Suman, a 30-year-old investor, has been investing in mutual funds for a few years now. He recently came across the term ‘index funds’ but didn’t understand it completely. Suman is not alone. There are a lot of mutual fund investors like Suman who either do not understand index funds or they are not convinced about its ability to compete with actively managed mutual funds.
So in this blog, we will explain in detail the differences between actively managed funds and index funds. We will also compare various aspects such as performance, risk, etc. in both these funds to help you take well-informed investment decisions.
Introduction Of Index Funds And Its Impact On Actively Managed Mutual Funds
To understand index funds better, we have to go back almost 100 years to another financial innovation that truly brought the financial markets into the lives of common people.
The modern mutual fund industry started in the year 1924. Since then, mutual funds have served millions and millions of people who do not have adequate time and knowledge to buy individual stocks. With the start of mutual funds, such investors relied on the services of a professional fund manager who would research the vast universe of companies and execute the most suitable trades for a small fee.
Interestingly, the investor’s expectations in the early 20th century were not as much on performance as it was on the convenience that mutual funds offered. This undemanding relationship between investors and mutual funds went on for a few decades.
It was largely in the 1950s and especially the 1960s when interest in mutual funds really picked up. And with this emerged many scholars who started to take more interest in understanding how available fund performance data could be used to select funds and fund managers who could overperform in the future.
| GROWTH OF MUTUAL FUNDS | |
| PERIOD | NET ASSETS (in $ bn) |
| 1924 – 1939 | 0.5 |
| 1940 – 1949 | 2.5 |
| 1950 – 1959 | 17 |
| 1960 – 1969 | 47.6 |
This was a critical moment in the development of index funds. Because when scholars actually started looking at the fund performance data, they realised that most mutual fund managers had been underperforming the market for many years and decades.
This became a catalyst for change and after a few misstarts, the first publicly available index fund was launched by the Vanguard Group in 1976.
To put this in perspective, it is not that the index funds first came in, and then after some years, they started outperforming actively managed mutual funds. Instead, index funds had already started on a solid base and it was then a matter of getting investors aware of the virtues of passive investing.
From the investment community perspective, the introduction of index funds was an inflection point as not only did the index funds give investors a choice, they also forced active fund management companies to redefine their purpose. The fund management companies realised that it was not enough to simply offer a basket of securities to investors, but beat the market as well.
In a way, the launch of index funds challenged the central belief that one needs to apply some intelligence to make money in the stock markets. After all, this is what the actively managed mutual funds want you to believe. And then there are index funds that challenge this same notion by questioning why the majority of fund managers cannot even beat the index.
What Are Index Funds?
In investment parlance, ‘index’ represents the value of a particular group of investments. For example, the SENSEX is an index that tracks the performance of 30 of the largest and most actively traded stocks on the Bombay Stock Exchange (BSE). Similarly, the NIFTY 50 Index represents the weighted average of 50 such companies on the National Stock Exchange (NSE).
So, simply put, an index is a generic term that describes a list of securities that are selected and weighted according to a set of rules. And because it is nothing more than a set of rules, an index can be created for just about anything.
For instance, on the website niftyindices.com, one can find over a hundred different types of indices. Yes, there are the common ones like the NIFTY 50, the NIFTY Next 50, NIFTY Midcap 150, but then there are also a lot of other indices like the NIFTY TATA Group index which specifically features the TATA group companies and so on.
In fact, recently, we wrote a blog on one such index called the NIFTY 200 Momentum 30 Index where we discussed specifics on how an index like this is constructed.
Read: Everything You Need To Know About Momentum Investing
An index fund is simply a fund that tracks a market index. In other words, the index fund simply buys up all the shares that make up a particular index per the weightage and methodology prescribed.
For example, the DSP NIFTY 50 Index Fund replicates the structure of the NIFTY 50 Index and ends up buying and holding all 50 stocks that are a part of the NIFTY 50 index in a similar proportion. This means if the NIFTY 50 index goes up by 2% today, then the DSP NIFTY 50 Index Fund will also go up by 2%.
In other words, since the index fund owns all the shares that make up the market you would end up earning the average returns of all stocks in that market. Moreover, a fund has some expenses. So the returns delivered by the index fund will be slightly lower than the index itself.
This of course raises the question that why would anyone be happy with the average performance. It’s a valid question and something that we will discuss in greater detail later in this blog.
