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

Active management is not only about identifying right companies but also about appropriate portfolio construction with overweight and underweight positions in companies.

The tussle between passive and active form of fund management may very well continue perpetually. In the passive fund management, as reflected by index mutual funds, the fund manager has no say in the selection and allocation of stocks and sector. In an active fund, the fund manager plays an important role. At times, over some period, the average return of most active funds lags the returns from passive funds. Many investors are, therefore, opting for passive index funds. There could be good enough reasons for active funds to be there in one’s portfolio. A mix of both worlds could be better, the actual allocation may depend on one’s risk profile.

Krishna Sanghavi, CIO- Equity, Mahindra Manulife Mutual Fund, in an exclusive interview with FE Online talks about the scenarios when active funds may outperform passive funds displaying the potential to generate alpha for the long term investors. Excerpts:

Is the concept of passive investing as against active management gaining strength in India?

We believe active investment management will continue to play a relevant role for investors as an enabler in their wealth creation journey. The current data does indicate that mutual funds are gaining the assets on the passive investing front. However, as of now this is essentially driven by EPFO’s (an institutional investor)allocation to equity as an asset class and has not yet gained popularity among retail investors.

What kind of growth environment is more suitable for passive investing?

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

Under what circumstances will active fund management be able to generate higher returns than passive funds?
A growth economy helps a wider spectrum of companies and hence an ideal scenario for active investment style to search for relatively faster growth areas. This has the potential to generate higher returns. This creates ample space for selecting small n mid cap companies that can grow much faster.

What are the advantages of active management over passive investing?

We believe each company should be evaluated on parameters of growth, cash flow, management and valuation to arrive at a decision about the company being acceptable in portfolio(s). We also believe that these parameters do undergo change in line with the economic environment.

Active management enables such continuous evaluation of companies. Active management is not only about identifying right companies but also about appropriate portfolio construction with overweight and underweight positions in companies. In contrast, passive investing benefits not from company growth and operating environment but solely from index inclusion and the weight in index.

How much flexibility a fund manager will have while actively deciding on allocation and stock selection?

An aspect of active investing is also the advantage of active decision making about the market capitalisation cycles. In a passive strategy, say if the benchmark is having 70:20:10 weight in Large:Mid:Small, allocation would exactly replicate the index. An actively managed strategy on the other hand permits the fund managers to choose a higher & a lower exposure between large, mid and small vis a vis the index weights. Flexi cap investing is an actively managed strategy on both stock selection as well as market capitalisation.