Should you opt for passive or active funds?

Morningstar Investment Conference on day one sees debate on active, passive funds

That actively-managed mutual fund (MF) schemes can be more volatile than index funds is well known. But while actively-managed funds are designed to outperform their benchmark indices (and also underperform if the fund is not well-managed), passively-managed funds are designed to give more consistency, in the sense that they mimic market returns. So should you opt for higher returns (and higher risk) or stable returns (with no fund manager risk)?

The debate continued on 1 November at the Morningstar Investment Conference 2012, a two-day event held in Mumbai. One of the panel discussions debated on whether investors should choose active or passive funds. While the panellists argued their cases, the more interesting points—or questions—came from the audience. Here’s a sample.

Fund manager churn

A member of the audience asked how could fund managers ensure consistency in long-term returns when fund managers themselves change.

He had a point. Changes in fund management are common. Sometimes, fund managers change before they complete three years—the minimum tenor for which investors are usually advised to stay in equities. For instance, Soumendra Nath Lahiri was the equity fund manager in Canara Robeco Asset Management Co. Ltd for only about 18 months, when he quit to join L&T Asset Management Co. Ltd. Harsha Upadhyaya, head (equities), Kotak Mahindra Asset Management Co. Ltd worked at DSP BlackRock Investment Managers Ltd for just under a year through 2011-12. Ravi Gopalakrishnan, head (equities), Canara Robeco Asset Management Co. Ltd worked at Pramerica Asset Managers Ltd as its chief investment officer for just under three years.

“To navigate the Indian markets successfully, you need a very good top-down understanding of the markets and for that you need the right kind of people at the job,” said Grant Kennaway, head (fund research), Asia Pacific, Morningstar, Inc. Kennaway moderated this panel discussion.

One way to tackle the churn, say fund houses, and to ensure that a fund’s continuity does not get hampered by its fund manager moving out, is to put processes in place. While stock picking is and will remain a personalized skill, some fund houses put risk mitigation steps in place to ensure that the new fund manager doesn’t change a scheme’s track, drastically. “While the risk of a fund manager quitting is there, if we put certain processes in place, the scheme’s character is maintained, by and large,” said Sandesh Kirkire, chief executive officer, Kotak Mahindra Asset Management Co. Ltd, one of the panellists.

While actively-managed funds carry fund manager’s risk—not just on the stock and sector selection, but also the risk of the manager quitting—passively-managed funds don’t come with such risks. Passively-managed funds, such as index funds and exchange-traded funds (ETFs), invest in all the companies, and in exactly the same proportion, that are there in the benchmark index they track.

Long-term alpha is zero

Another member of the audience questioned a panellist’s suggestion (who was supporting actively-managed funds) that actively-managed funds outperform passively-managed funds in the long run. The question: in the long-term, the alpha (the degree of outperformance caused by the fund manager’s expertise over and above his benchmark index) for active funds is zero. “While that may be true if you stay invested till infinity, the fact is that investors also don’t stay invested till infinity,” said Kirkire. Countered Rajiv Anand, CEO, Axis Asset Management Co. Ltd, another panellist, “The fact is that in the past 10 years, 60-70% of the funds have outperformed their benchmarks.”

One of the aspects that favour passively-managed funds is costs. While index funds can charge a maximum of 1.5% of fees from investors on an annual basis, costs in actively-managed funds can go up to 2.7-3%. Says Sanjiv Shah, co-CEO, Goldman Sachs Asset Management (India) Ltd: “High costs eat up returns in the long-run. ETFs have a low-cost structure because they are passively-managed.”

What should you do?

While one passively-managed fund is seldom different from another passively-managed one (if they track the same benchmark index), active funds have their share of good and bad performers.

If you’re starting out afresh in MFs, stick to funds that come with a track record and whose management philosophies give you comfort. But if you wish to avoid the fund manager’s risk and keep your costs in check, opt for passively-managed funds like ETFs.

Morningstar Investment Conference on day one sees debated on the pros and cons of actively-managed and passively-managed funds

Source: http://www.livemint.com/Money/FbvPwGe5saxyAMF65ayCKL/Should-you-opt-for-passive-or-active-funds.html