FUND FLAVOUR

May 2014

 

Active vs. Passive Approaches
 

One of the greatest debates in the investment world centers on whether mutual fund managers, in the aggregate, add any value for investors. Since Vanguard introduced the first index fund in the 1970s, skeptics and critics of the financial services industry have argued that professional money managers have failed to live up to our expectations. Taking all of them together, they simply do not do any better than a random selection of securities in any given market or investment style. On the other hand, there are many managers who have demonstrated that they can outperform a random selection of securities, even after subtracting their fees – you just need to know how to identify them. Furthermore, an active manager can provide benefits that a random basket of securities cannot. An active manager can hold more cash when things look ugly, or sidestep some bad news at a company by selling before the whole thing collapses. In contrast, indexers have to ride the bus off the cliff.

Who is right? Well, if you have to ask, then it is time to go back to the basics and look at how mutual funds – including index funds – are designed and built. You must also examine some of the key metrics. As with so many aspects of investing, context counts, and there is frequently a time and a place for both approaches. When you have a manager – or team of managers – that actively buys and sells selected securities in order to maximize return, minimize risk, or both, that approach is called active management. But what if you did not need to pay a team of analysts to sit around all day and analyze securities? It turns out you can, by means of a special kind of mutual fund called an index fund. Index funds are still mutual funds, arrangements in which you pool your money with other investors. And you still have an investment company that handles your transactions. The difference is that the investment company is not paying a fund manager and a team of analysts to try to cherry-pick stocks and bonds. Instead, the fund cuts out the middlemen, saves the investors their salaries, and just buys everything in the particular index it aims to replicate. This index could track stocks, bonds, or REITs, for example.   

Index funds – one up on active funds

Index funds offer built-in benefits. For the most part, index funds do not attempt to outperform their benchmark, but rather match the benchmark's performance. Index funds invest passively in a portfolio constructed to match or track the components of a broader market index, such as the Nifty. Index funds do not keep your money idle in cash. It is not uncommon for actively managed funds to keep 2% to 10% of their portfolios in cash. That cash can cost shareholders 0.5% a year in return, with no corresponding benefit. You get wide diversification in a single package. Index funds give you control of your exposure to the specific asset classes you want. In an actively managed fund, there is always the risk that a manager will acquire stocks that may seem attractive even though they do not fit the fund’s intentions. Index funds also eliminate the risk of duplication, which can leave you owning several funds that all own the same stocks. These funds have a much lower expense ratio. The absence of active management takes away a lot of risk involved in stock picking and market timing and reduces portfolio turnover ratio. Hence, index funds are potentially more tax efficient. You will most likely get above-average returns. Of course there is no guarantee, but if you buy an index fund and hold it for the long term, your return is likely to be among the top 10% of all returns for funds in that asset class. You will not have to worry about monitoring the performance of an index fund manager. The manager’s only stock-picking role is strictly mechanical - to mirror what is in the index. This is simple and inexpensive. And it is very easy to compare your performance with that of its index. They should be extremely close. Once you have found index funds in the asset classes you want, you do not have to do anything. The only exceptions are adding new money, withdrawing money, periodic rebalancing and occasionally changing the mix of your equity and bond exposure.

On the flip side

The biggest disadvantage is that there is no chance of outperforming the index or beating the market, which is possible with an actively managed equity fund. An index fund does not carry the potential to outpace the market the way that managed funds can. This means that if you invest in an index fund you are surrendering the possibility of a massive gain. The top-performing non-index funds in a given year perform better than the top-performing index funds, and the very best non-index funds can perform far better than an index fund in a year. However, the top-performing non-index funds may vary from year to year, so that under-performing years can cancel out the over-performing ones, while index funds' performance remains steady. Index funds are suitable for those who want to invest in equity but do not want to take the higher risk inherent in traditional equity funds. Because index fund managers must follow policies and strategies that require them to attempt to perform in lockstep with an index, they enjoy less flexibility than managed funds. Investment decisions on index funds must be made within the constraints of matching index returns. For instance, if the returns in an index are declining strongly, index fund managers have few options in an attempt to limit those losses. In contrast, managers of an actively managed fund have more flexibility to act to find better-performing options in good times or in bad.

Because of these built-in structural advantages which far outweigh the disadvantages, one would expect index funds to routinely outperform the median performance of actively managed funds that invest in the same category. Index funds cannot beat the index, but because they approximate the returns of the index while minimizing expenses, the lower expenses should give index funds a noticeable advantage. We would not expect to find a low-cost index fund in the bottom half of the universe of mutual funds with a similar investment style for a long time.

Why is investing in index funds not popular in India?

Index funds are a relatively small part of the overall mutual fund industry in India, and this is markedly different from the west, where index funds do quite well, and in fact the biggest fund in the US is an index fund (SPY) that tracks the popular S&P 500 index. There are two aspects to this – the first is that actively managed funds have performed better than index funds in the past and people expect that to continue in the future as well, and secondly, index funds are not really low cost in India. The question then is why do active funds do better than index funds in India? The markets in the west are so deep and developed that they are efficient to a large extent and it is difficult for stock pickers to find mis-pricings and benefit from them. Indian markets are not so efficient. So, stock pickers are still able to find undervalued stocks and benefit from owning them. The second aspect is that of cost and tracking error of the index funds themselves. The whole point of an index fund is that it should be extremely low cost since there is no active management needed but that low cost has not really materialized in the Indian market.

In the Indian market scenario index funds may not be the best option. The basic principle of indexing is - the more the number of stocks comprising an index the better is the diversification and price discovery. Indian indices like the Sensex (30) and the Nifty (50) cover a relatively small number of stocks and ignore many opportunities in the mid-cap sector. In addition, unlike the capital markets in developed countries, Indian markets have not been thoroughly researched and there is enormous scope to beat the market by sound research.

 

The Final Word

Naturally, investment companies are ferociously defending their turf. They make a good deal of money from people who hire active managers. And some managers have been able to add value for investors over and above their costs in expense ratios and fees. In fact, active management proponents argue that it does not make sense to compare index funds to the average fund because it is possible to identify stronger managers up front. You can, for example, restrict your analysis to active fund managers that have a tenure of at least 5 or 10 years and lower expense ratios. And the debate goes on. To determine which approach you prefer, start by assessing your needs and what you are investing for. For example, will capital gains be an issue – will you be investing in or outside a retirement account? And are you prepared to research mutual fund managers to identify which might procure gains over and above their relative index? The bottom line is that investing in index funds has the potential to offer some of the best returns of all fund investing.