Fund choice. Active vs. passive funds: decades of trouncing

The discourse between active and passive fund management is far from a new saga in the investment domain, with its roots tracing back many decades.

The real turning point, however, emerged with the advent of the first index mutual fund in 1976, which tracked the S&P 500 index and was introduced by John Bogle — often hailed as the father of indexing.

Since then, a plethora of data has tilted favourably towards index funds when juxtaposed against the performance of active funds. An actively-managed fund demands higher management costs, usually ranging from 1-1.5% of the assets under management (AUM). Moreover, they incur other costs, such as churning costs associated with the repeated buying and selling of positions within the fund.

Lower cost

Conversely, passively-managed index funds enjoy lower management costs, reduced churning costs, and fewer advisory-related fee, with the expense ratio meandering between a modest 0.07% to 0.3%.

Although the disparity may seem marginal in the short run, the long-term compounding effect unveils a stark difference. For instance, an investment of ₹1 lakh in a fund yielding an average return of 11% per annum with an expense ratio of 1.5% over 40 years would burgeon to ₹37.7 lakh. Contrastingly, the same fund with a 0.3% expense ratio would amplify the corpus to ₹58.3 lakh.

The narrative took a tangible form when, in 2007 Warren Buffett threw down the gauntlet to the hedge fund industry, wagering a simple S&P 500 index fund would outmanoeuvre a curation of actively-managed hedge funds over a decade. Protege Partners, an active management proponent, rose to the challenge by cherry-picking five hedge funds to substantiate the prowess of active fund management. While the bet was slated to run until 2017, the verdict was evident much earlier as Mr. Buffett’s Vanguard-managed S&P 500 index fund significantly outshone the selected hedge funds.

The final results were revealing: The Vanguard S&P 500 index fund culminated with a cumulative return of 85.4%, dwarfing the five hedge funds, which scraped together an average return of 22%. The pronounced divergence in returns not only unveiled the superiority of passive over active management in this scenario but also spotlighted the cost ramifications intrinsic to active management, including management fees and other ancillary costs that gnaw at returns over time. This empirical exposition demonstrated passive funds’ marked cost-saving and higher return potential, reinforcing the proposition of passive investment strategies, particularly for long-term investors.

Regulatory hurdles

Moreover, the road towards beating passive funds is strewn with regulatory and structural hurdles. The stringent oversight by SEBI, the propensity of active funds to mimic indices, relegating them to inferior returns, and the size limitations thwarting diversification into smaller market caps cast a formidable shadow. These dynamics tend to box funds in a narrow ambit of large firms, exerting pressure to align closely with the index, which often translates to mediocre returns.

As Anand Kalyanraman, an editor at The Ken, elucidates in his article, the departure of star fund managers in India has underscored the burgeoning chasm between active and passive fund management paradigms.

The exit of Jinesh Gopani from Axis Mutual Funds, Prashanth Jain from HDFC AMC and Santosh Kamath from Franklin Templeton marks a noteworthy inflexion point in the active fund-management arena. This transition unfolds against a backdrop where the AUM of passive funds have catapulted over 8.5 times within the last five years, soaring to an astounding $84 billion, mirroring a broader global trend and aligning with the empirical evidence dating back to the inception of index mutual funds in 1976.

Fund performance

The performance narrative has burgeoned into a hard-to-dismiss reality. As of December 31, 2022, 93.8% of large-cap active funds in India languished below the benchmark, as the S&P Indices Versus Active Funds India scorecard underscored. This narrative accentuates the Principal Agent dilemma — the discord between the incentives of fund managers and investors. Often, fund managers see their rewards tethered to the bulk of AUM, inadvertently driving mutual funds houses to channel more resources into marketing rather than robust market research.

As of today, the data heavily favours passive funds. It significantly supports the notion that adopting a passive indexing strategy is a wise decision for long-term investors. By avoiding the higher fees and operational complexities associated with active fund management and leveraging the historically solid performance of index funds, investors can position themselves favourably for reliable, long-term financial growth.

(Anand Srinivasan is a consultant, Sashwath Swaminathan is research assistant at Aionion Investment Services)