In passive, we trust. This is what many proponents of passive funds, given a choice, would say in support of their argument. They emphasize that these funds have worked well elsewhere, hence would work here as well. However, proponents of active funds don’t want to throw in their towels just yet.
Not even when, as per a recent survey of 2,000 respondents conducted by Motilal Oswal Mutual Fund, passive funds constituted just 1.4% of assets under management (AUM) in 2015 and are now at 17% of the AUM. This is phenomenal growth in AUM size, and if this rate of growth continues, it could reach 50%, just like in the US, in a few years. Warren Buffett was so convinced of the math behind passive funds that in 2008 he wagered a million-dollar bet with Protégé Partners, a hedge fund, that over a 10-year period, an S&P 500 index fund adjusted for fees would beat a hand-picked portfolio of active funds. Warren Buffett won that bet handsomely.
There is an old lawyer joke. “If the facts are against you, argue the law. If the law is against you, argue the facts. If the law and the facts are against you, pound the table and yell like hell.” Without pounding the table, let’s look at the facts and arrive at own conclusion about passive versus active funds.
For the uninitiated, passive funds replicate a benchmark index, such as Nifty50 or Sensex, and try to mimic its performance. When you invest in a passive fund, you are taking direct exposure to index constituents in the same proportion as they are present in the index. So, when one buys such funds, they are preparing themselves to get a return that is closer to the index performance in that period.
In contrast to this, an active fund employs a fund manager to try and outperform the index return. However, due to active management, these funds have higher expenses as well. Roughly, passive funds are 0.8% cheaper than active funds. So, if an active fund doesn’t generate a return greater than this, it would not beat the passive fund’s return. Despite this handicap, many opine that active funds would still beat passive funds in the long run. Let’s check out what data says about this opinion.
The most definitive study on passive versus active funds in India since 2013 is SPIVA India Scorecard. According to its latest report, 2 out of 3 large-cap funds did not beat S&P BSE 100 returns over a 10-year period. This essentially means that an investor is better off investing in a low-cost passive fund instead of trying to beat its return by investing in large-cap funds.
When it comes to mid-cap and small-cap active funds, 1 out of 2 funds underperformed the S&P BSE 400 MidSmallCap Index in the same period. However, this might not give a true picture of underperformance as mid-cap and small-cap active funds could also invest up to 35% of their portfolio outside of the mid-cap and small-cap stocks universe. Also, the SPIVA report suffers from another handicap. For example, it doesn’t compare mid and small-cap fund returns with the Midcap 150 and Smallcap 250 indices. So, the actual outperformance of active fund managers in a few instances could not be ascertained for sure.
Finally, just as one swallow doesn’t make a summer, likewise, only a few active funds beating the index in a decade doesn’t prove that they would continue their outperformance. More importantly, there is no way to predict with a reasonable amount of confidence which ones would beat passive fund returns in subsequent periods. This facet is evident by looking at the survivorship percentage in the SPIVA report, which states that only 4 out of 5 mid and small-cap funds survive in a 10-year period.
So why do many still believe that active funds would beat index returns? Maybe because human beings suffer from over-optimism bias, i.e., the tendency to exaggerate their own abilities, as we suffer from the illusion of control or knowledge. In a 2006 study conducted by James Montier with 300 fund managers across the globe, nearly 74% of respondents thought themselves above average at their jobs. This is statistically impossible and shows our inherent bias of superior talent when pitted against others. If we consider this sample size as representative of the fund manager population, then this indicates that most of the fund managers could be overconfident about their ability and are not looking at things from the right perspective.
So instead of hoping against hope, it might be worthwhile to just accept the reality until data says otherwise. As John Maynard Keynes once said, “When facts change, I change my mind—what do you do, sir?””
Abhishek Kumar is Sebi-registered investment adviser and founder of Sahaj Money
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Updated: 16 Aug 2023, 10:57 PM IST