Are you a busy professional and yet want to manage your own investments? We have observed that many individuals like you spend too much time trying to find investments that generate higher-than-market returns. In this article, we discuss why it may not be worthwhile for you to research and buy active funds (funds that have the mandate to beat the benchmark index). While there is virtue in buying active funds, we discuss below the issues associated with such investing.

One, you need to ensure that the fund’s chosen benchmark is appropriate. Why? You are buying the fund because it can beat its benchmark index. Logically, the fund manager should construct her portfolio from the stocks constituting the benchmark to make for meaningful comparison. Now, validating the benchmark is a time-consuming process. You need to analyse metrics such as the fund’s portfolio beta over the last 5 years.

Two, skilful managers have their share of bad luck and can underperform their benchmark. Likewise, unskilful managers can have a streak of good luck and can outperform their benchmark. You need to separate skill and luck. So, even if you validate the fund’s benchmark, you have to spend considerable time to separate the good active funds from the bad. Do you have the time to do so?

Third, if you invest in a wrong active fund, the fund may significantly underperform its peers. For instance, according to Valueresearchonline.com , the best performing diversified fund over a five-year horizon gave 10.5 per cent annualised return while the worst performing return fetched 6.5 per cent. Are you strong enough not to suffer regret, if the active fund that you buy underperforms its peers?

Fourth, a portfolio’s return in the long-term is primarily driven by its exposure to market risk. That is, close to 80-85 per cent of the returns generated by an active fund will be due to market factors. And you can take cheaper exposure to market factors through an index fund. So, why spend the time and effort in choosing an active fund, especially if you intend holding your investment for the long term?

Passive proposal

Buying active funds has its merits. You can enjoy the excess returns if the fund you buy beats its benchmark index. But funds that generate excess returns in the past may not necessarily sustain it in the future! One way you can check this phenomenon is to find whether the fund you selected is consistently ranked among the top five best performers over a one-year, two-year, three-year, five-year and 10-year horizon. More often than not, fund rankings change significantly, suggesting that excess returns that funds generate can be very volatile.

In light of the above discussion, you should consider buying index funds as part of your core equity investments. Why? For one, you do not have to check if the benchmark is correct. An index fund will always carry the same stocks in almost the same weights as the benchmark index.

For another, all index funds on the same benchmark provide the same returns. So, you do not suffer regret from choosing the wrong fund.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to >knowledge@thehindu.co.in )

Related Topics
comment COMMENT NOW