The debate between 'Active vs Passive' has become a fixture in our lives, not only in India but worldwide, as investors seek a lasting resolution to this puzzle.
The debate between 'Active vs Passive' has become a fixture in our lives, not only in India but worldwide, as investors seek a lasting resolution to this puzzle. While passive investing appeals to many for its simplicity, those with greater financial acumen express apprehension about its adverse effects on active investing. While both sides present some very valid arguments, let us look at the AUM growth of active and passive mutual funds in India. Clearly, passive AUM is gaining momentum.
In the US, passively managed funds surpassed actively managed funds in terms of AUM in the year 2023. By the end of December, passive mutual funds and ETFs had $13.3 trillion in AUM when compared to13.2 trillion in active funds.
Clearly passive investing is winning but let us not be oblivious about its negative impact on active funds.
Clearly, the below statistic would only reinforce all the limelight passive funds are getting these days.
It is highly likely that in the short-term active funds underperform the benchmark and passive funds. A longer holding period is paramount for alpha generation for the strategies and intuitions of the active fund manager to play out. According to a study conducted by CRISIL during the period from April 2010 to March 2021, the average underperformance of active mutual funds vs the benchmark reduced from 31% for a 1-year horizon to 3% for a 5-year horizon.
It is extremely important for investors to not get swayed by recency bias, in this context, performance in the short term. The mounting performance pressure can force the active fund managers to prioritize short-term gains over long-term value creation, potentially sacrificing investment discipline and strategic focus in pursuit of near-term performance targets.
There is a higher expense involved in active management as there are more resources at play – a research team and robust analytical tools. Moreover, it involves trying and testing out different strategies along with frequent trades. All these add up to the costs of active fund management and hence a higher expense ratio. In India, the average expense ratio of active funds range between 1-2%, whereas it is 0.1-0.5% for passive funds.
Amid rising fund flows to passive funds, active fund managers face mounting fee pressure and fee compression. With investors increasingly favoring low-cost options like index funds and ETFs, active managers struggle to justify their higher fees and deliver consistent outperformance. This dynamic intensifies competitive pricing dynamics, impacting revenue and profit margins. Institutional clients exert further pressure by negotiating lower fees, while regulatory scrutiny heightens fee transparency concerns. Some managers adopt performance-based fee structures, while others resort to fee waivers. The active managers need to adapt to fee structures, enhance performance, and demonstrate value in a fiercely competitive market.
The growing dominance of passive funds can lead to market distortions and price dislocations, particularly in securities included in popular indices or ETFs. Increased inflows to passive funds may drive up the prices of index constituents, creating potential misalignments between market valuations and fundamentals. The table below throws light to the stark difference between stock performance vis-a-vis return on equity.
Active fund managers may face challenges in identifying undervalued opportunities or avoiding overvalued securities in a market environment influenced by passive flows.
Similarly, due to the top-heavy nature of indices, especially large cap indices, there is no room for active managers to outperform the market. When the top companies by market cap outperform, the active manager is always at a disadvantage that his/her fund would be underweight on those shares.
Many active funds face challenges in distinguishing themselves from passive alternatives and proving their ability to outperform. Inefficient markets, crowded trades, and herd behavior constrain active managers' ability to identify mispriced securities and achieve excess returns. Without a clear value proposition or track record of alpha generation, active funds struggle to attract and retain investors. Additionally, the rise of passive funds may lead to homogenization and convergence in investment strategies and market behavior, reducing opportunities for active managers to differentiate themselves and add value through stock selection or sector rotation.
As capital flows increasingly concentrate in passive funds and ETFs, active fund managers may experience a liquidity squeeze in certain asset classes or market segments.
Illiquid or less liquid securities that are not included in major indices or ETFs may become harder to trade, leading to wider bid-ask spreads, increased trading costs, and reduced liquidity for active strategies.
Active managers may need to adjust their investment approaches, risk management practices, and liquidity management strategies to navigate liquidity challenges in a passive-dominated market.
It is quintessential to acknowledge the strengths and weaknesses of both styles. Both style of investing would prove beneficial depending on market conditions. Uncertainty is the only certain thing about stock markets. Having built a portfolio with active and passive funds would help in long-term financial success.
