A guide to mutual fund investment

Mutual funds can be broadly classified into two categories in terms of the fund management style i.e. actively managed funds and passively managed funds (popularly referred to as index funds).

Actively managed funds are the ones wherein the fund manager uses his skills and expertise to select invest-worthy stocks from across sectors and market segments. The sole intention of actively managed funds is to identify various investment opportunities in the market in order to clock superior returns, and in the process outperform the designated benchmark index.

On the contrary, passively managed funds/index funds are aligned to a particular benchmark index like the S&P CNX Nifty or the BSE Sensex. The endeavor of these funds is to mirror the performance of the designated benchmark index, by investing only in the stocks of the index with the corresponding allocation or weightage.

In the Indian context, index funds have never really caught the retail investor's fancy. This is in complete contrast to developed economies like the United States for instance wherein index funds form "staple diet" for retail investors. And the reasons for the same aren't very difficult to guess.

In the United States, stock markets are more efficient, so investment opportunities are at a premium and are relatively difficult to identify. Consequently, a number of actively managed funds fail to outperform the broader stock market. Also other factors like no loads and lower expenses further the cause of index funds.

Furthermore, investing in index funds is less cumbersome as compared to investing in actively managed funds. Broadly speaking, investors need to consider two important aspects i.e. the expense ratio and the tracking error (i.e. the difference between the returns clocked by the designated index and index fund).

Conversely, investing in actively managed funds demands a deeper review and understanding of the fund house's investment philosophy; also the investor needs to decide on the kind of funds he wishes to invest in - a large cap/mid cap/small cap fund among others.

In the Indian context, the mutual fund industry is dominated by actively managed funds; index funds occupy a smaller share of the market. Well-managed actively managed funds have been successful in outperforming index funds by a huge margin.

This could be attributed to the fact that the Indian markets are still in an evolutionary phase and there exist a number of inefficiencies. These inefficiencies are in turn utilised by competent fund managers to outperform the index. This explains why many actively managed funds manage to outperform the index over the long-term (3-5 years).

We conducted a study wherein we compared category averages of index funds (passive funds) with those of diversified equity funds (active funds), over varied time frames.

The active-passive tradeoff

The results are quite interesting. Over the 1-Yr time frame, index funds (40.75 per cent) aligned to the BSE Sensex have comfortably outscored diversified equity funds (29.05 per cent). However over longer time frames (3-Yr and 5-Yr), diversified equity funds have stolen the march over index funds powered by a strong showing. Over 3-Yr, diversified equity funds (38.37 per cent CAGR) have outperformed index funds (32.91 per cent CAGR). The degree of outperformance further widens over 5-Yr; diversified equity funds (41.05 per cent CAGR) fare better than index funds (32.38 per cent).

In a nutshell, in the Indian context, index funds have proven their mettle over shorter time frames. It's the opposite over longer time frames (3-5 years), where actively managed funds rule the roost.

However the same should not be seen as a blanket recommendation for actively managed funds. Not all actively managed funds are invest-worthy and capable of generating superior returns vis-à-vis benchmark indices (passively managed funds).

There are many laggards in the category as well who have failed to match the benchmark indices (in this case BSE Sensex). To substantiate this, we have outlined some non-performing actively managed funds (from diversified equity funds category), based on their performance over 3-Yr and 5-Yr (as these are the ideal time frames for evaluating equity funds).

Hence, investors would do well to understand that, though the actively managed funds category has delivered impressive performances over the long-term, there are duds within the category whose performance is nothing to write home about.

This in turn, necessitates that investors add to their portfolios well-managed diversified equity funds with proven track records over longer time frames and market phases. Given the performance of diversified equity funds and how domestic markets are placed, risk-taking investors would do well to hold a larger portion of their portfolio in actively managed (diversified equity) funds. Index funds, on the other hand can occupy a smaller portion therein, but purely from a diversification perspective.

By Personalfn.com, a financial planning initiative. It can be reached at info@personalfn.com. Personalfn.com also publishes a free-to-download financial planning guide, Money Simplified. To get a copy of the latest issue - How ULIPs fit in - please click here.