Index Funds vs actively managed Mutual Funds? The debate continues.

Index Funds vs actively managed Mutual Funds? The debate continues.

Shubham Satyarth  | Sep 18, 2019 16:23

A wide-ranging debate has been on for quite some time now – do actively managed mutual funds outperform passive strategies (index funds or index-based ETFs)?

Is it worthwhile to pay upwards of 1.5% as management fee for an actively managed mutual fund?

Before we move on to answer this question, let's first define the difference between actively and passively managed funds:

Actively managed funds are those that are managed by an individual or team who select the fund’s portfolio allocations and change them as time goes on. The goal is to outperform the benchmark index.

In passive management, investors expect a return that closely replicates the investment weighting and returns of a benchmark index and will often invest in an index fund. For example, HDFC Equity Fund is an example of an actively managed fund. The fund aims to outperform NIFTY 500 TRI. On the other hand, HDFC Index Fund Nifty 50 Plan is an example of passive investment that aims to replicate the NIFTY 50 portfolio.

Owing to their low cost, Index Funds and ETFs have been gaining popularity at a very fast rate. So much so that in the US, passive equity funds now account for almost 49% of total market share.

In terms of fresh inflows in the last 4 years (in US), the numbers are overwhelmingly tilted towards passive funds. Since April 2019, active funds (across all asset classes) have seen a net outflow of US$ 855 bn as against a net inflow on US$ 2.0 trillion in passive funds.

That is huge!

The chart below highlights the trend:

Active Vs Passive Chart

Source: Morningstar

The reason for this shift in the US market is twofold:

  1. Extremely low cost. The 1% – 1.5% that you pay as a fee in an active fund is saved. Your returns are boosted by that amount in a passive index fund (net of index fund expense).
  2. Historical evidence suggests that actively managed mutual funds have underperformed passive index funds.

Now let’s come back to the Indian markets.

Point 1 holds true even in India. Index funds and ETFs come at a fraction of cost compared to mutual funds.

But what about point 2? Do active mutual funds underperform index funds even in the Indian markets?

Let’s find out.

Setting up the historical analysis

In order to prove (or disprove) that actively managed funds do tend to underperform index funds, it is important to analyze the data with correct lenses.

Few important points to consider:

  1. Our analysis should not be restricted to a limited set of funds. This will bring in selection bias into our analysis.
  2. Again, our analysis should not be restricted to limited and specific time periods. This will introduce temporal bias in our analysis. For example, just by looking at last 1 year returns, one should not conclude that active funds “always” underperform index funds.

To overcome these problems, here is how we will set up our analysis:

  1. We will consider the entire universe of large cap funds and compare the performance with NIFTY 50 TRI index.
  2. We will consider 4 different scenarios – holding periods of 1 year, 3 years, 5 years and 10 years.
  3. We will consider all possible periods starting Jan 2004. Thus, we will look at rolling 1-year, 3-year, 5-year and 10-year periods all the way from Jan 2004.

Analyzing the percentage of large cap funds outperforming NIFTY 50

Let’s start by analyzing the 1-year holding period returns. The chart below shows the percentage of large cap funds that outperformed NIFTY for every 1-year period starting Jan 2004.

1-year return of NIFTY vs Large Cap Funds

At a first glance, this chart may not make much sense. As you can see, the numbers are all over the place. There are some periods where most of the funds outperformed NIFTY. On the other hand, there are also periods where hardly any fund beat NIFTY.

But one thing is clear. We do not have an overwhelming evidence that actively managed mutual funds have consistently outperformed the index. Nor do we have any conclusive evidence that they have underperformed.

In order to draw some meaningful inferences, we will look at average percentage of funds that have outperformed NIFTY during all these years.

On an average, during all 1-year periods, 53% of large cap funds have outperformed NIFTY 50 TRI index.

In order to get a feel for this number, think of it this way – if you were to pick a large cap mutual fund at random and invest in it for a 1 year period, there was a 53% chance that your returns would have beaten NIFTY 50.

53% is not a big number by any stretch of imagination. Think about it. Only half of all actively managed funds managed to beat the index.

What do the numbers look like for 3-year, 5-year and 10-year holding periods?

Without going into charts, we will simply look at the average percentages.

For a 3-year holding period, on an average, 60% of large cap funds have outperformed NIFTY 50. Similarly, for a 5-year period, 64% of large cap funds have outperformed NIFTY 50. And for 10 years, the number is a decent 73%.

Outperformance of Active Funds

The results are summarized in the table below:

Key takeaways:

  1. As our holding period increases, the overall number of funds beating NIFTY increases. From almost half for 1-year holding, it jumps to a respectable 73% for 10-year period. Yet another reason to stay invested in mutual funds for long term!
  2. Notwithstanding #1 above, even for a 10-year period, there is still a decent percentage of funds that underperform the index. This highlights the importance of selecting the right mutual funds.

Overall, it’s a 50-50 toss up between actively managed funds and index funds. If you manage to select the right mutual funds, you can outperform the index.

Here are some useful links for selecting the best Mutual Funds:

Outperformance of average of all large caps

How to select the best mutual funds to invest?

Best Mutual Funds to Invest in India in 2019
Analyzing the average returns of all large-cap funds
Assume that you invest equal amounts in all available large-cap funds. It will be interesting to see the percentage of times your portfolio outperformed NIFTY. The table below summarizes: These numbers are quite revealing. For 1 year holding period, it still remains a coin toss. However, as we increase the holding period, the number of times our portfolio of all funds outperforms NIFTY increases drastically. For a 10-year period, the portfolio outperforms NIFTY almost 92% of times. This further corroborates our previous finding – as you increase the holding period, chances of beating the index increases. This also highlights the importance of diversification. In our case, we have diversified by investing equal amounts in each available large-cap fund.
Bottom line A “reasonably diversified” portfolio of “good mutual funds” held for a “reasonably long” amount of time has historically outperformed the index a decent number of times.

Shubham Satyarth

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Roshan Mishra
Roshan Mishra

Thoughtful Article👍  ... (Read More)

Sep 18, 2019 11:34 GMT· 1 · Reply
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