But on the positive side, index funds do offer some unique advantages.
One, index funds offer a much broader diversification than what any actively managed mutual fund can offer. Two, index funds keep fund management expenses to a minimum. So, as an investor, you pay a very small amount as fees to the mutual company.
The management expense in an index fund is low because they do not pay any advisory fees or salary to a research team and save on account of low portfolio turnover which reduces trading fees and taxes.
In fact, to put this in numbers, the average expense ratio of the direct plan of a typical actively managed large-cap fund is 0.95%. Meanwhile, the expense ratio of the direct plan of a typical large-cap index fund like NIFTY 50, or NIFTY 100 is about 0.24%. This difference of 0.7% in expenses is quite a big number. And the impact of this 0.7% would get clearer later in this blog.
Actively Managed Mutual Funds vs Passively Managed Index Funds: Which is better?
Ever since index funds were introduced, there has been a battle going on between actively managed funds and passively managed index funds.
So let us examine this tussle from three perspectives – Moral angle, Performance angle, and Risk explanation
Moral Angle
From a moral perspective, actively managed funds are of the opinion that markets are often mispriced and the fund manager is in the best position to exploit this opportunity and make a lot of money for the investor.
On the other hand, the index fund manager’s view is that the current price at which any stock is quoted has already taken all known and available information. In other words, this is the price that has been agreed to by a willing buyer and a willing seller in the open market. Hence it is impossible to capture excess returns without taking additional risk.
Performance
To check how the index funds have performed in India, we looked at all available actively managed large-cap funds and large-cap index funds to draw a comparison.
There are a total of 29 actively managed funds and 13 large-cap index funds. And here is how the annual returns of the average index fund measures up to an average actively managed mutual fund.
| Yearly Performance of Large Cap Mutual Funds and Large Cap Index Funds | |||
| Year | Large Cap Index Fund | Actively Managed Large Cap Mutual Fund | Overperformance of Index over Active |
| 2013 | 5.9% | 6.4% | -0.5% |
| 2014 | 32.1% | 42.0% | -9.9% |
| 2015 | -3.5% | 1.7% | -5.2% |
| 2016 | 3.7% | 4.0% | -0.3% |
| 2017 | 29.5% | 31.5% | -2.0% |
| 2018 | 5.2% | -0.8% | 6.0% |
| 2019 | 13.5% | 13.3% | 0.2% |
| 2020 | 15.4% | 15.5% | -0.1% |
| 2021 | 4.9% | 4.8% | 0.1% |
In recent years, especially since 2018 onwards, the index funds have performed a bit better than the actively managed mutual funds. In any normal year, there is not much difference in performance between an average actively managed mutual fund and an index fund.
Let’s go further into the data and understand how many actively managed funds have underperformed when compared to the typical NIFTY 50 index fund.
| Number Of Under Performers Among Actively Managed Mutual Funds | |||
| Year | Total No. of Active Mutual Funds | Active Funds Underperforning the Index Fund | % of Underperformers |
| 2013 | 27 | 13 | 48% |
| 2014 | 27 | 3 | 11% |
| 2015 | 27 | 2 | 7% |
| 2016 | 27 | 10 | 37% |
| 2017 | 28 | 7 | 25% |
| 2018 | 28 | 26 | 93% |
| 2019 | 29 | 15 | 52% |
| 2020 | 31 | 15 | 48% |
| 2021 | 31 | 16 | 52% |
As the table shows, from 2018 onwards, slightly more than 50% of the actively managed large-cap funds have struggled to keep up with a NIFTY 50 index fund. In fact, in the year 2018, only 2 actively managed funds did better than the index funds and all other funds underperformed the index.
So if we average the last 4 years of data, 61% of the active funds have unperformed.
To put this in perspective, the global data on active vs passive funds shows that the win-loss ratio of about 1:2 i.e. about 66% of actively managed funds underperform the index funds. In India, this ratio seems to be more of 1:1 if we take the last three years of data. It comes very close to the 1:2 ratio if we take the last four years of data.
So this is definitely something that long-term investors need to look at and consider in their future portfolio decisions.
On the other hand, skeptic investors might feel that they have that special power to select a fund which overperforms every time. But this is easier said than done. As we showed in one of our earlier blogs ‘Why chasing top-performing Mutual Funds is not a good idea’, a large number of funds after being ranked 1, 2 or 3 in the previous year performed extremely poorly in their immediate next year.
