Actively managed or index funds: Where should you park your money? (2024)

Illustration: Binay Sinha

The report raises questions about the effectiveness of actively managed funds, particularly in mid and small-cap categories. Investors who choose actively managed funds expect these funds to be steered by skilled fund managers who can outperform the market. However, the data suggests that a large number of actively managed funds were unable to achieve this in 2023.

What is the difference between the two?

"Actively managed mutual funds strive to outperform the market, aiming for returns higher than a specific market index. On the other hand, index funds, often referred to as passively managed funds, simply try to mirror the performance of a market index. For instance, an index fund mirroring the BSE Sensex would hold stocks of the same 30 companies in the exact proportions as the Sensex. Consequently, investors in such a fund would experience returns mirroring those of the BSE Sensex. The philosophy behind index funds is grounded in the belief that, after accounting for expenses, most fund managers can't consistently outpace the market or that identifying those who can isn't consistently feasible," said Value Research in a note.

Active funds vs. Index funds: Key differences as explained by CA Sanchit Vijay, Partner, Corporate Professionals

1. Nature:

Active investing involves hands-on management, where the fund manager plays a significant role in selecting securities, timing trades, and seeking opportunities to outperform the market. In contrast, index investing follows a passive approach, aiming to replicate benchmark returns without active intervention from the fund manager.

2. Expense ratio:

Index funds typically offer lower expense ratios compared to active funds. This is because index funds do not incur the costs associated with active management, such as research expenses and high portfolio turnover. With lower expenses, index funds provide a cost-effective option for investors seeking broad market exposure.

3. Returns:

Index funds track benchmark indices and deliver returns closely aligned with the performance of the underlying index, adjusted for expenses and tracking error. Conversely, active funds rely on the expertise of the fund manager to generate returns that may outperform the benchmark. While active funds aim to beat the index, their performance can be more volatile compared to index funds.

4. Risk:

Index funds mitigate unsystematic risks by diversifying across a broad range of securities within the benchmark index. This passive approach reduces the risk associated with individual stock selection. Active funds, however, may exhibit higher risk levels depending on the fund's investment strategy and asset allocation. For example, an active equity fund may carry higher volatility compared to an active debt fund.

5. Effort:

From the investor's perspective, active funds typically require less effort as fund managers handle investment decisions. Investors delegate decision-making to managers, periodically reviewing fund performance. In contrast, index funds demand minimal effort as they passively track benchmarks. Investors choose index funds based on objectives and risk tolerance, requiring little ongoing involvement.

So, where should you invest?

With passive investing gaining traction in recent years, fund houses are looking to offer new sets of schemes in this space through index funds and exchange-traded funds (ETFs). In the past year, about half of actively managed large-cap funds did better than their benchmark (think of this as the average performance of the big companies they invest in). Experts say this isn't good enough. Over a longer period, passively managed funds (like index funds that track the Nifty 50) tend to do just as well, but with lower fees.

In fact, passive funds in India have not had a single net outflow month in 2023 and continue to attract positive flows, a testament to their growing demand and institutional support, as per the 'Baroda BNP Paribas Annual Outlook 2024' report.

"If first-time investor wants a stable portfolio, less volatile, with a low expense ratio, index funds may be a better choice for them. In case an investor wants sector/theme diversification for better alpha, and wants to have active management in his portfolio, actively managed mutual funds present a better opportunity," said Arvinder Singh Nanda, , Senior Vice President, of Master Capital Services.

"Index funds have lower expense ratios and hence over a period of time this differential compounding gives reasonably higher returns, other things remaining the same. Close to 85% of fund managers underperform the Index funds in US. In a nutshell, if you can identify good fund manager then go for actively managed funds else stick with ease of Index funds," said Gaurav Goel, a Sebi registered investment advisor.

"Considering the diversification they can provide, it may still be prudent for investors to allocate a small part of their assets to index funds in their portfolio. Having 1-2 index funds with exposure to the broad equity market can provide long-term benefits. That said, don't allocate more than 10 per cent of your money to these funds," said Ravi Banagere of Value Research.

General Recommendations:

For beginners: Index funds are often a good starting point due to their lower costs, diversification, and simpler approach.

For long-term investors: Index funds can be a solid choice for building wealth over time.

For experienced investors: Actively managed funds might be an option if you have the time and knowledge to research them carefully and understand the higher risk involved.

It's also not an either/or situation. You can consider a hybrid portfolio with both index funds and actively managed funds to balance risk and potential rewards.