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Which is Better – Index Funds VS Actively Managed Funds | History, Advantages, Performance and Risk - YouTube
Channel: ET Money
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for many weeks now we have been speaking
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to dozens of et money investors
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on their investing habits the strategies
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they use
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and also the opinions that they carry
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one of the questions we've always
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asked is do you invest in index funds
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hi everyone my name is shankarnath and
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this video is specifically made for
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people
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who don't understand passive investing
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or are skeptical
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about index funds and its ability to
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compete with
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actively managed mutual funds so whether
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you are
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ignorant or a skeptic there is something
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for everyone
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in this video as we too dive into this
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debate of
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active versus passive investing with
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some history
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some data some analysis and a little bit
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of opinion
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to understand index funds better we have
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to go back
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almost 100 years to another financial
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innovation
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which truly brought the financial
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markets into the lives of common people
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like you and me the modern mutual fund
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industry
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started in the year 1924. since then
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mutual funds have served
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millions and millions of people who have
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little time and knowledge to buy
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individual stocks
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but could now rely on the services of a
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professional fund manager
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who would research the vast universe of
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companies and execute the most suitable
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trades for a small fee
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interestingly the investors expectations
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in the early 20th century
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was not as much on performance as it was
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on the convenience that mutual funds
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offered likewise
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stock market benchmarks and indices like
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the dow jones
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industrial average or the s p 500 were
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also
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at a very early stage of their
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development and were used primarily in
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academic studies
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now this undemanding relationship
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between investors and mutual funds went
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on for a few decades
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and was largely in the 1950s and
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especially in the 1960s
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when interest in mutual funds really
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picked up and with this
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emerged many professors and scholars who
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started to take
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more interest in understanding how
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available
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fund performance data could be used to
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select funds
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and fund managers who could over perform
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in the future
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this was a critical moment in the
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development of index funds
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because when scholars actually started
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to look at the fund performance data
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they realized that most mutual fund
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managers had been
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underperforming the markets for many
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years and decades
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this sort of became a catalyst for
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change and after a few missed starts
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the first publicly available index fund
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was launched by the vanguard group
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in 1976. so we sort of look back at this
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history i've just shared
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it's not that the index funds first came
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in and after a few
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years they started over performing
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actively managed mutual funds instead
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index funds had already started on a
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solid base
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it was then a matter of getting
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investors aware
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of the virtues of passive investing but
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more importantly from an investment
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community perspective
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the introduction of index funds was an
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inflection point
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as not only did index funds give
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investors a choice
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they also forced active fund management
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companies
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to redefine their entire purpose which
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means for the first time the fund
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management companies realized that was
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not
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enough to simply offer a basket of
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securities to investors
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instead these fund managers now had to
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beat the market
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that is they had to beat the benchmark
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which was now no longer
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a measuring tape but something that
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investors could now
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invest into this is in fact the genesis
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of
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index funds and it's an important one
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because on
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one hand is the central belief that one
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needs to apply some
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intelligence to make money in the stock
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markets which is what the actively
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managed mutual funds want you to believe
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and then there are the index funds which
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challenge the same notion
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by questioning why the majority of fund
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managers cannot beat
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even a simple thing like an index so
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that's a bit of history and now let's
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understand a bit more about index funds
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in the field of investing an index
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represents the value
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of a particular group of investments for
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example the sensex is an
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index that tracks the performance of 30
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of the largest
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and most actively traded stocks on the
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bombay stock exchange
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likewise the nifty 50 index represents
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the weighted average
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of 50 such companies on the national
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stock exchange
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quite simply an index is nothing but a
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generic term that describes
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a list of securities that are selected
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and weighted
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according to a set of rules and because
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it is nothing more than a set of rules
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an
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index can be created for just about
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anything
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for instance on the website nifty
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indices dot com
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one can find over a hundred different
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types of indices
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yes there are the common one the nifty
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50 the nifty next 50
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the nifty mid cap 150 but then there are
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also a host of other indices
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like the nifty mid cap liquid 15
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the nifty 50 value 20 index
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the nifty tata group index which
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specifically features the tata group
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companies and so on
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in fact very recently we uploaded a
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video on one such strategy
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index called the nifty 200 momentum 30
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index where we discuss specifics on how
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an index is constructed it's a very
