Everything you need to know about passive and active fund management before buying index funds

Based on global experiences, a nominal growth rate environment below 5% is more suitable for passive investing.

The tussle between passive and active forms of fund management may very well go on forever. In passive fund management, as reflected by index mutual funds, the fund manager has no say in stock and sector selection and allocation. In an active fund, the fund manager plays an important role. Sometimes, over a period of time, the average return of most active funds is lower than the return of passive funds. Many investors therefore opt for passive index funds. There could be enough good reasons for active funds to be present in his portfolio. A mixture of both worlds might be preferable, the actual allocation may depend on the risk profile of each.

Krishna Sanghavi, CIO – Equities, Mahindra Manulife Mutual Fund, in an exclusive interview with FE Online, talks about scenarios where active funds can outperform passive funds showing the potential to generate alpha for long-term investors. Excerpts:

Is the concept of passive versus active investing gaining strength in India?

We believe that active investment management will continue to play a relevant role for investors as a catalyst in their wealth creation journey. Current data indicates that mutual funds are gaining assets on the passive investing front. However, at present, this is mainly due to EPFO ​​(an institutional investor) allocation to equities as an asset class and has yet to gain popularity among retail investors.

What type of growth environment is best suited for passive investing?

We believe that every economy experiences growth cycles where growth moves from high to moderate to low growth environments. Instead of real GDP growth, perhaps nominal growth may be a more appropriate indicator for this purpose, since the profitability of the corporate sector is also assessed in nominal terms. Based on global experiences, we believe that a sub-5% nominal growth rate environment may be more suitable for passive investing.

Under what circumstances can active fund management generate higher returns than passive funds?
A growth economy helps a wider range of businesses and is therefore an ideal scenario for an active style of investing aimed at seeking areas of relatively faster growth. This has the potential to generate higher returns. This creates enough space to select small and mid cap companies which can grow much faster.

What are the advantages of active management over passive investing?

We believe that every business should be evaluated on growth, cash flow, management and valuation metrics to arrive at a decision on the acceptability of the business in the portfolio(s). We also believe that these parameters evolve according to the economic environment.

Active management allows such continuous evaluation of companies. Active management is not only about identifying the right companies, but also building an appropriate portfolio with overweight and underweight positions in companies. In contrast, passive investing does not benefit from company growth and the operating environment, only index inclusion and index weighting.

How much flexibility will a fund manager have when actively deciding on the allocation and selection of securities?

An aspect of active investing is also the benefit of active decision making on market capitalization cycles. In a passive strategy, let’s say that if the benchmark has a weight of 70:20:10 in Large:Mid:Small, the allocation would replicate the index exactly. An actively managed strategy, on the other hand, allows fund managers to choose higher and lower exposure between large, medium, and small to index weightings. Flexi Cap investing is an actively managed strategy on both stock selection and market capitalization.

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