Do active funds still beat the benchmark?

The answer is yes, but not all of them. In this article we explain how to ensure your active funds beat the benchmark and what the index fund data is hiding.

Recently there has been a lot of debate to decide between the two styles of investing – active and passive. Active investing is the mutual fund model wherein a fund manager actively manages the portfolio and selects stocks at their discretion. Passive investing by the way of index funds is simply investing in a fund that will track the performance of an underlying index like Nifty 50, Sensex, etc and give almost the exact same returns.

The goal of passive funds is to give benchmark returns at a low cost

The goal of an active fund is to generate alpha or higher than benchmark returns in the long run after accounting for all added costs. If an active fund gives higher post-expense returns, surely the expense ratio won’t matter. But the question is do all active funds actually beat the benchmark?

Active vs index performance

There are various articles in the past 1 year that talk about how 70-80% of large cap mutual funds have not beaten the benchmark in a one-year period. There are several reasons why this data is not a fair representation of the reality -

• Performance or alpha in equities cannot be measured fairly over a 1 or even 3 year period.
• Comparing long term returns at a given point biases the data in favour of current market conditions. For example - 5 year returns in March 2021 are at 14-16%, but the same returns after the crash of March 2020 showed 0 or even negative returns.
• The mutual fund industry is huge. There are over 2000 active funds in the market. Even if 20% of the market outperforms the index, that is 400 funds. An investor only needs to choose 8-10 quality funds out of these.

While we understand, it may not be easy for everyone to have the level of expertise or quantum of time to make these decisions, this is where strong research and a good adviser steps in.

The AssetPlus Advantage

Let us see how AssetPlus recommended funds did against the benchmark and were we successful in selecting benchmark-beating funds

Our selected list of funds only includes 4-5 funds in each category. To check performance we measured the average rolling returns of our funds vs the respective benchmark in all 1,3,5 and 7 year periods from 2011-2021. Even though, the data talks only about large cap funds underperformance we measured the performance of all category funds just to be sure. We excluded a couple of funds that are recently launched and do not have a long track record.

We found that while the industry level data showed a clear win for passive funds, 94% of our recommended funds have beaten the benchmark on average across all time periods even after accounting for expenses

On an average, our funds especially categories other than large cap generated an alpha of around 4%. That is 4% higher return than what an index fund might have given.

To understand the significance of this number – a 5,00,000 investment at 15% for 20 years will be 80,00,000 whereas at 11% the value will be 40,00,000. A 4% higher return can give you 2x the amount in 20 years.

Other than performance, there are several factors that contribute to making active investing more lucrative

The case for active investing

Higher upside potential

At the time of publishing this, Nifty 50 was at a lifetime high. The scope for higher returns is limited by just investing in the index. Active investments with expert stock selection and regular portfolio churn (buy and sell) can generate good returns even at such a peak.

Index inefficiencies

The index is managed through a set of quantitative filters and does not take any qualitative factors into account. For example, Nifty 50 will include the top 50 companies in terms of market cap irrespective of the company’s fundamentals and future prospects. This can lead to various inefficiencies. In December 2020, Tata Steel had been excluded from Sensex after its share price fell. After a recent rally in the stock, it is set to be re-added in June 2021. However, the stock rallied 80% in this timeframe which the Sensex index missed.

Large cap indices remove stocks from the index after they have fallen and only add them back after they have gained back in value. Due to this, they miss various opportunities in cyclical stocks and turnaround opportunities.  

Small and Midcap alpha

Past data shows that small and midcap categories outperform large caps over a 5-7 year period. It is essential for investors to have these categories in their portfolio to give their returns a boost.

While large caps are relatively stable and safer, one has to be very selective while buying a midcap or smallcap stock. The index includes all the stocks, many of them which might be low quality or wrongly priced. As a result, the performance of the entire index will suffer. Active mutual funds have an expert fund manager who has experience in only selecting the high-quality, well researched stocks and eliminating the riskier ones.

When index funds are suitable

Index funds can be used for investing in asset classes like gold. Since there are limited investment opportunities available in global funds, investors can also use index funds to get exposure to certain global indices.

It is important you consult your financial adviser to ascertain which style of investing is suitable for your risk profile, goals and investment needs.