In the world of investing, striking a balance is key. Investors have long struggled with the question of how to most effectively allocate capital in the ever-changing stock market. And in this case, the debate between active funds and passive funds remains an important consideration for investors. However, recent market trends have shown that active funds have advantages over index funds, especially in their ability to respond quickly to unexpected crises and save investors from large losses.
The Adani Hindenburg fiasco in early 2023 vividly illustrates how quickly market sentiment can change. Following the incident, both the Nifty 50 and Nifty Next 50 indexes experienced significant declines, dropping 2% and 8%, respectively. The declines highlighted a key vulnerability of index funds, which are designed to mirror the performance of benchmark indexes, regardless of the performance of individual stocks. Index funds that track these benchmarks, for example, had no choice but to weather the storm. However, some active fund managers were able to quickly unwind their positions in Adani Group shares.
Given market volatility, should investors choose active or index funds?
The key here is to recognise that choosing between active and index funds is not a one-size-fits-all decision – an investor’s situation, risk tolerance and financial goals all play an important role in determining the right approach.
While index funds offer low-cost exposure to the market, they also come with restrictions: They must hold stocks proportional to their weighting in the index, regardless of changing fundamentals or market trends. This rigid structure can leave investors in a bind, especially if a stock with a high index weighting faces a sudden crisis.
In contrast, active funds have the flexibility to adapt to rapidly changing market conditions. For example, during the Adani Group crisis, index funds were forced to hold on to their holdings, but active managers were able to make real-time decisions to reduce exposure to affected stocks and reallocate to more promising opportunities.
While index funds cannot hold cash, active funds can hold cash to take advantage of market inefficiencies and opportunities. This cash provides some protection to the active fund’s portfolio during times of volatility and safeguards returns.
Moreover, active funds have the advantage of being able to exploit market inefficiencies. With over 5,000 listed companies, the Indian market offers multiple opportunities for fund managers to find undervalued stocks. For example, in the small and mid-cap segment, active managers can leverage their research capabilities to unearth hidden gems.
However, it is worth noting that active management is not without its own challenges. The S&P Indexes vs Active Funds (SPIVA) India Year End 2023 report revealed that 74% of actively managed small and mid-cap funds underperformed their benchmarks. However, the stats also showed that 26% of funds outperformed their benchmarks, highlighting the potential for skilled managers to add value.
Moreover, active funds have proven their prowess in managing downside risk: When the Nifty 50 fell by around 13% during the market correction in March 2020, several top-performing large active funds were able to limit losses, demonstrating their ability to provide some cushion during market downturns.
We see that the Indian market offers unique challenges and opportunities that favor active management. To provide context, let’s look at another example – the recent case of Brightcom Group Ltd. When news of the company’s impending delisting broke, index funds holding the company’s shares found themselves in a bind as they were unable to sell due to their passive management mandate. Active fund managers, on the other hand, had the discretion to limit their exposure or exit the position altogether.
Our economy is characterized by rapidly evolving sectors, frequent policy shifts, and diverse companies at different stages of growth and governance. Navigating this landscape requires insight, analysis, and timely decision-making capabilities, not just index tracking.
Active fund managers have several tools available to them to manage risk and potentially increase returns.
Carefully selected stocks: Managers can avoid or undervalue stocks that they believe to be overvalued or facing significant risks.
Sector Allocation: You can adjust your exposure to different sectors based on economic outlook and market trends.
Cash management: During periods of high volatility, managers can increase their cash holdings to act as a buffer against market declines.
Opportunistic buying: When quality stocks are oversold, active managers can quickly deploy capital to capture the potential upside.
The bottom line is that passive investing through index funds offers simplicity and low costs, while the dynamic nature of active funds can provide an important layer of protection against market shocks.
(The writer is founder and director of mutual fund distributor Valtrust.)
Published July 7, 2024 22:20 IST
