The “active vs passive” debate is not of primary importance in portfolio management

Published: July 19, 2022 at 6:00 am

The prominence of index funds and ETFs in the last few years due to their visible outperformance has resulted in a heated active vs passive debate on social media, personal finance forums etc. While cost, the underperformance of active management, simplicity of fund maintenance etc are all important factors they are not of primary importance in portfolio management.

First, let us list the facts.

 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, stabler 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.

Now let us zoom out a bit and consider overall portfolio management for long-term goals (> 10 years).

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    • First I need to be clear about my goal (or when I need the money)
    • Then I need to determine the target corpus with a reasonable inflation estimate.
    • The asset allocation necessary to beat inflation and achieve this target corpus has to be determined. That is how much should be invested in equity and how in fixed income.
    • How this asset allocation should be varied down the line to systematically reduce portfolio risk should be planned. This cannot be postponed because the investment amount required depends on this.
    • Then and only then comes product selection and the active fund or passive fund debate.
    • Then comes probably the most vital step: the execution. The discipline to keep investing systematically and manage portfolio risk systematically

    Choosing index funds without proper planning or the discipline to stick to the plan is of little use.  And if one does have a proper plan and the discipline to see it through it matters little if one chooses active funds or passive funds – at least for those who currently hold active funds.

    Yes, yes cost, underperformance, simplicity, fund management risk – all these factors are important but not as important as the right plan or the associated discipline which most investors, unfortunately, do not have. Without these, the risk of failure is just as high with passive products as with active ones.

    Both active and passive camps suffer from the same problem – they want to make the best or at least an optimal choice for their portfolio.  Such things do not exist in personal finance. Choose something that is suited to you, but doesn’t claim what you have selected is the best.

    My portfolio has only active funds except for UTI Low Vol Index which is a factor-based passive fund. By some confounded stroke of luck at least until Dec. 2021 my overall equity portfolio has outperformed the Nifty 50.

    If today, I find that outperformance is lost (I am yet to find out for the record), I will not rush to buy index funds. For three reasons:

    • To be honest, I don’t care about costs. Just like diversification people talk about it a lot but no one sits and computes/quantifies it. Even a ballpark estimate of 1% of my portfolio lost (on a compounded basis) due to extra fees is not enough to ruffle me. If it bothers you, you must act. Just that I won’t. Along with discipline, I also value inertia in portfolio management (once a plan is in place).
      • That the tax associated with shifting from active to passive now is too prohibitive is another matter.
      • Adding an index fund now to my already cluttered portfolio is of little use.
    • I have come to the realization that returns are unimportant (and anyway not in our control). What matters the most is systematic investing and a systematic increase in the investment amount and portfolio risk management.
    • These are orders of magnitude more important than costs or active fund manager risk.

    Yes, index funds are an excellent choice and we “actively” encourage young earners to choose them but not before proper goal-planning and its associated responsibilities. Choice of a product alone cannot determine our investment success. It has always been of tertiary importance.

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      Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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