Why passive funds are better

The debate over the suitability of passive mutual funds over active funds is getting more heated, of late. With growing evidence that fund managers of actively managed funds are struggling to deliver superior returns, many are now rooting for passive investing, through index funds or Exchange Traded Funds (ETFs)

Fund managers have no role to play in passive investing, thus reducing the expense charged to investors. The money is invested according to the composition of the index on which the fund is based. For instance, an index fund tracking the Nifty 50 will invest in the Nifty 50 stocks, following the same allocation pattern as the index.

But does passive investing work in India? A BusinessLine analysis shows that fund managers of active large-cap funds are struggling to deliver returns higher than index funds but mid- and small-cap funds can deliver for investors willing to take risk.

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Growing trend According to research published in October last year by S&P Dow Jones, the company that constructs some of the most widely used indices, only 2 per cent of the global actively managed funds have given returns that are superior to S&P Global 1200 since 2006. More than 90 per cent of emerging market funds are reported to have fared poorly.

While returns vary depending on the time period considered, there is no doubt that the popularity of passive investing is growing by leaps and bounds in recent times. Inflows into ETFs in the US in the first quarter of 2017 were four times what the funds received in the same period in 2016, at $135 billion. In India too, assets managed by ETFs almost doubled in FY17 to ₹43,179 crore.

Passive funds in India But Indian investors have not really taken to passive investing and mutual funds too have not launched too many index funds or ETF products to enable this form of investing. There are just 21 index funds available in India, with assets of ₹2,363 crore. 17 of them track the Nifty or the Sensex.

The corpus of the few index funds based on the Nifty next 50 index or mid-cap index is meagre.

There are around 47 equity ETFs listed and traded in India, but here too, the choice is very limited. The size of the passive investing segment in Indian equity market compares quite unfavourably with the total corpus of ₹5,13,853 crore for equity mutual funds in India.

Besides lack of options, the fact that Indian equity markets are not mature enough is another argument put forth by supporters of active funds.

We decided to check out if passive funds (index funds ) are better than active funds (large, mid & small-cap and multi-cap funds) in the equity segment. This is what we found.

Investors in large-cap funds Passive investing is based on the premise that markets are efficient where information dissemination takes place simultaneously to everyone, at the same time. In such a market, the ability of the active fund manager to be privy to information that is not publicly available, reduces. This, in turn, makes it difficult to deliver out-sized returns.

The mid- and small-cap stocks in the Indian market can be categorised under inefficient market, where information asymmetry exists, which can be exploited by fund managers. Active fund management can, therefore, work in this segment. But in large-caps, the Indian market is getting close to an efficient market, with fewer opportunities for active fund managers to use.

A BusinessLine analysis comparing the average one-year rolling returns of index funds based on the Nifty and the Sensex with the average one-year rolling returns of large-cap funds throws up some interesting takeaways.

a) Reducing out-performance To check if the outperformance of active large-cap funds over index funds based on the Sensex and Nifty has sustained over the years, we checked the daily difference in the one-year rolling returns of the large-cap funds (category average) over index funds (category average) from 2000 till date. We found that while the extent of outperformance was much larger before the 2008-crisis; this gap has narrowed considerably in recent times.

For instance, in the bull market from March 2003 to December 2007, large-cap funds were able to deliver average returns that were 12 percentage points higher than index funds, when one-year rolling returns of both categories were considered.

When markets recovered from the 2008 crash, the average daily performance of large-cap funds was 6.5 percentage points higher in the period between March 2009 and October 2010. However, if we consider the recent phases of market up-cycles, from September 2013 to January 2015 or from February 2016 to now, the out-performance gap has narrowed considerably to 2.7 and 1.8 percentage points, respectively.

We have considered the category average for this analysis and many funds would have done better relative to the category average. For instance, Reliance Vision, HSBC Equity and Franklin India Bluechip were able to bump up the large-cap fund average in the 2003-2007 period. The 2009 bull market had another set of large-cap fund outperformers such as ICICI focused bluechip equity, L&T India Largecap, and UTI Opportunities Fund that helped the category average with their stellar returns.

This out-performance has, however, narrowed in the last two market-up-cycles despite some large-cap funds such as Birla Sunlife Front-line Equity, ICICI Pru Top 100, SBI Bluechip and Templeton India Growth Fund delivering strong returns, above category average.

b) Market cycle matters Actively managed large-cap funds have been able to deliver returns that were much higher than index funds in the early stages of a market up-cycle. The difference in outperformance however, narrows, significantly as the bull-market matures and stock valuations gets pricey.

For instance, between September 2003 and April 2004, one-year rolling returns delivered by large-cap funds were almost 30 percentage points higher than index funds. The performance gap narrowed as the bull market matured and the larger funds finally began under-performing index funds by early 2007.

This trend is probably applicable in the current phase in the market too. The market has been rising on a sustained basis from the bear-market low in 2009; with minor corrections in between. Most opportunities that could be exploited in the large-cap space might have already been exhausted. Large-cap funds could, in fact, under-perform index funds, going ahead, as they begin making mistakes in a bid to generate alpha (superior returns).

c) No use in sideways market While large-cap-stocks-oriented funds have managed to better index funds when the market is in a clearcut up or down cycle, the managers of active funds seem to lose the plot when the market meanders sideways. Excessive churn, in an attempt to out-guess the market, seems to be hurting the returns of large-cap funds in such phases.

