Active vs Passive debate rolls on

Aarti Krishnan of Prime Investor posted today an article titled “What are the Risks in Index Funds”. 

Basically she boils it down to 

1. They do not protect you from market volatility
2. They may have concentrated portfolios
3. They don’t shield you from business or governance risks
4. They do not guarantee superior returns

I believe that the above reasons aren’t in themselves reasons that make Index funds Risky in any way compared to the alternatives (Active Mutual Funds). My views on the points raised and my thoughts on what is the better approach.

They do not protect you from market volatility

While there are various ways to measure volatility, for me the choice is to look at maximum draw-down. Draw-down is the percentage change the instrument has suffered from the time it hit its peak. 

For example, Nifty 50 hit a high of 6357 in January 2008. By March of next year, it was down to 2600 levels. In other words the Index had declined by nearly 60%. If you had invested in a passive fund or ETF, this is the draw-down you would have seen since the fund mimics the Index, nothing more nothing less.

On the other hand, Active Mutual funds have a fund manager to look after the portfolio and hence your interests. It’s the very reason you pay 2.5% yearly. They wouldn’t have done so badly, right?

Here is the chart depicting the draw-down faced by various mutual funds. Do note that some of these funds weren’t large cap at that time.

As you can see, Mutual Fund’s did not shine themselves too well. But that is excusable as long as they deliver alpha – or gain more than the Index gains itself you may say which is true. As long as a fund manager delivers a higher return than the Index after fees, his fee is none of the concern unless you believe that you can do better than him.

The following table from S&P shows 6 out of 10 funds have failed to beat the Index. This presents an issue – Can you select the better fund 10 years ahead of time. In the last three years, just one or two funds out of 10 have outperformed. 

Maybe this can reverse, Maybe it won’t. But purely based on Data, Active funds carry the same risks as passive while not really delivering big, at least when it comes to Large Cap Funds.

They may have concentrated portfolios

Since Indices are free float market weighted, sectors that are the current favorite have a higher degree of concentration than the one’s that have fallen out of favor. With the current favorite being financials, it no wonder that it dominates the Index. But this has always been the case. If you remember in 2007, Index weight was dominated by Infrastructure & Ambani companies. 

Concentrated Portfolio in itself isn’t wrong. The key is to have conviction in the stock and bet on the same. A diversified portfolio is good when conviction in the stocks is low and one reason my own Momentum Portfolio has a 30 stock portfolio.

If you look at the portfolio’s of most funds and compare them to the benchmark index, you can see very little differentiation out there. Its as if they are closet index funds with a pinch of active.

They don’t shield you from business or governance risks

Indices that are fundamental agnostic do once in a way add a stock that carries significant risks. But that risk is carried by even active funds. When Manpasand fells on questions of Corporate Governance, more than a few funds were found to be holding the same. Everyone makes mistakes, Active or not, you cannot avoid such risks completely.

They do not guarantee superior returns

I think this point was the focus of the article going the replies in response to a tweet. Index funds actually underperform the Index to the extent of their fees and slippages. But with fees for ETF’s (different from Index funds) as low as 0.07%, one wonders should one be concerned.

Does all the above info mean that it makes no sense to go active and instead one should buy the cheapest ETF or Index traded fund? 

I disagree. Mutual Funds have their use case, but it’s more of an active strategy than a passive one of just Buy and Hold for a lifetime. If your use case if Buy and Forget, I think there is more benefit buying a Multi Cap fund than buying an Index which buys the top 100 stocks of today.

When we invest in funds, we are betting on the fund philosophy / fund manager. That being the case, why should you limit him to buying only from the top 100 stocks or stocks ranked from 100 to 250 for instance.

Multicap funds allow the fund manager to take a call on where he feels value is there in the current market scenario and bet on those segment regardless whether its from the large cap or small cap.

Another style of funds that is worth being in active vs passive is from the Small Cap and Thematic funds. But here too some amount of timing is required unless you can stomach draw-downs of 70%+ that few funds saw in 2008 / 09 for instance and one that took years to reclaim.

The biggest risk of Index investing is that Indices can go flat for a long time. India has limited data. I hence calculated the % of time, your investment could have yielded negative returns even post holding for 10 years. For the S&P 500 where data goes back to 1950, that comes to 8% of the time. Not high, but something that you should bear in mind.

The best use case for ETF’s that track Indices is to have a tactical allocation strategy. Be long when the trend is in favor of you and be out when its not. Right now the trend in large cap is hot and strong and a good time to be invested. But there will come a time when its out of favor and it makes no sense to go through the pain.