Passive vs active mutual funds: Which can generate higher return, where you should invest (2024)

The active-passive investing debate has gained momentum with the release of the 2023 S&P Indices Versus Active Funds (SPIVA) India Scorecard. It shows that a large chunk of actively managed Indian equity mutual funds underperformed their benchmarks. Many advocate for lowercost index funds and ETFs citing such studies. However, investors should understand that knee-jerk reactions concerning long-term investment plans are best avoided. Ultimately, the choice of active, passive, or both should be determined by individual preferences.

Most active funds lagging

Active equity funds rely on managers’ decisions, while passive funds attempt to track indices efficiently. As per SPIVA, five out of 10 large-cap funds underperformed the S&P BSE 100, while over 73% of mid- and smallcap schemes lagged the S&P BSE 400 MidSmallCap in 2023. ELSS funds did better, with 30% underperforming the S&P BSE 200. Longer-term data (see table) reveals various nuances about the frequency of underperformance.

Before using such insights to guide investment decisions, one should recognise the differences between active and passive investment avenues. Like fluctuating weather patterns, active and passive funds experience different performance cycles. For instance, during broad-based market movements, well-diversified large-cap active funds tend to perform well. In contrast, the Nifty50 index is heavily influenced by stocks like HDFC Bank and RIL, each accounting for over 10%. Thus, concentrated holdings prove beneficial during narrow rallies or downturns, helping index offerings outperform.

The numbers cited in such studies change frequently. The 2023 SPIVA study revealed 52% of active large-cap funds lagged the index in a one-year period but in 2022 it was as high as 87.5%. The latest study also showed that 75% of mid-/small-cap schemes lagged their benchmarks over a 10-year period. However, the SPIVA 2022 report showed only 50% of such schemes had underperformed. Nirav Karkera, Head of Research at Fisdom, highlights that in the case of mid- and small-cap funds, investors should understand that allocation to cash and exposure to largecaps may lead to a return drag.

Passive fund investors should note that when active funds deliver alpha (excess of benchmark return), that could be substantial. For instance, the best active midcap fund’s 23.6% ten-year CAGR dwarfs the 19% CAGR of the best passive alternative. “However, there are no guarantees of outperformance. Market dynamics, poor manager skill, and risk mitigation follies can negatively impact an active fund’s returns,” says Suman Banerjee, an independent analyst.

The battle of generating alpha

Comparing apples with apples
People understand that city and highway driving yield significantly different mileage for automobiles. But many of them will still compare active fund returns solely against indices, overlooking key differences. “Indices are fully invested. There is no cash allocation. Also, indices bear no investment expenses,” says Yoganand D., an investment planner at Ladco Crest Wealth.

Active fund returns against peer index funds and ETFs is a better comparison. About three-fourths of active large caps beat top-performing BSE 100 ETFs or Nifty 50 index funds/ETFs in 2023. Similarly, all active ELSS funds surpassed the lone tax-saver index fund’s performance last year.

Instead of choosing between active and passive options, investors need to understand that active and passive funds can coexist. Passive funds, particularly large-cap index funds, can still be valuable components of diversified portfolios. “It is imperative to have the right mix of largely active funds with smaller amounts in passive funds,” says Anand K. Rathi, Co-Founder, Mira Money.

Many choices, lower costs
While there are 31 active large-cap funds today, there are over 100 passive options (including index funds and ETFs) in the same category. Over 20 passive options compete with nearly 60 active mid- and small-cap funds. One may argue the burden of choice remains irrespective of choosing active or passive options. But, practically the choice in the case of passive funds doesn’t alter outcomes much. For instance, the 5-year return of the best-performing active large-cap fund is 19% CAGR while the same for the worst is 14% CAGR. However, all Nifty 50 ETFs in the same period have given around 15% CAGR, with a few basis-point difference in returns.

Passive funds score big on lower costs. Just one percentage point difference in total expense ratio (TER) could boost the lump sum corpus by 20% over 20 years, assuming 8% annual returns. The lower cost in passive funds comes from doing away with a fund manager, the factor behind alpha in active funds. Instead of solely focussing on passive fund costs, experts urge investors to consider other parameters. “Pay attention to precise benchmark tracking, minimal tracking deviations, and robust trading volumes (particularly for ETFs),” says Ramesh Gowda, founder-director of GGG Investment Services.

Some investors will prefer actively managed funds, believing that skilled fund managers can outperform the market. Others would go for passive funds due to their lower costs, simplicity and efficient tracking of market indices. In the end, whether to opt for active management, passive strategies, or a combination of both should be based on an individual’s investment approach, tolerance for risk, and personal preferences.