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interesting video so do check that
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out and if you haven't done that already
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do subscribe to the etmoney youtube
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channel
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and tap on the notification bell icon
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for timely video alerts
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now an index fund is simply a fund that
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tracks a market index
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in other words the index fund simply
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buys up all the shares that make up
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a particular index for the weightages
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and the methodology prescribed
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for example the dsp nifty 50 index
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replicates the structure of the nifty 50
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index
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and ends up buying and holding all 50
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stocks that are part of the nifty 50
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index
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which means if the nifty 50 index goes
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up by 2
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today the dsp nifty 50 index fund will
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also go up by 2
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now do remember that a fund has some
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expenses so the returns delivered by the
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index fund
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will be slightly lower than the index
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itself which in other words means
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since the index fund owns all the shares
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that make up the market
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one would end up earning the average
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returns of all stocks in that market
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this of course raises the question why
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would anyone be happy with just average
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performance
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it's a pretty valid question and
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something that we'll discuss in greater
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details later in this video
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but on the positive side index funds do
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offer some unique advantages
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for one index funds offer a much broader
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diversification than what
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an actively managed mutual fund can
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offer but probably the biggest
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visible advantage of index funds has to
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do with its unique
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ability to keep the fund management
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expenses to a minimum
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the index fund achieves this by a
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not having to pay any advisory fees or
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salary to a research team
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and b by saving on account of low
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portfolio turnover which reduces the
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trading fees and the taxes
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in fact to put this in numbers the
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average expense ratio
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of a direct plan of a typical actively
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managed large cap fund
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is 0.95 percent as against this the
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expense ratio of the direct plan
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of a typical large cap index fund like
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nifty 50
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next 50 or the nifty 100 is about
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0.24 so we can clearly see a difference
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of
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seven percent in expenses which i must
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say is quite a big number
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and the impact of this point seven
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percent would get clearer as we proceed
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in this video
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in addition to diversification and low
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expenses index funds serve
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as one of the finest vehicles that
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support asset allocation
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in a previous video we had shown how
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asset allocation can be done
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and how it serves as the backbone of a
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good investment plan
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now we won't be covering asset
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allocation in this video but we'll be
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definitely
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detailing this process very soon in a
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follow-up video on how to build
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a passive investing plan
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[Music]
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ever since index funds were introduced
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in the 1970s there has been a battle
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going on
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between actively managed funds and
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passively managed index funds
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in this section we shall examine this
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tussle in three perspectives
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one the moral justification two the
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performance angle
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and finally the risk explanation from a
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moral perspective
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actively managed funds are of the
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opinion that markets are often mispriced
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and the fund manager is in the best
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position to exploit this opportunity and
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make a lot of money for the investor
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on the other hand the index manager's
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view is that the current price at which
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any stock is quoted has already taken
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into account
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all known and available information in
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other words
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this is the price that has been agreed
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to by a willing buyer
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and a willing seller in the open market
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and hence it is impossible to capture
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excess returns without taking additional
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risks
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so these are the moral perspectives from
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the active side and the passive side
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who is right who is wrong is probably
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going to remain
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unanswered for maybe another 100 years
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so we really don't want to get into this
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now
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but with that being said let's move to
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the performance angle
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now there is already a lot of data
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available that pertains to the s
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p 500 and other u.s based indices
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so for this video we started looking at
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some indian data so as to help us shape
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our opinion
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more specifically we looked at all
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available actively managed large cap
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funds
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and all available large cap index funds
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to draw a comparison
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this turned out to be a pretty decent
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universe of 44 large cap funds
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so there were 29 actively managed funds
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and 13
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large cap index funds and here's how the
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annual returns of the average
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index fund measures up to the average
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actively managed mutual fund
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the more recent years especially since
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2018
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onwards we see that the index funds have
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performed a bit better than the average
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mutual fund
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in fact we see quite a number of point
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one percent
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point two percent point three percent
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all through the data which shows that
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in any normal year there is not much
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difference in the performance between
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an average actively managed mutual fund
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and an index fund
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now let's go further into the data and
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understand how
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many of these active funds have
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underperformed
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when compared to the typical nifty 50
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index funds
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if you give more weightage to the recent
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years that is 2018 onwards
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we see that half or slightly more than
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50 percent of the actively managed large
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cap funds
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have struggled to keep up with a nifty
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50 index fund
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in fact our research shows that in the
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year 2018