Risk
Most consumers don’t buy units in just one mutual fund but over time they have a portfolio of mutual funds. In that context, the risk that needs to be discussed is the selection risk.
For example, there are 29 actively managed mutual funds and say, you choose 2 funds.
The risk here is the possibility that 1 fund underperforms the index while the other overperforms. This means the 1:1 ratio is at play here.
So, the 1 overperforming active fund will need to compensate for the losses made in the other underperforming one.
To gauge the possibility of one outperforming fund compensating for the loss in the underperforming fund in the portfolio, let’s look at the average alpha or excess returns created by all actively managed large-cap mutual funds which have outperformed the average index fund. And also look at the return of underperforming funds.
| Outperformance And Underperformance Of Actively Managed Mutual Funds | ||
| Year | % Return of Overperformance | % Return of Underperformance |
| 2013 | 2.20% | -2.40% |
| 2014 | 10.90% | -0.80% |
| 2015 | 5.30% | -0.20% |
| 2016 | 2.00% | -0.90% |
| 2017 | 3.30% | -0.50% |
| 2018 | 1.90% | -4.50% |
| 2019 | 2.40% | -1.80% |
| 2020 | 2.10% | -0.70% |
| 2021 | 1.30% | -0.80% |
The table shows that for most years the sum of average outperformance and underperformance is a positive number. This means the selection risk is mostly not there unless you were to pick two underperforming funds. Only in 2013 and 2018, there was a selection risk and the average underperformance was higher than the overperformance.
| Outcome Of Selecting Underperforming Funds | |||
| Year | % Return of Overperformance | % Return of Underperformance | Selection Risk with 1:1 |
| 2013 | 2.2% | -2.4% | -0.1% |
| 2014 | 10.9% | -0.8% | 5.1% |
| 2015 | 5.3% | -0.2% | 2.6% |
| 2016 | 2.0% | -0.9% | 0.6% |
| 2017 | 3.3% | -0.5% | 1.4% |
| 2018 | 1.9% | -4.5% | -1.3% |
| 2019 | 2.4% | -1.8% | 0.3% |
| 2020 | 2.1% | -0.7% | 0.7% |
| 2021 | 1.3% | -0.8% | 0.3% |
But the problem is assuming a 1:1 ratio. Data shows that India too is moving towards a 1:2 ratio of active and passive fund performance. So when a 1:2 weightage is plugged, especially in the last 4 years, it shows the selection risk that investors are likely to face going forward.
| Possible Increase In Underperformance Risk | ||||
| Year | % Return of Overperformance | % Return of Underperformance | Selection Risk with 1:1 | Selection Risk with 1:2 |
| 2013 | 2.2% | -2.4% | -0.1% | -0.9% |
| 2014 | 10.9% | -0.8% | 5.1% | 3.1% |
| 2015 | 5.3% | -0.2% | 2.6% | 1.7% |
| 2016 | 2.0% | -0.9% | 0.6% | 0.1% |
| 2017 | 3.3% | -0.5% | 1.4% | 0.8% |
| 2018 | 1.9% | -4.5% | -1.3% | -2.4% |
| 2019 | 2.4% | -1.8% | 0.3% | -0.4% |
| 2020 | 2.1% | -0.7% | 0.7% | 0.2% |
| 2021 | 1.3% | -0.8% | 0.3% | -0.1% |
So, from a risk perspective, the message here is that if not tracked, investing in actively managed funds can create high uncompensated risk in a portfolio. This is something that no investor would want.
ETMONEY Opinion
This battle between actively managed mutual funds and passively managed index funds is now 50 years in the making. And if data were to be believed, index funds seem to be winning.
Globally, index funds have captured a larger share of the wallet as compared to active funds. And there is a growing case for that happening in India too over the next decade.
If some of you are wondering why you haven’t switched to index funds sooner, the only plausible explanation is to do with our cultural belief that investing success is a function of a person’s ability to successfully pick winning stocks.
In other words, we believe that there needs to be some kind of mental labour to make money.
It is something that has been ingrained into us through our education, upbringing and the media exposure we have received over the years. But we hope this blog has established that this need not be the case.
Do help us spread the good word by sharing this blog over Whatsapp, Facebook, LinkedIn and Twitter with your friends and connections. And if you have any questions for us, do send them across in the comments box below.
