and Toubro, Maruti Suzuki, Adani Ports and NTPC) stocks too which did the rounds for the similar reason. It is quite natural that when the market direction is decided by such select stocks , Indices which hold these stocks tend to perform well and even outperform the actively managed fund for that specific period of time.

But this is only a short term phenomenon and in the long run hard work of active funds prevails over passive funds as it has to be.

Appended below is a sheet showing the returns delivered by the top most performing fund in the actively managed Smallcap, Midcap, Flexicap, Multicap fund categories and the Passive fund(Index fund) category in the last 3,5,10,15 & 20 year periods. This sheet below clarifies a sea of difference in the returns delivered by actively managed funds over Passive/Index Funds .

The sheet also has the current value of an investment of 1 Crs in these funds and the opportunity loss of choosing the best performing active fund over the best performing passive fund.

For a 20-year period, the opportunity loss by choosing a passive fund over the best performing active fund is a whoppingly high 57 Crs on an investment of 1 Cr. The difference in returns is significantly high even in lower time frames. This goes on to say the humungous opportunity active funds offer over passive funds.

So those fans of hard work can look up high. Though the hard work of actively managed funds can have temporary rough patches during phases such as the period of HRITHIK and SALMAN stocks, the long term will always be in favour of the active funds. So investors should pick more actively managed funds while constructing their investment portfolio for stellar long-term returns.

Written by

V.Krishna Dassan, Director -Wealth Management, Dhanavruksha Financial Services

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