Evaluate both, then pick what suits you best. If you aren’t sure if active funds will outperform the benchmark, then opt to go passive.
There is a debate going on, between holding actively and passively managed funds. Debates are healthy, as various perspectives come out. However, as experts debate the topic, your focus should be on how to benefit and apply it in your context. We will discuss the relevant parameters that you should evaluate. Let us first look at the concept being discussed.
An actively managed fund is one where the decisions about the portfolio, e.g. which instrument to buy, how much to buy, when to sell, etc., are taken by the fund manager. There are investment objectives and contours set for the fund, as per SE- BI regulations and internal norms of the asset management company (AMO within the regulations. As per the norms, the portfolio is managed by the fund manager designated for the fund by the AMC. There is usually a committee of AMC personnel who supervise the decisions of the individual fund manager.
A passively managed fund is one where there is a defined index which the fund is supposed to replicate. There is a designated fund manager in a passively managed fund as well, but s/he does not take any portfolio management decision. His/her job is just to replicate the index – monitor the index composition and tweak the fund composition accordingly.
Performance The big question is, which one is good for you? The most common yardstick is performance vis-ik-vis the relevant index. For active funds, the yardstick is the out-performance or under- performance against the index. A frequently-used indicator is point-to-point performance over various time periods e.g. last one year, five years, 10 years, etc.
On this parameter, a lot of noise is being made on under- performance of active funds, particularly in the large-cap category. In the mid-cap and small-cap category, active funds have done well against their benchmarks. However, there is another method of measurement, called the daily- rolling method, which takes the return on a daily basis rather than last one year or five years. On this basis, active funds in the large-cap category have done much better vis-a-vis the relevant benchmark, than as measured by the conventional method. The takeaway for you is that, in mid and small-cap category, active funds have done better as there is a wider scope for the fund manager whereas in the large-cap category, it is a mixed picture depending on how you evaluate performance.
In passive funds also, performance against the benchmark is relevant, though the job of the fund manager is only to replicate the index. The purpose is to gauge how closely the fund is tracking the benchmark, or is failing to do so. There is one metric called “tracking error” which is a statistical measure, which looks at deviations from the benchmark on both sides,
positive or negative, as a pure number. The other metric is “tracking difference”, which shows during the time period under consideration, how much lower the return is from the benchmark, due to errors and expenses.
Expense ratio There is a lot of noise about the relatively higher expense ratio in active funds and the fact that some of the active funds, in spite of charging the expenses, are not delivering the alpha i.e. out-performance over the benchmark. However, Mutual Fund NAVs are post the fund management recurring expenses charged, and the returns are anyway net of expenses. When you look at the performance of a fund, either active or passive, and you compare it with the benchmark, you are anyway comparing the net result. To put the same thing in other words, if a fund has done well in spite of relatively higher expenses, it should not be penalised further.
Fund objective The objective of passive funds is to replicate the designated index. Hence, there is no attempt to gun for the alpha like in active funds, where they try to beat the benchmark. If you are in doubt as to whether active funds would be able to outper form the index or not, and if you are happy to earn just the index returns, then you may go for passive funds.
In case of theme-based funds or mid-cap/small-cap funds, where you are going with the skills of the fund manager, you would rather go for active funds.
In active funds, apart from ELSS funds that have a lock-in and a few close-ended funds, liquidity is easy, in the form of purchase from/redemption with the AMC, in the usual course. Passive funds come in two formats. One is that of index funds, which track an index and you can transact with the AMC in the usual course. The other format is Exchange Traded Funds, which also track an index, but you have to trade the units at the stock exchange. This won’t be an issue, but you have to have an account with a broker and a demat account, for dealing in ETFs.
We started off by saying that you should take advantage of what is there on offer and learn from the debate. For you, it is not about “active versus passive” but “active and passive”. You pick and choose what is suitable for you. For certain categories, you may go with active, and for other categories of funds, opt for passive ones.
If your priority is to just earn index-driven returns without worrying for that little extra, you can take passive. Mind you, returns from passives will be as volatile as the underlying market. There should not be a confusion that just because a fund is passively managed, returns would be like a straight line. If you want the fund manager to bat for you, then actives are for you.