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Are active funds better than passive funds? - Outside View by PersonalFN

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Are active funds better than passive funds?
Jan 18, 2019

Is today a right day to have this discussion?

Many of you might feel, no.

The world of investment is mourning today!

Death of John Bogle, founder of Vanguard group-one of the leading low-cost investment management companies, has been the irreparable loss to the investment world, indeed.

It wouldn't be inappropriate to say that he pioneered the concept of low-cost-passive investing. He was a staunch proponent of the passive investment philosophy: 'trying to beat the market was wasteful and expensive for common investors'.

PersonalFN believes, today is the right day to acknowledge his great work, one more time.

About 43 years ago, in 1975, he launched world's first index fund in the U.S.

Since then, the acceptance to passive form of investing has been on the steady rise.

The past 20 years have been remarkable specifically.

According to Forbes, merely 12% equity mutual fund assets were passively managed in the U.S. in 2000. By the end of 2017, the share of passively managed equity AUM jumped over 42%.

Globally, the perception about passive investing has dramatically changed over last 10-20 years. Until then, if you had invested in passively managed index-based equity Exchange Traded Funds (ETFs), you were perhaps a lazy/novice/scant investor.

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But in the aftermath of global financial crisis of 2008, investors realised the importance of (or learned it hard way) asset allocation and preferred the safer route of passive investing.

This doesn't mean that passive investing is safe and free from the risks equity investors generally face. However, passive investing drastically reduces the risks associated with wrong selection of stocks in a portfolio (at the mutual fund level) and wrong selection of a mutual fund scheme (at investor's level).

With the advent of technology, asset management industry became competitive and costs associated with passive investing fell sharply.

At present, some fund houses in the developed economies offer zero cost index products.

Speaking about India, the debate about active vs. passive mutual fund schemes is heating up.

Passively managed ETFs have been gaining acceptance in India. Their Assets Under Management (AUM) have surpassed Rs 1 lakh crore mark (approximately 4% of mutual fund industry's total AUM) and more people seem to be getting convinced with them.

Does that mean globally, investors are forming a consensus that actively managed funds can't generate market beating returns anymore?

Will passive investing displace active investing soon?

According Ernst & Young (EY), the market share of passive funds (in the equity segment) globally is expected to rise from 14% in 2011 to 31% in 2020. Currently, it's estimated to be approximately 26%. In other words, active funds are here to stay, despite rapidly gaining popularity of passive funds.

In India, a considerable part of organised pension money has started to flow into equity markets through ETFs, thanks to Employee Provident Funds Organization's (EPFO's) decision to

invest 15% of its corpus in equities. Besides, High Net-Worth Individuals (HNIs) and some retail investors have been showing more faith in passively managed funds lately.

Shall you select a passively managed Index-ETF over an actively managed equity mutual fund? PersonalFN believes you shouldn't.

In fact you should try to invest in mutual fund schemes that offer you better results than passive funds without compromising on the benefits of passive funds.

Hence you should invest in mutual funds that can consistently beat markets and their peers. And prefer mutual fund houses that pass on cost-savings to their investors through lower expense ratios.

In fact, John Bogle's firm belief in passive investing has served a lot even for the investors of actively managed funds.

Given the fierce competition posed by the passively managed funds, active funds braced up, became more competitive, slashed their expenses, and, more importantly, became more responsible.

Here's why actively managed funds shall form the core of your portfolio in 2019 and beyond

  • Historically, top-quartile actively managed funds in India have managed to beat their respective benchmarks consistently and especially in difficult market phases. 2019 is expected to be a highly volatile year for global markets. Apart from facing global headwinds, markets in India will have to deal with Lok Sabha election 2019. If India gets a weak mandate, India's index stocks might not fare well. Under such circumstances, passively managed funds might underperform actively managed funds.
  • Relatively higher costs associated with actively managed funds are often construed as a disadvantage in comparison with passively managed funds. However, expense ratios are likely to come down in India as investing in Systematic Investment Plans (SIPs) through direct plans is getting popular. Direct plans can help you save costs associated with mutual fund investing.
  • Developing countries like India are unlikely to run out of alpha-opportunities any time soon. Simply going by the dominant share of the unorganised sector in the Indian industry, there will be enough alpha-opportunities when these businesses join the mainstream. That said, the recent failure of actively managed funds to outperform broader indices will haunt the industry for some more time.

[Read: What's In Store For The Indian Mutual Fund Industry In 2019 And Beyond?]

To build a solid portfolio of actively managed mutual fund schemes, you should follow various quantitative and qualitative parameters.

Before you invest in mutual funds it is necessary to check the following:

  • Your risk profile
  • Your investment objective
  • Your financial goals
  • The time horizon you have in hand before goals befall

Watch this video to learn the formula of selecting the winning mutual fund

PS: If you're looking for "high investment gains at relatively moderate risk", this report is extremely worthy. In this report, PersonalFN will provide you with a readymade portfolio of its top equity mutual funds schemes for 2025 that have the ability to generate lucrative returns over the long term. PersonalFN's "The Strategic Funds Portfolio for 2025" is geared to potentially multiply your wealth in the years to come. Subscribe now! .

Author: PersonalFN Content & Research Team

This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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