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only two actively managed funds did
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better than the index funds
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and all other 26 funds underperformed
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the index
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this data table is actually very
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important because if we average the last
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four years of data
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we see that 61 of the active funds have
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underperformed
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now the reason i mention this is because
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the global data
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on active versus passive funds shows
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that the win
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loss ratio is about one is to two that
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is
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about 66 percent of actively managed
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funds
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actually underperform the index funds in
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india this ratio seems to be more of one
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is to one
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if we take the last three years of data
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but
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it does come very close to one is to two
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ratio if we take the last four years of
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data
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so this is definitely something that
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long-term investors like
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us need to look at and consider in our
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future portfolio decisions
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okay now here's what our skeptic
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investor might say
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he might say well i have special powers
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and i can select a fund which over
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performs
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every time well good for you then but if
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you all recall there was a video we had
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done on the follies
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of chasing top performing mutual funds
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where we showed with data that a large
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number of funds
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after being ranked one two or three in
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the previous years have performed
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extremely poorly in their immediate next
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year
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but this is where we need to examine the
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third and the last perspective which is
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the risk angle
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now most consumers don't buy units in
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just one
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mutual funds but over time they have a
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portfolio of mutual funds
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in that context the risk we shall talk
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about is the selection risk
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like in our case there are 29 actively
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managed mutual funds and say the
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investor chooses two funds
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the danger here is that it is very much
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possible that one fund
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underperforms the index while the other
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overperforms
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that's the one is to one ratio at play
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here which means
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that the one over performing active fund
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will need to compensate for the losses
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made on the other underperforming one
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with that being said let's look at the
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data again
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the second column here shows the average
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alpha or
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excess returns created by all mutual
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funds which have
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outperformed the average index fund for
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example in the year 2019 the 14
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active funds that did better than the
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index funds
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delivered an excess returns of 2.4
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percent over the index fund returns
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similarly the third column shows the
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level of deficient returns from the
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underperforming active funds
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so for the year 2019 the 15
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underperforming funds averaged a
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negative 1.8 percent returns
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now if you do a weighted average of plus
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2.4
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with negative 1.8 percent we find that
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our portfolio would end up with a
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positive number
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which means the selection risk is mostly
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not there
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unless you were to pick two
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underperforming funds
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which hopefully should not happen more
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so with the ones to one ratio we see
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that in most years
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except 2013 and 2018
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we don't face as much of a selection
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risk
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but the problem is a one is to one ratio
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is an aggressive ratio
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because our data shows that india two is
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moving towards a one is to two ratio
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of active and passive fund performance
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so when we plug a one is to two
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weightage
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our data and especially in the last four
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years start showing a higher level of
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selection risk
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so from a risk perspective the message
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here is that if not dragged
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investing in actively managed funds can
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create
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high uncompensated risk in a portfolio
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which is something that we really don't
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want
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[Music]
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this battle between actively managed and
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indexed funds is now
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50 years in the making and if data were
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to be believed
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index funds seem to be winning globally
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index funds have captured a larger share
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of the wallet
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as compared to active funds and there is
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a growing case for that
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happening in india over the next decade
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and if some of you are wondering why you
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haven't switched to index fund sooner
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the only plausible explanation we found
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to this
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is with our cultural belief that
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investing success is a function
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of a person's ability to successfully
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pick winning stocks
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in other words we need to do some kind
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of mental labor to make money
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it's something that has been ingrained
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into us through our education
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our upbringing and the media exposure we
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have received over the years
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but we truly hope that this video has
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proven that this need not be the case
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and a model or strategy is capable
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enough to offer adequate
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and excellent returns on your capital in
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fact if you like this video then do
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visit our channel again next week when
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we release another video
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on index funds where we detail out some
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specific strategies and steps one can
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take to improve your index fund returns
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while taking lower risk and with this we
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come to the end
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of this video do help us spread the good
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word by sharing this video over whatsapp
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facebook and twitter
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with your friends and connections and if
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you have any questions for us
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do send them across in the comments box
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below
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thank you for your time and we look
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forward to catching up with you next
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week
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with another insightful video until then
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mutual fund investments are subject to
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market risks
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read all scheme related documents
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carefully
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