In terms of fund management, mutual funds can be broadly classified into two categories: actively managed funds and passively managed -- better known as index funds. In an actively managed fund, the fund manager uses his expertise and skills to select stocks across sectors and market segments.
The sole intention of actively managed funds is to identify the best investment opportunities and exploit it in order to generate superior returns, and in the process outperform the benchmark index.
On the contrary, index funds are aligned to a particular benchmark index like the Nifty or Sensex. They attempt to mirror the performance of the designated benchmark index, by investing only in the stocks of the index with the corresponding allocations.
In developed economies like the United States for instance, index funds are very popular among mutual fund investors and are preferred over actively managed funds. This is because of the clear advantages they offer to investors, like no loads and lower expenses among others.
Moreover, in the United States, stock markets are more efficient, so investment opportunities are at a premium. They are relatively difficult to identify, because widely disseminated research makes just about everyone aware of these opportunities, so this blunts the first mover advantage.
As a result, a number of actively managed funds in developed economies fail to outperform the broader stock market indices thereby pushing the cause of index funds.
Investing in index funds is relatively less cumbersome. Here, the two most important points which investors have to look out for are the expense ratio and the tracking error (i.e., the difference between the returns clocked by the benchmark index and index funds).
Thus, unlike actively managed funds, index fund investors can forgo other aspects of investing such as fund house's investment philosophy and the kind of funds to choose -- a large cap/mid cap/small cap fund.
On the other hand, investors investing in actively managed funds have to assess all the above-mentioned criteria and more before investing. These funds have to capitalise on the opportunities in the market to generate superior returns. Thus, in the process they employ more resources (more analysts/fund managers) and in turn charge higher expenses than index funds.
In the Indian context, the mutual funds segment is dominated by actively managed funds. Index funds occupy a much smaller share of the market.
This is because Indian stock markets, being in a developing phase, still offer enough investment opportunities that if identified earlier on can outperform the benchmark index over the long-term (3-5 years). So well-managed actively managed funds have done a reasonable job of going one up over the index over the long-term.
We did a brief study wherein we faced-off the average category returns of index funds (passively managed) vis-à-vis those of diversified equity funds (actively managed). In a way, the results are on predictable lines.
Active Funds: Long-term bets
| Categories | Average category returns | ||
| 1-year (%) | 3-year (%) | 5-year (%) | |
| Index funds | 55.5 | 35.0 | 32.7 |
| Diversified equity funds | 40.4 | 42.6 | 45.3 |
On comparing the category average returns of active funds and passive funds over varying time frames, one can conclude that it's something of a mixed bag, with each category performing well only over a certain time frame.
For instance, over 1-year, index funds (55.5%) are ahead of diversified equity funds (40.4%). However, extend this time frame to 3-year and even 5-year, and the scenario changes completely. Gone is the sheer domination of index funds over active funds.
Over 3-year, diversified equity funds (42.6%) have comprehensively outperformed index funds (35.0%) by 7.6%, and this gap further widens to 12.6 % over 5-year.
In a nutshell, even in the Indian context, index funds offer advantages like lower expenses (although they aren't quite as low as they should be compared to US Index Funds) and lower volatility in performance as compared to actively managed funds.
They can also outperform actively managed funds although usually only over shorter time frames (less than 3 years). But over longer time frames of 3-5 years (which is ideal for evaluating equity-oriented funds), actively managed funds more than hold their own against index funds.
Hence, for risk-taking investors, actively managed funds should occupy a larger share of the portfolio. Index funds can also occupy a smaller share, mainly from a diversification perspective.
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