Do passive mutual funds make sense in all equity categories?

view original post

Last week, Peter Lynch, former fund manager of Fidelity Magellan Fund (one of the world’s largest actively-managed equity schemes) swore by active funds. “The move to passive is a mistake. Our active guys have beaten the market for 10, 20, 30 years, and I think they’ll keep on doing it,” he said at a function held at Boston College. Lynch retired from Fidelity at age 46, but helped grow the assets of this scheme from $14 million to $18 billion.

The Rs 38 lakh crore Indian mutual fund industry doesn’t seem to agree with him.

Past performance

Data sourced and analysed from ACE MF shows that in three-year and five-year periods, 30 percent and 11 percent of large-cap schemes have beaten their respective benchmarks. The returns are calculated as of January 4, 2022, and analysed for performance of large, mid and small-cap schemes.

The outperformance record is better for mid-cap schemes, with 48 percent and 24 percent of mid-cap schemes beating their benchmarks in the same (three-year and five-year) periods.

However, small-cap category is where most instances of outperformance can be seen. In three-year period, 79 percent of small-cap schemes beat their benchmark indices and 86 percent of their schemes beat benchmarks in five-year period (see: table).

This struggle in outperforming actively-managed schemes has, in part, pushed investors to towards passively-managed schemes. And hence we saw a slew of new fund offers (NFOs). In 2021, fund houses consistently launched passively-managed schemes – index and exchange traded funds (ETFs).

Large-cap funds face the challenge

A closer look at the performance numbers tells us that large-cap funds have struggled the most. Over the past 5-year period, just about 11 percent of large-cap schemes have beaten their benchmark indices.

Large-cap schemes invest in stocks that are well-researched and widely tracked by analysts and other institutional investors. “Almost all the stocks are well-known, so there is little scope to discover new investment ideas that could help schemes to outperform,” says Ravi Kumar TV, co-founder of Gaining Ground Investment Services.

The polarisation of stock markets in 2018 and 2019 has also contributed to underperformance of the actively-managed schemes.

This was a period that saw only few index heavyweights gaining on the stock markets, with most other stocks in major benchmarks, as well as broader markets, lagging behind.

However, the data shows that the stock market rally seen in last two years (since market crash of March 2020) has helped small-cap schemes to more than cover for underperformance during these periods.

Passive approach in large-cap schemes

When it comes to large-cap schemes, financial planners say it is better to stick to passively-managed schemes.

“Large-cap space is widely followed by analysts and institutional investors. Also, all information is publicly available. As this segment of market is quite efficient, it is difficult for fund managers to outperform,” says Suresh Sadagopan, founder of Ladder 7 Financial Services.

Also, active fund management comes with asset management fees, so the scheme returns also need to cover for that before it can beat the benchmark returns.

“Investors coming in large-cap funds are looking for low volatility. So, fund managers also stick to taking limited risks,” says Rupesh Nagda, founder and managing director of Family First Capital.

To take a passive large-cap exposure, you can either combine a Nifty 50 Index Fund with a Nifty Next 50 Index Fund or a Nifty 100 Index Fund.

MC30 – Moneycontrol’s curated portfolio of 30 investment-worthy mutual fund schemes – recommends UTI Nifty Index and ICICI Prudential Nifty Next 50 Index funds.

More active in mid- and small-cap schemes

Within the mid- and small-cap category, there is a lot more scope for fund managers to outperform their benchmarks.

“There are more options for fund managers to choose from when it comes to mid- and small-cap stocks. After SEBI categorisation, the top-100 stocks in terms of market capitalisation are classified as large-cap stocks, 101-250 as mid-caps and 251st to the rest of the stocks are classified as small-caps,” says Nagda.

“With small-caps, there is a lot more scope for stock-picking for fund managers, given the vast universe to choose from. Stocks that can graduate from being small-caps, to mid-caps and then to large-caps, can make a significant contribution to scheme returns,” points out Ravi Kumar TV.

However, for those who wish to go passive in a big way, fund houses like DSP MF, Kotak MF, Motilal Oswal MF, ICICI Prudential MF, Nippon India MF and Aditya Birla Sun Life MF have launched passive funds even in the mid-cap space.

What should investors do?

Even though large-cap funds have found it tougher to beat their benchmark indices, it’s a bit early to completely rule them out as investment options. However, the choice of low-cost passive funds, especially in the large-cap space, has widened. Many fund houses have launched passive funds in the mid-cap space for those who wish to build a complete suite of passive funds.

Kaustubh Belapurkar, director-fund research, Morningstar India, says advisors could help investors zero in on a suitable active scheme and make sure they stick for a long-term horizon.

While passive funds have made inroads into our portfolios, you do not need to shun active funds altogether, just yet. There is a lot of steam left. Financial planners say a more prudent approach is to have a mix of both active and passive funds.

Related Posts