This was observed in the period between September 2013 and January 2015 when stocks did not adopt a clear trend. While index funds tracking the Nifty and the Sensex delivered 12 per cent annualised returns (in absolute terms) in this period, large-cap funds delivered only 9.8 per cent. Investors would have been better off putting money in index funds in such phases.

d) Down-side protection limited It is generally believed that actively managed large-cap funds help contain down-side risk in periods of market fall. This too appears an exaggerated claim since the difference between the loss suffered by index funds and large-cap funds in the market down-cycles witnessed since 2000 is less than 2 percentage points.

In the 2008 crash, while index funds lost 51 per cent, large-cap funds lost 49 per cent. Similarly in the 2015 down-trend, while index funds lost 20 per cent, large-cap funds lost 18 per cent.

e) Savings in expenses What clinches the argument in favour of index funds, when compared to large-cap funds, is the expense ratio charged to investors. All actively managed funds can charge up to 2.5 per cent of their assets as expense while the expense ratios for index funds is capped at 1.5 per cent. The expense charge can increase depending on certain factors. As of March 2017, the average expense ratio charged by index funds with Nifty and Sensex as benchmark was 0.9 per cent of their assets whereas large-cap funds charged 2.5 per cent on average to investors.

The difference in expense ratios can matter significantly to returns, once compounded. With the narrowing gap in performance, the lower expense ratios matter. Expense ratios of ETFs are however much lower. But if you do not prefer exchange traded products, then index funds are for you.

The bottom line: Investors with lower risk appetite who prefer large-cap funds are better off investing in index funds tracking Nifty and Sensex. Our picks among index funds based on tracking error, expense ratio and the size of the fund are UTI Nifty Index Fund , IDFC Nifty Fund and HDFC Index Fund.

Investors in mid, small and multi-cap funds Comparison of passive funds with active in the mid and small cap space is however not possible since there are no index funds or ETFs based on small-caps. Investors with a greater penchant for risk can therefore pick actively managed mid and small-cap funds. In terms of returns, mid- and small-cap funds win by a large margin across all time frames, be it one, three, five, 10, 15 or 17 years. These funds have also managed to beat the Nifty 500 index by more than 10 percentage points over one-, three- and five-year periods. In terms of absolute returns, multi-cap funds come next, delivering strong returns over all time frames.

When we looked at the extent of outperformance of mid- and small-cap funds (category average of one-year rolling return) over the Nifty 500 index’ one-year rolling return since 2000, we found that unlike large-cap funds, mid- and small-cap funds are continuing to do better than the index funds in recent times too. However when the rolling returns was compared with the Nifty mid & small cap 400 index, the outperformance narrowed significantly.

The presence of greater information asymmetry in the mid- and small-cap segment makes it easier for fund managers to pick under-valued stocks early that can boost fund returns.

But due to the lack of sufficient options in index funds and ETFs, mid and small-cap funds are needed to take exposure to this segment and add zest to your portfolio.

Also, given the higher volatility in earnings and quickly changing business cycles in smaller companies, greater involvement in tracking the portfolio performance is required in mid- and small-cap funds. Active fund management might, therefore, be a better idea in this segment.

It is also not correct to assume that mid- and small-cap funds deliver higher losses in market falls. While this was true earlier, in recent market falls, fund managers have managed to contain declines through right cash and stock calls.

For instance, in the 2008 crash, while large-cap funds lost around 50 per cent, the loss in mid- and small-cap fund category was 9 percentage points higher. But in the recent market fall recorded in 2015, while large-cap funds lost 18 per cent, the loss in mid- and small-cap funds was only 12.6 per cent.

Bottom line: If you have higher risk-taking ability, go for actively managed mid- and small-cap funds. Our picks in this category are HDFC Midcap Opportunities, Mirae Emerging Bluechip, SBI Magnum Midcap and Franklin Smaller Companies Fund.

For instance, the Nifty Quality 30 index includes companies that have a strong business and have shown a sustained improvement in margins and earnings. Stocks are selected based on ROE, debt-to-equity and profit growth, etc.

Indices such as the S&P BSE Greenex and the S&P BSE Carbonex can help you contribute towards a cleaner environment.

Problems galore Despite the promise, ETFs are not popular in India. There are just around 47 equity ETFs listed on Indian exchanges, compared with more than 1,000 ETFs listed on the New York Stock Exchange, Deutsche Borse and London Stock Exchange.

Retail interest was high when gold ETFs were popular, prior to 2011. But since then, retail investors have withdrawn from the ETF segment. Only ₹50 crore of ETFs are traded on the exchanges daily. This lack of depth can, in turn, lead to tracking error (difference between traded price and the underlying index).

The reason why ETFs are not popular is because mutual funds do not make any special effort to market them. Distributors also do not promote them aggressively since they seldom get commission on selling ETFs. That ETFs need both trading account and demat account is also considered a deterrent by some.

Since demand is low, fund houses have not launched new products. This is leading to a chicken-and-egg situation as lack of options is affecting demand. But the menu can be widened if other strategic and thematic indices launched by the BSE and the NSE are used to issue ETFs. Only when ETFs become more popular can passive investing really gain ground.

(With inputs from Dhuraivel Gunasekaran)

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