Index Funds vs Actively Managed Mutual Funds

There is an ongoing debate in India about Index Mutual Funds Vs Actively Managed Mutual Funds. Is the debate worth it? Which type of Mutual Funds are better for Indian market? Is Indian market mature enough to switch to Index Funds across all segments of Mutual Funds? Who is the winner? Read on...

What is an Index?

With thousands of company listed on a stock exchange, it is really hard to track every single stock, and therefore, evaluate the 'market performance' at any given point of time. So, then, how do you judge the performance of a market? Here is the solution. A smaller sample from these thousands of Stocks, but the sample is so chosen that it is a close representative of the whole market. This small, carefully chosen sample, is called Index and it helps in the measurement of the value of a section of the stock market. The index is computed from the prices of selected stocks. For example, Sensex also called BSE 30, is the market index consisting of 30 well-established and financially sound companies listed on the Bombay Stock Exchange (BSE). And Nifty, also called NIFTY 50, is the market index which consists of 50 well-established and financially sound companies listed on National Stock Exchange of India (NSE).

What are Index Funds?

Index funds, as the name suggests, are the funds or the schemes that invest in a particular index. These funds purchase all the stocks in the same proportion as the index it is bench-marked to. This means the scheme will perform in tandem with the index it is tracking. For example, if an index fund is bench-marked to Nifty 50, it will buy all the 50 stocks in the Nifty index in the same proportion as Nifty 50.  

Some examples of popular Index Funds include NSE Nifty 500 TRI, S&P BSE 100 TRI, NSE Midcap 100 TRI, S&P BSE Small cap TRI. Big institutions such as the Employees Provident Fund Organisation (EPFO) also invest through index funds rather than actively managed funds. Such funds are process driven rather than person driven. And the reason is obvious. These funds invest in an index and the manager doesn’t have to choose the stocks to invest.  These are, therefore, also known as Passive Funds. 

[Recommended Read --> What are Index Funds in India]

What are Actively Managed Funds?

Actively Managed Funds or Active Funds, or simply referred as 'Mutual Funds' are just the reverse of Passive Funds. These are the most preferred route for Mutual Fund investments in India as on date. In an active fund, the fund managers choose the stock to invest based on the goal of that fund. Here, the manager tries to beat the market by choosing better stocks. Nevertheless, the problem with active funds is that the return on these funds depends on the goal and efficiency of the fund manager. Moreover, even if you are able to find a good fund with a coherent manager, still there is some danger of what might happen in the case the manager quits and moves to some other company. Tracking the manager along with the fund becomes a headache for many investors. Since these funds have more freedom and flexibility on investments, they are expected to outperform the index funds.

There are hundreds and thousands of Actively Managed Funds to chose from. Some of the examples are ICICI Pru Value Discovery Fund, Reliance Small Cap Fund etc.

Well, if an actively managed fund can outperform the index fund, then why would anyone invest in an index fund? And why is there even a comparison discussion being done between Index Funds and Actively Managed Funds? 

To be able to understand that, one must understand the origin of Index Funds.

History of Index Investing

In the 1950s, American investor John C. Bogle conducted a study for his undergraduate thesis. He found that most mutual funds in the US failed to beat their benchmark index. Some of the funds did beat the benchmarks, but couldn’t pass on the benefits to the investors as the fund running charges (covered in various Expense Ratios) were higher than the margin of out-performance. Hence Bogle concluded that it was better for retail investors to invest directly in the index. [Recommended Read --> Understand the Charges on Mutual Funds]

In 1976, Bogle launched the first passively managed fund, also known as an index fund, based on the S&P 500. The fund was called Vanguard 500 Index fund. This index constitutes the 500 largest companies in the US market. Because it was passively managed, Bogle charged a very low fee. Later Bogle launched more funds, but the Vanguard 500 Index fund remains the most popular fund till date in the history of Index Funds.

From there on, Index Investing became popular in most countries. And for some, it happened to be the preferred vehicle of investment.

