(Image source: Image by Olichel Adamovich from Pixabay)
Experts have since long recommended actively managed mutual funds over passively managed funds because of their ability to strategically pick stocks and outperform the market. However, there are many who argue otherwise and bet on passively managed funds like ETFs.
What are ETFs?
Exchange Traded Funds (ETFs) are mutual funds that mimic the performance of a particular index and are traded on stock exchanges like shares. Investors can trade in ETFs during market hours. ETFs aim to deliver returns in line with the index, subject to tracking error.
In the recent past, many fund houses have launched ETFs. So is the idea of passive investing taking centre stage?
Here are the possible reasons for the recent uptick in the number of ETF launches:
Earlier, the ETFs that were launched mainly mirrored the performance of large-cap index. New funds launched offer a variety of options to choose from mid-caps, small-caps, fund of funds (FoF), theme-based, and so on. Thus, investors looking to invest in passively managed fund can now build a portfolio of diversified funds.
[Read: Small-Caps Have Been Beaten Down. Ripe Time To Invest In Small-Cap Funds?]
Secondly, actively managed funds have not performed well in the last one and a half year. This can be attributed to SEBI's norms on the re-categorisation of mutual fund schemes which took effect from March-May 2018. This led to the merging, renaming, and changes in fundamental attributes of numerous schemes. Many stocks were offloaded in the process and this affected the performance of the schemes.
Besides that, the poor earnings growth of companies and slowdown in economy has made stock-picking a challenge. Thus, the outperformance between actively managed funds and passively managed ones may narrow down.
[Read: Why Are Fund Houses Introducing Passively Managed Funds Now]
Can ETFs beat actively managed funds in the long run?
Table 1: Top 10 diversified equity schemes on the basis of 5-year returns
(1 year return-annualised, 3 year and 5 year return compounded annualized)
Direct plans are considered
(Data as on July 30, 2019)
(Source: ACE MF)
Table 2: Top 10 ETFs on the basis of 5-year returns
(1 year return-annualised, 3 year and 5 year return compounded annualized)
(Data as on July 30, 2019)
(Source: ACE MF)
The average returns of actively managed diversified equity funds underperformed the average ETF returns when 1-year and 3-year returns were compared. The margin was significantly higher on a 1-year return basis, whereas it has narrowed down on a 3-year returns basis.
During the longer time horizon of 5 years, the average returns of actively managed diversified equity funds almost doubled to that of ETFs. Thus, investors who stay invested in actively managed funds for longer time periods are rewarded for their patience.
The way forward
Index funds are popular in developed countries like the U.S because it is cost effective. If you are aware, the U.S. is a saturated economy, where the active-fund managers find it difficult to generate alpha over the benchmark. In contrast, India is a growing economy, which continues to offer a lot of opportunities to active-fund managers.
Notably, the size of the mutual fund industry in the U.S. is about 80% of its GDP, while the Indian mutual fund industry is just about 12% of the GDP. So, there is a long way to go before we get to a level where the active fund management becomes completely ineffective and redundant.
Developing countries like India are unlikely to run out of alpha-opportunities any time soon.
What should investors do?
An ETF investment does not offer the option to invest via a systematic investment plan (SIP). Investors may thus lose out on the benefit of cost averaging and compounding of wealth.
So if you want to invest in ETFs, follow a goal-based approach and assess your risk profile and investment horizon before investing in a scheme. Actively managed funds can form a part of your core portfolio, while passively managed funds can be allocated to your satellite portfolio. You may opt for `Direct plans' to reduce the overall cost.
One should select the funds after evaluating it on various quantitative and qualitative parameters. If you choose mutual funds carefully after thorough research, your portfolio can generate significant alpha over the benchmark and peers.
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