Active vs passive investing: the ground reality

There is a considerable amount of debate about active vs passive investing. The truth is, it is a tertiary concern. You need to have a proper investment plan in place. If this is done, you need the conviction to implement it and stay the course. Then it matters little if you choose active or passive funds, as we have explained before: The “active vs passive” debate is not of primary importance in portfolio management.

We have repeatedly stated the facts about passive funds.

• Watch my talk on active vs. passive investing in India. Only 50% of active funds in any category consistently outperform representative benchmarks.
• Be it large cap funds, mid cap funds or small cap funds*, only half the funds in a category are able to beat their benchmarks.
  •  Active mutual funds have struggled to beat the Nifty 50 for the last seven years!
  • Poor performance of active mutual funds: Is this a recent development?
  • Only Five Large Cap funds have comfortably beat the Nifty 100!
  • Myth Busted: Active mid cap mutual fund managers can easily beat the index
• * In the case of small caps the funds easily beat the small cap benchmark but fail to beat a mid cap index or Nifty Next 50 which is just as bad.
  • Why investing in small cap mutual funds does not make sense!
  • Only 3 Small Cap MFs have outperformed Nifty Next 50 consistently

 There are many obvious inferences from these results:

Index funds are the obvious choice for at least new mutual fund investors.

• Choosing a simple Nifty or Sensex Index Fund (do not use ETFs for investing unless you want to trade intraday – ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!) is enough to have “equity exposure” in the portfolio.
• If an investor wants to look beyond large caps, a Nifty Next 50 index fund is all that is required. This index is volatile and can be frustrating to hold.
• Index funds work best for those who appreciate that choosing the “best active fund” based on past data is easy, but there is no guarantee that it will continue to do well in future. Instead of going through frustrating waves of outperformance and underperformance with an active fund, an index fund is a simpler, stable choice to beat inflation and accumulate enough corpus for our future goals.
• Even within the sub-section of fund selection, the low cost associated with index funds is only a tertiary consideration.

Suppose we leave all technical, quantitative, and qualitative factors alone. Suppose you say I am “convinced” that active funds are better for me. 

The ground reality is that if you wish to be an active investor, you must be prepared to (1) face long years of underperformance (at the portfolio levels which many active investors are scared to check) or (2) get ready to clutter your portfolio with fund-hopping in the name of “diversification”.

I have moved from stage (2) to stage (1), aka buffalo nonchalantly standing in the rain phase. See: Why are you recommending index funds when your portfolio has beaten the market? It is immature to assume, “I will somehow choose the best active funds and my portfolio will beat the market”. The law of averages spares no one.

Passive investing is also not easy. There are 100 options to confuse you, and one could end up in stage (2).

Life taught me one important lesson: to choose something, not act like you made the best choice. There is no such thing. It is about which is more suitable to you (assuming you can turn off the noise around and listen to what you need)