Most actively managed mutual funds have underperformed their benchmarks in recent years. Seven of the ten best-performing large-cap mutual funds over the three- and five-year period are passively managed funds such as ETFs (Exchange Traded Funds) or index funds. A passive fund is a type of mutual fund that religiously tracks a market index for maximum returns. In contrast to an active fund, the fund manager of a passive fund does not actively select which stocks to contain. Passive funds are therefore significantly cheaper. But are actively managed funds not in vogue? And is it time to switch from the low-cost passive funds for better returns, especially in the large-cap mutual funds category?
The performance of funds over long periods of time is always influenced by more recent runs. Mutual fund experts continue to rely on the active management strategy, as they believe that the equity segment offers fund managers sufficient opportunities to generate alpha within large caps. Alpha is an excess return on an investment that is above the benchmark return. The experts are not convinced that the lower fees for passive fund programs are reason enough to switch completely from active funds.
“Nifty 50 has clearly outperformed the large-cap category average over the past year. This has resulted in outperformance over the three and five year periods. However, some individual funds have managed to generate alpha over 50 in three and five years, ”says Dr. Ashish Shanker and CEO of Motilal Oswal Private Wealth Management. “The domestic stock market still offers scope for alpha generation within large caps, as managers demonstrated last year.”
Passive funds are cheaper
Passively managed large-cap funds calculate an expense ratio of 0.05 to 1.11 percent, while the expense ratio in actively managed large-cap systems can be up to 2.72 percent, according to data from Value Research. The expense ratio is the annual maintenance fee that mutual funds charge to fund their expenses. It includes annual operating costs such as management fees, allotment fees and fund advertising costs.
In the past year, Nifty 50 is up 67 percent. A comparison between the returns of some large-cap funds (chosen at random, with a 10-year track record) and the returns achieved by the Nifty 50 index and the category average over the 10-year period shows that actively managed systems outperformed the index achieved (see Fund Facts). Some actively managed funds have also generated alpha above the index over the one, three and five year periods.
Past performance is never an indication of the future. In contrast to passively managed funds, actively managed funds are better able to take advantage of dynamic market conditions and make tactical allocations in attractive stocks or sectors at the discretion of the fund manager.
Choosing the right fund
Developed markets like the United States have shown that both active and passive funds have enough headroom to coexist. So you don’t have to choose one over the other. However, investors should pursue either an active or a passive strategy in their portfolio that matches their financial goals, experts say.
“Passive funds are primarily suitable for institutional players or investors looking to take a look at the broader markets. Active funds are better suited for investors who have access to quality advice to identify managers who have the potential to outperform the markets, ”says Dr. Raghvendra Nath, Ladderup Wealth Management.
Any debate about active and passive funds is usually about investing in large-cap schemes. This is because there are few passively managed systems in the mid- and small-cap fund categories. According to Value Research, 59 of the 93 large-cap funds are passively managed, but there are only three passive systems in the mid-cap category out of a total of 30.
Mid and small cap funds are more volatile than large caps. The mid-cap index comprises 150 stocks, while the small-cap index comprises 250 stocks. According to Shanker, this is an area that is conducive to stock selection. “So it makes sense to stick to actively managed mid- and small-cap strategies,” he says.
Another factor that complicates the passive management style – especially with mid and small caps – is illiquidity. This can lead to a higher tracking error. The tracking error is the difference between the return of the scheme and that of the benchmark. “Because many small-cap stocks are fairly illiquid, it may not be possible to get them without a major impact. And when the index funds get big, they’ll add increased volatility in many of those stocks, which in turn would lead to higher tracking error, ”says Nath.
The idea of a passively managed fund is to reduce the tracking error to the lowest possible value. The greater the deviation from the benchmark returns, the higher the tracking error of a scheme should be.
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