• BlueFort Financial

The Active vs. Passive Debate

Updated: Jan 18

Passive investing - Investors purchase an instrument that mimics a benchmark index e.g. the Nifty 50 or Sensex. They believe it's not possible to consistently beat the index with active stock selection. Other advantages include lower risk and costs. Examples of passive investing are exchange traded funds (ETFs) & index funds.

Active investing - Investors believe that with the right market research, it's possible to outperform the benchmark. It is a knowledge intensive and hands on approach that can be extremely rewarding if done right. Examples of this strategy include direct equity investors, active mutual funds, PMSs, etc.

After an avalanche of passive new fund offers (NFOs) in the past one year, it's natural to wonder whether passive investing makes sense in India. Have we reached a stage where active fund managers will underperform the Nifty/Sensex going forward (like the developed markets)? Or is there plenty of time before our markets reach that stage? Let's take a look at how the two strategies have pitted against each other historically.

Source: "Why active funds beat the markets in India" - Live Mint

Since the industry's inception, actively managed mutual funds have on average beaten the Nifty by ~10% per annum. Of course, this outperformance hasn't come in a linear fashion i.e. there's been a few years where actively managed funds have actually under performed. Please note that the first column takes an average of ALL (good & bad) actively managed mutual funds with no selection filters. It's evident from the data that a long term investor with a wisely chosen mutual fund portfolio would've comprehensively beaten India's benchmark indexes.

This begs the question - Should actively managed strategies continue to form the crux of equity investors in India? We believe the answer is yes. Let's take a look at why fund managers in India are able to create this kind of alpha (outperformance) and will most likely continue to do so in the foreseeable future.

1. Different Risk Factors - India is an emerging economy where most industries/businesses are primarily controlled and operated by families, unlike the developed market counterparts that are professionally run. Due to this, the primary risk factor for equity investors is bad corporate governance. Most retail investors are victims of an inability to judge accounting fraud, capital misallocation, siphoning, etc. A professional fund manager has the resources (access to promoters/management) and information to weed out these wealth destroying companies. Furthermore, there is a misconception that corporate governance issues are prominent in small caps only. It's a rampant problem even in some of our largest listed companies that are present in the Nifty/Sensex. A good example is Yes Bank. The fallen private bank was formerly a part of Nifty. All actively managed mutual funds had eliminated exposure to its stock well before the public debacle.

2. Is Nifty/Sensex really a good representation of the Future India? - Investable indexes miss several high quality stocks. Since their construction is based on market capitalization, only the largest companies are included in the index. Ironically the size of a company is in no way correlated to its wealth compounding potential. There are a lot of PSUs in the Nifty due to their size but they are badly run businesses and haven't created wealth for their investors. Fund managers are best placed to scout for quality businesses by bottom up research. Also by investing in Nifty for example, investors tend to get stuck with industries/companies of the past. They don't get access to upcoming growth sectors like technology, healthcare, IOT, etc. Below is the sector breakup of Nifty as on Jan 2022 -

Source; NSE India

3. Difference between India and the Developed Markets - Research shows that active fund managers in the developed markets rarely beat their benchmarks. Why is this the case? The answer lies in a concept called efficient market hypothesis (EMH). This states that share prices reflect all information and therefore consistent alpha generation is impossible. This makes sense for highly developed and institutionalized markets like the US. The mutual fund assets under management (AUM) in the US is 103% of the US GDP which means almost the entire market's volume is run by professionals. In India the equity mutual funds AUM is just 4% of our GDP! Clearly participation in Indian equity markets is still very fragmented and far from institutionalized. Penetration is abysmally low. This is why fund managers are able to outpeform the broader markets and direct equity portfolios. They're basically competing with individuals…

4. Lack of Investable Passive Products - There are close to 170 passive funds in India with Rs. ~3 lakh crores in assets. However a majority of the AUM lies with the top few funds confined to the Nifty and Sensex. In fact SBI ETF Nifty 50 holds almost half the category's AUM. In other words passive investing in India is still very underdeveloped. This leaves most other ETFs/index funds tracking other, perhaps more interesting indexes illiquid and barely investable. In fact India is a unique market. It is one of the largest stock markets in the world (~3.50 USD trillion) with the most amount of listed companies (>5000) but yet liquidity is highly concentrated around the top 100-150 stocks. Everything after barely offers liquidity. Market breath is very limited. For passive investing to work, market penetration has to wildly improve as discussed in the previous point.

There seems to be a consensus among Indian asset managers, who run both active and passive strategies that active strategies will continue to outpeform. Nilesh Shah, MD of Kotak Mahindra MF and a member of the advisory committee to SEBI says "alpha may not be generated on a daily basis, it could be sometimes up and down. In 2017 lot of midcaps underperformed benchmark indices because indices had a particular IT stock which moved from 1 percent to 4 percent and most good fund managers avoided investing in that company. With the benefit of hindsight today, fund managers are proven right as that stock is down 90 percent from the top. So there will be a deliberate underperformance to index because people don’t want to compromise on their investment processes. If active funds are outperforming, invest with them because you are generating better returns than benchmark indices." The current bull cycle will inevitably show a similar result.

At BlueFort Financial too we believe active funds should continue to dominate portfolios. However there is a caveat. As our markets develop choosing the right fund manager to generate outperformance will require more research and time. This is where having a high quality selection process that takes into account both quantitative and qualitative filters becomes more and more important. It's imperative that your advisor is able to explain their recommendations with a selection process in detail.

Siddhanth Jain | Partner

BlueFort Financial