Why passive investors should avoid making the same mistakes as active investors

Published: March 27, 2021 at 6:22 pm

Interest in passive investing has increased in India over the last few years. This trend was driven by perceptible outperformance: first was the increase in interest in Nifty Next 50 – as usual after the index started moving south in 2018. Then in the Nifty and Sensex as they were held up by a few stocks while the rest of the market suffered. In this article, I discuss why passive investors should avoid making the same mistakes as active investors.

Before we begin, we must understand that active funds’ underperformance is not a “recent phenomenon” in India. We have already established that Active mutual funds have struggled to beat Nifty 50 for the last seven years! Also, see: Poor performance of active mutual funds: Is this a recent development?

Just that after Feb 2018, the opportunities in the bottom half of Nifty 50 and Nifty 100 visibility dried up, and index funds shot up to the top of the returns table, and the return difference of Nifty 50 vs Nifty 50 Equal-weight index was at an all-time high in Dec 2019. It took the March 2020 crash to reset it.

We have crunched enough data. In this article, I would like to discuss the mindset of active and passive investors. It is not necessary to take an extreme stance to justify one’s choices. In fact, it is not necessary to justify it at all!

Allow me to explain. The justifications provided for choosing active funds are well known: “Indian is not a developed market like the US; finding alpha is not as difficult; there are opportunities in the mid and smallcap segments”, etc.

Sadly, some of the justifications for choosing passive funds are just as extreme: “if you choose passive funds, you are sure to beat most active funds over the long term”.

Yes, this is already a fact we saw for US mutual funds: Only 582 out of 3474 US Large-cap funds outperformed S&P 500 over the last 10 years. And it could well be a fact for Indian MFs in future too (it currently about 50:50, which is just as bad – links within the above article).

However, “believing this” when starting with passive funds is no different from expecting 15% returns from a “long-term SIP” or assuming “alpha is definitely possible in the Indian market”.

There will always be some funds that beat the market – today or tomorrow. Only an investor who recognises the impossibility of selecting future winners today should get into passive funds. Otherwise, the moment they see a few funds outperform, the “fear of missing out” will take over. See for example: After the market crash, 80% of active large-cap funds outperform Nifty, Nifty 100.

It should be irrelevant for the wannabe passive investor, whether 25% or 50% or 85% of active funds underperform the market today or tomorrow. Nothing changes the fact that a future outperformer cannot be identified today and active investing means fund-hopping based on past data. Everyone likes extra returns, but the true passive investor appreciates the true cost of the search for alpha.

Unless a passive investor accepts this reality, the interest in passive funds will wane as quickly as it started. The passive investing gang tend to have a holier-than-thou attitude and make it sound as if only the alpha-seekers are subject to cognitive biases. Well, sample this:

  • I am invested in a Sensex fund, but everyone is talking about only NSE indices. Am I missing out on anything?
  • Which is the best index fund to start a SIP?
  • Can I invest in more of Nifty Next 50 for more returns?
  • ABC is coming out with the ABC nanocap index fund. I am already holding four index funds; Should I consider this NFO to cover the nanocap segment?

Fact-based investing must determine our choices, but what makes us stay the course is what we believe in. A feeling of superiority in our investment beliefs and choices is both unnecessary and harmful.

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