Active vs passive: Mixed strategy works well, have your feet in both funds

Experts favour passive funds up to 40% in core and a bunch of active funds in satellite portfolio

The Covid-19 pandemic has not just impacted the health of millions, but also turned out to be a wealth destroyer. Equity markets, globally, have fallen significantly over the past month owing to the choking of supply chains and fears that things may not improve soon. The Indian markets, too, have been hit. Since January, the S&P BSE Sensex has gone from a high of 42,274 to 25,638, and the Nifty50 from 12,431 to 7,511. The large-, mid- and small-cap indices have fallen in the range of 24-26 per cent over the past three months. Investors, sitting on significant wealth erosion, would like to see their fortunes change. Some tips from investment experts:      

Active funds for faster recovery: Many leading market experts are of the view that active funds can help investors stage a faster recovery. According to A Balasubramanian, managing director and chief executive officer (CEO), Aditya Birla Sun Life AMC, “In an uncertain economy, active funds will perform better than the broad market.” His logic: A basket of stronger companies, cherry-picked by fund managers, is likely to perform better than the broader markets, irrespective of the economy.

The Indian market’s inefficiency could also work in active fund managers’ favour. Says Nimish Shah, head of Investments, BNP Paribas Wealth Management: “Keeping in mind the inefficiency of the Indian markets compared to those abroad, there are a lot of opportunities here that can be capitalised upon by active managers.” While delivering higher returns, he believes active fund managers can also offer lower volatility. “Most good-quality actively-managed funds have a standard deviation lower than that of their benchmark index,” he adds.  

Contrary to popular perception, market volatility can be a blessing for the active fund manager by throwing up opportunities to pick quality stocks at attractive valuations. “Many businesses that appeared over-priced in December are available at very attractive valuations currently,” says Swarup Mohanty, chief executive officer, Mirae Asset Investment Managers (India). The market’s over-reaction in the short term creates a margin of safety. “Suppose the value of a company gets eroded by 10 per cent, but if the fall in its stock price is 30 per cent, the fund manager entering it enjoys a 20-percentage point margin of safety. Bigger the margin of safety, safer the investor is,” adds Mohanty.

Passive has its place, too: Funds run by talented active fund managers may indeed recover faster than the markets. But the passive investing strategy is gaining currency in India, and not without reason. According to the latest edition of the SPIVA (S&P Indices Versus Active) report, many categories of active funds are, on an average, underperforming their benchmarks even over the long-term (see five- and 10-year performance in the table).

While passive funds can’t give you market-beating returns, they don’t underperform either (or do so only by a small margin, called the tracking error). Moreover, while a small proportion of active fund managers will always beat their benchmarks, predicting in advance who among the hundreds operating in the mutual fund universe will do so is a very difficult task. 

Moreover, returns of active fund managers tend to oscillate. A fund manager who was a top performer over the past five years may not remain so over the next five years.

Highlighting the benefits of a passive strategy, Koel Ghosh, head of South Asia, S&P Dow Jones Indices, says: “The index is created by independent index providers using transparent rules. There’s no fund manager bias in indexing, as happens in active investing. It also comes with advantages like low cost and diversification.”

A simpler strategy to execute: A steep fall in the equity market often plays havoc with the investor’s state of mind. In that state, he is not ideally placed to pick the right stocks or the right active funds. Investors can avoid the trouble of choosing by taking the passive route. As Sundeep Sikka, executive director and CEO, Nippon India Mutual Fund, says: “One can just go along with Jack Bogle’s suggestion: ‘Don’t look for a needle in the haystack, just buy the haystack’. The haystack is a broad market index like the Nifty50.”

Passive funds make investing simpler. You don’t have to keep an eye on the portfolio to see which fund is underperforming, only rebalance periodically. And Indian fund houses are becoming better at managing passive funds. Says Pratik Oswal, head of passive funds, Motilal Oswal Asset Management Company: “Today index funds have become a lot more efficient in terms of how they track the index.”

A mixed strategy works well: Increasingly, experts and advisors are veering towards the view that investors should not stick exclusively to either the active or the passive camp, but have their feet in both. Says Mohanty: “This year onward retail investors should have an active plus passive investing strategy.”

Investors cannot just rely on their ability to pick the right funds and fund managers’ ability to pick the right stocks. At the same time, they need not stick entirely to passive funds that will never outperform the benchmarks. Says Oswal: “Your core equity portfolio, which could be 20-40 per cent of the entire portfolio, should be in passive funds. Leave this part untouched for 10-15 years. In addition, have a bunch of active funds in your satellite portfolio.” What worked in the past may not work in the future. As Amit Jain, CEO and co-founder, Ashika Wealth Advisors, says: “You can’t rely on any one strategy, so have a combination of both.”