Not only is there a vigorous debate going on between active and passive fund management, but there is a conscious shift in favor of passive. For legitimate reasons, investors prefer to save on fund management expenses, especially if active funds are not outperforming the benchmark. Having said that, let’s look at this in perspective. The usual way performance is measured to compare an actively managed fund with a benchmark is point-to-point (P2P) returns over time periods like 1 year, 3 years, 5 years, etc. Over these time periods, the returns given by an actively managed fund are compared to the Total Return Index (TRI) benchmark. It is easy to detect outperformance or underperformance, which is given by the return differential. However, it has another angle.
A study has been done by Union Mutual Fund on the relative performance of active funds with their respective benchmarks. This study is done on the basis of daily rolling returns rather than P2P returns. Daily rolling means take that day’s NAV (Net Asset Value), compare with previous day’s NAV, calculate returns of one day. Follow the same procedure for the benchmark returns and compare the fund’s performance with the benchmark for each day. The difference between the two methods of comparison is that P2P is a “single date” approach whereas the rolling method takes into account all dates in that period. In this context, “single date” means the NAV of today is taken, the NAV of 1 year ago, 3 years ago and 5 years ago is taken, and the comparison is made. It ignores data for the whole year and across the entire time period. Over several interim periods, the fund may have outperformed or underperformed the benchmark. Rolling returns capture market events, volatility and the skill of the fund manager, which are ignored in the P2P method.
The results of the study show that as of 30 September 2021, on a traditional basis of calculation, more active funds underperformed their benchmarks. To give some numbers, considering all MF (Mutual Fund) schemes, over a 1-year horizon, only 36% of the funds could beat the benchmark, in 3 years 41% did better than the benchmark and in 5 years only 29% did better. The result is dependent on the rolling return method of calculation. As on 30 September 2021, considering all MF schemes, over 1 year horizon, 53% of funds beat the benchmark (as against 36% mentioned earlier), 58% did better in 3 years (as against 41% earlier). compared), and in 5 years it is up to 62% against 29% in the traditional method. For more information, in the large-cap fund category, less than 50% of the funds may outperform the benchmark in 1, 3 and 5 years. There’s a reason for this: In the large-cap category, the playing field for a fund manager is limited to 100 stocks and that’s all they can do to outperform. In other fund categories, more than 50% of the funds have outperformed, which affects the outcome of the P2P approach. Notably, the small cap fund category stands out: in 1, 3 and 5 years, 71%, 81% and 86% of the funds, respectively, have outperformed the benchmark on a rolling return basis.
What does this mean for you? It is not a one-to-one correspondence that in passively managed funds such as index funds or ETFs (exchange-traded funds), you are better off because you are charged less fund management expenses than in actively managed funds. There is an advantage though; In an active fund, the fund manager has to do as much as possible to beat the benchmark, recover higher expenses and then outperform. One thing to note is that the data given above is on fund NAV which is anyway net of fund management expenses. So active funds that outperform the benchmark index have done so after spending more than passive ones.
Another difference between active and passive is that actively managed funds may have a relatively higher cash-equivalent component, as the fund manager decides, during frenzied market conditions. In passively managed funds, the cash-equivalent component is at the bottom, say less than 1%. Allocation for cash is a drag on performance in a bull market, but it is easier when the market is turning right.
What should you do? In the large-cap fund category, since less than 50% of the fund has outperformed the benchmark even on a rolling return basis, you can allocate the better performing actively managed funds and ETFs/index funds. In the small-cap category, the canvas for stock-picking is huge; It is about the skill of the fund manager in active funds. In other categories like mid-cap, large-and-mid-cap, more than 50% of the funds have outperformed the benchmark on a rolling basis. Therefore, in categories other than large-cap, you may have a larger allocation for active people.
Joydeep Sen is a corporate trainer and author.
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