Why Index Funds are preferred?

1/ Low Total Expense Ration (TER)

These funds incur significantly lower expenses than actively-managed funds. For example, UTI Nifty Index Fund has an expense ratio of 0.20 per cent, whereas actively-managed funds may charge around 1 per cent on direct plans and around 2 per cent in regular plans. 

2/ No dependency on Fund Manager

In the index funds, the stocks are not picked by the fund managers. These funds are merely copying the index. That’s why even if the fund manager of an index fund quits, it won’t create any havoc (unlike actively managed funds).

3/ Easy Selection of Funds

For the active funds, you need to read and understand the reason why the fund manager believes any stock can perform well in future. And this can be a very tedious job.  On the other hand, the stock selection in the index fund is quite straightforward.

Can lower Index Fund charges cause significant difference in your portfolio returns?

1% difference to your returns can definitely be mind boggling if allowed to compound over a long term, say, 30 years. 

[Recommended Read --> How powerful can Compound Interest be?]

So, lower charges of Index Funds can definitely help. However, the same holds true if the actively managed funds give you even 1-2% extra returns over index funds (this difference is often referred to as Alpha). This out-performance is what you expect from any Actively Managed Fund. Even a little out-performance can help investors build a better corpus over a long-term. So, the debate that lower charges of Index Funds can help, stands true only if the actively managed funds are unable to generate that 2% alpha that they promise to. And what if they can deliver more?

What are the factors causing a shift towards Index Funds in India?

A host of factors have brought maturity to the Mutual Fund market in India. And the more the market matures, it becomes more and more difficult for actively managed funds to outperform the index funds. Some of the most recent key factors in India that have triggered this debate on media are as follows:

1/ Re-categorization of Mutual Funds

With SEBI laying down strict mandate for schemes after re-categorization, there won’t be a 'huge' disparity in the return given by most schemes within a category. Earlier, we used to compare oranges to apples. For example, 80 per cent assets of all the large-cap schemes will now be chasing the top 100 companies. There is not much room for experiment. When your universe is strictly defined, you will more or less be betting on the index. Still, the fund manager can pick better stocks and beat the benchmark, but the quantum of that out-performance will be less.

But remember that this is restriction of universe is primarily constrained for Large Cap Funds. The big money is, however, made in the mid and small cap segment. And there is still enough room to experiment here.

[Recommended Read--> What are Large, Mid and Small Cap Funds]

2/ Introduction of Total Return Index or TRI as benchmark

The move was to make the out-performance of schemes more transparent. The regulators believed that the performance claimed by the mutual fund schemes (actively managed ones) was not fair because the returns shown by the schemes had dividends from their stock-holdings whereas the benchmarks were based only on price. This bought the percentage of out-performance down by 1.5 per cent annually. 

Such moves by the regulating authorities are a step towards market maturity and have created an environment where a shift towards index funds looks inevitable. However, nobody is sure when it would actually happen, though. One must keep in mind that Active out-performance is also associated with young, developing markets. As markets mature, the out-performance of active managers may wither away. India may well be approaching exactly this sort of stage in its own markets.

How soon will the switch to Index Funds happen in India?

The shift to index funds is inevitable. Index Funds rule the developed countries today. However, it is unlikely to happen anytime soon here in India. If at all it happens, it would be a very gradual process. This is mainly because the actively-managed mutual fund schemes would continue to offer superior returns in a developing market like India. Sebi's effort to bring down the TER of mutual fund schemes have been working. Mutual fund houses have been mailing investors about the changes in TER of their schemes, lately. This transparency would result in lesser difference in the expense ratios between actively and passively managed schemes, which might dissuade investors from shifting to index funds in a hurry - since low expense ratios was the biggest strength of the passively managed funds.

Then, Does it makes sense to stay with actively managed funds?

