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:
The reason for this shift in the US market is twofold:
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:
To overcome these problems, here is how we will set up our analysis:
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.
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%.
The results are summarized in the table below:
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:
Written By: Shubham Satyarth
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