Should you pick an active mutual fund or a passive one?

As a mutual fund investor, what do you expect from your fund manager? Most would want good returns on their capital over and above that offered by the market. After all, as the manager of an actively managed mutual fund, it is his job to deliver returns in excess of the fund's benchmark index. If he is unable to do so consistently, why should you pay the extra fee that the fund charges for delivering alpha returns?




Instead, wouldn't it be better to put your money in a passive fund , such as an index fund? These have lower charges, are less risky and deliver returns in line with the benchmark indices. So, which is a better investment? To find an answer, here's a look at both the types of funds.



How equity funds measure up



Let us consider whether the equity funds outperform their benchmarks consistently and create value for investors. To ascertain this, we looked at the performance of all open-ended equity diversified growth schemes over different time periods. Over the past year, only 51% of the 169 equity schemes have managed to beat their benchmark indices. Of these, just 39% succeeded in delivering returns that were 5% higher than their benchmarks.



The picture is similar over a three-year time frame. As many as 45% of the schemes have underperformed their respective indices over this period. Of the 55% that have outperformed, 52% have beaten the respective benchmarks by a margin of at least 5%. Over the past five years, as many as 44% of the schemes have failed to catch up with their benchmark indices.



It may be argued that many of these funds do not track a benchmark appropriate to their investment mandate. For instance, some mid-cap funds are benchmarked against the BSE-500, which is too broad for this category. Ideally, such a fund should be pitched against a comparable index such as the BSE Midcap Index. If one were to re-assign more suitable benchmarks to the respective equity schemes, how would they fare?



Investment consulting firm Mercer, in its study of the Indian equity mutual funds published in May this year, carried out this exercise of classifying funds appropriately and measuring these against more appropriate benchmarks.



It then analysed the fund performance vis-a-vis the newly defined benchmarks. What were the findings? Over the past three years, a healthy 70% of large-cap funds outperformed the BSE-100. However, only 55% managed to do so over a five-year period. Among the diversified equity funds, 63% yielded returns in excess of their benchmark, the BSE-500 Index. This ratio dropped to 52% for the five-year period.



Mid-cap funds have fared poorly. While 61% beat the benchmark index (CNX Midcap) over the three-year time frame, only 32% managed to outperform over the five-year term. Why do some funds underperform? There are several factors that come in the way of good performance by actively managed funds. Since these fund managers indulge in buying and selling stocks regularly (churning the portfolio), it burdens the fund with transaction costs. These expenses are over and above the fund management charges. This, in turn, reduces its value.



Active management brings an added element of risk to the portfolio. As the fund managers are tasked with beating their benchmark indices, they are forced to take positions that would give them an edge over the index. But such bets can go awry. Most fund managers, in their desperate attempt to time the market, invariably get it wrong.