Yes, it still makes a lot of sense to stay with the actively managed funds, at least for the next 5-10 years in a country like India. There are various reasons, if you compare Indian fund market with that of a developed market in US:

1/ The number of actively traded companies in India is significantly lower than that of the US. That means markets are far less efficient thus providing enough opportunities to generate alpha. 

2/ The size of the mutual fund industry in India compared with the total market capitalisation is insignificant. For example, the size of mutual fund industry crossed 16% of total market cap only last year. As opposed to this, mutual fund AUM accounts for over 85% of the total US market cap.  

3/ Indexes in India are not managed the same way as the S&P 500 of the US. Popular Indian indices simply weigh the components based on their market capitalisation. The S&P 500 weights are actively decided.

4/ Expense Ratios for actively managed funds are shrinking and coming more close to passive index funds - closer than ever before.

5/ There is a lot of churn happening even within the index funds, as new index funds get created depending on the market maturity. Read more about them in the below section.

What is new in the Industry?

There is the emergence of newer index funds such as the Nifty Next 50 that can provide competition, especially to the large-cap category. Smart-beta and multi-factor index strategies which decide stock allocations based on factors such as sector/ theme, volatility, valuations, fundamental metrics and so on are also emerging; albeit with limited awareness at this stage. These have the potential to to outperform the traditional market-cap weighted index funds. For example, the Nifty Next 50 is one index which has managed to beat traditional large cap index funds like Nifty 100 as well as some multi-cap funds.

These emerging products, which may be little more actively managed than traditional index funds, may provide efficient substitutes to the lagging segments in mutual funds.

What does the Data point to?

1/ On a 3-year rolling return basis, apart from large-cap category, all other categories beat their indices over 70% of the times in the last 8 years. The large-cap category still managed 53%.

2/ On a 5-year rolling return basis, multi-cap and small-cap funds have almost always beaten their indices over the last 6 years. ELSS and mid-cap funds have managed to beat the indices around 90% of the times. Large-caps beat the index 60% of the time.

3/ The average margin of out-performance is very small for large-cap funds, slightly more for multi-cap and ELSS funds and bigger for mid-cap and small-cap funds. Again, the margin of out-performance was higher over a 5-year period.

4/ Looking at any period less than 3 years is not going to give you a reliable conclusion - because the period is too small to make a judgement.

5/ Large Cap funds has been a struggle for actively managed funds compared to Index Funds. The Nifty 50 index has outperformed the average large-cap funds’ returns by 1.3% in the last one year (point-to-point returns). However, if you look at even slightly longer term returns, you will find actively managed funds, on an average, doing better than the indices, with better managed funds (above-average funds) doing significantly better. For the last 3-, 5-, and 10-year periods, actively managed funds have outdone the benchmark index by 1.2-2%.

6/ investing in any of the 10 largest actively managed equity funds in India would have given you 1.5 times the return of the Nifty over the last five or ten years.

Summary

You cannot beat the market, so you must buy the market - that's the rationale for index investing. We are still a long way from being a perfect market, so there is still a lot of scope for investors to gain from actively-managed funds. 

The first type of fund that will get constrained is the Large Cap funds in the next few years to come. However, I would still advise you to stick to actively managed funds for other parts of your portfolio such as small-cap and mid-cap funds and diversified funds - especially if you have a high Risk Capacity or Risk Tolerance - which is decided by various factors including your age, risk appetite etc. 

We are approaching a hybrid market where the differences will get blurred. It is important that you do the basics right. Know how much equity % you need - and what should be the split of Large Cap, Mid Cap and Small Cap that suits your needs. 

We do run a very unique ELITE program for this purpose. Apart from coaching you on Financial Freedom, this program also helps you find your Risk Capacity and Tolerance - and recommends you fund investments accordingly - else it is very difficult for retail investors to know how much equity they need to buy - and then - how much to invest in Large Cap, Mid Cap or Small Cap - and thus - how much Index Funds to go for, and how much actively managed funds. 

These proportions are continuously changing in an evolving market like India.

Regards

Manoj Arora
Official Website