Active and Passive Funds

Active and Passive Funds

John Bogle launched Vanguard index funds in 1975, and sure enough, even he would not have imagined the kind of growth that index funds have seen over time. On a global scale, passive index funds have amassed USD 3 trillion in assets over the last decade, while active funds have accumulated USD 200 billion. This trend accelerated post the global financial crisis of 2008 as investors developed a sense of disillusionment with active fund managers. Even in India, we are beginning to hear arguments about the superiority of passive index funds over actively managed funds. These arguments are gaining traction from the recent underperformance of previously highly successful actively managed funds. Through this blog, we will try to cover the following:

1.Defining actively managed funds and passive index funds

2.Drivers of alpha creation [alpha =higher returns than the benchmark]

3.Why has alpha disappeared in Indian equity mutual funds?

4.How should an investor decide on allocation between the two categories?  

1.Active and Index funds

A. Actively managed funds: As its name suggests, active investing requires someone to manage the security selection actively. The objective of active management is to generate higher returns (alpha) than the benchmark index. The fund managers managing these schemes believe that the markets are imperfect and that they can use these inefficiencies to generate superior returns. 

B. Passive/Index Funds: In contrast to actively managed funds, an index fund is a form of a passive mutual fund or exchange-traded fund designed to match an underlying index’s performance. Portfolios of index funds are adjusted corresponding to changes in benchmark indexes to maintain the alignment with their benchmarks. For example, an index fund on Nifty 50 will change its portfolio whenever there is any change in the Nifty 50 index. Proponents of index funds believe that markets are highly efficient and there is no possibility of alpha creation. 

2. Drivers of alpha creation 

There are four distinct drivers of alpha creation:

A. Information asymmetry: If a fund manager has superior access to information that can influence the future price of the stocks, then he is likely to do better than the others.

B. Size: A smaller corpus allows the funds to be nimble in the approach and makes it conducive to invest money in companies with low liquidity. For instance, let’s say a fund manager wants to allocate to a company with a market cap of 4000cr and a public float of 1000cr. However, if this fund is large, they will not be able to make a sufficient allocation to the stock. 

C. Research Framework: A superior research framework may lead to a better financial projection of the underlying companies and, therefore, an excellent portfolio performance. Furthermore, a strategy with significantly divergent attributes relative to the benchmark, for example, a higher stock/sector concentration, may contribute to the alpha.

D. Behavioural attributes: A fund manager’s ability to dynamically align a fund’s portfolio with various economic scenarios is an essential behavioural attribute to generate alpha.     

These are the factors that contribute to the alpha generation and present arguments in favour of active investing. Now the obvious question is, “If these factors work, then why is alpha reducing?” Let’s try and understand this in the Indian context.

3. Where has my alpha gone?

Funds Outperformed by the Index(Based on Absolute Return)

The above graph highlights how most active funds struggle to deliver alpha and how apparent their underperformance is relative to the benchmark. The reason lies in the reduced intensity of the factors that contribute to the alpha. These factors are explained below:- 

A. Reduced information asymmetry: Increased corporate disclosure requirements and lightning-quick dissemination of information due to social media are reducing information arbitrage and consequently making markets highly efficient.

B. Size: Corpus sizes of the actively managed funds have gone up significantly. Larger fund sizes affect the fund managers’ ability to be nimble, reducing their investable universe.

C. Increasing research coverage: The proliferation of multiple funds has significantly increased the stock research coverage, impacting fund managers’ ability to unearth unique stock ideas.        

D. Regulatory changes: Regulators over time have reduced the flexibility for the fund managers by defining tight boundaries for funds. For instance, large-cap funds need to maintain a minimum of 80 per cent allocation in large-cap stocks. These changes have reduced the flexibility for the fund managers.

Other factors like higher flows in index funds from EPFO (Employees provident fund) and Global funds has created positive momentum for the index funds. However, even after understanding these factors, the big question remains, ‘Whether to invest in active funds or passive funds ?’ Let’s cover this in the next section. 

4. The allocation conundrum 

There is every reason for investors to be confused and feel unsure about their allocation decisions. To help simplify it, let’s divide the markets into two segments:

 A. Efficient segment: Large capital allocation, higher research coverage, and lower information asymmetry drive the efficiency of this segment. The top 100 stocks in India represent the efficient segment of the market. Given the efficiency of this segment, it’s better to participate in this segment through passively managed index funds. 

 B. Under-discovered segment: There is a large universe outside the top 100 stocks where institutional participation is low. It results in high price inefficiency and low research coverage. However, active funds focusing on this segment can generate significant alpha.  These active funds include multi-cap, Flexi,- cap, mid-cap, and small-cap funds.

In a nutshell

Investors should not think of allocation decisions as active or passive decisions. In fact, over the long term, a combination of active and passive will deliver superior returns. 

Allocation decisions can be made by following the below steps:

1.Decide on allocation preference– Split between Large-cap and  Mid-cap.

2. Identification of the fund managers – Basis the allocation, choose the funds in each bucket with a consistent track record for an extended period.

3. Periodic review– It is essential to periodically review the consistency of the fund’s portfolio with the investment objectives. 

Author: Vaibhav Porwal (Co-founder — dezerv.)

Follow us on: