The "active vs passive" debate is not of primary importance in portfolio management (2024)

The prominence of index funds and ETFs in the last few years due to their visible outperformance has resulted in a heated active vs passive debate on social media, personal finance forums etc. While cost, the underperformance of active management, simplicity of fund maintenance etc are all important factors they are not of primary importance in portfolio management.

First, let us list the facts.

Be it large cap funds or mid cap funds or small cap funds*, only half the funds in a category are able to beat their benchmarks.
- Active mutual funds struggle to beat the Nifty 50 for the last seven years!
- Poor performance of active mutual funds: Is this a recent development?
- Only Five Large Cap funds have comfortably beat the Nifty 100!
- Myth Busted: Active mid cap mutual fund managers can easily beat the index
* In the case of small caps the funds easily beat the small cap benchmark but fail to beat a mid cap index or Nifty Next 50 which is just as bad.
- Why investing in small cap mutual funds does not make sense!
- Only 3 Small Cap MFs have outperformed Nifty Next 50 consistently

There are many obvious inferences from these results:

Index funds are the obvious choice for at least new mutual fund investors.

Choosing a simple Nifty or Sensex Index Fund (do not use ETFs for investing unless you want to trade intraday –ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!) is enough to have “equity exposure” in the portfolio.
If an investor wants to look beyond large caps a Nifty Next 50 index fund is all that is required. This index is volatile and can be frustrating to hold.
Index funds work best for those who appreciate that choosing the “best active fund” based on past data is easy but there is no guarantee that it will continue to do well in future. Instead of going through frustrating waves of outperformance and underperformance with an active fund, an index fund is a simpler, stabler choice to beat inflation and accumulate enough corpus for our future goals.
Even within the sub-section of fund selection, the low cost associated with index funds is only a tertiary consideration.

Now let us zoom out a bit and consider overall portfolio management for long-term goals (> 10 years).

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First I need to be clear about my goal (or when I need the money)
Then I need to determine the target corpus with a reasonable inflation estimate.
The asset allocation necessary to beat inflation and achieve this target corpus has to be determined. That is how much should be invested in equity and how in fixed income.
How this asset allocation should be varied down the line to systematically reduce portfolio risk should be planned. This cannot be postponed because the investment amount required depends on this.
Then andonly then comes product selection and the active fund or passive fund debate.
Then comes probably the most vital step: the execution. The discipline to keep investing systematically and manage portfolio risk systematically

Choosing index funds without proper planning or the discipline to stick to the plan is of little use. And if one does have a proper planand the discipline to see it through it matters little if one chooses active funds or passive funds – at least for those who currently hold active funds.

Yes, yes cost, underperformance, simplicity, fund management risk – all these factors are important but not as important as the right plan or the associated discipline which most investors, unfortunately, do not have. Without these, the risk of failure is just as high with passive products as with active ones.

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Dr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.

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The "active vs passive" debate is not of primary importance in portfolio management (2024)

FAQs

Which is better active or passive portfolio management? ›

For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go.

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What is the debate between active and passive investing? ›

In simple terms, active investors attempt to outperform the returns of a specific benchmark, whereas passive investors accept the market return by tracking a specific index.

What is passive portfolio strategy? ›

Passive portfolio strategy. A strategy that involves minimal expectational input, and instead relies on diversification to match the performance of some market index.

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What is the difference between active and passive management in Fidelity? ›

As the ETF market has evolved, different types of ETFs have been developed. They can be passively managed or actively managed. Passively managed ETFs attempt to closely track a benchmark (such as a broad stock market index, like the S&P 500), whereas actively managed ETFs intend to outperform a benchmark.

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What is the difference between active and passive management of an investment in terms of creating value within the investment? ›

The objective of an active strategy is to achieve 'alpha' – in other words, to beat the market benchmark. “A passive strategy is more of a buy-and-hold strategy. You have to decide yourself when and how to reposition your exposure, whereas with active investing, it is done for you by the fund manager.”

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What is a commonly used strategy to minimize investing risk? ›

Portfolio diversification is the process of selecting a variety of investments within each asset class, which can help those looking to reduce their investment risk.

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Which type of portfolio management is best? ›

Investors looking to outperform the market may opt for an actively managed portfolio, while long-term investors may prefer a passive management approach. Investing your money in stocks, bonds and other assets can grow your wealth much quicker than leaving it in your bank account.

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What are the disadvantages of active portfolio management? ›

Additionally, active managers may be more likely to take on more risk than passive managers. The main disadvantage of active management is the higher costs associated with the research and analysis required to generate alpha. Active managers must also overcome the increased risk of making errors in their decisions.

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Is it better to invest in a passively managed fund or an actively managed one? ›

Passive investment is less expensive, less complex, and often produces superior after-tax results over medium to long time horizons when compared to actively managed portfolios.

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Are active funds better than passive funds? ›

Active funds generally have higher expense ratios due to the extensive research, analysis, and management activities performed by the fund manager. On the other hand, passive funds have lower expense ratios because the fund manager's role is limited, and the investment strategy is relatively straightforward.

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