The active versus passive investing debate cannot really be resolved academically. In theory, a perfectly efficient market offers an advantage to passive index players. However, perfection is as unattainable in financial markets as in other spheres of life.
The efficient market hypothesis suggests that, given equal access to information, equal ease of trading, and so on, all news is immediately absorbed by the crowd. Investors take individual actions. Price swings more or less randomly in response to the combined effect of their buys and sells.
In an efficient market, the optimal investment strategy is therefore, to stick to the index. However, access to information is rarely equal. Nor do all participants find it equally easy to trade – for one thing, brokerages are skewed. A third condition is also rarely if ever, met – there shouldn’t be any participants who have overwhelming influence. If we include “non-playing captains” such as policy-making institutions, this condition is never met.
So markets are to varying degrees, imperfect. These imperfection help to explain the small but significant number of investors who consistently outperform indices. Some are plain lucky. Some have access to better information, or deeper pockets, or both. Finally some are perhaps genuinely gifted at forecasting trends and manage their money more efficiently.
However, the available data suggests that most active investors get it wrong. Markets may not perfectly efficient but they are efficient enough to make a strong case for index-investing. An easy basis for comparison is the performance of index funds versus actively managed funds.
Apart from anything else, active funds pay more brokerage and they usually charge larger fees. The global data clearly suggests that there isn’t much percentage in paying for active fund management. The performance of Indian mutual funds mirrors global data to a certain extent. But it also suggests that India is more imperfect than most large markets because there are more outperformers.
S&P (and Crisil) has a global methodology, SPIVA (S&P Indices versus Active funds), which generates scorecards of performances of funds. The India SPIVA which covers most categories like equity, debt, ELSS, hybrids throws up some interesting points, which investors could bear in mind.
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First, if you must buy actively managed equity funds, you should buy into the diversified equity segment (DE) rather than large-caps. Large cap focussed funds tend to underperform their respective indices more consistently.
Roughly one in three large cap active funds beats the benchmark, over five years. ELSS has similar levels of underperformance despite the lock-in periods, which ensure that fund managers don’t have to worry about unexpected redemption pressures. Diversified equity funds also tend to underperform but there are more outperformers in the DE segment. About 45 per cent of DE funds beat the benchmark over five years and half the DE universe beat the benchmark over three years.
A second learning seems to be, buy into bigger funds. Funds with more assets under management tend to be better performers. This could be some sort of effect caused by selection bias. Investors put more money into better performing funds and this means the better performers end up with more AUM.
Third, unlike equity, speculation in debt actually seems to offer rewards for active investors. Quite a few pure debt funds outperformed benchmarks. Despite the significant structural risks of Monthly Income Plans, hybrid MIPs with a higher debt component have done well.
Debt funds that focussed in corporate debt also tended to beat the benchmarks. This is interesting because it implies that fund managers made the right calls in assessing the relative risks of different corporate debtors. Given that the interest rate environment went through two full cycles, it is quite impressive. Conversely gilt funds didn’t do so well, which means that fund managers are more liable to misjudge policy rate moves.
If we look at highly evolved markets, such as the US, roughly one in ten equity-oriented funds beats the market over a 5-year period. The ratio is also skewed against actively managed debt funds in the US. That is more understandable because the US bond markets is much broader, and deeper and more liquid. So where does that leave the Indian fund investor? There’s evidence that, unless you’re great at equity fund selection, going with indexation is sensible. However, though it’s odds against, it’s not really too bad at 1:2 for large caps or 9:11 in the case of DE.
The data confirms that the debt market, especially corporate debt, is very inefficient . Here, active management definitely has the edge. However debt fund managers are better are judging the credit-worthiness of corporates than second-guessing the RBI.