active or passive? don’t ignore either

There is an ongoing debate between having actively and passively managed funds. Debates are healthy, as different points of view come to the fore. However, as experts debate the topic, your focus should be on how to benefit and apply it in your own context. We will discuss the relevant parameters you should evaluate. Let us first look at the concept being discussed.

An actively managed fund is one where decisions about the portfolio, such as which instrument to buy, how much to buy, when to sell, etc., are taken by the fund manager. As per the internal norms of the Asset Management Company (AMC) within the rules and regulations of SEBI, the investment objectives and framework for the fund are prescribed. As per the norms, the portfolio is managed by the Fund Manager designated by the AMC for the fund. There is usually a committee of AMC personnel who oversee the decisions of the individual fund manager.

A passively managed fund is one where there is a defined index that the fund must replicate. Passively managed funds also have a designated fund manager, but he does not make any portfolio management decisions. His job is just to replicate the index – monitoring the index composition and adjusting the fund composition accordingly.

performance

The big question is, which one is best for you? The most common criterion is performance in comparison to the relevant index. For active funds, the criterion is out-performance or under-performance against the index. A frequently used indicator is the point-by-point performance over different time periods such as the last one year, five years, 10 years etc.

A lot of noise is being made on this parameter, especially on the poor performance of funds operating in the large-cap category. In the mid-cap and small-cap category, active funds have outperformed their benchmarks. However, there is another method of measurement, called the daily-rolling method, which takes returns on a daily basis rather than over the past one year or five years. On this basis, funds operating in the large-cap category have outperformed the relevant benchmarks as measured by the traditional method. What is important for you is that in the mid- and small-cap category, active funds have outperformed as there is a wider scope for the fund manager, whereas in the large-cap category, it is a mixed picture depending on the How do you evaluate performance?

replication index

Even in passive funds, performance against the benchmark is relevant, though the fund manager’s job is only to replicate the index. Its purpose is to find out how closely the fund is tracking the benchmark, or is failing to do so. There is a metric called “tracking error” which is a statistical measure that looks at the deviation from the benchmark, both positive or negative, as a pure number. The other metric is the “tracking gap,” which shows how much returns have underperformed the benchmark due to errors and expenses during the time period in question.

expense ratio

There is a lot of noise about relatively high expense ratios in active funds and the fact that some active funds, despite charging expenses, are not giving alpha on the benchmark. However, mutual fund NAVs are after expenses incurred on recurring expenses of fund management, and the returns are the net of expenses anyway. When you look at the performance of a fund, whether it is active or passive, and you compare it to the benchmark, you are comparing the net result anyway. In other words, if a fund has performed well despite relatively high expenses, it should not be penalized further.

Fund Objective

The objective of a passive fund is to replicate the specified index. Therefore, there is no attempt to gun the alpha like active funds, where they try to outperform the benchmark. If you are in doubt whether active funds will be able to outperform the index or not, and if you are happy with just earning index returns, then you can go for passive funds.

In case of theme-based funds or mid-cap/small-cap funds, where you are going with the skills of a fund manager, you would prefer to go for active funds.

liquidity

In active funds, apart from ELSS funds having lock-in and some close-ended funds, liquidity is easy, in the normal course, in the form of buy/redemption from AMCs. Passive funds come in two formats. One belongs to an index fund, which tracks an index and you can transact with the AMC in the normal manner. The second format is an exchange-traded fund, which also tracks an index, but you must trade the units on a stock exchange. This will not be a problem, but you need to have a broker and a demat account to transact in ETFs.

We started by saying that you should take advantage of what has been offered and learn from the debate. For You, It’s Not About “Activating” Vs inactive” but “active” And Passive”. You pick and choose what suits you. For some categories, you can go with active, and for other categories of funds, opt for passive.

If your priority is simply to earn index-driven returns without worrying about that little extra, you can take the passive. Keep in mind, the returns from the passive will be as volatile as the underlying market. There should be no confusion that just because a fund is passively managed, the returns will be like a straight line. If you want a fund manager to bat for you, then Active is for you.

(The author is a corporate trainer and author)